Court Finds Recharacterization of "Loans" Depends on State Law

The Fifth Circuit has upheld a Texas bankruptcy court's order recharacterizing the ostensible debt of a non-insider as equity. Matter of Lothian Oil Incorporated, No. 10-50683 (5th Cir. 8/9/11). Unlike other circuits to consider the issue, the Fifth Circuit relied on Sec. 502(b) and Texas state law rather than the Court's equitable powers under Sec. 105. You can find the opinion here.

What Happened

Israel Grossman advanced $350,000.00 to Lothian Oil pursuant to two ambiguous documents. The documents stated that Grossman "loans" or "shall loan" a sum of money to the company. In return for the "loans," he would receive a royalty from certain oil wells "without further investment" and would receive repayment of the funds advanced from certain equity placements.

When Lothian filed for Chapter 11, Grossman filed numerous proofs of claim. Some were allowed. However, the Bankruptcy Court denied the two claims making up the $350,000 on the basis that they were equity rather than debt. The District Court reversed, holding that recharacterization could only be applied to insiders.

The Fifth Circuit's Approach to Recharacterization

The Fifth Circuit upheld the Bankruptcy Court's recharacterization order, but did not rely on the Court's equitable powers under Sec. 105(a). In doing so, the Court broke with the Third, Fourth and Sixth Circuits.

The opinion, authored by Chief Judge Edith Jones, relied on a seductively simple logic. Under Sec. 502(b)(1), a claim shall be allowed unless it is "unenforceable against the debtor . . . under any agreement or applicable law." The term "applicable law" refers to State law. Thus, if state law would classify an instrument as equity rather than debt, the Court should disallow the claim and recognize the interest as equity.

Taken together, Butner and § 502(b) support the bankruptcy courts’ authority to recharacterize claims. If a claim asserts a debt that is contrary to state law, the bankruptcy court may not allow the claim. Moreover, where the reason for such disallowance is that state law classifies the interest as equity rather than debt, then implementing state law as envisioned in Butner requires different treatment than simply disallowing the claim. The Fourth Circuit identified the inadequacy of traditional disallowance in noting that “[w]hen a bankruptcy court disallows a claim, the claim is completely discharged. By contrast, recharacterization is appropriate when the claimant has some rights via-a-vis the bankrupt.” In re Dornier Aviation, Inc., 453 F.3d 225, 232 (4th Cir. 2006) (internal citation omitted; emphasis in original). These rights, fixed by state law, are not irrelevant to the court’s decision to disallow a claim. To the contrary, recharacterizing the claim as an equity interest is the logical outcome of the reason for disallowing it as debt.

Opinion, p. 6.

Because Sec. 502(b) and state law provided a direct route to determining the issue, it simply was "unnecessary" to resort to Sec. 105. Similarly, equitable subordination under Sec. 510(c) was not implicated.

Equitable subordination and recharacterization, although sometimes based on the same facts, are directed at different conduct and have different remedies.

Id.

Applying the Test

Turning to Texas state law, the Court found that Texas uses a sixteen factor test imported from federal tax law. Thus, it was a case of a federal court turning to state law which redirected the Court back to federal law. The Court also noted that the Fifth Circuit has also applied a thirteen-factor test and an eleven-factor test. Fortunately, the confluence of these tests does not require the Court to weigh the sixteen, thirteen and eleven factors together in a forty-point balancing test. Instead, it is a more organic exercise of asking: Does this look more like debt or equity? (Ed.--my characterization, not the Court's).

In the specific case, although the documents used the word "loan" in them, they did not provide for an interest rate, terms of repayment or a maturity date. Instead, they would be paid from royalties and "equity placements." Critical to the Court's ruling "was the inclusion of a royalty payment, which depended on the success of Lothian's business, instead of a prescribed interest rate." Opinion, p. 8.



An Objective Test

This brief opinion is a welcome addition to bankruptcy jurisprudence. In my practice, I have often seen equitable subordination and recharacterization applied interchangably as a rule against recognizing insider debt. The Lothian opinion helpfully distinguishes between the two doctrines and applies an objective test for determining recharacterization. The opinion also diminishes the relevance of insider status. While insiders may face greater scrutiny, they do not face automatic recharacterization.

Bidders Reimbursed For Auction Which Never Occurred: The Fifth Circuit's ASARCO Opinion

The Fifth Circuit has ruled that, under the facts of the specific case, that bidders could recover their costs without a showing of direct benefit to the estate. Matter of ASARCO LLC, No. 10-40930 (5th Cir. 8/16/11). The specific holding was that reimbursement of costs incurred in submitting a bid were governed by the business judgment standard under 11 U.S.C. Sec. 363(b) rather than the benefit to the estate standard under 11 U.S.C. Sec. 503(b). You can find the opinion here.

A Billion Dollar Judgment And An Auction That Wasn't

This was a case about a big judgment and a unique procedure to auction off that judgment. In 1999, Grupo Mexico S.A.B. de C.V. (Grupo Mexico) purchased ASARCO. ASARCO owned 260 million shares of Southern Peru Copper Company (SCC). Through a series of transfers, the SCC shares were transferred from ASARCO to a subsidiary of Grupo Mexico. After ASARCO filed for chapter 11 relief in 2005, it sued the transferee, which was a subsidiary of Grupo Mexico. ASARCO won big. It obtained a judgment for actual fraudulent transfer, aiding and abetting a breach of fiduciary duty and conspiracy. ASARCO LLC v. Americas Mining Corp., 396 B.R. 278 (S.D. Tex. 2008). Not only did it get the shares back, but it also recovered a judgment for $1.4 billion. ASARCO LLC v. Americas Mining Corp., 404 B.R. 150 (S.D. Tex. 2009). (I have included the citations here because they are informative opinions for fraudulent transfer litigation).

Having a valuable asset in hand, ASARCO proposed a plan of reorganization. Its plan was to be funded in part by selling the SCC Judgment. It proposed a two-stage bid solicitation process. In the first stage, its financial adviser identified potential bidders for the judgment. In a variant on the typical auction process, ASARCO invited a select group of bidders to proceed to the second phase of the process. In order to entice the bidders to perform the expensive legal due diligence necessary to evaluate the asset, ASARCO sought and obtained an order from the Bankruptcy Court authorizing it to reimburse qualified bidders for their due diligence expenses. The Bankruptcy Court granted the motion finding that ASARCO had demonstrated a "compelling and sound business justification" for the order.

Grupo Mexico appealed the reimbursement order which was stayed. Meanwhile Grupo Mexico confirmed a plan of reorganization which paid all creditors in full, released the judgment and gave it control of ASARCO. Since Grupo Mexico now controlled ASARCO, ASARCO was not interested in defending the appeal. However, two of the bidders were granted leave to intervene and defend the order.



The Appeal

On appeal, the Appellants argued that because the sale was never concluded, there was not a benefit to the estate and the bidders expenses could not be reimbursed under Sec. 503(b). The bidders argued that the Bankruptcy Court could authorize the payment under the business judgment standard of Sec. 363(b). The business judgment test was a lower bar since it looked at whether the order was reasonable at the time it was sought; on the other hand, the benefit to the estate standard would have analyzed the benefit in hindsight.

The Fifth Circuit distinguished two Third Circuit cases which had disallowed break-up fees. While the Third Circuit had rejected break-up fees on the ground that they chilled the bidding, here the Fifth Circuit found that the reimbursement order sought to increase competition and was offered to all bidders invited to the second round. The Fifth Circuit also distinguished the break-up fee cases on the basis that the auction involved a "very unique and very valuable but possibly worthless asset."

The Ruling

In upholding the order, the Fifth Circuit wrote:

On this record, we conclude that the business judgment standard is the better fit for assessing ASARCO’s reimbursement motion. Section 363 addresses the debtor’s use of the estate property, and in its motion ASARCO sought authorization to make discretionary use of the estate’s funds. Section 503, in contrast, generally applies to third parties that have already incurred expenses in connection to the debtor’s estate. The unsuccessful bidders in O’Brien and Reliant Energy sought payment for expenses incurred without the court’s preapproval for reimbursement, and thus section 503 was the proper channel for requesting payment. In ASARCO’s case, however, the bankruptcy court issued the Reimbursement Order before any potential qualified bidders, including the Intervenors, had incurred due diligence and work fees. In this context, application of the business judgment standard is appropriate.

Opinion, pp. 11-12. Having concluded that the business judgment standard applied, the court had no difficulty finding that the standard had been satisfied.

In a final footnote, the Court hinted that it would have upheld the award under the benefit to the estate standard as well, noting that the District Court had found that the auction process "was perhaps the final impetus needed to encourage the Parent to file its plan which pays creditors in full."

Why It Matters

This case is important for two reasons. One is that large bankruptcy cases are increasingly being resolved by Sec. 363 sales. There are not many circuit level opinions on 363 sales, since most appeals are rendered moot by the sale closing. As a result, any opinion which explains the Sec. 363 process is useful.

Second, this particular opinion, while very fact specific, provides some useful pointers. First, reimbursement orders should be obtained before any due diligence expenses are incurred. Second, the complexity of the asset will influence the advisability of reimbursing due diligence costs. There is a big difference between a tract of raw land and a billion dollar judgment. Finally, and perhaps most importantly, reimbursement orders are justifiable when they will increase competition. In the typical case, a stalking horse bidder is granted reimbursement if it is outbid. This encourages the stalking horse to invest in the due diligence necessary to submit a bid. Conversely, it can be used to tilt the auction procedures in favor of the stalking horse. Here, the unique aspect of the process was that all bidders invited to the second round were granted a right of reimbursement. Thus, the process was even-handed and fostered competition rather than inhibiting it.

Court Orders Turnover of Attorney Files in Billion Dollar Case

Attorneys are entrusted with a lot of sensitive information. The attorney-client privilege exists to allow clients to speak candidly with their attorneys. However, when the same attorney represents multiple parties, the privilege may not be so absolute. In the case of In re Crescent Resources, LLC, No. 09-11507 (Bankr. W.D. Tex. 7/22/11), Bankruptcy Judge Craig Gargotta was asked to decide who could access the attorney files in a billion dollar dispute. You can find the opinion here.

What Happened

Crescent Resources was a real estate development and management organization. It was formed by Duke Energy Corporation to manage and develop approximately 300,000 acres of real estate owned by Duke. Crescent grew over the years, eventually operating about 100 projects through over 120 entities. In 2006, Duke, Crescent and several real estate investment entities entered into a series of transactions where the Crescent entities pledged their assets to secure a loan from Bank of America in the amount of $1.225 billion, much of which was upstreamed to Duke.

By June 2009, the Crescent entities had filed for chapter 11 in Austin, Texas. The Court confirmed a plan which created a litigation trust. The litigation trust sued Duke Energy Corporation, et al alleging that the 2006 transaction rendered the debtors insolvent. Shortly after filing suit, Dan Bensimon, the litigation trustee, filed a motion to compel a firm named Robinson, Bradshaw & Hinton, P.A. (RBH) to turn over its files with regard to work done for the debtors. RBH responded that it had concerns about Duke's rights to keep the files confidential. After five months of procedural wrangling, the Court conducted a hearing and took the matter under advisement.

The files at issue fell into three categories: 1) pre-2006 files from the period when Crescent was a subsidiary of Duke; 2) files related to the 2006 transaction (known as Project Galaxy); and 3) files subsequent to 2006 when Crescent was no longer a Duke subsidiary.

On July 22, 2011, the Court delivered its decision. Based on stipulations, it was largely clear that Crescent was a joint client with Duke for the pre-2006 files and was the sole client for the post 2006 files. That left the Project Galaxy files. The Court ruled that the Trust was a joint client and thus entitled to use the files in its litigation with Duke.

Turnover/Burden of Proof

Section 542 has two relevant subsections relating to turnover. Sec. 542(a) provides that a person in possession of property which the trustee may use, sell or lease shall turn over such property to the trustee. On the other hand, Sec. 542(e) provides that "(s)ubject to any applicable privilege . . . an attorney, accountant, or other person that holds recorded information . . . related to the debtor's property or financial affairs" can be ordered to "turn over or disclose such recorded information to the trustee."

The Court found that the Trust had the initial burden to establish that the files "related to the debtor's property or financial affairs." At that point, the burden would shift to Duke to show that there was an attorney-client privilege between Duke and the law firm. The Court also rejected arguments from Duke that the Trust's burden had to be met by clear and convincing evidence. Instead, it found that the preponderance standard applied.

Project Galaxy

Having established this framework, the Court, following the lead of the parties, apparently assumed that the Trust had met its burden to show that the files related to the debtor's property or financial affairs. As a result, the Court spent the rest of its opinion discussing whether the Trust was "a joint or sole client, or no client at all, of RBH with respect to the Project Galaxy files." Opinion, p. 13.

Duke made an interesting argument. It suggested that RBH represented Crescent prior to Project Galaxy and after Project Galaxy, but that Crescent was not represented at all during Project Galaxy.

The Trust argues that RBH represented Crescent Resources, while Duke would have the Court believe that RBH jointly represented Crescent Resources before the 2006 Duke Transaction and after the 2006 Duke Transaction, but not during the 2006 Duke Transaction. Duke further alleges that Crescent Resources was not represented by counsel at all during the 2006 Duke Transaction.

Opinion, p. 14.

The Court had to analyze North Carolina law to determine whether Crescent had an attorney client relationship with RBH. North Carolina considers the question to be primarily one of fact and does not rely on formalities.

The Trust was able to bring forward some pretty good evidence. In its application to be employed in the Crescent bankruptcy case, RBH stated that it had represented Crescent since 1986. It also presented an Opinion letter in which RBH stated that it had represented Crescent and certain of its subsidiaries in connection with the execution and delivery of a credit agreement. Finally, several of the RBH lawyers stated that they had represented Crescent in $1.5 billion credit transaction.

Duke argued that it retained RBH to represent it in the transaction and that everyone but Crescent was represented by counsel. Duke presented evidence such as the engagement letter and declarations from RBH lawyers. However, the Engagement Letter stated that the firm was engaged to represent Duke Energy (or any of its subsidiaries or affiliates)." All invoices were submitted to and paid by Duke. Furthermore, RBH said that it took its direction from Duke and not Crescent and that no one at Crescent ever said that they thought they were represented by RBH.

The Court weighed several factors under North Carolina law, finding that:

1. Crescent was not represented by other counsel;
2. Crescent had been represented by RBH in the past;
3. RBH had access to Crescent's confidential information;
4. The services were billed to Duke, not Crescent;
5. RBH represented Crescent after the transaction;
6. There was no withdrawal of representation.

Weighing these factors, the Court found that RBH did, in fact, represent Crescent during the Galaxy Project transaction.

The Court relied on North Carolina law to find that "where two or more persons employ the same attorney to act for them in some business transaction, their communications to him are not ordinarily privileged inter sese." The Court also relied upon its own decision in In re Bounds, 443 B.R. 729 (Bankr. W.D. Tex. 2010), a case in which I represented the debtor subsequent to the events in the opinion.

In the end, the Court found that Crescent was a joint client and could use the files in its litigation with Duke but not otherwise.

The Court's order has been appealed and is subject to a stay pending appeal. As a result, it may be a while before the Trustee finds out what, if anything, is contained in the law firm's files. However, given the effort that Duke is taking to keep the files confidential, it may well be interesting.

I think the take away from this case is that if you are doing a billion dollar deal, make sure that everyone has their own counsel. It will be more expensive and may be more difficult, but at least your privileged will be protected.

Disclosure: My firm has engaged Dan Bensimon as a consultant and expert in several cases. Indeed, I would go so far as to say that he is a friend of the firm and an all around good guy. However, we do not represent him in the Crescent case and this post is based solely on my reading of Judge Gargotta's 39-page opinion. If you want to know as much as I do, read the opinion for yourself.

En Banc Fifth Circuit Changes Course on Judicial Estoppel

In an important ruling, the Fifth Circuit Court of Appeals sitting en banc ruled that a debtor's nondisclosure would not bar a trustee from pursuing a large judgment for the benefit of creditors. Reed v. City of Arlington, No. 08-11098 (5th Cir. 8/11/11). The opinion overruled an earlier panel decision. You can read the new opinion here.

A Quick Trip Through the Facts

Diane G. Reed was appointed chapter 7 trustee for debtor Kim Lubke. When Lubke filed his schedules, he neglected to mention that he had recovered a one million dollar judgment against the City of Arlington. He omitted several other assets as well. While the bankruptcy was proceeding, Lubke's case went up to the Fifth Circuit, which remanded for a new calculation of damages. At this point, the Debtor mentioned his bankruptcy to his trial lawyer, Roger Hurlbut. Hurlbut promptly informed the trustee about the undisclosed claim. However, when the trustee sought to intervene as real party in interest, the City of Arlington withdrew an offer of judgment and sought summary judgment based on judicial estoppel. U.S. District Judge Terry Means rendered a mixed decision. He ruled that the trustee was not barred by judicial estoppel, but that the debtor would be barred from any recovery.

On appeal to the Fifth Circuit, Chief Judge Edith Jones authored an opinion finding that both the debtor and the trustee were estopped from pursuing the claim. I wrote about the panel opinion in Fifth Circuit Muddles Judicial Estoppel; En Banc Review Needed. The decision set up a conflict between the circuit's two most prominent bankruptcy experts. Chief Judge Jones dismissed a prior opinion by Judge Carolyn King, In re Kane, 535 F.3d 380 (5th Cir. 2008), on the basis that it "purported" to distinguish prior precedents.

The Trustee, supported by the Commercial Law League of America as amicus curiae, sought en banc review.

On August 11, 2011, the full court released its opinion. Judge Carolyn King, joined by eleven other judges wrote the majority opinion, while Chief Judge Edith Jones, joined by two other judges penned the dissent.



The Majority Opinion

The majority set the tone for its opinion with a statement of purpose.

Here, we apply judicial estoppel “against the backdrop of the bankruptcy system and the ends it seeks to achieve.” (citation omitted). These ends are to “bring about an equitable distribution of the bankrupt’s estate among creditors holding just demands,” (citation omitted), and to “grant a fresh start to the honest but unfortunate debtor,” citation . Therefore, judicial estoppel must be applied in such a way as to deter dishonest debtors, whose failure to fully and honestly disclose all their assets undermines the integrity of the bankruptcy system, while protecting the rights of creditors to an equitable distribution of the assets of the debtor’s estate.

Opinion, p. 4.

The Court cited the three-part test which has been a consistent factor in its decisions:

(1) the party against whom judicial estoppel is sought has asserted a legal position which is plainly inconsistent with a prior position;

(2) a court accepted the prior position; and

(3) the party did not act inadvertently.

In applying the test, the Court found that four factors supported a decision that the trustee was not bound by the debtor's omission:

1. The result followed from bankruptcy law;
2. The result followed from equity;
3. The result was consistent with the Court's prior precedents; and
4. The result was consistent with other circuits.

A. Judicial Estoppel and Bankruptcy Law

The Court wrote:

Judicial estoppel, as an equitable remedy, must be consistent with the law. (citations omitted). In this case, the relevant law is the Bankruptcy Code, which distinguishes between the debtor and the debtor’s estate immediately upon the filing of a Chapter 7 bankruptcy. Therefore, while Lubke himself was properly estopped for his dishonesty, his post-petition misconduct does not adhere to the Trustee, who received the judgment asset free and clear of a defense that arose exclusively from Lubke’s post-petition actions.

Opinion, p. 5. The Court walked through a series of Code sections with regard to property of the estate, the role of the trustee and preservation of undisclosed causes of action. The Court noted that the trustee inherits causes of action subject only to defenses existing on the petition date. As a result, the debtor's post-petition misconduct in concealing a cause of action could not bind the trustee.

B. Equity

Judge King found that equity favored the trustee as well. She wrote:

Because judicial estoppel is an equitable doctrine, courts may apply it flexibly to achieve substantial justice. (citation omitted). “The challenge is to fashion a remedy that does not do inequity by punishing the innocent.” (citation omitted). Estopping the Trustee from pursuing the judgment against the City would thwart one of the core goals of the bankruptcy system—obtaining a maximum and equitable distribution for creditors—by unnecessarily “vaporizing” the assets effectively belonging to innocent creditors.

Lubke’s unsecured creditors, including his FMLA attorney Roger Hurlbut, filed timely proofs of claim in the reopened bankruptcy case in the sum of $504,951.87. Other creditors filed late claims in the sum of $84,846.61. Those creditors having meritorious claims are entitled to an equitable distribution of the estate’s assets, which include the judgment against the City.

Opinion, pp. 8-9.

In its equitable analysis, the Court rejected an argument that it was inequitable to allow a claim to be pursued where an attorney would be the primary benefactor:

The City argues that equity does not favor the Trustee. Chief among its complaints is the fact that Roger Hurlbut, whose claim for legal fees stemming from the FMLA action makes him the primary creditor of Lubke’s estate, is an attorney. Section 726 of the Bankruptcy Code requires the property of the estate to be distributed without considering whether the debt is owed to an attorney, a credit card company, or any other type of creditor. (citation omitted). Unable to articulate why Hurlbut’s occupation is relevant here, the City suggests that Hurlbut is somehow associated with Lubke’s deception and is therefore not an innocent creditor. The district court explicitly found otherwise, (citation omitted), and we find no reason to doubt its conclusion.

Opinion, p. 9. As an attorney, I am encouraged that the court rejected the appeal to attorney bashing.

C. Prior Precedents

Between 1999 and 2010, the Fifth Circuit decided four cases involving judicial estoppel in bankruptcy. Those cases can be summarized as follows:

In re Coastal Plains, Inc., 179 F.3d 197 (5th Cir. 1999). Debtor's insider failed to disclose claim and then bought assets of the debtor. Purchasing company entered into a sharing agreement with the trustee where the trustee would receive only 15% of the proceeds. Judicial estoppel applied because the "recovery would benefit the individual who actually perpetrated the bankruptcy fraud in great disproportion to the bankruptcy estate."

In re Superior Crewboats, Inc., 374 F.3d 330 (5th Cir. 2004). Debtors did not schedule the claim and incorrectly told the trustee that the claim was proscribed by the statute of limitations. As a result, the trustee abandoned the claim. The Court held that the debtors were estopped to pursue the undisclosed/mis-disclosed claims.

Kane v. National Union Fire Insurance Co., 535 F.3d 380 (5th Cir. 2008). Debtor failed to disclose claim. Trustee sought to pursue claim. Judicial estoppel was not applied.

Reed v. City of Arlington, 620 F.3d 477 (5th Cir. 2010). Debtor failed to disclose claim. Trustee sought to pursue claim. Judicial estoppel applied to trustee.

In analyzing the precedents, the Court concluded that the common factor was that the cases turned on whether an innocent trustee sought to pursue claims for the benefit of innocent creditors. Under this test, the panel opinion in Reed v. City of Arlington was the odd case out.

D. Other Circuits

The Court noted that its ruling was consistent with rulings in the Seventh, Tenth and Eleventh Circuits. Biesek v. Soo Line Railroad Co., 440 F.3d 410 (7th Cir. 2006); Eastman v. Union Pacific Railroad Co., 493 F.3d 1151 (10th Cir. 2007); Parker v. Wendy's International, Inc., 365 F.3d 1268 (11th Cir. 2004).

By harmonizing its result with sister circuits, the Fifth Circuit avoided a circuit split and reduced the likelihood of a trip to the Supreme Court.

The Bottom Line

Absent unusual circumstances, an innocent bankruptcy trustee may pursue for the benefit of creditors a judgment or cause of action that the debtor—having concealed that asset during bankruptcy—is himself estopped from pursuing.

Opinion, p. 13.

The Dissent

In dissent, Chief Judge Jones argued that the majority's bankruptcy centered inquiry was too narrow. She wrote:

With due respect to my brethren, I respectfully dissent from their balancing of the equities in this case and from one significant legal point. We do not disagree on the general principles governing judicial estoppel except for one thing. The majority posits that only the interests of the bankruptcy process are involved here. I would contend that the federal district and circuit courts are part of the relevant judicial process, and that a broader view should have been taken of the impact of satellite litigation generated by Lubke’s deception. First, our court had to expend significant resources concluding an opinion in the original appeal of this case, only to find that the plaintiff was no longer the proper party. Accordingly, we were required to remand for reconsideration by the district court a plethora of procedural issues made necessary only by Lubke’s deception. These events necessitated a special oral argument hearing, another appellate opinion, and eventually, an en banc decision attempting to resolve our conflicting precedents. Second, because this two-party dispute evolved into a protracted three-party dispute with the trustee and her counsel, the fairness of the fee award exacted against the taxpayers of the City of Arlington has been seriously compromised, contrary to the courts’ duty to impose reasonable fees on a defendant. This may be brushed off as simply the logical consequence of the convoluted legal proceedings, but it is Lubke’s deception that set them in motion,not the City’s violation of his FMLA rights. Thus, the majority’s reasoning purports to protect the interests of creditors in general, while overlooking that the goal of judicial estoppel is to protect the integrity of the entire judicial process.

* * *

One may extol the virtues of “innocent” trustees, and I do not question the integrity of this trustee at all, but let us not romanticize what’s going on here. Lubke is going on with his life, effectively freed by the passage of time from the claims of unsecured creditors. It is pure speculation to say, as does the majority, that he has “no assets.” He was not honest about this litigation, why not about other assets? The expressed concern for “the creditors” lacks a certain depth of feeling. Those creditors were, and remain, almost exclusively credit card companies. Two-thirds of their claims will never be repaid because they were not renewed when the case was re-opened long after it had been declared a no asset filing. The record suggests that others cut their losses by bundling and selling their unpaid claims to third parties.

As for the lawyers, Hurlbut received over $100,000 from Lubke even before the bankruptcy was filed, yet claims from the estate nearly $450,000 in additional fees. The trustee and her attorney will be reimbursed well into six figures as administrative priority claimants who will be paid ahead of the unsecured creditors. All this is legal, but in the commercial world, the transactional costs of such creditor recovery are wildly disproportionate. Surely courts need not cover our eyes against the real dollar impact of our balancing of “equities.”

The majority notes that in “unusual circumstances,” the doctrine of judicial estoppel may occasionally prevent a trustee from recovering on a claim that the debtor concealed from the courts upon filing for bankruptcy relief. Unfortunately, the majority did not balance the factual equities here as I think was obviously appropriate.

Opinion, pp. 14-15, 16.

The dissent is curious. Its balancing test grants priority to the courts, who were required to spend undue time dealing with the debtor's dishonesty, and the City of Arlington, whose taxpayers will shoulder a greater obligation because its judicial estoppel argument failed. On the other hand, the interest of creditors was minimized because their claims were held by debt buyers and attorneys.

It is indisputable that the courts were required to exercise substantial resources to deal with the case. However, the courts were not a party to the dispute; rather, the courts exist for the purpose of resolving disputes. The City expended substantial resources. However, this was a direct result of the unsuccessful legal positions taken by the City. If the City had not withdrawn its Offer of Judgment, its taxpayers would have been better served.

Finally, the dissent's argument that the identity of the unsecured creditors is relevant is disturbing. Equal treatment of similar claims is a core principal of bankruptcy. Once we start down the road of dividing creditors between the worthy and the less worthy, we start down a slippery slope. Should we find that it is more equitable to favor trade vendors than banks? Should we look with greater favor on community banks than national banks? Should we look down on the tort victim who hit a home run in the litigation lottery? The majority's emphasis on the equality of creditors is both statutorily correct and practically sound. Congress established priorities among different classes of creditors. It is not for the courts to rewrite those priorities.

While I may be biased (see Personal Note and Disclosure below), the dissent seems rather subjective. Equity should be about more than picking winners and losers based on our personal predilections. Indeed, the entire concept of the rule of law over the rule of man seems to be that we make decisions without regard to whether we like the persons who benefit, or perhaps that we make decisions based on fixed rules despite our personal preferences. The dissent seems to be based on the lowest common denominator of deciding who we like and ruling in their favor.

We are all subject to subjectivity. If I were a taxpayer in the City of Arlington, I would not like the result in this case. However, the focus of that anger should be at the public officials who caused the liability, not the courts or the trustee or the debtor's creditors.

Personal Note and Disclosure:

In this blog, I have written favorably about Kane and have critiqued the panel opinion in Reed. I was the principal author of the amicus brief filed by the Commercial Law League of America and participated in oral argument on behalf of the League. I consider the opportunity to argue before the full Court of Appeals, if only for ten minutes, to be one of the most exciting moments of my career.

While I am a partisan, my views are my own. No client paid me to blog on this issue and the Commercial Law League did not pay me to write their brief (although they did reimburse my expenses to travel to New Orleans to argue on their behalf--thanks CLLA!).

As a lawyer, I am pleased that the majority resisted the urge to find that lawyers are less equal than other creditors. As a bankruptcy lawyer, I am gratified that the majority found that the statutory structure and goals of the bankruptcy system formed an appropriate frame of reference.

Civil Rights Opinion May Affect Attorney's Fees in Bankruptcy

A decision reviewing attorney's fees in a complex Title VII class action may have repercussions for attorney's fees in bankruptcy cases as well. McClain v. Lufkin Industries, Inc., No. 10-40036 (5th Cir. 8/8/11). You can find the opinion here.

What Happened

The Lufkin Industries case appears to be a David v. Goliath case where David decided he needed reinforcements. Timothy Garrigan, an attorney with a three attorney firm in Nacogdoches, Texas filed a class action suit against Lufkin Industries, Inc. under Title VII, alleging disparate treatment and disparate impact theories. While Mr. Garrigan was found to be well-qualified to handle the class-action, he determined that "it was imperative to associate with co-counsel in order to successfully try this case." The Court wryly noted that, "The case's ultimate trajectory, which spanned a decade and involved thousands of attorney hours, confirmed his initial impression."

When Mr. Garrigan went searching for co-counsel, he had to cast a wide net. After being turned down by multiple Texas firms, he ultimately associated Goldstein, Demchak, a firm from Oakland, California. The plaintiffs' team was successful. Although their initial judgment was reversed and paired down, the plaintiff class still recovered $3.3 million in back pay for discriminatorily lost promotions dating back to 1994.

The plaintiff's attorneys sought $7.7 million in fees. The Court allowed $4.7 million in fees. In doing so, they calculated the lodestar for both the Texas and the California lawyers at $400.00 per hour. This displeased the California lawyers who had sought an award based on $650.00 per hour. Specifically, the District Court ruled that fees should be awarded based on the prevailing market rate in the relevant legal market.

The Ruling

On appeal, the Fifth Circuit considered how to calculate the lodestar, that is, the proper hourly rate to be multiplied by the proper number of hours. The Court stated:

The precedents and purposes governing fee-shifting awards in civil rights cases are well established. The awards facilitate plaintiffs’ access to the courts to vindicate their rights by providing compensation sufficient to attract competent counsel. Fee awards must, however, be reasonable. (citation omitted). The linchpin of the reasonable fee is the lodestar calculation, a product of the hours reasonably expended by the law firms and the reasonable hourly rate for their services. (citation omitted). Charges for excessive, duplicative, or inadequately documented work must be excluded. (citation omitted).

Seminal to this case is the principle that “reasonable” hourly rates “are to be calculated according to the prevailing market rates in the relevant community.” (citation omitted). Further, Blum noted, “the burden is on the applicant to produce satisfactory evidence . . . that the requested rates are in line with those prevailing in the community for similar services by lawyers of reasonably comparable skill, experience and reputation.” (citation omitted). In an unbroken and consistent line of precedent, this court has interpreted rates “prevailing in the community” to mean what it says. Thus, as early as 1974, this court required district courts to consider the customary fee for similar work “in the community.” (citations omitted). Most telling, perhaps, is this court’s decision in a landmark affirmative action case reducing the fee of plaintiffs’ counsel, a former U.S. Assistant Attorney General and subsequent U.S. Solicitor General, from the rates he charged in Washington, D.C., to the prevailing rate in the forum, Austin, Texas. (citation omitted).

Opinion, pp. 8-9.

In the particular case, the Court found that

(W)here, as here, abundant and uncontradicted evidence proved the necessity of Garrigan's turning to out-of-district counsel, the co-counsel's '"home'' rates should be considered as a starting point for calculating the lodestar amount.

Opinion, p. 11.

What It Means

This conclusion is significant for the opposite of what it says. Out of district rates were allowed as the starting point for the lodestar because there was extensive evidence that no Texas lawyer was willing to touch the case. The converse is that an out-of-district lawyer cannot charge out-of-district rates if there was a qualified, local lawyer who could have taken the case.

The application to bankruptcy cases (which follow the same lodestar approach) is that a New York lawyer cannot charge New York rates in Houston without showing that a similarly qualified Houston lawyer was not available, or that a Houston lawyer could not charge Houston rates in Austin without showing that a similarly qualified Austin lawyer was not available, or that an Austin lawyer could not charge Austin rates in Waco without showing that a similarly qualified Waco lawyer was not available.

If this decision is applied to bankruptcy cases, it could prove to be a boon to local lawyers who are perfectly qualified to handle difficult cases but are willing to charge local rates. After all, if Ted Olson was limited to Austin rates in Hopwood v. State of Texas, why would a bankruptcy court in Austin allow a Washington, D.C. firm to charge D.C. rates in a bankruptcy case in Austin, Texas?

The Concurrences

Almost as interesting as the majority opinion are the concurrences. Chief Judge Jones and Circuit Judge Dennis each wrote separately to discuss aspects of the case. Since Chief Judge Jones authored the majority opinion, her concurrence to her own opinion is interesting to say the least.

Chief Judge Jones wrote to express her concern that the California lawyers were, let's be frank here, being greedy. She stated:

It cannot escape the reader’s attention that the Goldstein Demchak firm has been authorized to receive several million dollars in fees, and a million dollars in expenses, for prevailing in this protracted case. But to them, that’s not enough, and they seek an hourly increase that will add $3 million more to their award. If that happens, the attorneys will have received nearly double the dollar award of the plaintiffs. What has fee shifting come to? This is not an appeal about incentivizing modestly compensated attorneys for pursuing noble goals: the $400 hourly rate awarded to Mr. Garrigan is hardly a day laborer’s fee. This appeal is designed simply to enrich, not to enhance or encourage. The Supreme Court holds that fee-shifting cannot bring a windfall to attorneys. (citation omitted). On remand, the district court should exercise its discretion within the parameters we have set out to prevent a windfall recovery.

Opinion, at pp. 20-21. Do you think that Judge Jones made her feelings about the fees in this case clear enough? While Chief Judge Jones' majority opinion allowed the possibility of higher rates for out of district counsel, her concurrence suggests that she strongly objects to allowing that possibility in practice. Query whether she would show the same scorn for a bank's lawyers who sought to obtain a "windfall recovery"?

Judge Dennis wrote separately to suggest that the "hourly rates charged by the defendant's attorney's provide a helpful guide in determining whether similarly high rates and hours requested by the plaintiffs were reasonable." In the bankruptcy context, if the creditor's lawyers are charging obscene fees, then the debtor's lawyers may charge merely scandalous fees.

I think that this opinion, while affirming national rates in the specific case, is a victory for local rates in general. Of course, it bears mentioning that determining the appropriate market rates to use in the lodestar is only the starting point. Courts are still free to adjust upward or downward based upon the facts of the specific case.

Meet Judge Mott

Welcome to a new feature of A Texas Bankruptcy Lawyer’s Blog. This will be the first in a series of profiles on the bankruptcy judges in Texas, beginning with H. Christopher Mott.

On September 20, 2010, H. Christopher Mott became Texas’s newest bankruptcy judge, holding court in the Austin and El Paso divisions of the Western District of Texas. He grew up in El Paso, graduating from Eastwood High School (a distinction he shares with Jim Wilkins and myself). He earned a B.B.A with Highest Honors from Texas Tech University in 1980 and graduated with High Honors from Texas Tech School of Law in 1983.

Private Practice

Judge Mott had a twenty-seven year career in private practice in El Paso. He was a founding partner of the firm now known as Gordon, Davis, Johnson and Shane.

At the time he graduated, Texas was in the midst of an oil and gas bust. He said

I got my start in the bankruptcy arena right out of law school in 1983 with the oil industry bust in Midland/Odessa. Bettina Whyte was a chapter 11 trustee, examiner or Plan Agent in several cases where I was her counsel. Many debtors there were high-flying oilmen and the FDIC had closed the largest banks in the area, forcing debtors (individuals and companies) into bankruptcy. The result was many adventurous cases and quick experience for a young lawyer.

His most significant case in private practice was neither a bankruptcy case nor one in Texas. On April 14, 2000, the State Banking Commissioner of Illinois placed Independent Trust Company (known as Intrust) into receivership in Cook County State Court. PriceWaterhouseCoopers was appointed as Receiver and the Receiver hired Judge Mott as its counsel. According to Judge Mott:

Intrust was the largest trust company failure in Illinois history and the largest trust company nationally to fail since the Great Depression. Intrust administered approximately $2 billion in assets for over 17,000 account holders. Approximately $70 million in trust assets were missing, haven been stolen over the previous ten years. The case was significant as it involved issues of first impression under Illinois insolvency law, extremely complicated facts, eight months of litigation at the trial court level, expedited appeals and a high profile. The time pressures in the case were tremendous, as trust accounts were frozen due to lack of liquidity and solvency and over 17,000 account holders were impacted. In the end, the Receiver was successful in allocating the loss and selling the trust business and accounts to another trust company.

Another significant case that he handled was In re Clay, 35 F.3d 190 (5^th Cir. 1994), in which the Fifth Circuit held that Bankruptcy Courts did not have the statutory or constitutional authority to conduct a jury trial absent consent of the parties.

Bon Mots from Judge Mott

Judge Mott has been a prolific writer and speaker on bankruptcy topics. Here are a few bon mots* from his writings:

In some respects, working in a law firm should be like playing a secret agent in a James Bond movie. Secret agents learn confidential information that must be treated as “top secret” and cannot be disclosed. In the course of your law firm job, you become privy to sensitive and confidential information about clients of the law firm. This client information must be treated as “top secret” by law firm employees. Legal secretaries, paralegals, and other employees of the firm must be very careful not to disclose—whether inadvertently or intentionally—confidential client information to anyone outside the firm, including family and friends.

“Secret Agents: Your Responsibility to Protect Confidential Client Information,” http://www.texasals.org/Confidential.html.

Navigating the troubled seas of bankruptcy court jurisdiction makes many lawyers feel like Coleridge’s Ancient Mariner, or in more modern times, Russell Crowe as Captain Jack Aubrey in Master and Commander: The Far Side of the World. These seas are awash with technical phrases (such as core, related to, abstention, remand and removal), interlocking and sometimes conflicting statutes and rule, and multiple judicial interpretations of how to properly navigate the waters.

“Bankruptcy Jurisdiction—The Far Side of the World,” Bankruptcy Litigation: Pre-Trial Practice & Procedural Workshop (January 20-21, 2005).

Summary judgment practice is a rifle shot, not a shotgun approach to disposing of issues. The KISS rule (keep it simple stupid) applies to summary judgment motions. The chances of success on a summary judgment motion raise as you make the case appear simple, they fall if you make it look more complex.

“Drafting a Motion for Summary Judgment *Tips for Success*”, Bankruptcy Litigation: Advanced Pre-Trial Practice & Procedure Workshop (January 29-30, 2004).

From these brief quotes, we can learn that Judge Mott is a fan of a well-turned analogy, that he likes movies and that he takes a practical approach to law.

Honors

Judge Mott served a term as Chair of the State Bar of Texas Bankruptcy Section. He said:

My personal favorite has always been the Elliott Cup Bankruptcy Moot Court competition sponsored by the Section. It has expanded to include all law schools in the Fifth Circuit (including Texas). The talent level of the law students and their knowledge of bankruptcy law is astounding.

Other honors and credentials he has earned include being a Fellow of the American College of Bankruptcy, Board Certified in Business Bankruptcy Law by the Texas Board of Legal Specialization, a former Commissioner of the Texas Bankruptcy Certification Exam Commission, and being included as a Texas Super Lawyer as well as being named to Best Lawyers in America and Corporate Counsel—Top Lawyer.

He is no relation to Christopher Mott, the actor who played Howard K. Stern in an episode of The Final 24 devoted to Anna Nicole Smith.

Judge Mott in the Courtroom

His courtroom demeanor is very calm. In an interview with the ABA Section of Litigation, he said:

I just try to be myself, a plain, straight-speaking person. I do try to exercise more patience and display more even-handedness than I might in a private setting, such as with friends.

In the same interview, he said that he wears a shirt and tie under his robe, but not a jacket. He said, “For some reason wearing a tie helps me to focus better.”

He expressed admiration for his fellow judges, stating:

There is great camaraderie among bankruptcy judges. It is like a 300-person fraternity. Bankruptcy judges seem to be cut from a different cloth; they take their jobs seriously, but not themselves.

When asked about his biggest challenge on the bench, he said:

One of the biggest challenges is to figure out what hearings /trials are actually going to go forward and be contested; and what will be settled or continued (often at the last minute). I try to prepare for hearings so I can rule from the bench when possible. There is not enough time in the day for me (and my law clerks) to prepare for every hearing that gets set so the educated guess on what matters are actually going to be contested and go forward is a challenge.

Off the Bench

Judge Mott keeps busy off the bench.

I am kind of a workout nut, because my job is sedentary and exercise reduces stress. At this point, I mix it up a lot—run, mountain bike, swim (Barton Springs pool is awesome), rowing on Town Lake (new and fun for me), gym work. I have many hobbies that I enjoy, but am not particularly good at, such as golf, scuba diving, fly fishing, and mountain climbing. I also love watching football and reading, and most importantly, spending time with my wonderful wife of 30 years and my 20-year-old daughter and 23-year-old son.

The final word from Judge Mott:

"I may be stupid but I am not dumb."

*--A bon mot is defined as a clever saying, phrase or witticism.

Acknowledgement: Portions of this article were taken from “Interview with the Honorable H. Christopher Mott,” ABA Section of Litigation (July 14, 2011).