Tuesday, April 19, 2011

Judge Gargotta Writes Sweeping Opinion on Jurisdiction, Reverse Veil-piercing and Cayman Islands Law

In law school, students cope with concepts of subject matter jurisdiction, personal jurisdiction and stating a cause of action in civil procedure class. When they move on to bankruptcy class, they must try to make sense of the constitutionality of delegating jurisdiction to an Article I court when considering the Marathon Pipeline case. These are not easy issues to get your head around. Judge Craig Gargotta must have felt like he was writing a law school exam when faced with motions to dismiss in an adversary proceeding. Roberts, Trustee v. J. Howard Bass & Associates, Inc., et al, Adv. No. 10-1101 (Bankr. W.D. Tex. 2/15/11). You can find the opinion here.

Introduction

James H. Bass filed chapter 7 bankruptcy on June 3, 2009. The creditors included two judgment creditors holding claims of $5.5 million (including one that had been found to be non-dischargeable in a prior filing). Filing bankruptcy proved to be a mistake, since the court denied the debtor’s discharge and the trustee launched an adversary proceeding against nine Bass-related defendants seeking to recover assets. The defendants sought to make the adversary proceeding go away with motions to dismiss for failure to state a cause of action and for lack of jurisdiction. Among their more creative arguments was that the bankruptcy court lacked jurisdiction to hear the case because the bankruptcy jurisdiction scheme was unconstitutional.

Have We Been Working Under a Constitutionally Defective System?

In 1982, the Supreme Court found that Congress had “impermissibly removed most, if not all, of the ‘essential attributes of the judicial power’ from the Article III district court, and has vested those attributes in a non-Art. III adjunct.” Northern Pipeline Construction Co. v. Marathon Pipeline Co., 458 U.S. 50, 87 (1982). However, the defendants cited other language not actually found in the opinion for the proposition that “Congress could not vest in a non-Article III court the power to adjudicate, render final judgment, and issue binding orders in a traditional contract action arising under state law, without consent of the litigants, and subject only to ordinary appellate review.” Citing non-existent quotes from the Supreme Court is not a good way to impress the Bankruptcy Court. The defendants also argued that 28 U.S. C. §157, which referred bankruptcy matters to the bankruptcy courts was unconstitutional for the reason that it was an impermissible delegation of power to an Article I court.

The Court noted that the argument would have had some merit—if it had been made in 1982.

If this is where history ended, Defendants would be correct in stating that the bankruptcy code is unconstitutional. However, Defendants’ argument ignores approximately 30 years of subsequent history. In 1984, Congress enacted the Bankruptcy Amendments and Federal Judgeship Act of 1984 (BAFJA). One of the major changes, meant to remedy the constitutional challenges of Marathon, was 28 U.S.C. §157(b)(1) . . . .

This statutory language gave the bankruptcy courts the same broad jurisdiction as the 1978 system, but it forbade the bankruptcy courts from rendering final judgments in cases that were only “related to” the bankruptcy case.

Opinion, p. 8.

In 1987, the Fifth Circuit found the revised jurisdictional grant to be constitutional in In re Wood, 825 F.2d 90 (5th Cir. 1987). The Supreme Court cited favorably to Wood in Celotex Corp. v. Edwards, 514 U.S. 300 (1995). Not wishing to overrule the Fifth Circuit and the Supreme Court, Judge Gargotta found the jurisdictional scheme to be constitutional.

Jurisdictional to the Core?

Having found jurisdiction, the Court had to find whether it had core jurisdiction. The claims asserted by the trustee included substantive consolidation, alter-ego and declaratory judgment. Rights created by the Bankruptcy Code constitute core proceedings. Substantive consolidation arises from section 105. As a result, it is a claim created by the Bankruptcy Code and thus a core proceeding.

Alter-ego posed a more difficult question because these claims arose under state law. However, §157(b)(3) states that the fact that a claim arises under state law is not dispositive in determining core status. Because the alter ego claims would bring assets into the estate, they would have a direct effect on the liquidation of the assets of the estate under 28 U.S.C. §157(b)(2)(O).

The declaratory judgment claims arose under the Bankruptcy Code and thus were core proceedings.

Jury Trial

The next argument raised by the Defendants was that they were entitled to a jury trial and that the Bankruptcy Court could not conduct one absent consent. Although Judge Gargotta went through several pages of serious discussion, the results can be summarized as: 1) there is not constitutional right to a jury trial in an equitable action; and 2) substantive consolidation and alter ego are equitable claims.

Although Judge Gargotta went through several pages of serious discussion, the results can be summarized as: 1) there is not constitutional right to a jury trial in an equitable action; and 2) substantive consolidation and alter ego are equitable claims.

Does Texas Law Allow A Reverse Veil-Piercing Claim Against An Entity That Is Not Owned by the Debtor?

Traditional veil-piercing seeks to hold the shareholder liable for the debts of the corporation. Reverse veil-piercing is more exotic and seeks to hold a corporation liable for debts of an individual. However, in this case, the individual was not a shareholder of the corporations. Would Texas law allow reverse veil-piercing in this situation?

Judge Gargotta relied on The Cadle Co. v. Brunswick Homes, LLC, 379 B.R. 284 (Bankr. N.D. Tex. 2007) for the proposition that while ownership is traditionally a requirement for reverse veil piercing, the doctrine could also be extended to de facto ownership. Because the trustee’s complaint alleged that the debtor sought to disguise his actual control of the companies, the trustee stated a cause of action.

Can You Do Reverse Veil-Piercing on a Cayman Corporation?

One of the defendants was a Cayman Islands corporation. The defendants argued that reverse veil-piercing was not available under Cayman law. The ever-scholarly Judge Gargotta noted that the Cayman Islands generally follow British law and that the United Kingdom has recognized veil piercing for over 100 years, from Saloman vs. Saloman & Co. [1897] A.C. 22 to Adams v. Cape Industries [1990] Ch 433; 2 WLR 657; [1991] 1 All ER 929; [1990] BCC 786 Sealy 66. Thus, the trustee stated a cause of action against the Cayman corporation.

Personal Jurisdiction over the Cayman Corporation

The Cayman defendant argued that no state or federal statute allowed service on it and that it transacts no business in the U.S. and only owns assets in the Cayman Islands. The Court found that the Texas long arm statute allows service to the fullest extent provided by the Constitution. This requires minimum contacts and that exercising jurisdiction is consistent with “traditional notions of fair play and substantial justice.” The Court found that if the Cayman corporation was found to be the alter ego of the debtor, then the court would have jurisdiction over it. As a result, the court found that it had jurisdiction to determine whether the Cayman corporation was the alter ego of the debtor. This poses an interesting conundrum. If the Cayman entity is not the debtor’s alter ego, then the Court may not exercise jurisdiction over it. However, to determine whether the court has jurisdiction, it must exercise its jurisdiction. Thus, the Cayman Islands entity must appear regardless of whether there is jurisdiction. Perhaps another way to approach the problem would have been to find that the Cayman entity had minimum contacts with the United States in that it was formed with money from a United States entity and its control persons were all residents of the United States.

Substantive Consolidation

Finally, the Defendants argued that the Bankruptcy Court could not grant substantive consolidation and that substantive consolidation between a debtor and a non-debtor was improper. The argument against the applicability of substantive consolidation was unlikely to succeed given the fact that the Court had a recent opinion approving use of substantive consolidation. In re Introgen Therapeutics, Inc. 429 B.R. 570 (Bankr. W.D. Tex. 2010).

The Court was similarly unreceptive to the argument that a nondebtor could never be substantively consolidated with a debtor. While the defendants quoted from a Fifth Circuit opinion, they left out the words “under these facts.” Those words were pretty important because in Peoples State Bank v. GE Capital Corp. (In re Ark-La-Tex Timber Co.), 482 F.3d 319 (5th Cir. 2007), the debtor believed that its purchase of the ownership interest in two other entities automatically effected a substantive consolidation. The Court found that if the Trustee was successful in proving alter ego that the assets of the two non-debtor entities would be property of the estate and substantive consolidation would be moot. As a result, the Court determined that it would reserve judgment on the substantive consolidation claim.

Conclusion

After working through twenty-one pages of discussion, the Court concluded:

Having gone through the facts of the case and considered the evidence submitted by the parties, this Court finds that (1) this Court and the current bankruptcy system are constitutional; (2) Plaintiff sufficiently pled a complaint for alter-ego liability that survives the motions to dismiss; (3) this Court can exercise personal jurisdiction over Esperada for the purposes of discovery; and (4) substantive consolidation in general is permitted in the Fifth Circuit, but the issue of whether it is appropriate in this case will be reserved for later determination after discovery and a trial on the merits. For these reasons, Defendant‟s Motions to Dismiss (docket nos. 66-74) are DENIED.

Opinion, p. 21. The lesson to be learned here is that the Bankruptcy Court is fully up to the challenge of sorting through difficult procedural and jurisdictional issues. However, when raising difficult procedural and jurisdictional issues, it is important to accurately quote the cases.

Class dismissed.

Sunday, April 10, 2011

Not a Good Idea to Object to Every Claim

You know that nothing good can come from an opinion which begins like this:

This is a case about an affluent debtor who sought to manipulate bankruptcy procedures to accomplish what the Code prohibits--the elimination of all of her credit card debts despite her obvious ability to repay those debts over time. The debtor, Diane Davis, obtained confirmation of a plan in which she proposed to pay her credit card debts in full. The debtor subsequently objected to every claim filed by her creditors based on their alleged failure to attach sufficient documents to their proofs of claim. The debtor withdrew several objections after the creditors responded. The Court has before it the debtor's request for a default order sustaining the remaining objections.

In re Diane Davis, No. 09-42865 (Bankr. E. D. Tex.3/31/11). p. 1. You can find the opinion here.

The Davis case is one of a debtor who tried to follow the letter but not the spirit of the law. The debtor was an above median income debtor who would not qualify for relief under chapter 7. She filed under chapter 13 but tried to avoid paying any of her unsecured debts. She scheduled all of her unsecured debts as disputed and then objected to every claim filed. If the creditor responded, she withdrew her objection. Since most of the creditors did not respond, she thought that she was home free. However, the court had other ideas.

A Few Facts

The Debtor was a single woman with gross monthly wages of $10,428 and disposable income of $3,923.92. The only debts she was delinquent upon were credit cards. She scheduled eight creditors with debts totaling $81,564. Every debt was listed as disputed with the notation "Debtor listed the balance shown on last statement; debtor not presently able to determine if balance is correct and is uncertain if trade name is correct legal creditor."

The debtor filed a plan proposing to pay $3,190 to the chapter 13 trustee for 60 months. Twelve creditors filed proofs of claim totaling$147,400.68. Because the plan proposed to pay $190,400 on claims which were less than this amount, no creditors objected to the plan and it was confirmed.

Then the debtor objected to every claim. The objections asserted that the creditors had not attached sufficient documentation to the claim and that the debtor would withdraw the objection if presented with adequate documentation. The debtor withdrew her objections to five claims after the creditors filed responses. However, the debtor sought default orders on the remaining seven claims. One of the claims that the debtor sought a default on was from Neiman Marcus. Neiman Marcus amended its claim to add documentation but did not file a response. The debtor's statement of financial affairs revealed that the debtor had been making payments on this claim prior to bankruptcy.

The court conducted several hearings on the claims objections. While the debtor was present at one hearing, she did not testify. Debtor's counsel offered a brief on why the claims should be denied but never presented any substantive grounds why the debtor did not owe the debts.

Can the Debtor Deny the Claims of the Non-Responding Creditors?

The Court's answer was "no." Failure to attach supporting documentation, without more, is not a sufficient ground for denying a claim. Judge Rhoades stated:

If an objection to a claim is raised, Section 502(b) provides that the court "shall allow the claim in such amount, except to the extent that" a grounds for disallowance provided by Section 502(b)(1)-(9) applies. (citation omitted). Thus, the Code requires us to overrule a claim objection that does not comply with Section 502(b)--even if the claimant does not appear to raise the issue.

Opinion, p. 11. Thus, the mere fact that the creditor failed to attach sufficient documentation to the claim and then failed to respond to the claims objection was not grounds for denying the claim.

Not only that, the court found that the claims did "substantially" conform to Bankruptcy Rule 3001 such that they were entitled to prima facie validity. Because the debtor did not produce evidence sufficient to rebut the prima facie validity of the claims, the creditor had no duty to respond.

An Interesting Twist

While Judge Rhoades found that the objections should be denied, she also raised the possibility that the debtor was asking for something she really didn't want.

The discharge in a chapter 13 case is different than in a chapter 7 case. (citation omitted). In a chapter 13 case, upon completion of plan payments, a debtor generally is discharged of all debts "provided for by the plan or disallowed under section 502" of the Code. (citation omitted). Section 1328(a) does not, by its terms, discharge a chapter 13 debtor of her obligation to repay claims denied solely under Bankruptcy Rule 3001.

Opinion, p. 15. Thus, had the debtor been successful in her non-substantive objections, she would not have discharged the debts.


The Ethical Obligations of the Debtor's Counsel

The Court was not amused as shown by the subheading "The Ethical Obligations of the Debtor's Counsel." The Court noted that filing the schedules and objecting to the claims, debtor's counsel
deliberately chose to (i) ignore the debtor's personal knowledge,and (ii) conduct no independent investigation prior to filing the debtor's bankruptcy schedules and claim objections."
Opinion, p. 21.

The Court went on to state:

It appears to the Court that the debtor and her counsel were motivated by the off-chance that the claimants would not respond to the objections and, consequently, that this Court would sustain the objections without substantive review. 'An off-chance does not satisfy [Bankruptcy] Rule [9011].' (citation omitted). 'This approach of throwing it against the wall and seeing what sticks is precisely the sort of conduct [Bankrutpcy Rule 9011] seeks to counter. (citations omitted).

Opinion, pp.21-22.

The Debtor's Obligation to Act in Good Faith

The Court was not any more impressed with the debtor's conduct.

Regardless of the advice the debtor may have received from her counsel regarding the claims allowance process, she has an obligation to the Court to act in good faith. To confirm a chapter 13 plan, the bankruptcy court must find, among other elements, that 'the plan has been proposed in good faith.' (citation omitted). . . Good faith in this context is not an esoteric legal concept that only lawyers and judges can understand. The question is whether the totality of the circumstances indicates that the plan is unreasonable or that the debtor is attempting to abuse the spirit of the Code. (citation omitted).

Opinion, pp. 22-23.

The Bottom Line

The Court overruled the claims objections, vacated the order confirming the plan, gave the debtor 30 days to file a new plan and scheduled a hearing to determine whether debtor's counsel violated Rule 9011.

What It Means

The chapter 13 bargain is about paying creditors in return for a discharge. The debtor had enough disposable income to pay all of the filed claims in less than sixty months. This would have been a good deal because the debtor would have been able to repay the debts without interest. However, the debtor tried to take a shortcut and eliminate all of her claims on a defect of form. The Court was right to be concerned about the good faith of this practice.