A Warning Against Do It Yourself Legal Forms

A debtor avoided losing her home in a recent case illustrating the perils of do it yourself legal forms.    Lowe v. Vazquez, No. SA-12-CV-00399-DAE (W.D. Tex. 3/28/13).    

The Debtor paid $10 to download a living trust form while she was living in Nevada.   When she moved to Texas, she conveyed her homestead to the trust.   Her stated reason for setting up the trust was:

 The one and only reason I created the Living Trust after my divorce was to be sure my son could have access to any assets I owned at the time I die and to avoid probate, so I named my son as Successor Trustee. Probate proceedings in Nevada are lengthy and costly and I only wanted to make things easier for him when I die.

When she filed bankruptcy in Texas, the trustee objected to her exemption on the basis that title to the home was vested in the trust.   The Bankruptcy Court denied the objection.    In re Vazquez, 2012 Bankr. LEXIS 642 (Bankr. W.D. Tex. 2012).    

On appeal, the Court found that notwithstanding some confusing language in the pre-printed form, that the Debtor was the sole beneficiary of the trust.   As the sole trustee and sole beneficiary, a valid trust had not formed as of the petition date and the property remained vested in the Debtor.

U.S. District Judge David Ezra had some insightful words for individuals who might want to save money by creating their own legal documents.

This case is a poster child for the proposition that one should not rely on prepaid legal forms with boilerplate language for important legal matters. Had Debtor passed away, it is clear to the Court that the document would not have accomplished what she hoped; indeed, all of the tax consequences she hoped to avoid would have been visited upon her son. It is also clear that a properly drafted trust prepared by a competent lawyer would have accomplished the goal she sought in the first instance.

Opinion, p. 8, n. 2.

I cannot say it any better than Judge Ezra.    If you own a Texas homestead, do not EVER convey it to a trust.   You may place your homestead exemption at risk for no good reason.    The Debtor in this case did not lose her homestead.   However, she had to defend an objection to exemption and an appeal at her own expense.
 

Disclosure:   My firm represented Karen Vazquez in the appeal.    

Fifth Circuit Issues Two Decisions Easing Path for Chapter 11 Debtors

Within the span of a few days, Judge Patrick Higginbotham of the Fifth Circuit released two decisions which will ease the way for chapter 11 debtors to confirm their plans.   In the first decision, the Court definitively put a stake through the heart of the artificial impairment doctrine, while in the second, the Court held that the Till prime + formula, while not mandatory, was becoming the "default" rule for calculating interest in chapter 11 plans.    The cases are Matter of Village at Camp Bowie I, LP, No. 12-10271 (5th Cir. 2/26/13), which can be found here, and Matter of Texas Grand Prairie Hotel Realty, LLC, No. 11-11109 (5th Cir. 3/1/13), which can be found here.

Village at Camp Bowie and Artificial Impairment

Village at Camp Bowie involved an oversecured creditor whose claim overshadowed those of other creditors.    Western Real Estate Equities held a debt of $32.1 miliion secured by property valued by the court at $34 million.    The Debtor owed $59,398 to thirty-eight (38) trade creditors.    Under the plan, the Debtor's equity holders and related parties were to infuse $1.5 million in new equity.   As a result, the Debtor had sufficient funds to simply pay off the trade creditors and leave their claims unimpaired.   This would have allowed Western to veto the plan since there would not have been another class available to accept the plan.

Western objected that the Debtor's plan had not been proposed in good faith and that the plan hadn't really been accepted by an impaired class since the impairment was "artificial."     The Bankruptcy Court confirmed the Plan over Western's objections.

The Court noted that the Eighth Circuit requires that impairment be driven by economic need, while the Ninth Circuit did not distinguish between "discretionary and artificially driven impairment."    The Court also noted that it had previously rejected the concept of artificial impairment in Matter of Sun Country, Ltd., 764 F.2d 406 (5th Cir. 1986), but that because the court concluded that the impairment in that case was economically motivated "we deprived our analysis of precedential force."    On the other hand, the court had expressed concern over potential artificial impairment in Matter of Sandy Ridge Development Corp., 881 F.2d 1346 (5th Cir. 1989).  (Parenthetically, it is interesting to note that these cases involved two individuals who went on to achieve prominence on the Texas bench.   Leif Clark was the Debtor's lawyer in Sun Country, while Wesley Steen was the bankruptcy judge for Sandy Ridge during the period in which he was a judge in Louisiana).      

Judge Higginbotham found that artificial impairment was inconsistent with the statutory language of the Code, writing:

Today, we expressly reject Windsor [the Eighth Circuit decision] and join the Ninth Circuit in holding that § 1129(a)(10) does not distinguish between discretionary and economically driven impairment. As the Windsor court itself acknowledged, § 1124 provides that “any alteration of a creditor’s rights, no matter how minor, constitutes ‘impairment.’” By shoehorning a motive inquiry and materiality requirement into § 1129(a)(10), Windsor warps the text of the Code, requiring a court to “deem” a claim unimpaired for purposes of § 1129(a)(10) even though it plainly qualifies as impaired under § 1124.   Windsor’s motive inquiry is also inconsistent with § 1123(b)(1), which provides that a plan proponent “may impair or leave unimpaired any class of claims,” and does not contain any indication that impairment must be driven by economic motives.

The Windsor court justified its strained reading of §§ 1129(a)(10) and 1124 on the ground that “Congress enacted section 1129(a)(10) . . . to provide some indicia of support [for a cramdown plan] by affected creditors,” reasoning that interpreting § 1124 literally would vitiate this congressional purpose.   But the Bankruptcy Code must be read literally, and congressional intent is relevant only when the statutory language is ambiguous.   Moreover, even if we were inclined to consider congressional intent in divining the meaning of §§ 1129(a)(10) and 1124, the scant legislative history on § 1129(a)(10) provides virtually no insight as to the provision’s intended role, and the Congress that passed § 1124 considered and rejected precisely the sort of materiality requirement that Windsor has imposed by judicial fiat.

The Windsor court also reasoned that condoning artificial impairment would “reduce [§ 1129](a)(10) to a nullity.”   But this logic sets the cart before the horse, resting on the unsupported assumption that Congress intended § 1129(a)(10) to implicitly mandate a materiality requirement and motive inquiry.   Moreover, it ignores the determinative role § 1129(a)(10) plays in the typical single-asset bankruptcy, in which the debtor has negative equity and the secured creditor receives a deficiency claim that allows it to control the vote of the unsecured class.   In such circumstances, secured creditors routinely invoke § 1129(a)(10) to block a cramdown, aided rather than impeded by the Code’s broad definition of impairment.

Opinion, pp. 8-10.

While the passage quoted above is rather long, I have quoted it in its entirety because I find its statutory analysis to be spot-on.  There is no need to make things more complicated by delving into the meaning of a provision when the words used are clear.   Congress set the bar for determining impairment quite low.  Thus, when Congress required acceptance by an impaired class, it similarly set an easily met standard.  (Note: when Judge Higginbotham speaks of judicial fiat, I can't help but think of a small Italian car filled with black-robed judges).

The Court also rejected the argument that Matter of Greystone III Joint Venture, 995 F.2d 1274 (5th Cir. 1991) embodied a "broad, extrastatutory policy against 'voting manipulation.'"   He stated:

Greystone does not stand for the proposition that a court can ride roughshod over affirmative language in the Bankruptcy Code to enforce some Platonic ideal of a fair voting process.    

Opinion, p. 11.    While it is comforting to see Greystone limited to its actual holding, you also have to admire a judge who can work "Platonic ideal" into a bankruptcy opinion.   (According to Wikipedia, Platonic idealism refers to universals or abstract objects.  Thus, a Platonic ideal of voting would mean voting according to abstract, universal principles.)

Nevertheless, the Court did point out that good faith was still a relevant inquiry.

We emphasize, however, that our decision today does not circumscribe the factors bankruptcy courts may consider in evaluating a plan proponent’s good faith. In particular, though we reject the concept of artificial impairment as developed in Windsor, we do not suggest that a debtor’s methods for achieving literal compliance with § 1129(a)(10) enjoy a free pass from scrutiny under § 1129(a)(3). It bears mentioning that Western here concedes that the trade creditors are independent third parties who extended pre-petition credit to the Village in the ordinary course of business. An inference of bad faith might be stronger where a debtor creates an impaired accepting class out of whole cloth by incurring a debt with a related party, particularly if there is evidence that the lending transaction is a sham.  Ultimately, the § 1129(a)(3) inquiry is factspecific, fully empowering the bankruptcy courts to deal with chicanery. We will continue to accord deference to their determinations.

Opinion, pp. 12-13.

Texas Grand Prairie and Cram-Down Interest Rates

In the second case, the Court affirmed a bankruptcy court ruling which confirmed a chapter 11 plan which using a 5% cram-down rate of interest under the Till decision.   In Grand Prairie, the parties agreed that the Till decision provided the appropriate method for calculating a chapter 11 cram-down interest rate.   The Debtor's expert, faithfully following the Till approach, concluded that prime + a risk factor of 1.75% was appropriate, so that the indicated interest rate was 5.0%.   Even though the lender stipulated that Till was the correct approach, its expert did not follow its methodology.  Instead, he opined that the proper rate was 8.8% by "taking the weighted average of the interest rates the market would charge for a multi-tiered exit financing package" and then adjusting for risk factors.  The Court adopted the 5.0% rate which had the effect of costing the lender $1,485,000 in interest per year based on the appraised value of $39,080,000.

On appeal, Wells Fargo sought to exclude the Debtor's expert testimony on the basis that his "purely subjective approach to interest-rate setting" violated the Supreme Court's call for an "objective inquiry" in Till.   The Court wisely observed that:

Here, Wells Fargo does not challenge Robichaux’s factual findings, calculations, or financial projections, but rather argues that Robichaux’s analysis as a whole rested on a flawed understanding of Till. As we read it, Wells Fargo’s Daubert motion is indistinguishable from its argument on the merits. It follows that the bankruptcy judge reasonably deferred Wells Fargo’s Daubert argument to the confirmation hearing instead of deciding it before the hearing.  We pursue the same path and proceed to the merits.

Opinion, p. 7. 

Next, the Court addressed the proper legal standard for calculating an interest rate under section 1129(b).   The court ultimately concluded that the Till decision was not binding on the court because:

•  Till was a plurality opinion; and

• Till expressly left open the issue of interest rates in chapter 11 in footnote 14.

As a result, the Court found that its prior decision in In re T-H New Orleans Partnership, 116 F.3d 790 (5th Cir. 1997) remained binding.   T-H New Orleans held that the Court would not "establish a particular formula for determining an appropriate cramdown interest rate," but would review the Bankruptcy Court's decision for "clear error."   Having concluded that the Till formula was not mandatory, the Court nevertheless found that it was becoming the majority approach.

In spite of Justice Scalia’s warning, the vast majority of bankruptcy courts have taken the Till plurality’s invitation to apply the prime-plus formula under Chapter 11. While courts often acknowledge that Till’s Footnote 14 appears to endorse a “market rate” approach under Chapter 11 if an “efficient market” for a loan substantially identical to the cramdown loan exists, courts almost invariably conclude that such markets are absent.   Among the courts that follow Till’s formula method in the Chapter 11 context, “risk adjustment” calculations have generally hewed to the plurality’s suggested range of 1% to 3%.   Within that range, courts typically select a rate on the basis of a holistic assessment of the risk of the debtor’s default on its restructured obligations, evaluating factors including the quality of the debtor’s management, the commitment of the debtor’s owners, the health and future prospects of the debtor’s business, the quality of the lender’s collateral, and the feasibility and duration of the plan.

 Opinion, pp. 14-15.

 
Under the Fifth Circuit's deferential clear error analysis, a bankruptcy court which followed the majority approach could not be faulted, even if the court could have found another approach more persuasive.   

The Court found that the Debtor's expert properly followed the Till approach.  

We agree with the bankruptcy court that Robichaux’s § 1129(b) cramdown rate determination rests on an uncontroversial application of the Till plurality’s formula method. As the plurality instructed, Robichaux engaged in a holistic evaluation of the Debtors, concluding that the quality of the bankruptcy estate was sterling, that the Debtors’ revenues were exceeding projections, that Wells Fargo’s collateral — primarily real estate — was liquid and stable or appreciating in value, and that the reorganization plan would be tight but feasible. On the basis of these findings — which were all independently verified by Ferrell — Robichaux assessed a risk adjustment of 1.75% over prime. This risk adjustment falls squarely within the range of adjustments other bankruptcy courts have assessed in similar circumstances.

Opinion, p. 18.

Finally, the Court rejected Wells Fargo's argument that the path taken by the Debtor's expert produces "absurd results."

Wells Fargo complains that Robichaux’s analysis produces “absurd results,” pointing to the undisputed fact that on the date of plan confirmation, the market was charging rates in excess of 5% on smaller, over-collateralized loans to comparable hotel owners. While Wells Fargo is undoubtedly correct that no willing lender would have extended credit on the terms it was forced to accept under the § 1129(b) cramdown plan, this “absurd result” is the natural consequence of the prime-plus method, which sacrifices market realities in favor of simple and feasible bankruptcy reorganizations.   Stated differently, while it may be “impossible to view” Robichaux’s 1.75% risk adjustment as “anything other than a smallish number picked out of a hat,” the Till plurality’s formula approach — not Justice Scalia’s dissent — has become the default rule in Chapter 11 bankruptcies.  (emphasis added).

Opinion, p. 19.    Thus, the Court is not required to apply Till, but if it does, it is not error to pick a "smallish number" out of a hat.

Final Thoughts

These two opinions, while both affirming confirmation of chapter 11 plans, take very different approaches to judging.    Village at Camp Bowie is very much a straightforward application of statutory analysis.    While I thought that Sun Country's statement that:

Congress made the cram down available to debtors; use of it to carry out a reorganization cannot be bad faith.

effectively killed the doctrine of artificial impairment, it is nonetheless heartening to see a judge put the final nail in the coffin.     Just as I noted in my prior post about Spillman Development Group, this is a case of a judge rejecting magical thinking.   In this case, the magical thinking was that Greystone III Joint Venture can be cited in talismanic fashion for the proposition that the secured creditor automatically gets a veto.

Texas Grand Prairie is a much more subversive opinion.   While ostensibly following T-H New Orleans' no formula approach, the court gave the green light to bankruptcy courts to follow the Till plurality's prime + approach, referring to it as the majority approach and the default rule.   On the other hand, the Court left bankruptcy courts free to reject Till as well.   If anything, this decision gives broad discretion to the factfinder, something that has been noticeably lacking since the adoption of BAPCPA. 

Finally, Texas Grand Prairie may spell the death of expert interest rate testimony in chapter 11 cases.   If the Debtor's expert can pull a "smallish number" out of a hat, why can't the Debtor's attorney do so without the intervention of an expert witness?   The irony of Wells Fargo's Daubert argument is that it probably was right, but not for the reason that Wells Fargo thought.   The logical extension of Till is that the fact-finder does not require "scientific, technical or other specialized knowledge . . . to understand the evidence or determine a fact in issue" as required by Fed.R.Evid. 702 so that neither side should have been allowed to tender an expert witness.   This case will probably not preclude courts from considering experts pontificating on interest rates, but it frees up the court to take it or trash it.


Post-script:   While Judge Higginbotham may not receive as much recognition as a scholar of bankruptcy law as some of his colleagues, it is worth noting that he has now authored about 50 bankruptcy opinions, which is more than some bankruptcy judges.   In addition to the opinions discussed in this post, some of his other influential opinions include Wells Fargo Bank, N.A. v. Stewart, 647 F.3d 553 (5th Cir. 2011); Milligan v. Trautman, 496 F.3d 366 (5th Cir. 2007); Supreme Beef Processors, Inc. v. USDA, 275 F.3d 432 (5th Cir. 2001); Krafsur v. Scurlock Petroleum Corp., 171 F.3d 249 (5th Cir. 1999); Miller v. J.D. Abrams, Inc., 156 F.3d 598 (5th Cir. 1998); In re Clay, 35 F.3d 190 (5th Cir. 1994); and In re Howard, 972 F.2d 639 (5th Cir. 1992).   In my view, this is sufficient to earn him a place among the leading bankruptcy lights on the court.

Fifth Circuit Affirms Ruling That "The Loan Has Been Paid!!!;" Rejects Stern and Jurisdictional Defenses

The case of a creditor who did not want to acknowledge that its debt had really and truly been paid received little sympathy from the Fifth Circuit which rejected a panoply of defenses and affirmed the Bankruptcy Court ruling that "The Senior Loan Has Been PAID!!!"   Fire Eagle, LLC v. Bischoff (Matter of Spillman Development Group, Ltd., Case No. 11-51057 (5th Cir. 2/28/13), which can be found here.   I previously wrote about the Bankruptcy Court decision from Judge Frank Monroe here.   The decision is significant because it shows that Stern v. Marshall is not a silver bullet for parties seeking to avoid bankruptcy court decisions.   As discussed below, it also rejects a magical approach to bankruptcy law.

What Happened

The case involved a golf course that filed for chapter 11, which was a common occurrence in Austin.   After the debtor and a lienholder fought to a stalemate, the Bankruptcy Court ordered a section 363 sale.   The lienholder, Fire Eagle, LLC, held two liens, a first lien which was guaranteed, and a second lien which was not.    Fire Eagle was the high bidder at the sale, making a $9.3 million credit bid, which was approximately $200,000 more than the amount of its guaranteed first lien debt.  

Rejoicing at their good fortune, the guarantors requested a declaratory judgment that their obligation had been satisfied.   Fire Eagle objected to the Bankruptcy Court's jurisdiction as well as venue.  It also contended that its credit bid reduced its "claim" but not its "debt" and that it was therefore free to continue pursuing the guarantors.    The Bankruptcy Court ruled for the guarantors.   In addition to the quoted language above, the Court told Fire Eagle that "This is the Bankruptcy Court; not fantasy land" and "This is not rocket science."    The District Court affirmed.

The Fifth Circuit Explains Jurisdiction and Authority

In the post-Stern era, it is helpful to remember that there are three separate doctrines that govern a bankruptcy court's ability to render a  final decision:

a.  Jurisdiction under section 1334;

b.  Statutory authority under section 157; and

c.  Constitutional authority under Article III of the Constitution.

Under 28 U.S.C. Sec. 1334, there is jurisdiction for "civil proceedings arising under title 11, or arising in or related to cases under title 11."   "Related to" jurisdiction, which is the broadest category, applies if the case "could conceivably have any effect on the estate being administered in bankruptcy."    While Fire Eagle correctly stated that bankruptcy courts generally cannot "entertain collateral disputes between third parties that do not involve the bankruptcy or its property," the Fifth Circuit found that if Fire Eagle were to succeed in recovering from the guarantors, this would reduce its deficiency claim which would free up more money for the other creditors.     The Court noted that "We have previously held that similar attenuated, hypothetical effects of third-party litigation can give rise to related-to bankruptcy jurisdiction."    Opinion, p. 5.

Thus, jurisdiction turns on the broad "any conceivable effect" test.   However, this is not the end of the inquiry.    Once jurisdiction is present, the question is which court has the power to exercise that jurisdiction.

Statutory authority to render a final judgment is contained in 28 U.S.C. Sec. 157(b).   If a matter is statutorily defined as a "core" proceeding the Bankruptcy Court may enter a final judgment.   Otherwise, the Court must submit proposed findings of fact and conclusions of law to the U.S. District Court absent consent of the parties.

The Fifth Circuit found that the dispute between Fire Eagle and the guarantors qualified as a core proceeding because it was "dependent upon the rights created in bankruptcy."

Because the basis for this dispute is whether Fire Eagle’s credit bid had the effect of extinguishing the Senior Indebtedness, and because the right to credit bid is purely a creature of the Bankruptcy Code, see 11 U.S.C. § 363(k), we fail to see how this proceeding does not qualify as core under § 157(b)(1) and therefore hold that the bankruptcy court’s entering an order without reference to the district court was within its statutory authority.

Opinion, pp. 6-7.

Finally, there is the matter of constitutional authority to render a final judgment.   This is the legacy of Stern v. Marshall.    Because the Court of Appeal's discussion of Stern is succinct and clear, I quote it in its entirety below:

 In Stern v. Marshall, the Supreme Court held that it was unconstitutional for a bankruptcy court to issue a judgment on a state-law counterclaim for tortious interference with a gift expectancy, despite the fact that the claim itself was statutorily “core” pursuant to § 157(b)(2)(C) (defining as core proceedings “counterclaims by the estate against persons filing claims against the estate”). 131 S. Ct. 2594, 2600–01 (2011). It based this decision on the fact that the counterclaim was in no way reliant or dependent on proceedings in bankruptcy—it just happened to have been a counterclaim to a claim asserted in a bankruptcy proceeding. Id. at 2611. Fire Eagle contends that its claims in this matter are similarly beyond the constitutional authority of the bankruptcy courts to decide.

However, Stern itself stated that its holding was reliant on the fact that the counterclaim at issue was “a state law action independent of the federal bankruptcy law and not necessarily resolvable by a ruling on the creditor’s proof of claim in bankruptcy.” Id. Fire Eagle’s claim, on the other hand, is inextricably intertwined with the interpretation of a right created by federal bankruptcy law—the interpretation of the effect of Fire Eagle’s credit bid is in fact determinative of Fire Eagle’s claim. We therefore conclude that Stern is inapplicable and that there was no constitutional bar to the bankruptcy court’s exercise of its jurisdiction over this statutorily core matter.

 Opinion, p. 7.

The Fire Eagle opinion contains a formulation that I believe will be widely used in Stern analysis, namely, that if an issue relates in some substantive manner to a creditor's claim, then the Bankruptcy Court has authority to enter a final judgment.   While this is not the full extent of authority under Stern, it is a convenient way to handle many of the disputes likely to arise.

Exploring the Zen of a Credit Bid

 There is a theory making the rounds of the creditor's bar that there is a critical distinction between a "debt" and a "claim" and that if a dispute can be phrased in terms of the "debt," that the Bankruptcy Court lacks the ability to act upon the "debt."   This theory finds its support in cases such as In re Five Boroughs Mortg. Co., Inc., 176 B.R. 708, 712 (Bankr. E.D. N.Y. 1995).  Fire Eagle made a variant of this argument, contending that the credit bid affected only the the claim in bankruptcy and not the underlying debt.   This required the Court to consider the meaning of a credit bid.   Not surprisingly, the Court of Appeals concluded that there is no functional difference between a credit bid and cash.   The Court wrote:

Fire Eagle’s first argument is logically unsound. If Fire Eagle had been outbid at the § 363(b) auction, as it nearly was, or if it had simply declined to credit bid its claims, then the cash proceeds from that auction would have been applied against the Senior Indebtedness as the most senior debt in the bankruptcy estate. If the Senior Indebtedness was paid in full with these cash proceeds, then it would be absurd to suggest that Fire Eagle could separately proceed against the guarantors. Under such a theory, Fire Eagle would be undeniably receiving recovery in excess of the face value of the Senior Indebtedness by virtue of guarantees that explicitly provide for their own termination on the payment in full of the Senior Indebtedness.

Consequently, for Fire Eagle’s argument to be correct, its credit bid must not have been equivalent to a cash payment for the assets purchased. Title 11U.S.C. § 363(k), though, provides that credit bidders “may offset [their] claim against the purchase price” of the property that is the subject of the § 363(b) bankruptcy sale. This provision explicitly contemplates mixed bids of cash and claims, implicitly presupposing an equivalence with cash of the value of the credit bid. We agree with the bankruptcy court and district court that Fire Eagle’s credit bid constituted a payment-in-full of the Senior Indebtedness, just as if SDG’s assets had been sold for cash.

Opinion, p. 10.    The Court of Appeals also rejected several other insubstantial arguments.

Conclusion

The Fifth Circuit should be commended for providing a clear road map on some difficult issues of bankruptcy law.   The Court also deserves kudos for rejecting the magical view of bankruptcy law.  I have heard apocryphal stories that when the Bankruptcy Code was in its infancy, creditors would make arguments that the automatic stay did not control over a creditor's contract rights or that the discharge was not effective without the creditor's consent.   These particular instances of wishful thinking are now in the distant past.    However, in recent years there have been a rash of cases in which unhappy parties asserted that the Bankruptcy Court simply did not have the power to do whatever it did.   The Supreme Court rejected these challenges in United Student Aid Funds, Inc. v. Espinosa, 130 S.Ct. 1367 (2010) and Travelers Indemn. co. v. Bailey, 129 S.Ct. 2195 (2009), each of which involved collateral attacks on bankruptcy court orders, but limited the Bankruptcy Court's power in Stern v. Marshall, 131 S.Ct. 2594 (2011).    The resurgence of these types of challenges requires practitioners to remain sharp in their basic bankruptcy concepts and requires courts to distinguish between serious arguments and those which are seductive but ultimately insubstantial.   In the present case, the Fifth Circuit succeeded in making this distinction.   

Two Cases Emphasize Distinct Approaches to Trustee Discretion

Trustees, like debtors-in-possession, owe a fiduciary duty to their constituents, but are protected by the business judgment rule.   Two recent cases illustrate how a trustee’s discretion can be exercised depending upon which rule is given primacy.    In  In re Tres-Ark,Inc., No. 09-12589 (Bankr. W.D. Tex. 11/21/12), which can be found here, the Bankruptcy Court denied Debtor’s Motion to Remove Trustee finding that the Trustee properly exercised his business judgment. On the other hand, In In re CNC Payroll, Inc., No. 12-33012 (Bankr. S.D. Tex. 3/4/13), the Court sua sponte issued an Order to Show Cause Why Trustee Should Not Be Removed Pursuant to 11 U.S.C. §324 based upon concerns over breach of fiduciary duty in employing the trustee’s firm as counsel.  The order can be found here (PACER registration required).

Tres-Ark and the Business Judgment Standard

In the Tres-Ark case, a chapter 7 debtor listed a counterclaim against a creditor and a possible legal malpractice claim against its former counsel in its schedules.   The only parties to file claims were Horiba, the same party against whom the debtor was asserting the counterclaim, and the Debtor’s president and his wife.    

John Patrick Lowe, the trustee, requested court permission to dismiss the counterclaim against Horriba to allow him to pursue the legal malpractice claim.   Subsequently, he sought permission to compromise the malpractice claim for $1,550,000.    Rather than being thrilled with this substantial recovery, the insiders sued the trustee for negligence and gross negligence and then filed a Motion to Remove Trustee.    

The Court noted that neither the Bankruptcy Code nor Fifth Circuit precedent set forth substantive standards for removing a trustee.    The Court noted that under the business judgment rule that a trustee would not be removed for “mistakes in judgment where the judgment is discretionary and reasonable under the circumstances” (quoting Collier on Bankruptcy) and that removal of a trustee “is as serious an action as a bankruptcy judge could possibly decide.”    

With respect to the Horriba counterclaim, the Debtor complained that the trustee had dismissed the counterclaim “with prejudice” when he had merely requested permission to dismiss it without specifying whether it would or would not be with prejudice and that he had undervalued the counterclaim.   The Court rejected these contentions, stating:

Put simply, this boils down to a difference of opinion in how Trustee should proceed with the administration of the estate.   Such scenarios do not place a trustee’s status as a disinterested person in jeopardy.  The fact that Debtor, or some of the estate’s creditors, want the Trustee to take different action is not cause for removal.

 Opinion at 10.

The Debtor also sought to remove the trustee on the ground that the trustee’s relationship with the Debtor had grown acrimonious, minimizing the likelihood for cooperation.   In the typical case, it is common for the Debtor and the trustee to have a testy relationship since the trustee may often pursue avenues the Debtor would prefer to leave unexamined.   However, in this case, the Debtor’s insiders were also some of the principal creditors.   The Court noted that the case cited by the Debtor did not appear to support a “continuing animosity” standard for removal, but noted that the Debtor had failed to establish this ground as a factual matter.

Finally, the Debtor argued that the trustee was no longer disinterested because the Debtor had commenced an adversary proceeding against him and because he had retained counsel to defend himself.   The Court dismissed each of these concerns, stating that:

If filing an adversary proceeding constituted cause, any creditor unhappy with the administration of the estate would simply file an adversary proceeding against Trustee and then come to the court seeking the trustee’s removal.  

 ***

 Debtor should have reasonably understood that its decision to file a claim against Trustee, whether to preserve the statute of limitations or otherwise, would require Trustee to seek legal counsel to defend himself.

 Opinion, pp. 12, 13.

CNC Payroll and the Fiduciary Duty Standard

Less comforting to the Trustee was the Court’s Order to Show Cause Why Trustee Should Not Be Removed in CNC Payroll.   That case involved W. Steve Smith, “a chapter 7 panel trustee in this District with a long history of commendable service.”   Order, p. 1.    Trustee Smith sought to employ his own firm as general counsel in the case.    The application disclosed that the estate was holding cash of $219,523, but stated that only the trustee’s firm or other firms used to representing trustees would be “willing or able to perform services ‘betting on the come,’ even with a significant contingent fee factor.”    

Although no party objected, the Court required the Trustee to supplement his application to “detail the efforts undertaken by the Trustee to find alternative counsel.”    As the Court subsequently stated in its Order to Show Cause:

(T)rustees must demonstrate more than the competence of their own firms.   Trustees must demonstrate that retention of their own firm is better than any available alternative.

Order to Show Cause, p. 2.

On December 18, 2012, the Trustee sent letters to 31 firms offering to let them be considered for employment.   The letter requested a response by December 31, 2012.  The letter requested that firms applying for employment provide extensive information as to their experience and plans for proceeding with the case.    The letter also contained disclosures as to the unpleasantness of representing a trustee, including that payment of fees would be subject to court approval and that the Court “mandates that counsel provide an ‘identifiable, tangible and material benefit’ to the estate in order to be compensated.”     No firm timely responded to the trustee’s solicitation.

After conducting a hearing on February 11, 2013, the Court issued its Show Cause Order.  It was concerned that the Trustee did not seek other counsel prior to the Court’s December 14 letter and that the December 18 letter effectively gave interested attorneys only three business days in which to reply.     The Court also expressed concern that the Trustee did not directly contact attorneys he knew because he did not wish to be accused of “cronyism” and did not respond to late requests from other firms because he did not personally know the attorneys.    As stated by the Court:

In essence, Smith would not directly contact people he knew and refused to consider people he did not know.   These decisions appear calculated to preordain the selection of Smith’s law firm, in which he has a personal financial interest.

 Accordingly, the court requires Smith to demonstrate that the December 18, 2012 letter was not a breach of his fiduciary duty to the Estate.

Order to Show Cause, p. 5.  

Comparing the Two Decisions

Serving as a trustee is often a thankless job.    Pro se debtors sometimes accuse trustees of participating in elaborate conspiracies while disgruntled creditors may write letters of complaint to the U.S. Trustee.    Trustees must sift through hundreds for no-asset cases for the princely sum of $60.00 per case while looking for a case that can result in a distribution to creditors.  Because trustees have such an important but undesirable job, Courts typically give them the benefit of the doubt, as illustrated by the Tres-Ark case.  

The fiduciary duty standard articulated by CNC Payroll, Inc., and the prior decision that it relied, upon, In re Interamericas, Ltd., 321 B.R. 830 (Bankr. S.D. Tex. 2005), give short shrift to the trustee’s exercise of business judgment.   It seems inconsistent to this author to say that trustees should ordinarily be allowed to make a decision within the range of reasonable choices in all matters except for employment of counsel, in which the trustee must make a choice that is “better than any available alternative.”    The Court acknowledged the business judgment rule in a footnote, but overruled it as a practical matter.   If the Court had relied on a business judgment standard instead of the breach of fiduciary duty rubric it invoked, then the trustee would have been protected so long as he engaged a firm that was up to the task.

Having staked out that position, I will note two caveats:

First, Judge Isgur’s approach is in my own personal pecuniary interest.  My firm does not employ a trustee.   However, we have done a substantial amount of trustee work over the years.   A rule that trustees must ordinarily look beyond their own firms for counsel would benefit me personally.   In fact, I plan to submit my resume to Trustee Smith.

Second, Judge Isgur’s concern about trustees being too willing to engage their own firms as counsel echoes the debate in Congress while the Bankruptcy Code was being formulated about breaking up the “bankruptcy ring.”   As stated by one early case:

Throughout the entire time that the Bankruptcy Reform Act of 1978 was being debated and drafted, Congress was concerned with a phenomenon known as the "bankruptcy ring." Basically, this was a pre-Reform Act situation where the creditors could select a Trustee who, in turn, would select a counsel favorable to both the Trustee and creditors.  "Where creditors do vote for a trustee, it is frequently only because law firms solicit such votes as a means of obtaining the business which will be supplied by this trustee." Report  of the Commission on the Bankruptcy Laws of the United States (July 1973) as reported in Appendix 2 Collier on Bankruptcy 4 (15th ed.).  "Persons practicing in the bankruptcy field tended to confine their activities exclusively to that area . . . .  Therefore, a relatively small group of lawyers controlled the bankruptcy field.  Those not within this group tended to regard them with suspicion and distrust." Id. at 93.  "The creditors' attorneys exact their influence to elect friendly trustees or committees in order to pluck the plum of counsel to the trustee or counsel for the committee . . . This creates the so-called bankruptcy ring with all the implications that might fall from that connotation." H.R. Debates (Oct. 27, 1977) as reported in Appendix 3 Collier on Bankruptcy IV-18 (15th ed.).

 In re Allard, 20 B.R. 902, 905 (Bankr. E.D. Mich. 1982), rev’d, 23 B.R. 517 (E.D. Mich. 1982).

In the Allard case, the Bankruptcy Court’s solution was for the Court to appoint counsel for the trustee.   That ruling was promptly reversed by the District Court.    Similarly, in this case, while Judge Isgur’s concern about a modern-day bankruptcy ring (my words) may have some validity, the solution is not for the Court to micromanage employment of counsel by the trustee.    

Debtors-in-Possession, as well as Committees sometimes (often?) do not employ the best-qualified attorney.    However, the Court does not step in to ensure that they engaged in a public solicitation process.    Section 327(a) states that:

(T)he trustee, with the court’s approval,  may employ one or more . . . professional persons that do not hold or represent an interest adverse to the estate, and that are disinterested persons . . . .

 While the statute requires the Court’s approval, the only stated standards for employment of professionals are: 1)  that they not hold or represent an interest adverse to the estate and 2) that they are disinterested persons.    While some minimum standard is probably implied (for example, the trustee should not be allowed to engage a disbarred attorney currently residing in the penitentiary), the statute does not expressly require any Code-created fiduciary to employ the best qualified professional.   By the same token, I  don’t believe that there is anything other than the Court’s self-interest which requires it to hire the best qualified law clerk (although I am willing to be proven wrong on this point).   

On the other hand, section 330 does allow the Court to consider the abilities of counsel when awarding fees.    

When Congress adopted the present structure of the Bankruptcy Code, it reduced the Court’s role in the administration of Bankruptcy cases.    For example, Bankruptcy Judges no longer preside over creditor’s meetings and the U.S. Trustee appoints trustees and examiners.   The Order to Show Cause in CNC Payroll, Inc. appears to reflect a desire by the Court to take a more active role in the day to day administration of cases.   While there may be benefits from such an approach, it raises concerns as well.