Friday, February 27, 2015

Energy Resources Remains Viable for Allocation of Tax Payments

Twenty-five years ago, the Supreme Court held that a Bankruptcy Court had the authority to order the IRS to allocate payments made "voluntarily" by a Debtor when necessary to effectuate a successful reorganization.    United States v. Energy Resources Co., 495 U.S. 545 (1990).   Left to its own devices, the IRS will generally allocate payments to the oldest taxes first, or, in the case of payroll taxes, to non-trust funds taxes first.   If the Debtor can require the IRS to allocate payments differently, it can greatly impact the overall amount the Debtor will be required to pay.   A recent decision out of Fort Worth illustrates how Energy Resources continues to provide a valuable tool for Debtors with tax obligations.    In re Fielding, 522 B.R. 888 (Bankr. N.D. Tex. 2014).  

Fielding was a chapter 13 case where the Debtors owed $539,885.26 to the IRS.    The debt was secured by a lien against all of the Debtors' real and personal property.    The Debtors filed a motion to sell their homestead.   After paying superior obligations, there was approximately $128,000 available to pay on the IRS claim.    The Debtors sought to apply the payment to the base tax amounts but not to interest or penalty.    The IRS, on the other hand, wanted to apply the payments to the oldest taxes first, including penalties and interest.    This could have resulted in paying priority and unsecured claims prior to secured claims.   

The IRS argued that it could not be compelled to allocate the proceeds and that payments from a bankruptcy sale were not "voluntary" payments which could be designated by the taxpayer.    The Court held that Energy Resources could be applied in a chapter 13 case.    In doing so, it noted that other courts and commentators had been hesitant to limit the case to its facts.    (One of the authorities it cited was a law review article that I wrote).    

However, having found that the designation doctrine could be applied to a chapter 13 case, the Court raised the issue of whether it could be done in the absence of a confirmed plan.   The Court noted that:
(J)ust as a debtor in a chapter 11 case must make payments in accordance with its chapter 11 plan upon confirmation, a chapter 13 debtor must make payments in accordance with its proposed plan even prior to confirmation.
Opinion at *15.   Based on this distinction between chapter 11 and chapter 13, the court found that payments could be designated in chapter 13 even prior to confirmation.

Next, the court found that the designation was necessary to effectuate the reorganization.   The Court stated:
In the case at bar, to achieve success through the reorganization, Debtors must be capable of complying with Amended Plan provisions.   To do so, Debtors rely on the sale of assets to reduce the debt owed to the IRS.   If the IRS is permitted to apply the Proceeds to unsecured or priority portions of the debt as requested, then the lien held by the IRS for the secured claim would continue to attach to Debtors' property.   thus, any reduction in the IRS secured claim would not sufficiently correspond with the assets being sold.  Debtors would also continue to incur the interest and penalties on the unpaid, secured portion of the debt, further decreasing the plan's feasibility.
Opinion, at *18.

 Finally, the Court rejected the IRS's argument that payments made in bankruptcy proceedings could never be considered to be voluntary.   It noted that the Supreme Court rejected this position in Energy Resources and there was no basis for limiting the case to its facts.   The Court found that chapter 13 itself was a voluntary process and that the case involved the voluntary sale of exempt property.   As a result, the Court found that the payment was voluntary and could be designated by the Debtors.

The Court's 28-page opinion is very thorough which makes at times for difficult reading.  It has a lot of good discussion of bankruptcy policy in general and chapter 13 in particular.  The main lessons that I picked up are that:   1) it is possible to use chapter 13 creatively and 2) it pays to dust off old precedents you haven't thought about in a while.   

Sunday, February 22, 2015

Exemptions Continue to Feel Frost's Bite

The rift in the bankruptcy universe created by Viegelahn v. Frost (Matter of Frost), 744 F.3d 384 (5th Cir. 2014) continues to widen, drawing more exemptions into its vortex in seeming disregard of Supreme Court precedent.   The latest opinion to come down is  In re Hawk, 2015 Bankr. LEXIS 309 (Bankr. S.D. Tex. 1/30/15) which holds that the Debtor in a chapter 7 proceeding forfeited his IRA exemption when he liquidated the account after the deadline to object had expired.   

The Debtors filed their chapter 7 proceeding on December 15, 2013.   On this date, they held an IRA in the amount of $164,902.   Over the period from December 11, 2013 to July 14, 2014, the Debtors withdrew the funds from the IRA. The Trustee filed a no asset report on April 3, 2014.  The deadline to object to exemptions expired on April 28, 2014.  No party filed an objection.

A creditor objected to the Debtors' discharge.   At a deposition on November 18, 2014, the creditor learned of the liquidated IRA in a deposition.   The Trustee then made demand for the Debtors to turn over the IRA proceeds because they had not been reinvested within sixty days.   The Trustee then filed a motion for turnover of the funds.

The Bankruptcy Court granted the Trustee's motion for turnover, finding that the failure to file a timely objection was not material.   The Court stated:
(T)he Court finds that the pertinent threshold question is whether property deemed exempt under state law loses its statutory protection at any point during the pendency of a Chapter 7 case. Here, the Liquidated IRA Funds lost their exempt status under state law while the Debtors' bankruptcy case was open. Once the Liquidated IRA Funds became non-exempt, the Funds automatically became property of the estate and the Chapter 7 Trustee was immediately entitled to them.
Opinion, at *9.    The Court emphasized the Fifth Circuit's language in Frost that

a change in the character of the property that eliminates an element required for the exemption voids the exemption, even if the bankruptcy proceedings have already begun.

Frost at 388.   The Court found that it was significant that the IRA exemption under the Texas Property Code included a provision allowing proceeds to retain their exempt character if reinvested within sixty days.   As explained by the Court:
(A)pplication of the 60-day rule here is merely applying the entire IRA exemption statute and should not turn on whether a party in interest lodged an objection to the claimed IRA exemption In fact, the imposition of an objection condition when applying either the Texas homestead or IRA exemption statute would violate state law. There is no objection requirement in either sections 41.001 or 42.0021. Construing an extratextual objection requirement would preclude application of the reinvestment provisions--thereby contravening the intent of the Texas legislature.  (emphasis added).
Opinion, at *20-21.   Thus, according to the Court, in order to give effect to the intent of the Texas legislature, proceeds from an IRA must be timely reinvested to retain their exempt status.

While the Court may be correct as to the intent of the Texas legislature, why is this relevant?   Exemptions in bankruptcy are a matter of federal law.  When a Debtor claims exemptions under Texas law, he does so as a matter of federal law.    In re Dyke, 943 F.2d 1435 (5th Cir. 1991).  Federal bankruptcy law very definitely does contain an objection requirement.  Under bankruptcy law, any property claimed by the Debtor as exempt leaves the estate absent a timely objection.   According to this term's opinion in Law v. Siegel, 134 S.Ct. 1188 (2014), "a trustee's failure to make a timely objection prevents him from challenging an exemption."   Under the previous Supreme Court opinion in Taylor v. Freeland & Kronz, 503 U.S. 638 (1992), a clearly invalid claim of exemption could not be challenged once the objection period had passed.    According to the Court:
We reject Taylor's argument. Davis claimed the lawsuit proceeds as exempt on a list filed with the Bankruptcy Court. Section 522(l), to repeat, says that "unless a party in interest objects, the property claimed as exempt on such list is exempt." Rule 4003(b) gives the trustee and creditors 30 days from the initial creditors' meeting to object. By negative implication, the Rule indicates that creditors may not object after 30 days "unless, within such period, further time is granted by the court." The Bankruptcy Court did not extend the 30-day period. Section 522(l) therefore has made the property exempt. Taylor cannot contest the exemption at this time whether or not Davis had a colorable statutory basis for claiming it.
 Taylor, at 643-44. 

There seems to be a clear conflict here.   The Supreme Court has stated that once property becomes exempt, it remains exempt.   It has now said this for over twenty years.   However, under Frost, as interpreted by Judge Bohm, property must retain its exempt character at all times during the pendency of the case or be subject to turnover.    It does not seem possible to reconcile the Supreme Court opinions in Taylor and Law with Frost and Hawk.  If property could be claimed by the trustee at any time that it lost its exempt character, then property which was never exempt could be challenged at any time.    However, the Supreme Court expressly rejected that proposition.   To reiterate, if we protect property claimed as exempt with no colorable basis, as the Supreme Court did in Taylor, how can we fail to protect property which was legitimately exempt on the date of filing?

With any luck, this issue will eventually make its way back to the Fifth Circuit, or if necessary, the Supreme Court.   Until then, the watchword is debtors beware:  your exemptions are less secure than you might think.

Hat tip to Steve Roberts.

Thursday, February 19, 2015

Recovering Attorneys' Fees in Dischargeability Litigation

A new opinion from Judge Tony Davis answers some interesting questions about recovery of attorneys' fees in dischargeability litigation.   Schwertner Backhoe Services, Inc. v. Kirk (In re Kirk), Adv. No. 11-1239 (Bankr. W.D. Tex. 1/28/15), which can be found here.    The Court concluded that a prevailing plaintiff could recover attorneys' fees allowable under state law but could not recover for litigating pure issues of dischargeability.   

The case involved a dischargeability complaint brought under 11 U.S.C. Sec. 523(a)(4) based on the Texas Construction Trust Fund Act.   The Debtor owned a homebuilding company which did not pay one of its subcontractors.   The Debtor's answer was ambiguous as to whether the creditor's underlying debt was owed.   However, when the Debtor's deposition was taken, about two years into the litigation, the Debtor acknowledged that the debt was owed.   Prior to trial, the Debtor stipulated that the underlying debt was non-dischargeable but disputed that the creditor could recover attorneys' fees.

The Court reached several conclusions.   First, it concluded that if a debt includes pre-petition attorneys' fees and is determined to be non-dischargeable, the attorneys' fees are part of the non-dischargeable debt.   Second, the Court concluded that "(s)ince the Bankruptcy Code does not address whether creditors can recover attorney’s fees in nondischargeability cases, they can only do so if allowed by another statute or by contract."    Opinion, p. 6.    
The Court clarified that the recovery of attorneys' fees depended on the specific language of the contract or statute.   In discussing prior Texas bankruptcy cases, the Court noted that where a contractual debt was determined to be non-dischargeable based on fraud, the attorneys' fees were not included in the non-dischargeable debt.   On the other hand, where the contract allowed recovery of fees for "all costs of collection and enforcement," the cost of prosecuting the non-dischargeability action "contributed directly" to the effort to collect and enforce the notes.  

In the specific case, the Court concluded that the Texas Construction Trust Fund Act did not allow for recovery of attorney's fees.   In doing so, the Court was required to choose between competing lines of state court precedent.    However, it did find that under the Texas Civil Practices and Remedies Code, fees could be imposed for fees incurred in establishing the liability for labor and materials provided.    As a result, the Court concluded that the creditor could recover reasonable attorneys' fees for amounts incurred prior to the Debtor's admission that his company was liable for the underlying debt but not afterwards.  

The Court explained:
(F)ees cannot be awarded for litigating defalcation in this case because doing so is essentially the same as establishing Kirk’s liability under the Texas Construction Trust Fund Act; both determinations are predicated on the same facts – that Kirk was a fiduciary, and that he failed to handle funds properly. Put another way, this aspect of what Schwertner Backhoe had to prove is an action for which the Texas legislature has not shifted fees. Cohen renders properly awarded fees nondischargeable; it does not provide an independent basis for awarding fees.
Opinion, p. 14.    As a result, the Court awarded the creditor approximately half of the attorneys' fees that it requested.

The practice point here is that the Debtor should be cautious about disputing liability on the underlying claim asserted in the dischargeability action.    If the Debtor had admitted liability for the underlying debt from the beginning, the creditor could not have recovered its attorneys' fees.

Note:  This is a case which I took over from another attorney.   However, I can't sure that I would have caught the importance of admitting liability on the underlying debt if I had represented the Debtor from the outset.   

Tuesday, February 17, 2015

Fifth Circuit Report: December-January Edition

The Fifth Circuit decided five bankruptcy cases over the past two months.  They include cases where the effort to recite the facts exceeded the importance of the decision, cases about the effect of summary judgments granted, denied and reversed and a footnote about Florida strip clubs.

United States v. Stanley, No. 13-60704 (5th Cir. 12/12/14).    This case concerns dischargeability of taxes.   Stanley filed for bankruptcy in 2009.   He owed taxes for the years 1998-2008 at the time.   In 2011, the government filed suit to reduce to judgment the tax claims.     The District Court granted summary judgment in favor of the government for years 2005-2008 because they came due in the three years prior to bankruptcy and years 2009-2010 because they were post-petition years.   Despite trial testimony that he suffered from bipolar disorder, the District Court ultimately found that Stanley had "willfully" failed to pay his taxes and that they were not discharged.  

The Court of Appeals noted that section 523(a)(1)(C) has both a conduct requirement and a mental state requirement.   There was no dispute that the Debtor met the conduct standard.   The mental state was based on a three part test that the debtor  (1) had a duty to pay taxes under the law (which basically duplicates the conduct requirement), (2) that he knew that he had a duty and (3) that he voluntarily and intentionally violated that duty.      The Fifth Circuit affirmed the District Court finding that:
In light of Stanley’s demonstrated ability to continue his medical practice, tend to many of his other financial obligations, and participate in complex financial transactions, compounded by the length of time at issue (over a decade) and evidence that Stanley would have had periods when he exhibited no symptoms of bipolar disorder during this span, the district court did not clearly err when it concluded that Stanley voluntarily and intentionally attempted to evade his tax obligations. We therefore uphold the district court’s finding that Stanley willfully attempted to evade his federal income taxes.
Opinion, p. 10.

Isbell v. DM Records, Inc. (Matter of Isbell Records, Inc.), No. 13-40878 (5th Cir. 12/18/14).   In this opinion, we learn that the song "Whoomp (There It Is)" was based on a chant when women disrobed in Florida strip clubs in the 1990s.  (It's in a footnote so it must be true).    We also learn that for half of the song's existence, the parties have been litigating over who owns the composition rights.    

The writers entered into a Recording Agreement with Isbell Records, Inc. d/b/a Bellmark Records which provided that 50% of the composition rights would go to Bellmark's publishing affiliate.   Bellmark filed bankruptcy and in 1997, its trustee sold all of its assets to DM Records.  DM exploited the copyright to Whoomp.   However, it turns out that the president of Bellmark, Albertis Isbell, had his own music publishing company, Alvert Music and he thought that it owned the rights rather than DM..    In 2002, Isbell filed suit against DM.    The District Court dismissed finding that Isbell had assigned his rights to someone else.   However, the Fifth Circuit reversed and remanded and the case finally went to trial in 2012.    The District Court ruled as a matter of law that Isbell owned the rights.  The jury awarded actual damages of $2.1 million.  The Fifth Circuit affirmed.   The opinion deals with a number of technical arguments about the trial itself which have nothing to do with bankruptcy.

The important take away here is that a sale free and clear of liens only conveys what the Debtor owned.    It will not create title where none existed.        

Ferguson v. Baron (Matter of Baron), No. 14-10092 (5th Cir. 12/22/14)(unpublished).   This case concerned procedural complications arising from an involuntary proceeding brought against an individual by various attorneys who he had hired and fired but did not pay.   This is unfortunately a case where the courts created confusion for the litigants.

As mentioned above, Baron hired multiple lawyers for one of his companies.  The District Court ordered a receivership over Baron and his companies.   It also conducted a hearing on the amount of fees owed to the various law firms and concluded that $879,000 was owed.  Baron appealed both orders to the Fifth Circuit.   The Fifth Circuit reversed the receivership order but did not address the order determining the amount of the fees.    Indeed, the Fifth Circuit said that the other orders of the District Court were not affected.

On the same  day that the reversal came down, the lawyers filed an involuntary bankruptcy petition.  The Bankruptcy Court granted partial summary judgment that the creditors held undisputed claims based on the fee order.   It then held a trial and concluded that the Debtor was not generally paying his debts as they came due.  The District Court reversed, concluding that the Fifth Circuit's order dissolving the receivership meant that the fee order was also no good. The District Court also concluded that there was at least some bona fide dispute as to the amount of the fees. The District Court remanded the case to the Bankruptcy Court with orders to dismiss. This was a problem for the attorneys because they had never had the chance to prove up their claims in Bankruptcy Court because they had been granted summary judgment.

The Fifth Circuit reversed the District Court's dismissal of the involuntary petition.   It did so based on the fact that the Debtor and the attorneys had expressly stipulated that if the summary judgment was denied, they would still be entitled to a hearing to prove up whether their claims were subject to a bona fide dispute.   However, the Court could have ruled on another equally important ground.  When a Court denies summary judgment, it does not automatically mean that the other side is entitled to relief.  It simply means that there is an issue for trial.   Here, the fact that there was a dispute about whether there was a dispute did not mean that the creditors held disputed claims and were ineligible to file the involuntary.  It simply meant that their status had yet to be determined.  

Thompson v. Deutsche Bank National Trust Company, No. 14-10084 (5th Cir. 12/29/14).    While this is not a bankruptcy case, it relates to Texas Home Equity loans, a subject which often arises in bankruptcy cases. The Thompson obtained a home equity loan from Option One in 2006.  They sued Deutsche Bank in state court and obtained a default judgment.    Deutsche Bank contended that it had never been properly served and removed the case to federal court.   The U.S. District Court set aside the default judgment and dismissed the suit on the basis that the Thompsons were required to bring their suit within four years after the loan was made, which would have been in 2010.   The Fifth Circuit affirmed based on prior precedent that suits based on constitutional infirmities in Texas Home Equity loans must be brought within four years from when the loan was made.   This ruling and the prior case which it follows mean that infirm home equity loans will be purified four years after they are made.   Since many borrowers will not examine their paperwork and discover problems until years later when problems arise, they will lose the benefits that the legislature (and the voters) intended to provide them with.   This problem can be solved by the Texas legislature enacting a discovery rule provision.

Trang v. Taylor, Bean & Whitaker Mortgage, No. 14-50281 (5th Cir. 1/7/15)(unpublished).    Debtor sued to block a foreclosure.   The lender removed to District Court and moved for dismissal.   The District Court denied a motion for remand and dismissed the suit.     

On appeal, the Fifth Circuit found that the District Court properly denied the motion to remand.   Even though the law firm, Barrett, Daffin, Frappier & Engel, LLP, was a Texas resident, the complaint did not allege sufficient facts against the firm.   Therefore, they were improperly joined and did not factor into the diversity equation.

 The Debtor made the novel argument that because the lender had filed its own bankruptcy proceeding and had not assumed the deed of trust as an executory contract, that the deed of trust was rejected and therefore could not be assigned to a new holder.   The Court ruled that even if the deed of trust was an executory contract (which it said was "highly contestable"), rejection did not render the deed of trust unenforceable.

TCI Courtyard, Incorporated v. Wells Fargo Bank, N.A. (Matter of TCI Courtyard Incorporated), No. 14-10635 (5th Cir. 1/22/15)(unpublished).    This is a case where the feasibility of Debtor's plan depended upon how interest was calculated.   The note provided that after default, accrued interest would be added to the balance of the note.   The Fifth Circuit affirmed the conclusion that this meant that post-default interest was compounded.    Because the plan was infeasible based upon calculation of the debt, confirmation was denied and the case was dismissed.

Ratliff Ready-Mix, LP v. Pledger (Matter of Pledger), No. 14-50023 (5th Cir. 1/23/15)(unpublished). This case involves the rare situation where a debtor prevailed on a dischargeability complaint based on the Texas Construction Trust Fund Act.   Barry Joe Pledger had a construction company.   It was paid for three construction projects but did not pay its concrete subcontractor.   When Pledger filed for chapter 7 bankruptcy, Ratliff Ready-Mix filed a non-dischargeability action under section 523(a)(4).    Both parties filed for summary judgment asserting that there were no material disputed facts.   The Bankruptcy Court granted summary judgment for the Plaintiff.  On Motion for Reconsideration, the Court reversed the ruling for the Plaintiffs and entered summary judgment for the Defendant.   Among other things, the Bankruptcy Court found that the Plaintiffs must “adduce some evidence that funds were misapplied under the test.” I

The Fifth Circuit affirmed the Bankruptcy Court's ruling in favor of the Debtor.   Even though the Debtor's company was paid in full but didn't pay Ratliff, this was not enough to ensure victory for the creditor.   The critical factor was whether a contractor that uses Construction Trust Funds to pay general overhead expenses instead of subcontractor bills has violated the trust.   The Fifth Circuit ruled that under prior precedent, the answer was no.  As a result, the Debtor was entitled to a take nothing judgment.