Monday, June 25, 2018

Fifth Circuit Report: First Quarter 2018

Bankruptcy Cases

            During the first quarter of 2018, the Fifth Circuit’s bankruptcy opinions gave a break for Chapter 7 trustees on their fees, resolved important issues on exemptions and explored the interplay between valuation and the elusive Section 1111(b) election among others.

Trustee’s Compensation; Appellate Procedure (Section 326)

LeJeune v. JFK Capital Holdings, LLC (In re JFK Capital Holdings, LLC), 880 F.3d 747 (5th Cir. 1/26/18)

A trustee sought compensation under 11 U.S.C. §326.   Although no objection was filed, the bankruptcy court substantially reduced the trustee’s commission.   The district court reversed and remanded because the bankruptcy court had failed to give a reason for its action.   The trustee argued that certain creditors in another bankruptcy estate lacked standing to participate in the appeal.    The Fifth Circuit found that because those creditors had claimed an interest in the estate at issue, they had standing to participate in the appeal.   The Court of Appeals then found that the statutory formula under11 U.S.C. §326 was not only the maximum for trustee compensation but was also “a baseline presumption for reasonableness in each case.”  
Sale Free and Clear of Interest of a Co-Owner; Claims (Sections 363(h) and 502)

UTSA Apartments, LLC v. UTSA Apartments 8, LLC (In re UTSA Apartments 8, LLC), 886 F.3d 473 (5th Cir. 3/27/18)

A student housing complex was owned by multiple tenants-in-common.   The tenants-in-common had multiple disagreements with Woodlark, the management company for the complex.  Some but not all of the tenants-in-common filed bankruptcy.    While the bankruptcy was pending, several non-bankrupt co-tenants assigned their interests to UTSA, an affiliate of the management company.    The property was sold free and clear of the interests of the co-owners pursuant to 11 U.S.C. Sec. 363(h).  

The debtor co-tenants objected to paying the affiliate of the management company based on the interests that were assigned to it post-petition.  Instead, they sought to limit the affiliate to the interest it owned on the petition date and to award the interests that were transferred to it to the co-tenants who had filed bankruptcy.     The Bankruptcy Court agreed and reduced the interest of UTSA from 21.17% to 3.14%.

The Debtors also sued Woodlark for breach of fiduciary duty.   The Court found breach of fiduciary duty but did not find any specific damages.   Instead, it denied the portion of Woodlark’s claim for deferred management fees based on Texas law allowing for fee forfeiture in a case of insider dealings.   However, it affirmed the portion of the claim relating to funds advanced to the project.

On appeal, the debtor co-tenants argued that the share attributable to UTSA, the affiliate of the management company, could be reduced as an “equitable remedy” for Woodlark’s breaches of fiduciary duty.  However, UTSA was never sued.   The Fifth Circuit found that the Bankruptcy Court could not reduce the share of proceeds payable to a non-debtor party who had not been sued.   

The Fifth Circuit affirmed the reduction in the proof of claim based on breach of fiduciary duty.
Disclosure:   I represented Woodlark and UTSA in the Bankruptcy Court and subsequent appeals.   There is a motion for rehearing still pending.

Valuation/Section 1111(b) Election (Sections 506 and 1111)

Houston Sportsnet Finance, LLC v. Houston Astros, LLC (Matter of Houston Regional Sports Network, LP),  886 F.3d 523 (5th Cir. 3/29/18)

The Houston Astros and the Houston Rockets formed a television network (the Network) to televise their games.   The Network entered into an agreement with the Teams granting them the exclusive rights to broadcast their games.  It also entered into an Affiliation Agreement with Comcast to carry the Network on its cable systems in return for a fee.  An affiliate of Comcast  loaned the Network $100 million secured by tangible and intangible assets.  

After the Network defaulted on its payments to the Astros, the Astros threatened to terminate their agreement.   This would have jeopardized Comcast which would not have been able to broadcast the games.   Various Comcast entities filed an involuntary petition against the Network.  

The Network reached an agreement with AT&T and DirecTV for those entities to acquire its equity and to enter into separate agreements to pay the Network to broadcast its content.   In connection with this deal, the Teams agreed to waive $107 million in media-rights fees which had accrued during the bankruptcy.

Comcast made an 1111(b) election to have its claim treated as fully secured.   The election did not apply to the Network’s tangible assets because those assets were to be sold and the 1111(b) election does not apply in the context of a sale.   The Bankruptcy Court valued the Affiliation Agreement with Comcast as of the petition date.  As of the petition date, the Court concluded that the value of the Affiliation Agreement was less than the amount of the media-rights fees to be paid by the Network.  As a result, the Court valued the Affiliation Agreement at $0.   Because an 1111(b) election cannot be made with regard to property which is of inconsequential value, the Court denied the election.

On appeal, the Fifth Circuit evaluated whether the collateral should have been valued as of the petition date or as of the effective date of the plan.   It stated:

We conclude that a court is not required to use either the petition date or the effective date. Courts have the flexibility to select the valuation date so long as the bankruptcy court takes into account the purpose of the valuation and the proposed use or disposition of the collateral at issue.
Because the proposed use was under the plan, the Affiliation Agreement should have been valued based on that use.   Because the Teams had agreed to waive the media rights fees, the Fifth Circuit found that it was error to deduct them from the value of the collateral.  The Court stated:

Therefore, the value of the Agreement in the reorganized debtor’s hands is unaffected by these waived fees. Subtracting those costs from the value of Comcast’s collateral would value the Agreement in light of a hypothetical disposition of the property—i.e. liquidation—that will not occur.
As a result, the Court remanded for a new valuation.   

It is important to note that this result is unique to a Chapter 9, 11 or 12 proceeding.   In 2005, Congress amended Section 506 to state that valuation in Chapter 7 and 13 cases should be made as of the petition date based on replacement value.

Exemptions (Section 522)

Lowe v. DeBerry (In re DeBerry), 864 F.3d 526 (5th Cir. 3/7/18)

A debtor filed chapter 7 and claimed a Texas homestead as exempt.  No party objected.  While the case was still open, the debtor sold the homestead and used the proceeds to hire a criminal attorney among other items.   The trustee then sued to recover the proceeds on the basis that failure to re-invest them in another Texas homestead within six months caused the exemption to lapse.   The bankruptcy court denied the trustee’s motion but the district court reversed.

The Fifth Circuit ruled that property claimed as exempt in a chapter 7 case could not re-enter the estate based on subsequent events.   The Court distinguished its prior precedent in Frost as being limited to the chapter 13 context.

Peake v. Ayobami (In re Ayobami), 879 F.3d 152 (5th Cir. 1/3/18)

A chapter 13 debtor sought to exempt 100% of the value of an asset up to the applicable limit under the federal exemptions.   Following several rounds of objections to exemptions, the bankruptcy court certified a question to the Fifth Circuit as follows:  “May a debtor claiming federal exemptions under §522 of the Bankruptcy Code ever exempt a 100% interest in an asset?”   The Court’s answer was yes.   Where the value of the asset, taken together with other exemptions in the same category, is below the statutory cap, the debtor may properly exempt 100% of the value of the asset.  However, the Court declined to address whether exempting 100% of the value would be the same as exempting the asset itself.    

Sanctions; Appellate Procedure

Kenneth Michael Wright, LLC v. Kite Bros., LLC (In re Kite), 710 Fed. Appx. 628 (5th Cir. 1/12/18)(unpublished)

A creditor filed an untimely appeal to the U.S. District Court.   The District Court dismissed the appeal and awarded sanctions.   The creditor appealed to the Fifth Circuit and the appellees again asked for sanctions.

On appeal, the appellant argued that the time limit of Rule 8002 to file a notice of appeal was not jurisdictional.    The Fifth Circuit said that “an appeal is frivolous if the result is obvious or the arguments of error are wholly without merit and the appeal is taken 'in the face of clear, unambiguous, dispositive holdings of this and other appellate courts.”   The Court noted that a deadline is jurisdictional if it is mandated by Congress.   Because 28 U.S.C. §158(c)(2) specifically adopts the time limit set forth in Fed.R.Bankr.P. 8002, the deadline was jurisdictional and the argument that it was not was frivolous.    The Court awarded nominal damages of $1 and double costs.  


Mandel v. Thrasher (Matter of Mandel), 720 Fed.Appx. 186 (5th Cir. 2/15/18) (unpublished)

A debtor misappropriated trade secrets.   The bankruptcy court awarded $1 million to the inventor and $400,000 to the company’s chief creative officer.   In the first appeal, the Fifth Circuit affirmed the liability finding but remanded for a new hearing on damages.   On remand, the bankruptcy court awarded the same damages.   

The Fifth Circuit quoted its prior opinion that damages for theft of trade secrets could be based on:

the value of plaintiff's lost profits; the defendant's actual profits from the use of the secret, the value that a reasonably prudent investor would have paid for the trade secret; the development costs the defendant avoided incurring through misappropriation; and a reasonable royalty.
The Fifth Circuit affirmed the damages awards from the lower courts.   

Judge Jennifer Walker Elrod dissented.    She said, “Our caselaw cannot be bent to support the award of unproven damages.”    She explained that in the first instance, the bankruptcy judge had rejected all of the damage models offered and then awarded damages without stating what model it did use.   On remand, the bankruptcy court awarded damages on a model it had previously rejected—the lost asset theory.   She faulted the bankruptcy court for accepting a valuation based on a range of values of successful companies without considering the risk of failure.   She concluded:

Valuing intellectual property is hard, and the misappropriation of that technology is potentially as easy as a download to a flashdrive. The difficulty of determining a correct valuation methodology, however, does not excuse the burden to show that the technology's value rises above mere speculation and is based on just and reasonable inferences from the credible evidence. Our flexible and creative standard is not a license for pie-in-the-sky damages; rather, damages must be grounded both in theory and fact.
The opinion is interesting not so much for the majority opinion but for the spirited dissent.

 Non-Bankruptcy Decisions

Here are a few non-bankruptcy decisions that I found interesting.


Trois v. Apple Tree Auction Center, Incorporated, 882 F.3d 485 (5th Cir. 2/5/18)

A Texas resident sued Ohio citizens in a Texas court based on breach of contract and fraudulent misrepresentation.   The breach of contract claim was based on a contract executed and performed in Ohio.    The fraudulent misrepresentation claim was based on a conference call from Ohio to Texas.   

The Fifth Circuit found that there were not minimum contacts with regard to the breach of contract claim.   The only Texas contacts were phone calls with regard to the contract.   "[C]ommunications relating to the performance of a contract themselves are insufficient to establish minimum contacts.").    
However, the Court found jurisdiction with regard to the fraud claim although narrowly so.  The Court stated:

This case falls within the fuzzy boundaries of the middle of the spectrum. Although Schnaidt did not initiate the conference call to Trois in Texas, Schnaidt was not a passive participant on the call. Instead, he was the key negotiating party who made representations regarding his business in a call to Texas. It is that intentional conduct on the part of Schnaidt that led to this litigation. So Schnaidt is not being haled into Texas court "based on [his] 'random, fortuitous, or attenuated' contacts."  To be sure, we are somewhat wary of drawing a bright line at who may push the buttons on the telephone.
Texas Debt Collection Act

Clark v. Deutsche Bank National Trust Company, 719 Fed. Appx. 341 (5th Cir. 1/22/18)(unpublished)

Homeowner sued under Texas Debt Collection Act Sec. 392.304(a)(19) which prohibits debt collectors from using any other false representation or deceptive means to collect a debt.   The Court found that communications with regard to renegotiation of a debt do not concern the collection of a debt.   Therefore the District Court was correct to dismiss the action for failure to state a claim.


Williams v. Wells Fargo Bank, N.A., 884 F.3d 239 (5th Cir. 2/26/18)

Swis Community, Limited built a low-income housing project.   The project was financed with debt which was assigned to Fannie Mae with Wells Fargo Bank as servicer.   Swis Community defaulted on the debt.   A Wells Fargo employee provided incorrect notice addresses to the substitute trustee.  As a result, at least some obligors did not receive notice of acceleration or substitute trustee’s sale.    Fannie Mae purchased the property at foreclosure.   

Parties associated with the debtor brought suit against Fannie Mae, Wells Fargo and the substitute trustees.   The District Court granted summary judgment in favor of the Defendants.  The plaintiffs appealed the summary judgments in favor of Wells Fargo and Fannie Mae.  

The Fifth Circuit affirmed the judgment as to Wells Fargo.   Because Wells Fargo was merely the servicer of the debt, it was not a party to the deed of trust.   Therefore, it could not have breached the deed of trust.   However, the Fifth Circuit reversed the judgment in favor of Fannie Mae for breach of contract.   Generally under Texas law, a party who has materially breached a contract cannot bring an action for breach of contract.   However, the plaintiffs argued that the obligation to give proper notice under the deed of trust was an independent covenant which could still be enforced notwithstanding default under the note.   The Fifth Circuit agreed.   The notice provisions under the deed of trust could only come into play in the event of default.   If they could not be enforced based on breach of the note, they would be of little benefit.

Smitherman v. Bayview Loan Servicing, LLC, 2018 U.S. App. LEXIS 5660 (5th Cir. 3/6/18)

Smitherman acquired property in 2005.  He stopped making payments in 2011.   When Bank of America sought to foreclose, he filed various suits to stop the foreclosure.   In June 2016, he brought his fourth suit in which he alleged wrongful foreclosure and to quiet title.   The District Court dismissed his claims and enjoined him from interfering with future foreclosure sales.   

The Fifth Circuit found that the wrongful foreclosure claim was premature at the time the claim was dismissed since no foreclosure had occurred.  The quiet title claim failed because the plaintiff made only conclusory claims that the assignment to the current lender was improper.  As a result, it failed to state a cause of action.  

Warren v. Bank of America,  N.A., 717 Fed.Appx. 474 (5th Cir. 3/9/18)(unpublished)

A lender foreclosed upon a property and sent its contractor to change the locks.  The lender did not allow the borrower to remove her property.   The Court found that Warren was a tenant at sufferance following the foreclosure.  As a result, the Court found that the District Court properly dismissed the borrower’s claims for wrongful foreclosure, unlawful lockout, trespass and invasion of privacy.    The opinion raises the possibility that the borrower could have raised a claim for conversion.    However, this point is not developed.

Friday, June 08, 2018

Supreme Court Decides Three Narrow Bankruptcy Issues

The Supreme Court resolves about eighty cases each year, ranging from major constitutional issues to smallish questions of statutory interpretation. The three bankruptcy cases decided this term fall into the latter category, answering narrow statutory questions.

Supreme Court Sinks Safe Harbor

The first case decided was Merit Management Group, LP v. FTI Consulting. Inc., Case No. 16-784 (2/27/18). This case asked whether a shareholder of a business could be protected from a fraudulent transfer action where the funds passed through a third-party escrow agent which happened to be a bank. Section 546(e) of the Bankruptcy Code exempts from recovery "a transfer made by or to (or for the benefit of) … a financial connection with a securities contract...." In this case, the funds to purchase the stock flowed from the purchaser through two financial institutions to the stock seller. The statutory issue was whether the payment was protected where it flowed through two financial institutions that were merely intermediaries and did not receive the funds for their own benefit.

Writing for a unanimous court, Justice Sotomayor held that the relevant transfer to consider was the one that the Trustee sought to avoid. Since neither the buyer nor the seller was a financial institution, the safe harbor did not apply.   This decision prevents parties from insulating themselves from potential liability for a fraudulent transfer by routing the proceeds through a financial institution which does not have an interest in the transaction.

How Do You Review a Non-Statutory Insider?

Next, the Supreme Court weighed in on the narrow issue of the proper burden of proof when deciding whether a transferee was a non-statutory insider under 11 U.S.C. § 101(31).  U.S. Bank, N.A. v. Village at Lakeridge, LLC, No. 15-1509 (3/5/18).  In order to achieve a cram-down of a chapter 11 plan, a debtor must obtain the consent of a least one impaired class of creditors without counting votes of insiders. The class that accepted the plan consisted of a claim held by the debtor's sole owner, clearly an insider. One of the directors of the insider creditor  (Bartlett) offered to sell the claim to a retired surgeon (Rabkin) with whom she had a romantic relationship (more on this later). Rabkin agreed to purchase the $2.76 million claim for $5,000.00 and agreed to accept the plan. 

The list of defined insiders does not include a person in a romantic relationship with a director of an insider. However, the definition of "insider" states that the term "includes" the defined categories, meaning that the list is not exhaustive. U.S. Bank, which objected to the plan, argued that the romantic doctor was a non-statutory insider. The Bankruptcy Court found that the doctor was not an insider because he purchased the claim as a speculative investment after conducting due diligence. The Ninth Circuit affirmed applying a test that looked at (1) the closeness of the relationship and (2) whether the transaction was negotiated at less than arms-length. The Circuit found that the Bankruptcy Court's determination that the transaction was negotiated at arms-length was not clearly erroneous and affirmed.

The Supreme Court accepted the case, not on the question of the correct legal test to apply, but whether the Court of Appeals had applied the proper standard of review. Factual determinations must be upheld unless they are clearly erroneous while legal conclusions are reviewed on a de novo basis.

Justice Kagan, again writing for a unanimous court, found that it took a three step process to answer the question.    The first step was purely legal, to determine the appropriate legal test to apply.   The second step was purely factual, to determine the “basic” or “historical” facts relevant to the legal test.   The final step was to apply the historical facts to the legal test.   If factual issues predominated, the final step would be reviewed on the clear error standard, while de novo review would apply if legal issues dominated.

The Supreme Court denied cert on whether the Ninth Circuit applied the right legal test, which was the more interesting question.   While applying the historic facts to the legal test is a mixed question of law and fact, it ultimately depends on its component parts—the legal test and the facts.   Since the legal test was not at issue, what remained was the Bankruptcy Court’s fact-finding which is reviewed for clear error.   

The Ninth Circuit’s clear error review may have been assisted by the following testimony from Bartlett, the party offering the claim for sale:

Q:        Okay.  I think the term has been a romantic relationship—you have a romantic relationship?
A:        I guess.
Q.        Why do you say I guess?
A.        Well, no—yes.

Justice Kagan observed that “One hopes Rabkin was not listening.”

It is not clear why the Supreme Court accepted this case and this question since the answer was rather obvious.   Justice Sotomayor, joined by Justices Kennedy, Thomas and Gorsuch, had the same concern.   Justice Sotomayor said that “if that test is not the right one, our holding regarding the standard of review may be for naught.”  Because the Court did not accept the legal standard question, Justice Sotomayor did not provide an answer either.   However, she did suggest that the lower courts might want to spend some time thinking about what the legal test should be.   Justice Kennedy, in his own concurrence, went further.   He said, “The Court’s holding should not be read as indicating that the non-statutory insider test as formulated by the Court of Appeals is the proper or complete standard to use in determining insider status.”   He also suggested that the Bankruptcy Judge may have erred in concluding that the transaction was made on an arms-length basis since the claim was not shopped to other parties.

Thus, what we have is a rather unnecessary explication of how to decide mixed questions of law and fact combined with a statement by four Justices encouraging the lower courts to look for a different standard than the one articulated by the Ninth Circuit.    As a result, this opinion is more interesting for what it didn’t decide than for what it did.

Supreme Court Says Get It in Writing

            Finally, in Lamar, Archer & Cofrin v. Appling, No. 16-1215 (6/4/18), the Court decided whether a false statement about a single asset constituted a statement of financial condition which must be in writing to form the basis for a non-dischargeable debt.  11 U.S.C. §523(a)(2)(B) carves out an exception from the general rule that debts arising from fraud are non-dischargeable.  It provides that a statement “regarding the debtor’s or an insider’s financial condition” must be in writing in order to give rise to a non-dischargeable debt.   

            The case involved a client who got behind on paying his lawyers.   When the lawyers threatened to withdraw, he told them that he was expecting to receive a tax refund of approximately $100,000 and would use those funds to bring the lawyers current and pay future fees.   The trusting lawyers accepted his promise and soldiered on.   However, it turned out that the tax refund was closer to $60,000 and the client spent the money on business expenses.

            When the debtor filed bankruptcy, the unhappy law firm sued to prevent the debt from being discharged, claiming that the client made a false representation to gain their continued services.   The Bankruptcy Court ruled that a statement regarding a single asset, in this case, the tax refund, was not a statement regarding financial condition, and found the debt to be non-dischargeable.   The Eleventh Circuit disagreed.

            Justice Sotomayor, writing once more for a unanimous court, found that a statement regarding a single asset qualified as regarding the debtor’s financial condition.   Relying on grammar, she found that the term “regarding” in the statute broadened the clause such that it referred to both the object, statements of financial condition, and items related to the object.   She also relied on the fact that cases interpreting similar language under the Bankruptcy Act had arrived at the same result.   Since Congress did not change the verbiage, it must have intended to adopt the prior jurisprudence.   

            The lesson here is that a verbal statement about a debtor’s assets is not worth the paper it isn’t written on.   If a creditor wants to rely on a statement about a debtor’s assets, it should get it in writing.   In the case of the law firm, a simple email asking the debtor to confirm that he was expecting to receive a $100,000 tax refund (as opposed to the paltry $60,000 refund), if acknowledged by the client would have sufficed.