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.   

New Opinion Makes Sense of "Identifiable, Tangible and Material Benefit" Language From Pro-Snax

In Matter of Pro-Snax Distributors, Inc., 157 F.3d 414 (5^th Cir. 1998), a panel of the Fifth Circuit made the uncontroversial ruling that a chapter 11 debtor’s attorney could not recover attorney’s fees from the bankruptcy estate after appointment of a trustee.   However, the court went one step further and stated that in order to recover fees for the period prior to appointment of the trustee, the applicant must demonstrate an “identifiable, tangible and material benefit to the estate” in order to be compensated.   Most courts to consider this standard have concluded that when a case does not generate results notwithstanding the best professional efforts of the attorney that compensation may not be allowed except for certain mandatory services.   That consensus was broken when Judge Michael Lynn ruled that an “identifiable, tangible and material result to the estate” means that an attorney acted at the behest of his client acting in the exercise of its business judgment.   In re Broughton Ltd. Partnership, No. 10-42327 (Bankr. N.D. Tex. 4/25/12), a copy of which can be found here.   Judge Lynn’s ruling transforms the standard for compensation from a one-sided contingency fee to a professional judgment standard and is consistent with the text of 11 U.S.C. §330.    (Disclosure:  I am currently appealing a Pro-Snax ruling and will be relying upon the Broughton Ltd. Partnership case.).

What Happened

The facts are straightforward.  The debtors’ business was “the development of high-end residential subdivisions and sales of the developed lots.”  Special counsel was retained to negotiate the sale of 22 lots to a specific purchaser.     The purchaser required that a homeowners association waive certain rights.   When the homeowners association refused, the contract fell through notwithstanding counsel's efforts.  When     the sale fell through, the case ultimately converted.    When special counsel applied for its fees, the U.S. Trustee objected based upon Pro-Snax.  

The Ruling

 The Court noted that bankruptcy courts within the Fifth Circuit following Pro-Snax had required that fees be reasonable on both a prospective basis and based on a retrospective review.    The prospective test is based on section 330(a)(3)(C)  which provides that “the services (be) necessary to the administration of, or beneficial at the time at which the service was rendered toward the completion of, [the bankruptcy case].”   The retrospective or hindsight test incorporates the Pro-Snax requirement that the services actually result in an “identifiable, tangible and material benefit to the estate.”

Prospective Test

The U.S. Trustee argued that it was not even necessary to apply the retrospective test since the attorney should have realized early on that the proposed transaction would not result in a benefit to the estate.   The Court disagreed, noting that “(t)he proposed sale to SPOT was viewed in late 2010, not only by the court, but by the various parties, as the keystone of Debtors’ potential reorganization.”   Opinion, p. 5.   The Court went on to state that: 

That the transaction was a difficult one to put together and that the idiosyncrasies of the parties might frustrate the efforts of counsel does not mean that counsel was required to cease work and give up. Rather, so long as a professional is doing its principal’s bidding and there is a reasonable prospect of success, the professional is entitled to work in the expectation of being paid.

 Opinion, p. 6.   It is nice to see that the Court did not adopt the position that when the going gets tough, those who want to get paid give up.   

Retrospective Test

The Court approached the question of what constituted an “identifiable, tangible and material benefit to the estate” from several angles.  First, the Court noted that a literal application of the phrase could result in absurd results. 

The problem posed by Pro-Snax is that use of the word “benefit” suggests a positive contribution is required. An “identifiable, tangible, and material” benefit to the estate at first blush would appear to be something that augments the estate. Yet it seems clear that professionals serving a debtor or other fiduciary in a chapter 11 case cannot be limited in their compensation to those activities that actually add to the estate. First, such a determination would exclude from compensation many critical functions performed by professionals in the course of a chapter 11 case. Administrative matters, operational oversight, disputes respecting control, steps in the plan process such as extensions of exclusivity and many other matters dealt with by professionals covered by Pro-Snax do not increase the debtor’s estate or reduce the claims against it – yet the chapter 11 case could not work if professionals did not perform services in connection with these functions.

 

Second, as with the Firm’s work, that work which a professional undertakes doesn’t always lead to success.16 Deals – as with SPOT – fall through. Litigation on behalf of the estate may offer the prospect of substantial recoveries, but will not necessarily be won. It may be that counsel representing Stern, the estate representative in Stern v. Marshall, --- U.S. ----, 131 S.Ct. 2594, 180 L.Ed.2d 475 (2011), was unsuccessful, ultimately losing the estate’s case in the United States Supreme Court in a 5-4 decision. It is unthinkable that that counsel’s work leading to that result should be uncompensated.   The very fact that section 328(b) permits (but does not require) retention of professionals on, inter alia, a contingency basis demonstrates that Congress did not intend all professional services to be compensable only on that basis. Yet, as some courts have noted, to apply Pro-Snax as requiring estate augmentation would be tantamount to doing so. 

Opinion, pp. 10-11.

 Digging deeper, the Court looked at the Pro-Snax case itself.   The only clue that the Fifth Circuit gave as to the meaning of “identifiable, tangible and material” was a citation to In re Melp, Ltd., 179 B.R. 636 (E.D. Mo. 1995).   That case in turn referred to: 

In undertaking a “benefit analysis,” a court should consider: (1) whether the debtor’s attorney’s actions duplicated the duties of the trustee or the trustee’s counsel under 11 U.S.C. § 1106; (2) whether the services have in fact, obstructed or impeded the administration of the estate; and (3) whether the debtor’s attorney’s actions are consistent with the debtor’s duties under 11 U.S.C. § 521.

 In re Melp, 179 B.R. at 640.    Since the Fifth Circuit relied on Melp in formulating its test, it is only reasonable to see what the Melp Court meant.

Judge Lynn also examined the construction given to “identifiable, tangle and material benefit” by District Judge Jane Boyle in Kaye v. Hughes & Luce, LLP, (In re Gadzooks, Inc.), 2007 WL 2059724, at *9 (N.D. Tex. Jul.13, 2007).   I have previously written about the Gadzooks case here, here and here. 

The Gadzooks court, which applied the benefit test to counsel representing an equity committee, struggled with how to reconcile the Pro-Snax requirement of an “identifiable, tangible, and material benefit” to the estate, including its suggestion of a retrospective review of counsel’s work, with section 330(a)(3)(C) which indicate a professional’s efforts should be assessed prospectively, as of the time they were to be performed. Judge Boyle, in Gadzooks, concluded that the requirement set by the Court of Appeals of a benefit to the estate constituted a gloss on the provision in section 330(a)(1)(A) that counsel be awarded “reasonable compensation for actual, necessary services rendered by the…professional person.” See In re Gadzooks¸ 2007 WL 2059724, at *9. That is, services will benefit the estate if they are actual and necessary. 

Opinion, pp. 14-15.    

The Court also looked to how similar language in section 503(b)(1) has been interpreted. 

As it happens, the term “actual, necessary” is found not only in section 330(a)(1)(A) but as well in section 503(b)(1)(A), where it modifies the words “costs and expenses of preserving the estate” and limits what costs and expenses are entitled to priority payment as administrative claims. As used in section 503(b)(1)(A), “actual, necessary” clearly does not mean administrative expenses are limited to only those that enhance or at least preserve a debtor’s estate. It has been black letter law since the Supreme Court rendered its decision in Reading Co. v. Brown, 391 U.S. 471, 478, 88 S.Ct. 1759, 20 L.Ed.2d 751 (1968), that torts committed by an estate representative in the course of performing his, her or its duties give rise to claims entitled to administrative priority. This is because, as the Court reasoned in Reading, a bankruptcy estate, just like any other participant in the business world, must pay those costs necessarily incident to its operations, including satisfying claims arising from torts attributable to the estate.

 

Similar reasoning can be applied to the efforts of the professionals of a debtor in possession (or other statutory bankruptcy fiduciary). It is the duty of a debtor in possession –like any estate representative – to realize any possible value from assets of the estate. If it eventually proves true that an asset cannot be realized upon, that does not mean it should not be investigated and its liquidation (or other means of realization) pursued, so long as, as the Pro-Snax court observed, “the chances of success…outweigh the costs of pursuing the action.” 157 F.3d at 426. Thus, for example, in Stern v. Marshall, pursuit of Stern’s counterclaim was appropriate and compensable, since the chances of success were good. That the case ultimately was lost 5-4 in the Supreme Court (on the basis of the bankruptcy court’s constitutional inability to enter a final judgment on Stern’s counterclaim) does not change the fact that the estate representative and estate professionals were doing their duty in pursuing it. 

Opinion, pp. 15-16.

The Conclusion

Having considered all of these factors, the Court reached its ultimate conclusion that a professional confers an identifiable, tangible and material benefit to the estate when it performs services at the direction of the representative of the estate which is acting within its business judgment. 

The court today holds that a professional provides an “identifiable, tangible and material benefit” to a bankruptcy estate within the meaning of Pro-Snax through assisting the estate representative in administering an asset of the estate, whether or not the effect of administration of the asset is enhancement of the estate, so long as the professional’s services are performed at the direction of the estate representative and the estate representative is acting in accordance with the Code and its sound business judgment.  In doing so, the court focuses on the nature of the benefit provided but also takes account of public policy and an estate representative’s decision making authority in bankruptcy.

 

With regard to the latter, the court relies on an estate representative’s sound business judgment in approving acts outside the ordinary course of business.  (citation omtted).Unless the manner in which an estate representative arrives at a decision is seriously flawed, the court will defer to the estate representative.  (citation omitted). A professional should similarly be able to rely on its client’s business judgment in acting in accordance with the client’s instructions.

 

As to public policy, professionals are retained by an estate representative to advise and assist the representative in carrying out his, her or its duties under the Code. To burden professionals by making their compensation contingent upon the result of the estate representative’s decisions must necessarily skew the regime intended in the Code and will surely create conflicts where a professional believes its client’s decision, though arrived at through due diligence, is not the right one. Had Congress wished professionals retained under section 327 of the Code to second-guess and perhaps veto decisions of a trustee or debtor in possession, it surely would have said so. 

Opinion, pp. 17-18.

What It Means

While I acknowledge my own bias, I think that Broughton Ltd. Partnership should change the way that Courts in the Fifth Circuit interpret Pro-Snax.     Judge Lynn’s interpretation allows courts to follow the language used in Pro-Snax without doing violence to the language or the logic of the Code.

Unlocking the Code    

Section 330(a) contains several criteria for allowing compensation in bankruptcy, but does not use the words identifiable, tangible and material benefit.   In fact, it expressly adopts a prospective analysis.

The statute reads:

§ 330.  Compensation of officers

(a) (1) After notice to the parties in interest and the United States Trustee and a hearing, and subject to sections 326, 328, and 329, the court may award to a trustee, a consumer privacy ombudsman appointed under section 332, an examiner, an ombudsman appointed under section 333, or a professional person employed under section 327 or 1103--       (A) reasonable compensation for actual, necessary services rendered by the trustee, examiner, ombudsman, professional person, or attorney and by any paraprofessional person employed by any such person; and      (B) reimbursement for actual, necessary expenses.

***

      (3) In determining the amount of reasonable compensation to be awarded to an examiner, trustee under chapter 11, or professional person, the court shall consider the nature, the extent, and the value of such services, taking into account all relevant factors, including--       (A) the time spent on such services;      (B) the rates charged for such services;      (C) whether the services were necessary to the administration of, or beneficial at the time at which the service was rendered toward the completion of, a case under this title;       (D) whether the services were performed within a reasonable amount of time commensurate with the complexity, importance, and nature of the problem, issue, or task addressed;       (E) with respect to a professional person, whether the person is board certified or otherwise has demonstrated skill and experience in the bankruptcy field; and       (F) whether the compensation is reasonable based on the customary compensation charged by comparably skilled practitioners in cases other than cases under this title.    (4) (A) Except as provided in subparagraph (B), the court shall not allow compensation for--          (i) unnecessary duplication of services; or          (ii) services that were not--             (I) reasonably likely to benefit the debtor's estate; or             (II) necessary to the administration of the case.

***

     (6) Any compensation awarded for the preparation of a fee application shall be based on the level and skill reasonably required to prepare the application.   

***

 (emphasis added).

Interpreting Pro-Snax to require a positive result in order to get paid would be to eliminate the words “at the time at which the services were rendered” and “reasonably likely to benefit the debtor’s estate” from section 330(a).  Such a view (even though it has been the prevailing one) effectively accuses the panel of negligence at best or judicial activism at worst.   

This tension was acknowledged by Judge Frank Monroe in In re Weaver, 336 B.R. 115 (Bankr. W.D. Tex. 2005), when he stated: 

Applicant Borsheim argues that Pro-Snax is at odds with the statute and misinterprets it since the statute plainly authorizes fees "for actual, necessary services"-as well as services that are "reasonably likely to benefit the debtor's estate".    Even if such be true, this Court is constrained to follow the 5th Circuit's interpretation. 

Weaver, at 119. 

Judge Lynn, by following Judge Boyle’s conclusion that “identifiable, tangible and material benefit” was merely a gloss upon “actual, necessary services,” has tethered Pro-Snax to the language of the Code and has consistently followed the underlying authority relied upon by the Pro-Snax panel.

 

With all respect to Judge Monroe (who was a venerable and well-respected judge), it is far better to follow the Fifth Circuit and follow the language of the Code at the same time.   Judge Lynn has succeeded in doing both.

(In fairness to Judge Monroe, he had a subsequent opinion in In re Spillman Development Group, Ltd., 376 B.R. 543 (Bankr. W.D. Tex. 2007),  in which he which took a more nuanced approach to Pro-Snax.) 

When the Going Gets Tough

The Broughton Ltd. Partnership opinion is also good for the system.    The English common law system adopted in the United States relies upon an adversarial system in which opposing parties are represented by zealous advocates.    Bankruptcy is a multi-party process.   If the most aggressive creditor can threaten debtor's counsel with not getting paid, debtor's counsel will have an incentive to placate that party at the expense of everyone else.   Moreover, if the court increases the risk of not getting paid, then either lawyers will demand higher fees to compensate for that risk or will forego those representations altogether, leaving them to less qualified lawyers.    In order for the system to work, good lawyers need to have a reasonable opportunity to be compensated without being a guarantor of the success of their client's case.  While some debtors may be less than deserving scoundrels who use bankruptcy to escape payment of their just debts, the opposite is also true.   Some creditors are more interested in using their position to prevent debtors from paying their debts, either so that they can foreclose and reap a windfall or simply to crush another party out of malice and spite.    While the bankruptcy court cannot grant equal resources to all parties, it can at least avoid penalizing one side.

Best of the Rest

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Every year, I read more cases than I have time to blog about. Here are some cases that I meant to write about but didn't have the time. My inability to get to these cases is demonstrated by the fact that I am concluding my year-end clean-up on January 2nd, two days into the new year.

Philadelphia Newspapers:

River Road Partners v. Amalgamated Bank, 651 F.3d 642 (7th Cir. 2011), cert granted, RadLAX Gateway Hotel, LLC v. Amalgamated Bank, No. 11-166 (2011). The Supreme Court has granted cert to resolve the Philadelphia Newspapers issue of whether a debtor can deny a creditor's right to credit bid in a plan by offering the creditor the "indubitable equivalent." The Third Circuit said yes. The Seventh Circuit said no. You can access all the relevant documents at SCOTUS Blog here.

Gifting and Bad Faith:

In re DBSD, North America, Inc., 634 F.3d 79 (2nd Cir. 2011). The Second Circuit held that "gifting" where a senior class of claims gives up property in favor of a junior class violates the absolute priority rule where an intervening class of claims is skipped. The Court also held that votes of a competitor could be designated as cast in bad faith.

Collateral Attacks on Plans:

Matter of Davis Offshore, LP, No. 09-41294 (5th Cir. 7/16/11), which can be found here.

Chapter 11 cases are frequently criticized for languishing in the courts. However, this prepackaged chapter 11 case proceeded to confirmation in less than a week, resulting in a sale to a group which included a member of the family which owned the companies. Unfortunately, that is when the bickering began. Although no party appealed the confirmation order, one of the former shareholders filed a motion to revoke confirmation under 11 U.S.C. §1144. The bankruptcy court determined that no fraud had taken place. The district court vacated the bankruptcy court’s order but dismissed the appeal due to equitable mootness. Rather than appealing this decision, the former shareholder then sued the purchasers for fraud. The bankruptcy court found that the fraud suit was an impermissible collateral attack on the confirmation order. A direct appeal to the Fifth Circuit was authorized.

The Fifth Circuit, in an opinion by Chief Judge Edith Jones affirmed the bankruptcy court. The following passage captures the essence of the opinion:

The principal question posed on appeal is whether the Plan and confirmation order bar the assertion of fraud claims against the defendants/appellees. This is an issue of perennial importance in bankruptcy procedure. Bankruptcy cases must be and often are resolved in haste to prevent the continuing depletion of a debtor’s value and assets. Haste, however, creates the danger that inadequate supervision of deals, valuations, and participants in the process may occur, leaving a fertile field for fraud. To this extent, the demands for finality and integrity in the process may be in tension. In some situations, fraud and related claims may outlive the bankruptcy process. (citation omitted).

We conclude that in this case, in the context of reorganizing a family owned company all of whose shareholders had access to sophisticated financial and legal assistance, and where the releases and exculpatory provisions in the Plan and confirmation order were essential to a reorganization that no party appealed, those provisions bar the (Appellant’s) current claims.

Opinion, pp. 3-4. This case goes to show that when you push to get a deal done quickly, you may be stuck with results that you don’t like.

Section 502(b)(6):

In re Dronebarger, No. 10-10889 (Bankr. W.D. Tex. 1/31/11), which can be found here. This case is significant as the maiden opinion from Judge H. Christopher Mott, who took the bench in October 2010. The issue was whether the guarantor of a lease could take advantage of the cap on damages resulting from lease termination under section 502(b)(6). In a forty page opinion, the Court said no. The Court's primary reasoning was that section 502(b)(6) was limited to damages arising from termination of a lease. Here, the damages arose from failure to repair the property during the pendency of the lease, not from termination of the lease. As a result, he distinguished the case from In re Mr. Gatti's, Inc., 162 B.R. 1004 (Bankr. W.D. Tex. 1994), where the damages resulted from rejection of the lease in bankruptcy. He also ruled that a guarantor could not take advantage of the cap because his liability arose under a guaranty rather than under the lease. The opinion has an excellent discussion of section 502(b)(6) and should be must reading for any party litigating under that section.

Disclosure: My firm became co-counsel to the Debtors subsequent to the court's opinion. We were not involved in the claims issue. Another interesting historical note is that Eric Taube represented the landlord in both Mr. Gatti's and Dronebarger. I represented the Debtor in Mr. Gatti's.

Fraudulent Transfers:

In re Wren Alexander Investments, LLC, No. 08-52914 (Bankr. W.D. Tex. 2/17/11). You can find the opinion here. This case goes to show that not all second acts are for the better. Charles Pircher is a former banker who went to prison during the bank scandal of the 1980s. After prison, he managed a series of professional employee organizations which minimized workers compensation costs by forming new entities to take advantage of lower rates given to new companies. The PEOs were supposed to pay wages and remit taxes to the government. They failed to accomplish the latter, resulting in a large IRS tax liability.

One of the PEOs acquired a ranch in Medina County, Texas. It proved to be a good investment because it was purchased for $630,000 in 1999 and was sold for $5,250,000 in 2009. Pircher used money from the PEOs to build a 10,000 square foot house, a 12,000 square foot horse stable and a 39,000 square foot quarter horse arena. While Pircher said that he had an informal agreement to pay the money back at some point, no documents were drafted and he paid no rent.

The first owner of the property, United Capital Investment Group, Inc., took out a hard money loan to pay off the original purchase price, to build improvements on the property and to pay Pircher's criminal restitution obligations. When the IRS started filing tax liens against the PEOs, Pircher transferred the property to Medina Heritage, Ltd., an entity he controlled. While the deed was dated prior to the filing of an IRS tax lien, it was not recorded until afterwards. The consideration for the transfer was assumption of the existing liabilities on the property.

The property was then transferred to Wren Alexander Investments, Ltd., the debtor in this case. Wren Alexander was controlled by a close business associate of Pircher's. The purchase price was the amount necessary to pay off the existing liens (although not the tax lien). Pircher's stated intent in selling the property was to get it out of his name while retaining control. The IRS filed a nominee lien against Wren Alexander Investments, Ltd.

Wren Alexander filed chapter 11 and the property was sold. The Debtor filed an objection to the claim of the IRS. The principal issue was whether the tax lien was valid against the transferee of the property. Judge Ronald King has an excellent discussion of Texas fraudulent transfer law. Judge King found that the transfer from United Capital to Medina Heritage was a fraudulent transfer because the property was sold for less than reasonably equivalent value while insolvent. The found that this provision could not be used to avoid the second transfer because the IRS was not an existing creditor of Wren Alexander. However, he did find that the transfer could be avoided as one made with actual intent to hinder, delay or defraud. The result was that the IRS received the remaining proceeds in the amount of approximately $1.2 million.

Avoiding a Foreclosure Sale:

Munoz v. James S. Nutter & Co., Adv. No. 10-3039 (Bankr. W.D. Tex. 2/22/11), found here.

The Munoz case involved the situation of a bankruptcy being filed after a foreclosure sale had been conducted but before the deed was recorded. The Court found that the debtors could not use the strong arm powers under section 522(h) because the recorded deed of trust would have placed a prospective purchaser on inquiry notice. The opinion is memorable for the following passage:

What a difference a day can make. This case presents a regrettable situation where Plaintiffs’ bankruptcy petition, for whatever reason, was filed one day late and Plaintiffs’ home was foreclosed upon before the bankruptcy. Thankfully these occurrences are infrequent, as the result can be disastrous to a debtor who can lose the opportunity to save their home. With the right set of facts and proof, the bankruptcy laws can provide relief to “undo” a pre-bankruptcy foreclosure, but the mountain that must be climbed is very technical and extremely steep. Few debtors have been successful in reaching the summit of this mountain and setting aside a foreclosure sale that occurred prior to the bankruptcy filing. Although this Court is extremely sympathetic to Plaintiffs’ plight, in this case it is unable to “reverse” the foreclosure and give Plaintiffs back their home.

Plaintiffs’ attempt to set aside the foreclosure sale under the “strong-arm power” of §544 must be denied as a hypothetical purchaser on the date of Plaintiffs’ bankruptcy filing would not have “bona fide purchaser” status under §544(a)(3) of the Bankruptcy Code and Texas state law. Plaintiffs also did not meet their burden of proof under §544, and for these reasons and those set forth in this Opinion, Plaintiffs may not avoid the foreclosure sale transfer of the Property to Navar under §544(a)(3).

Opinion, pp. 36-37.

Homestead Exemption on a Golf Course:

In re Schott, No. 10-54276 (Bankr. W.D. Tex. 3/15/11), found here.

Many golf widows may feel that their husbands live at the golf course. However, in this case involving a Texas homestead exemption, the debtor literally did live in the clubhouse (at least for a period of time.). When he filed bankruptcy, he claimed the golf course as his homestead and a creditor objected.

The court found that the property was rural and that the debtor had not abandoned the homestead. Therefore, the question was whether he could claim some of all of the property as homestead. The property consisted of two tracts separated by a county road.

Judge Leif Clark noted that under Texas law, where a rural homestead consists of two noncontiguous tracts, one tract must be used as a residence and the other tract must be used for the “comfort, convenience or support of the family.” The tract containing the clubhouse qualified as a residence. However, the tract containing the golf course did not fit within the definition of a homestead.

The court found that the debtor “does not play or even enjoy golf,” that he sometimes likes to take walks on the golf course and that he had intended to develop the property as a resort. While the term “comfort, convenience or support of the family” is a broad one, taking occasional walks on the property was not sufficient.

Non-Dischargeability Among Friends:

Turbo Aleae Investments, Inv. v. Borschow, Adv. No. 09-3005 (Bankr. W.D. Tex. 4/8/11), which can be found here. Judge Mott succinctly described the dispute in this case when he stated:

This case illustrates what can happen when a friend loans money to another friend, and then the relationship turns sour when the friend cannot repay the loan.

Opinion, p. 1.

The opinion contains a lengthy recitation of the conflicting narratives of the parties, highlighting that many of the critical terms were never reduced to writing.

The court distinguished between false pretenses and actual fraud, noting that earlier cases considered these two grounds for nondischargeabiilty under section 523(a)(2)(A) to have separate elements, while more recent Fifth Circuit cases pointed to a single test. The court rejected a claim of false pretenses on the basis that, if it still existed as a separate ground for nondischargeability, it required a false statement about current or past facts, not actions to be performed in the future.

The opinion is a good case study in how to prove or defend a non-dischargeability case. There were two main contentions made: 1. that the debtor lied about intending to use the loan proceeds to pay off a prior secured debt; and 2. that the debtor lied about intending to use the loan proceeds to pay off a debt owed to a related party to the lender.

In the case of the first representation, the court found insufficient evidence that the representation was made. The first time the representation was mentioned in writing was in an email after the fact. Although the stated reason for wanting the prior debt paid off was to obtain a security interest in the company's equipment, the loan documents did not provide for a security interest. Additionally, the lender did not inspect the equipment or attempt to determine its value. Finally, the lender acted inconsistently by referring the debtor to Chase Bank to get a loan to pay off the prior debt. As Judge Mott concluded:

While the Court is sympathetic to Turbo and believes that Omar and Ernest likely thought Allen should have used the money to pay off the SNB loan, after weighing the evidence and testimony, the Court concludes that Turbo has failed to show that Allen obtained the loan proceeds through actual fraud by falsely representing he would use the loan proceeds to pay off the SNB loan.

Opinion, p. 27.

On the other hand, the plaintiff's did show that the debtor committed fraud with regard to the second representation. The lender initially wanted to withhold the funds and pay them directly to the related party. The debtor said that he needed to receive the funds directly "for accounting purposes." However, when he received the funds, his business account was so far overdrawn that there were no funds left to repay the related party.

The differing outcomes between the two claims demonstrates that parties are rarely completely honest or completely devious, but that the truth is largely a combination of shades of gray.

In a very brief passage, the Court denied attorney's fees to the plaintiffs, noting that:

The Court also determines that each party shall bear their own attorneys fees and expenses. Specifically, the Court finds that the loan at issue is not primarily consumer debt, and that the positions of parties in this proceeding were substantially justified. Thus, awarding attorney fees is not appropriate in this case. See 11 U.S.C. §523(d).

Opinion, p. 37. Section 523(d) allows the court to award attorney's fees against a creditor who unsuccessfully seeks a determination of nondischargeability on a consumer debt and asserts a position that is not substantially justified. In this case, the debts involved were business debts so that the debtor could not have recovered attorney's fees. However, the court appears to be using the principles of section 523(d) by analogy to deny recovery of attorney's fees in a business dispute where each side offered positions that were substantially justified. I would have preferred to see the Court invoke the American Rule that each side pays its own fees in the absence of specific authority for fee-shifting. However, the court's ruling roughly adheres to this standard.

The take-away from this case is don't loan money to friends if you can't afford to lose the money or the friendship.

Remand:

Legal Xtranet, Inc. v. AT&T Management Services, LP, Adv. No. 11-5042 (Bankr. W.D. Tex. 5/24/11), which can be found here. This was a case involving a motion to remand. The Court found that state law contract disputes were non-core proceedings subject to mandatory abstention and that disputes over the tax liability of AT&T did not qualify for even "related to" jurisdiction. The most interesting part of the opinion is the Court's lament over AT&T's successful attempt at forum shopping. Judge Leif Clark wrote:

The court is reluctant to reward AT&T’s blatant forum shopping in this case. AT&T filed a jury demand and refused to consent to a jury trial in this court in an effort to bolster its argument that the parties’ dispute could be timely adjudicated in state court: AT&T’s refusal to consent to a jury trial here meant that even if the court retained jurisdiction over the parties’ dispute, the case would have to be tried in the federal district court, assuring AT&T that it would have a different judge to hear the case. That would also almost certainly mean that the case would not likely be heard for quite some time. Furthermore, it is not entirely clear that the parties’ dispute, as it currently stands, involves any factual issues for a jury to decide – the request of declaratory relief will not go beyond the terms of the contract itself unless there is ambiguity in the agreement (or unless the contract itself is found to point outside itself for the determination or application of its terms). Thus, AT&T’s jury demand machinations appear to be nothing more than an effort to forum shop. Nonetheless, as noted above, the question is not whether the case can be more timely adjudicated in state court than in the bankruptcy or district court; the question is simply whether it can be timely adjudicated in state court. AT&T established that it could be timely adjudicated in state court, and the court’s determination to that effect did not depend upon a finding that the case could not be timely adjudicated in the district court. And there is nothing in section 1334(c)(2) that permits a court to deny relief on grounds that the effort is motivated by a desire to forum shop. Indeed, the sad truth is that the structure of bankruptcy jurisdiction actually encourages and rewards forum shopping strategies. There is little this court can about that, other than to encourage Congress to consider the consequences that seem to flow from the current structure.

Opinion, at p. 17. It seems unlikely that Congress will be moved to change section 1334(c)(2).

Till Interest Rate:

In re Village at Camp Bowie I, LP, No. 10-45097 (Bankr. N.D. Tex. 8/4/11), found here. In this single asset real estate case, the court considered, among other things, artificial impairment and
the proper interest rate for cramdown of a secured creditor.

The court found that artificial impairment standing alone was not enough to prevent a finding of good faith.

Indeed, at least one court has persuasively suggested that the drafters of the Code did not intend to create a system in which – even in a single asset real estate case – a lender could use its overwhelming share of the claims in a case to divest other creditors and equity owners of their economic interests. (citation omitted). Yet the only way around control of the reorganization by a debtor’s lender in a case like that at bar is through impairment and an affirmative vote of a class of unsecured creditors who will typically have small claims that could be readily satisfied through full payment with interest. For a debtor to have any leverage at all in such a case – e.g., in negotiations – it must be possible to look to those unsecured creditors to satisfy section 1129(a)(10).

Opinion, p. 10.

The Court also had an interest take on applying Till v. SCS Corporation, 541 U.S. 465 (2007). The court noted that under Till, the court left open the issue of whether a market rate could be set in the case where there was an efficient market for loans of the type proposed by the debtor in its plan. Because there was no such efficient market, the court determined to apply a formula approach. However, rather than using the Prime + 1-3% formula suggested by the Till Court, the Bankruptcy Court went through an elaborate approach of valuing different tranches of debt and adjusting for risk.

One of the experts (it is not clear whose) started with the five year treasury bill rate of 1.71% as a risk free rate. He then adjusted it for several factors and concluded that the rate for the first 65% of the collateral's value would be between 4.76%-5.01%. He concluded that the mezzanine rate for 65-85% of collateral value would be 13.02-14.88%. Finally, he concluded that the appropriate rate for amounts in excess of 85% of collateral value would be 18.63%. Taking all of these tranches into account and making other adjustments, he somehow came up with a blended rate of 6.25-7.75%.

The court adopted his methodology but tinkered with the assumptions to come up with a rate of 6.27-6.59%. Because the Debtor had proposed a rate of 5.83%, the Court denied confirmation with leave to file a plan providing for an interest rate of 6.4%.

Camp Bowie was a case involving a property valued at $34 million. Therefore, it might have been able to support the cost for the type of expert witness testimony used here. However, I have two concerns here. The first is that Till was supposed to provide an inexpensive and simple method for determining value. Most chapter 11 cases are small business cases which cannot afford the cost of an expert. Second, unless the Court has an advanced degree in finance (which several of the Texas bankruptcy judges do), it is likely that the competing experts will bamboozle the court which will be forced to split the difference.

In the Camp Bowie case, the Court could just as easily said prime + 3 and arrived at 6.25%, which is within .15% of the rate it reached through the elaborate calculations.

Recently, I was at a CLE seminar in New York sponsored by the Commercial Law League of America. Judge Robert Drain from the Southern District of Texas polled the room as to who represented debtors and who represented creditors. He then offered a hypothetical with choices between a prime rate + approach, a tranche approach and a there is no rate high enough approach. When only one hand went up for the prime + approach, he said, I see we've found the debtor's lawyer in the room (which was me). He then offered a very thoughtful analysis of why he thought the Supreme Court would adopt the prime + approach in a chapter 11 case.

This just goes to show that even after Till, there is still a lot of debate over how to select the cram-down interest rate.

Stern and Fraudulent Conveyances:

Kirschner v. Agoglia, Adv. No. 07-3060 (Bankr. S.D. N.Y. 11/30/11), found here. (Link will take you to the Southern District of New York Bankruptcy website. Go to opinions, then to Judge Drain to find the case).

During the past six months, practitioners have heard a lot of volume about Stern v. Marshall without getting a lot of clarity. (I plead guilty there since I have been on multiple panels and I am still trying to figure it out). Judge Robert Drain from the Southern District of New York has recently penned a very thoughtful opinion about the "firmly established historical practice" doctrine suggested by Justice Scalia in his concurrence. He noted that "the pursuit of avoidance claims has been 'a core aspect of the administration of bankruptcy estates since the 18th century.'" Opinion, at 9. He then offered a very thorough history of the ability of Article I judges to enter final judgments in fraudulent transfer cases. After all that, he found that the complaint did not state a cause of action and dismissed it as to one defendant.

The analysis that I would like to see (and would like to write some day if I had the time) would trace the origin of bankruptcy as a device to punish debtors who made fraudulent transfers. I suspect that it would show that bankruptcy law and fraudulent transfer law have been bound together since the very beginning.

Texas Bankruptcy Courts Split Over Application of Schwab v. Reilly

The Supreme Court's decision in Schwab v. Reilly, 130 S.Ct. 2652 (2010) last term provoked a lot of concern about the finality of exemptions. Under Taylor v. Freeland & Kronz, 503 U.S. 638 (1992), a trustee's failure to timely object to an exemption, even a frivolous one, meant that the asset left the estate. However, in Schwab v. Reilly, the Supreme Court held that an exemption of a specific dollar amount in value of property exempted only the value claimed but not the asset itself, allowing a trustee to sell the asset if the value ultimately exceeded the amount of the debtor's exemption.

I have written about Schwab v. Reilly and its consequences here and here.

Now Texas Bankruptcy Judges are struggling with whether Schwab permits, or even dictates, that a debtor may claim 100% of fair market value, forcing the trustee to object within 30 days. Judge Michael Lynn and Judge Craig Gargotta have held that claiming 100% of FMV is permissible, In re Moore, 442 B.R. 865 (Bankr. N.D. Tex. 2010), In re Dominguez-Ortega, No. 10-61416 (Bankr. W.D. Tex. 5/17/11), while Judge Robert Jones has ruled the opposite way, In re Salazar, 2011 Bankr. LEXIS 1117 (Bankr. N.D. Tex. 2011).

Because Judge Gargotta's opinion is the latest word, I will start with his ruling in this post. The transcript is not yet available online. I will be happy to provide a copy to anyone who requests it.

The Permissible Approach

In the Dominguez-Ortega case, the court was faced with objections filed by the chapter 7 and chapter 13 trustees in six cases in which the debtors claimed 100% of FMV. Relying upon the Moore decision and scholarly articles from the American Bankruptcy Institute, Judge Gargotta denied the objections. He stated:

As everyone knows, in Schwab v. Reilly, the Supreme Court unequivocally says at least two things--it may say other things in addition to that.

One, that one hundred percent of fair market value on Schedule C is permissible and correct.

And second, that the trustee may not be bound by the 30 day objection period under Federal Rule of Bankruptcy Procedure 4003(b).

Transcript, pp. 6-7. He went on to adopt the reasoning of Judge Lynn of the Northern District. He stated:

(T)he judges in the (Fort Worth) division had the following observations.

First of all, fair market value of one hundred percent is the correct methodology. It puts the trustee on notice to object within 30 days. Then there can be an evidentiary hearing . . . regarding whether or not that's a fair objection.

For purposes of the proceedings here in Waco, I agree with that. I think that's exactly what the Supreme Court requires.

Second as to the discussion that we had on the record day about whether or not debtors may use a numeric amount for the interest they claim as an aid, they are free to do that, but they are not required to do that. And I will leave it up to them as to whether or not they want to do that.

Transcript, pp. 8-9.

Judge Gargotta acknowledged that his ruling would result in more work for the trustees and the court, but stated that his mandate was to follow the Supreme Court.

Now, what is the consequence to the Court? Well, the consequence to the Court is, in those situations where the trustee thinks that . . . when (the debtors) use the designation of one hundred percent of fair market value, that it may exceed the amount of the interest in an asset, the trustee is going to have to object, and I'll have to conduct a hearing on it and we'll . . . figure out how that plays out.

I recognize that, ultimately, it may increase the litigation in this Court. But, by the same token, I'm of the opinion, and I think it's unequivocally clear that what debtors are doing in that consequence is precisely what the Supreme Court ordered, and I'm not going to alter their methodology in terms of claiming it.

I apologize to both Mr. Hendren and Mr. Studensky if it increases their workload. That is not my intent. Rather, I am complying with what the Supreme Court commands.

Transcript, p. 10.

The Impermissible Approach

Writing in Salazar, Judge Robert Jones agreed that if a debtor claimed 100% of fair market value and no party objected, that "the debtor effectively reclaims the property." 2011 Bankr. LEXIS 1117 at *15. However, he disagreed with Judge Lynn about what to do if there was a timely objection. His conclusion was that an objection to 100% of fair market value was a facially valid objection and that the debtor would be required to amend his exemption to state a specific dollar amount.

He explained his reasoning as follows:

The Court will set forth its reasons for the approach it adopts. First, the Court fails to see the necessity of a hearing under the circumstances as presented. The debtors' exemption claims are limited to an interest in the property. The value of the property itself is relevant only to the extent that there is sufficient value to support the amount of the exemptible interest. If, as suggested by the Supreme Court, the debtor is trying to exempt the property in-kind rather than an interest in property, such goal may still be thwarted if, for example, the property subsequently appreciates in value. This is the very issue confronted by the Ninth Circuit in In re Gebhart, 621 F.3d 1206 (9th Cir. 2010). There the debtors made an exemption claim to the equity in their house, which amount was well within the amount they were allowed under § 522(d)(1). The trustee did not object; like the trustee in Schwab, the trustee in Gebhart had no reason to object. During the pendency of the bankruptcy case, the house appreciated in value. Two years later, after the debtors had defaulted on their mortgage payments and the mortgage company moved for stay relief, the trustee sought approval to sell the house to recover the value of the house that then well exceeded the exemption claim. The Ninth Circuit, consistent with Schwab, emphasized that the debtors' allowable exemptions did not permit the exemption of the house itself, but rather the specific dollar amount of their interest in the house.

2011 Bankr. LEXIS 1117 at *17-18. The Court went on to state

The Supreme Court in Schwab predicted such claims would likely draw objections. Claiming "100% of FMV" is the debtors' way of stating that they wish to keep the asset in-kind. While this is their desire, the Court must construe that such claim has the legal effect of claiming an interest in the property up to an amount that is determined by the fair market value of the property in-kind. Accordingly, if the trustee wishes to preserve for the estate any excess value--value over the amount of the statutory limit that may exist either at the time the exemption is claimed, as was the case in Schwab, or any excess value that may exist as a result of an anticipated appreciation in the property, as happened in Gebhart--the trustee must object to the exemption claim itself. That is precisely what has been done here. The trustees' objections are facially valid. The objections do not otherwise contest the exemption claims. The Court certainly concedes that, given the items against which the exemptions were made and the claimed values of the items in-kind, it is highly unlikely that any of the items would ever achieve a value that would exceed the statutory limit for the exemption. Regardless, the Court recognizes the trustees' right to preserve this eventuality for the estates.

2011 Bankr. LEXIS 1117 at *25-26.

Reconciling the Cases

Moore, Salazar and Dominguez-Ortega all agree that if a debtor claims 100% of fair market value and no party objects, that the debtor gets to keep the property. However, where they split is in allocating the burden of proof. Under Fed.R.Bankr. P. 4003(c), the objecting party has the burden of proof on an objection to exemptions. Moore and Dominguez-Ortega require the trustee to meet the burden of proof with evidence. On the other hand, Salazar holds that the objection should be sustained as a matter of law and that the debtor has the burden of proof to state what the value of the property is. Even then, the debtor has no security. If the value of the property increases beyond the exempt amount, the trustee may sell it out from underneath the debtor.

I have mixed feelings about these opinions. Moore and Dominguez-Ortega bring order to the force by restoring the status quo under Taylor v. Freeland & Kronz. On the other hand, Salazar is more faithful to the Supreme Court's reasoning that an exemption attaches to a dollar amount rather than the thing itself. However, that is a horrible result. It allows trustees to sleep on their rights and leave estates open in the hope that an asset may appreciate. As a practical matter, it is much better to require the trustee to put up or shut up in an evidentiary hearing. This will ensure that the trustee only objects when there is a genuine basis for doing so and gives all parties certainty in dealing with assets claimed as exempt.

Post-Script

I typically do not blog about oral rulings. I chose to do so in this case because it was a very definitive ruling from one of my local judges. However, I do want to acknowledge that all of the Texas bankruptcy judges that I appear in front of put a lot of thought and hard work into their oral rulings. In most cases, the oral rulings are equivalent in force to a written opinion, just delivered in a more informal manner. In this case, it was refreshing to hear the directness of the Court’s comments.

Finally, I apologize to Judge Robert Nelms. In his ruling, Judge Gargotta referred to rulings by Judge Michael Lynn and Judge Robert Nelms. I could only find Judge Lynn's opinion. When Judge Gargotta refers to the Fort Worth judges, he is referring to both Judge Lynn and Judge Nelms.