When Is a Small Business Debtor Not a Small Business Debtor?

One of the changes that the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 made to small business bankruptcy cases was to eliminate the ability to opt in to treatment as a small business debtor. However, it appears that the Bankruptcy Rules may have given back the option which Congress intended to take away.

Under the 1994 bankruptcy reform legislation, special provisions for small business debtors were created. However, debtors were given the option to elect whether to be considered as a small business debtor and few did. The National Bankruptcy Review Commission recommended that this option be removed, stating:

The Commission recommends that choice of treatment as a "small business" debtor under the Bankruptcy Code should not be optional. If as a policy matter, Congress decides that small business debtors merit special treatment under the Bankruptcy Code, all debtors who meet the definition of "small business" should be subject to the same special track. Otherwise, the separate track will not likely be used.

Report of the National Bankruptcy Review Commission, Sec. 2.5.1.

BAPCPA added a new definition of "small business debtor" to the Bankruptcy Code. Under Sec. 101(51D), a debtor was a small business debtor if: (i) it was a person engaged in commercial or business activities (ii) but not a person whose primary activity was the business of owning or operating real property (iii) that has aggregate noncontingent liquidated secured and unsecured debts as of the date of the petition or the date of the order for relief in an amount not more than $2,000,000 (which has been adjusted for inflation to $2,190,000) and (iv) for which a creditor's committee has not been appointed or is not sufficiently active and representative to provide effective oversight of the debtor. Under this definition a debtor either is or is not a small business debtor. There is no choice in the matter.

If a person is a small business debtor, it is subject to added scrutiny designed to weed out nonviable cases. 11 U.S.C. Sec. 1116. It is also subject to more flexible provisions for proposing and confirming a plan. A small business debtor has an exclusivity period of 180 days (as compared to just 100 days for a small business debtor under the prior law). 11 U.S.C. Sec. 1121(e)(1). However, the outside date for any party to file a plan is 300 days. 11 U.S.C. Sec. 1121(e)(2). The debtor is allowed to file a combined plan and disclosure statement and receive conditional approval of its disclosures, thus eliminating the need for a separate disclosure statement hearing. 11 U.S.C. Sec. 1125(f). However, the plan proponent must obtain confirmation of a plan within 45 days after filing. 11 U.S.C. Sec. 1129(e).

Thus, the small business debtor provisions offer a series of carrots and sticks which are intended to be mandatory. However, Fed.R.Bankr.P. 1020(a) brings the right to elect in through the back door. Under this Rule, "the debtor shall state in the petition whether the debtor is a small business debtor." The U.S. Trustee and creditors may object to this statement within 30 days after the conclusion of the creditors' meeting. However, "the status of the case with respect to whether it is a small business case shall be in accordance with the debtor's statement . . . unless and until the court enters an order finding that the debtor's statement is incorrect."

Thus, a debtor can make an election not to be treated as a small business debtor by checking the wrong box and hoping that no one objects. One of the reasons that Congress eliminated the small business election was the perceived apathy of creditors in these cases. However, the provision in the rules allows debtors to make an incorrect designation and count on creditor apathy to allow it to pass unnoticed.

However, the fact that the debtor has a de facto election does not mean that the debtor can change status at will. In the case of In re Save Our Springs (SOS) Alliance, Inc., 393 B.R. 452 (Bankr. W.D. Tex. 2008), a debtor designated itself as a small business debtor. The debtor was arguably not eligible to be a small business debtor because it was an environmental advocacy group, which likely would not fall within the definition of a person engaged in commercial or business activities. The debtor proposed a plan which was hotly contested. By the time that the court denied confirmation, the debtor was beyond its 300 day window for proposing a plan. The debtor then amended its petition to revoke its designation as a small business debtor. The court found that having received expedited treatment based on its designation as a small business debtor, the debtor was judicially estopped to say that it wasn't. As a result, the court dismissed the case.

However, an incorrect designation may be corrected. In a case where I am involved, the debtor's previous counsel failed to check the box to indicate small business status. The debtor then proposed a combined plan and disclosure statement within the 300 day window given to a small business debtor. When the court noted that the debtor had not designated itself as a small business debtor, I filed a motion to designate the debtor as a small business debtor which the court granted. The difference in my case was that the debtor had never tried to obtain a benefit from not being a small business debtor and indeed had acted as if it were one from the beginning of the case. (Of course, it probably also helped that the designation in my case really was incorrect).

Thus, the small business election lives on in a practical sense, but is subject to challenge.

Texas Chapter 11 Filings Double

Chapter 11 filings are a good indicator of how the economy is doing as well as the market for bankruptcy lawyers. If the latest filings are any indication, Texas bankruptcy lawyers are going to be very busy. In the first quarter of 2009, chapter 11 filings doubled over their level from the same time during 2008. During the first quarter of 2009, 259 cases were filed statewide compared to 129 the previous year. Over the first three quarters of 2008, filings fell within a lackluster range of 128 to 152 per quarter or about 50 cases per month. In the fourth quarter of 2008, filings jumped to 213 and then increased again in the first quarter of 2009.

When I have more time, I will look at the types of entities filing (i.e., real estate, health care, etc.) and the size of the filings (small business debtors to mega-cases).

Remembering Our Colleagues

Yesterday I heard that a bankruptcy lawyer I know had passed away. It turned out to be a case of mistaken identity, much to my relief. However, it got me thinking that we have lost several members of our bar in the past months and I wanted to take a moment to remember them. Please feel free to share your memories in the comments section as well as letting me know if I missed anyone.

Gray Byron Jolink: June 23, 2008

Gray was a dear friend and a colleague. For a complete article about Gray, go to In Memory of Gray Byron Jolink.

Garry Offerman: August 2, 2008

Garry Offerman was a witty, urbane bank lawyer from Beaumont. He was unfailingly gracious and offered us the use of his office when we were in Beaumont. He passed away in a motorcycle accident at the age of 52.

David Young: October 5, 2008

The intellectual light of the bankruptcy bar dimmed when David Young passed away on October 5, 2008. David was the ultimate law nerd, a former history professor who became an in-house academic for Austin's McGinnis, Lochridge & Kilgore. David had a graceful manner and a far-reaching intellect which made him the epitomy of a scholar and a gentleman.

Two anecdotes from his memorial service bear repeating.

One of David's law school professors told of how David completed a curve-busting exam which found and correctly addressed every issue the professor had thought of, as well as a few that he hadn't thought of. Later, David sheepishly admitted that he was unsure about the course, so that he had taken it pass-fail.

David's son recalled his dad laughing hysterically at a scene from the raunchy cartoon South Park. It seems that David had noticed an inscription in Latin over the doorway to the planetarium, which translated to "Beam Me Up Scotty." David was one of the few people who would have caught an inside joke in a dead language in an off-color cartoon.

John Ventura: October 28, 2008

John Ventura was a consumer bankruptcy attorney who practiced in Austin and in the Valley. However, he was best-known for his writing. John was the author of many how-to books on legal topics, including Good Advice for a Bad Economy (2002), Divorce for Dummies (2009) and The Credit Repair Handbook: Everything You Need to Know to Maintain, Rebuild and Protect Your Credit (2007). He was also the 2nd place winner in the 2008 Texas Bar Journal Short Story Fiction Contest. He was the executive director of the Texas Consumer Complaint Center at the University of Houston Law Center and was an associate professor at the school.

Michael C. Barrett: January 11, 2009

Michael Barrett founded and served as chairman of the powerhouse Barrett Burke law firm. He served on the Executive Advisory Board of Frost Bank Group and on the Executive Board of the Dedman School of Law at Southern Methodist University. He received Safari Club International records, including No. 2 elk in the world in January 2009. He was a philanthropist and supporter of veteran's causes.

Paul N. Buchanan: January 23, 2009

Paul Buchanan was a consumer bankruptcy attorney from Round Rock. He lost a painful battle with cancer this year.

Weldon Grisham: January 24, 2009

Weldon Grisham was a consumer bankruptcy attorney from Fort Worth. He passed away at the age of 62 after practicing bankruptcy law for over 20 years.

Bill Turman: March 6, 2009

Bill Turman was an attorney in Austin for over 40 years. He practiced with McGinnis, Lochridge & Kilgore and for many years with his own firm. He appeared in over 1,000 cases on behalf of individuals, financial institutions and taxing authorities.

They will be missed.

The Bankruptcy Reform Rube Goldberg Device

The Bankruptcy Code of 1978 was intended to simplify the law and make it more functional. In most respects, it worked beautifully. The same cannot be said for the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Badly drafted is one of the kinder adjectives applied to it. Now history seems poised to repeat itself. On March 5, 2009, the House passed H.R. 1106, the Helping Families Save Their Homes Act. While the bill’s purposes are laudatory, its drafting is tortured. This article will walk you through the bankruptcy-related provisions of the bill section by section. If you want to skip ahead to the good stuff, start with Section 103.

Section 100 Definition

The first thing that the bill does is introduce a definition of “qualified loan modification.” We later learn that this definition has almost nothing to do with modifying mortgages in bankruptcy and amounts to little more than legislative clutter. To further complicate things, the definition of a “qualified loan modification” is tied to “the guidelines of the Obama Administration’s Homeowner Affordability and Stability Plan as implemented March 4, 2009.” Thus, a definition in the Bankruptcy Code is tied to a non-legislative document. However, it does get President Obama’s name permanently added to the Bankruptcy Code.

Section 101 Eligibility for Relief

The next thing that the bill does is eliminate certain home mortgage debts from the chapter 13 debt limits. The bill eliminates any home mortgage or debt that was previously secured by a home which was foreclosed upon if the value of the home was less than the applicable debt limits. While this provision isn’t entirely clear, I think that it means that if a home mortgage is less than $1,010,650, that debt is not included in calculating eligibility for chapter 13, so that a debtor can have an additional $1,010,650 in secured debts and still file for chapter 13. This is an interesting idea, but what problem is it solving? If the problem is that some homeowners don’t qualify for chapter 13 because their home mortgages exceed $1,010,650, wouldn’t it be easier just to raise the debt limits?

Section 102 Prohibiting Claims Arising from Violations of the Truth in Lending Act

The third substantive bankruptcy provision of the bill allows a claim to be denied if the debtor could have rescinded the loan based upon a truth in lending violation. While this is certainly a good result, how does this add anything to Sec. 502(b)(1) which allows a claim to be denied because it is unenforceable against the debtor?

Sections 103 and 105 Authority to Modify Certain Mortgages

Finally, six pages into the bill, we get to the heart of the matter. Section 103 contains the major terms allowing modification of home mortgages in chapter 13. The section modifies Sec. 1322, which is the permissive list of provisions which may be included in a chapter 13 plan by adding four new subsections. The new subsections go on for nearly seven pages and contain a lot of material to digest. Additionally, Section 105 modifies section 1325, which contains the requirements for confirmation of a plan.

Eligibility

In order to be eligible for modification, proposed Sec. 1322(b)(11) states that a loan must be “originated before the effective date of this paragraph and secured by a security interest in the debtor’s principal residence that is the subject of a notice that a foreclosure may be commenced with respect to such loan.” This provision reflects two interesting policy choices. First, it only applies to loan originated before the effective date of the bill. Thus, no future mortgages will be subject to modification. If mortgage modification is a good idea, why limit it to only pre-existing mortgages? One possible answer is that the bill is intended to encourage lenders to make new loans, secure in the knowledge that they will not be subject to modification. However, since Congress can always modify the provision, it seems like this is a bit illusory. The other curious choice about eligibility is that a mortgage must be the subject of a foreclosure notice before it can be modified in a bankruptcy. Thus, if a debtor has been keeping his mortgage current by borrowing against credit cards or from relatives and reaches the point where he can’t go on, he would not immediately be able to file chapter 13 and restructure the mortgage. On the other hand, a debtor who stopped paying his mortgage to finance a trip to Las Vegas would be able to secure a modification. It seems like a questionable decision to deny relief to someone who has made an honest effort to pay his debts, while granting it to his more profligate neighbor.

To make things more complicated, there is a second eligibility provision a few pages later in proposed Sec. 1322(h). For a case commenced more than 30 days after the effective date of the bill, the debtor must certify that that he contacted his lender and provided it with documentation equivalent to Schedules I and J and then “considered any qualified loan modification offered to the debtor by the holder of the claim.” Of course, all the debtor has to do is “consider” the offer so it doesn’t offer much protection to the lender. In the alternative, the debtor may certify that the property was subject to a foreclosure sale scheduled to be held within 30 days. Since the property already has to be subject to a foreclosure notice (as contrasted with a scheduled foreclosure sale) in order to be eligible under the first eligibility section, it is unlikely that the requirement to ask the lender for a pre-foreclosure modification contains any teeth. However, with regard to a case already pending, before the debtor may submit a plan proposing to modify a loan or propose to modify an existing plan to modify a loan, the debtor must certify that he “attempted to contact the holder of such claim (or the entity collecting payments on behalf of such holder) regarding modification of the loan that is the subject of such claim.” This requirement is pretty toothless as well, since all the debtor need do is certify that he attempted to contact the lender regarding modification. Thus, a debtor could certify that one hour prior to filing his motion to modify, he sent the lender an email requesting that the loan be modified to eliminate the requirement to make payments. That would comply with the technical language of the statute.

Why place the eligibility provisions in two different places? Cue up Avril Lavigne singing “Why do you have to make things so complicated?”

If a debtor is eligible, he can choose from the following menu of modifications:

Valuation

First, she can provide for payment of the secured claim as provided by Sec. 506(a)(1), that is, write the mortgage down to the value of the property. However, we learn in subsequent section 1322(i) that valuation under Sec. 506(a)(1) “shall be the fair market value of such residence on the date such value is determined and, if the issue of value is contested, the court shall determine such value in accordance with the appraisal rules used by the Federal Housing Administration.” Thus, we are using Sec. 506(a)(1) for valuation, but this section shall have a special meaning applicable only to valuing home mortgages.

If the property is sold during the life of the plan, the debtor must share any gain with the lender based upon a sliding scale. If the property is sold in the first year of the plan, then the lender receives 90% of the difference between the sales price (after subtracting cost of sale and the value of improvements made) and the amount of the secured claim as determined under Sec. 506(a)(1). By year 5, the lender’s share of the gain is limited to 10% of the excess.

Interest Rates

Second, a debtor may convert an adjustable rate loan into a fixed rate loan or make adjustments to the manner in which the adjustable rate is calculated. Additionally, another provision allows the debtor to adjust the interest rate to a fixed rate based on the “currently applicable average prime rate offer as of the date of the order for relief under this chapter corresponding to the repayment term determined under the preceding paragraph as published by the Federal Financial Institutions Examination Council in its table entitled ‘Average Prime Offer Rates—Fixed’ plus a reasonable premium for risk.” Why have two different sub-parts dealing with setting the interest rate, especially when the provision allowing tinkering with adjustable rates is completely unnecessary in light of the later provision allowing a fixed rate. By tying the interest rate to a rate announced in a specific table of a specific publication, Congress runs the risk that it will have to amend the bill if the publication ever goes away or is changed. For example, what happens if the Federal Financial Examination Council changes its name to the Federal Lending Institution Council? Is there still an applicable rate? Further, the use of a specified rate is undercut somewhat by allowing the addition of a “reasonable” risk premium. Wouldn’t it just be easier to use the Till standard for interest rates?

There is also a provision stating that on request of the debtor or a senior secured creditor, the court can confirm a plan which reduces the interest rate but does not reduce the principal amount of the debt “provided the total monthly mortgage payment is reduced to a percentage of the debtor’s income in accordance with the guidelines of the Obama Administration’s Homeowner Affordability and Stability Plan as implemented March 4, 2009 if, taking into account the debtor’s financial situation, after allowance of expenses that would be permitted for a debtor under this chapter subject to paragraph (3) of subsection 9b), regardless of whether the debtor is otherwise subject to such paragraph, and taking into account additional debts and fees that are to be paid in this chapter and thereafter, the debtor would be able to prevent foreclosure and pay a fully amortizing 3-year loan at such reduced interest rate without such reduction in principal.” Wouldn’t it just have been easier to say that a debtor cannot reduce principal if a reduction in the interest rate would be enough to grant relief to the debtor?

Reamortization

Third, the debtor may reamortize the loan to provide for a term not to exceed 40 years from its origination.

Trustee Payments

Proposed Sec. 1322(b)(11)(D) allows for a modified mortgage to be paid either directly to the lender or through the Chapter 13 trustee. If payments are made directly through the standing trustee, the trustee’s commission on the mortgage payments will be reduced to 4% or may be waived altogether if the debtor’s income is less than 150% of the poverty threshold.

Good Faith

Proposed Sec. 1325(a)(11) imposes a special good faith requirement applicable only to mortgage modifications in chapter 13. In order to confirm a plan providing for modification of a mortgage, the court must find that “such modification is in good faith.” Of course, Sec. 1325(a)(3) already requires that the entire plan be proposed in good faith, so that this requirement must require really good faith. The statute proceeds to tell us what really good faith is and is not. It is not good faith if the debtor proposes to modify a mortgage which he could afford to pay without modification. Additionally, in deciding whether the debtor acted in good faith “the court shall consider whether the holder of such claim (or the entity collecting payments on behalf of such holder) has offered to the debtor a qualified loan modification that would enable the debtor to pay such debts and such loan without reducing such principal amount.” Also, the court must find that “the debtor has not been convicted of obtaining by actual fraud the extension, renewal or refinancing of credit that gives rise to a modified claim.”

The new requirements for good faith modifications raise several issues. Good faith is a term which is not defined anywhere in the Code, but has an established meaning. By adding a definition here, is Congress intending to define good faith elsewhere in the Code or is this a special subset of good faith applicable only to this subsection? Considering whether the debtor rejected a reasonable proposal from the lender and whether the debtor needs to modify the loan in order to be able to pay his debts both make good sense. However, what to make of the provision that the debtor is not acting in good faith if he has been convicted of fraud with respect to the loan? Do we really need to put this in a statute or isn’t it obvious? Further, by providing that the debtor acted in bad faith if he was convicted of fraud, it suggests that it would not be bad faith if the debtor acted fraudulently but was never prosecuted or even was indicted but hadn’t been convicted yet.

Section 104 Combating Excessive Fees

Wedged inbetween sections 103 and 105, which contain the mortgage modification provisions, is section 104 which establishes a new procedure for establishing the reasonableness of post-petition fees and charges assessed to a debtor. Under this section, the debtor, the debtor’s property and the property of the estate are not liable for a fee, cost or charge incurred while the case is pending unless (i) the creditor serves a notice of the charges on the debtor, debtor’s attorney and chapter 13 trustee not later than one year after the charges are incurred or less than 60 days before the case is closed, (ii) the charges are law, reasonable and authorized by the applicable security agreement; and (iii) secured by property worth more than the amount of the claim. Failure to follow the procedure would result in waiver of the charge and any attempt to collect the charge would subject to the lender to liability for violation of the automatic stay or discharge. The section also provides for waiver of prepayment penalties on claims secured by the debtor’s principal residence.

Section 108 Effective Date

The statute would take effect upon enactment and would apply to cases filed before, on or after that date. As a result, debtors with pending cases could go back and modify their plans under this legislation.

What Are The Lessons Here?

What can we learn from this confusing bill? A few lessons for drafting emerge.

1. Don’t add unnecessary definitions to Sec. 101of the Bankruptcy Code. It is too long and confusing as it is.

2. Don’t tie definitions in Title 11 to executive branch documents. While H.R. 1106 does this with the Obama Administration’s Homeowner Affordability and Stability Plan and the Federal Financial Institutions Examination Council’s table entitled “Average Primate Offer Rates—Fixed,” BAPCPA made the same mistake when it incorporated the IRS collection standards. There are two problems here, one practical and one substantive. The practical problem is that tying legislation to outside sources requires the reader to consult another document in order to understand the legislation. The substantive problem is that the legislative branch is effectively allowing the executive branch to define the content of a statute. This raises important separation of powers issues.

3. Don’t rely on a complicated solution when a simple one will do because there may be unintended consequences. In Sec. 101, the bill excludes home mortgages from the chapter 13 eligibility limits. This means that a debtor could file chapter 13 even though he had a million dollar home and a million dollar vacation home. While that may benefit AIG executives who may face financial hardship from not receiving large bonuses anymore, it doesn’t really help the average homeowner.

4. Don’t add feel-good grounds for objecting to claims in Sec. 502(b) if they aren’t necessary. One of the reasons that the Bankruptcy Code is beginning to resemble the Internal Revenue Code (or the Los Angeles phone book) is that Congress keeps adding minutiae to existing statutes. BAPCPA did this to Sec. 362 and 523. Adding a definition of good faith applicable only to home mortgage modifications is confusing and could change the meaning of the term in other situations as well. Stating that value will be determined according to Sec. 506(a)(1) and then setting specific rules for determining value under that section is confusing and contradictory.

5. Keep similar provisions together. HR 1106 tosses rules for eligibility for mortgage modification and determining interest rates around randomly, requiring the reader to go to multiple locations to figure out how the statute works.

6. Don’t come up with a complicated solution when a simple one is available. The Supreme Court provided a standard for calculating interest rates in bankruptcy which was elegant in its simplicity. Rather than using the existing concept, HR 1106 requires the reader to look up a table published somewhere else and then requires the court to apply a “reasonable” risk premium. Why not just use the prime rate plus an appropriate risk premium. The effort to incorporate the Obama Administration’s Homeowner Affordability and Stability Plan is confusing at best. This Plan factors into the legislation in at least three places. First, it applies in determining eligibility for mortgage modification depending upon whether the lender made a proposal in compliance with the Obama Administration’s Plan and whether the debtor “considered” it. If all the debtor has to do is “consider” a proposal from the lender, wouldn’t it be easier to just say that the debtor has to consider any proposal offered by the lender in good faith? Second, the Obama Plan comes into play in determining whether the debtor’s proposal is made in good faith. Wouldn’t it be easier to just say that the debtor can’t modify the mortgage if the debtor rejected a plan which was at least as generous as the debtor could have obtained in bankruptcy? Finally, the Obama Plan is used in deciding whether the debtor should be allowed to propose a plan which reduces the interest rate but doesn’t reduce principal. Wouldn’t it be easier just to say that the debtor cannot reduce principal if an interest rate reduction would be enough to make the plan work?

7. Don’t include meaningless requirements. Requiring the debtor to “consider” an offer from the lender doesn’t impose a meaningful restriction, since the debtor is free to consider the proposal and then reject it. Similarly, does it really help to say that a debtor who has been convicted of fraud in connection with a loan is not acting in good faith? This will exclude very few debtors while potentially protecting fraudulent actors who managed to avoid a criminal conviction. Thus, the “restriction” lets in more people than it keeps out.

I haven’t had a chance to review the Senate Bill yet. However, if it is as quirky and complex as the House bill, the likelihood that a conference committee could sort out the difficulties or that the resulting product would make any sense are not cause for optimism.

Exemption Cases Take a Campy Turn

When Bankruptcy Judge Craig Gargotta decided In re Camp, 396 B.R. 194 (Bankr. W.D. Tex. 2008), he staked out a unique position on how exemption laws should be applied when Sec. 522(b)(3)(A) requires application of the law of another state. Judge Gargotta concluded that Sec. 522(b)(3)(A) was a choice of law provision so that the law chosen should be applied to the debtor as though the state where he currently resided was the state whose law was being applied. As a result, Judge Gargotta concluded that where a Florida resident living in Florida would be prevented from using the federal exemption scheme that a Texas resident subject to Florida law could not claim federal exemptions either. In reaching this decision, Judge Gargotta disagreed with In re Battle, 366 B.R. 635 (Bankr. W.D. Tex. 2006), a decision by his Western District colleague Judge Leif Clark. Indeed, Judge Gargotta's analysis appeared to be unique to him. Now two additional courts have considered the Camp analysis, reaching differing results.

Camp Followed

The Camp choice of law approach has now been applied by a second judge. In re Morgan C. Smith, No. 07-20614 (Bankr. S.D. Tex. 3/12/09) is a decision by Judge Richard Schmidt which applies Louisiana law to a Texas resident. The Debtors lived in Louisiana from 1991 to 2007. During that time, his parents conveyed 245 acres in San Patricio County to the debtor and his siblings. After the property was partitioned, the Debtor received 81.79 acres solely in his name. Later in 2007, the Debtors filed under Chapter 12 and claimed Texas exemptions. Under these facts, the exemption allowed to the Debtor would be:

Unlimited as to 81.79 acres if Texas law applied;
Limited to $40,400 if federal exemptions could be claimed; or
Limited to $25,000 if Louisiana law applied.

The Court concluded that because the Debtors had only been domiciled in Texas for 230 days prior to filing that Texas law did not apply.

The Court then concluded that under the Camp decision, because Louisiana law did not allow debtors to choose federal exemptions, that this choice was not available either.

As a result, the Court found that Louisiana law was the only choice available for the Debtors and limited the exemption to $25,000. The Louisiana statute did not specify that only land in Louisiana could be claimed as homestead. However, if the Court followed the Camp opinion to its logical conclusion, the Debtor would be able to claim the full Louisiana exemption on a Texas property for the reason that the Court would be required to apply the law as if the Texas property were really in Louisiana.

Camp Rejected

While Smith followed Camp to allow extra-terratorial application of the Louisiana law, the 10th Circuit BAP rejected Camp but still allowed extra-terratorial application of the Iowas homestead law. In In re Stephens, 2009 Bankr. LEXIS 305 (10th Cir. BAP 3/9/09), a debtor sold his Iowa homestead and moved to Oklahoma. Iowa law allowed an exemption in proceeds of a homestead sale for a "reasonable" time. The Court rejected the Camp choice of law analysis, which would have held that restrictions on applying Iowa law to property outside of Iowa were preempted. However, the court reached the same result by concluding that nothing in the Iowa law prevented it from being applied to homestead proceeds taken to another state. As a result, the Court concluded that Iowa could have chosen to prevent its homestead exemption from being applied to property located in another state, but had not done so.

I have one final comment after reading these cases: Does your head hurt yet? Mine does.

Accountant's Mistake on Financial Statement Leads to Non-Dischargeable Debt

A recent opinion from the Fifth Circuit demonstrates that non-dischargeable claims for false financial statements can extend beyond the traditional lender-borrower relationship and that a third party's error can create liability when it is knowingly adopted by the debtor. Matter of Morrison, No. 07-51118 (5th Cir. 1/16/09).

David Morrison was president of Morrison Excavation. Like many construction contractors, the firm was short of cash and looking for new work. On February 6, 2002, the company's CPA informed David that the company's financial condition was dire. To make things worse, on February 15, the company's bookkeeper found an accounting error which inflated the company's accounts receivable by $857,000. When the inflated receivables were removed, the company was insolvent. The previous day, the company had submitted a bid for a subcontract with Western Builders. After reviewing the company's work at several job sites and performing a credit check, Western requested a financial statement. On February 22, David faxed the financial statement containing the inflated receiveables to Western. On March 6, Morrison Excavation entered into a subcontract with Western and started taking draws on March 28. During that time, the company used the draws from Western to pay off lienholders who they said had previously been paid. David also gave himself a raise and paid off a personal home equity loan from company funds. By mid-August, Morrison Excavation abandoned the job. Western hired another contractor to finish the job at and additional cost of over half a million dollars. David Morrison filed chapter 7 on March 13, 2004.

Western filed a non-dischargeability action against David based upon submitting a false financial statement. At trial, two company employees testified that David was informed about the error in the financial statement somewhere around February 15, which was prior to the time that he provided the statement to Western. The bankruptcy court found that the subcontract created a debt which could be nondischargeable under Sec. 523(a)(2)(B) because Morrison could be held liable for the misrepresentation which benefited Morrison Excavation. The bankruptcy court also entered a money judgment against David in the amount of $549,773.63. On appeal, the Fifth Circuit affirmed, finding that the Bankruptcy Court had the jurisdiction to enter a money judgment in a dischargeability action (agreeing with five other circuits) and affirming the Bankruptcy Court's conclusions on liability and non-dischargeability.

While the result in this case is not particularly remarkable, it demonstrates how personal liability for a non-dischargeable debt can arise in a business setting.

1. While false financial statement cases often arise from a loan application, the Morrison case shows that they can arise in any context. What is interesting about this case is the fact that Western Builders did a substantial amount of due diligence before entering into the contract with Morrison Excavation. It observed job sites, ran a credit check and requested a financial statement. Although reliance was not discussed in the Fifth Circuit opinion, it seems clear that Western was trying to protect itself from doing business with a financially shaky subcontractor who would not be able to complete the job.

2. It did not matter that the financial statement was for Morrison Excavation or that David Morrison was not the person responsible for preparing the financial statement. When David Morrison faxed the financial statement to Western for the purpose of being awarded the subcontract and after being informed that it erroneously showed a positive net worth instead of a negative one, he fell within the statutory language of receiving money or property based upon "use of a statement in writing:

(i) that is materially false;

(ii) respecting the debtor's or an insider's financial condition;

(iii) on which the creditor to whom the debtor is liable . . . reasonably relied; and

(iv) that the debtor caused to be made or published with intent to deceive."

The financial statement was materially false because it showed the company as solvent rather than insolvent. It depicted the financial condition of an insider. The creditor reasonably relied on the statement as shown by the fact that it conducted several types of due diligence before entering into the contract. Finally, the debtor's intent to deceive was shown by the fact that he had been told that the statement was inaccurate but faxed it anyway.

3. It was not necessary to pierce the corporate veil to impose liability on the corporate officer. Under Texas tort law, an individual may be held liable for "fraudulent or tortious acts commited while in the service of his corporation."

4. The creditor was allowed to obtain both a judgment of non-dischargeability and a money judgment in the same proceeding. This allowed the creditor to obtain all of the necessary relief in one action.

Judge to Secured Creditor: The Loan has been PAID!!!!!

In the latest opinion from a single asset real estate case which has taken on the ferocity of a cage match brawl, the bankruptcy court has told a secured lender that it must treat its credit bid under Section 363(k) the same as if it had received a cash payment. The audacious secured creditor had asserted that its credit bid applied to reduce its bankruptcy claim but not its debt, so that it was still free to pursue guarantors and other collateral. Spillman Investment Group, Ltd. v. American Bank of Texas, Adv. No. 08-1018 (Bankr. W.D. Tex. 1/29/09).

In a fact pattern which is showing up more frequently these days, the case started off with a golf course development. The debtor borrowed money from American Bank of Texas and Fire Eagle, LLC. American Bank held the first lien and also held a CD and limited guaranties. Fire Eagle held a junior lien and did not have personal guaranties. After the loans went into default and the debtor filed chapter 11, Fire Eagle bought the American bank debt so that it held both the senior and junior liens. After a bidding process in which a group lead by insiders of the debtor offered $9.2 million in cash, Fire Eagle made a credit bid in the amount of $9.3 million and acquired the property. Fire Eagle also received cash collateral in the amount of $500,000, increasing its total amount credited and paid to $9.8 million. At the time, the amount of the first lien debt was approximately $9,250,000. Thus, the combination of the credit bid and the cash collateral clearly exceeded the amount of the first lien debt.

Notwithstanding the math, Fire Eagle asserted that the senior debt (and with it the right to collect against the CD collateral and the guarantors) remained alive because the credit bid under Section 363(k) reduced its bankruptcy claim, but not the underlying debt. The Bankruptcy Court did not have any trouble rejecting the distinction between debt and claim.

Fire Eagle's claim is also its debt. "Debt" is defined as liability on a claim. 11 U.S.C. Sec. 101(12). "Claim" means "right to payment, whether or not such right is reduced to jdugment, liquidated, unliquidated, fixed, contingent, matured, unmatued, disputed, undisputed, legal, equitable, secured or unsecured." 11 U.S.C. Sec. 101(5A). Payment against the claim necessarily reduces the debt. It cannot reduce one and not the other. This is the bankruptcy court; not fantasy land.

Memorandum Opinion, p. 27.

The Bankruptcy Court also rejected arguments that language in the guaranty agreements which provided that setoffs or defenses of other parties and discharge in bankruptcy would not impair the guarantees allowed continued pursuit of the guarantors. The Court noted that payment of the debt was neither a setoff nor a discharge, so that the guarantees were extinguished when the debt was paid.

To make sure that there was no room for confusion, the Court added the following conclusion:

Fire Eagle's Senior Loan was paid in full. As such Fire Eagle has no claim against the SIG CD or the Guarantors under their respective Guarantees. Fire Eagle's feigned ability to not understand the Court's reasoning falls on deaf ears. This is not rocket science. The Senior Loan has been PAID!!!!!

Memorandum Opinion, p. 34.

First Post-Script:

Judge Monroe will be retiring this year after nearly twenty years on the bench. While Spillman is an example of his rather direct writing style, it is not the only time that he has used all capitals to make a point. In an opinion discussing allowance of late filed claims in chapter 11, he quoted from the then-recent Supreme Court opinion in Pioneer Investments v. Brunswick, followed by the exclamation: "WRONG." Judge Monroe has never had trouble telling us what he really thinks.

Second Post-Script:

This marks the 100th posting to A Texas Bankruptcy Lawyer's Blog.

Texas Supreme Court Allows Malicious Prosecution Claim Based on Bankruptcy Adversary Proceeding to Proceed, Finds No Preemption

In an interesting case dealing with concurrent jurisdiction and preemption, the Texas Supreme Court has found that a state court had jurisdiction to consider a malicious prosecution action based upon an adversary proceeding. Graber v. Fuqua, No. 05-0303 (Tex. 1/9/09).

Bankruptcy attorney Richard Fuqua filed his own bankruptcy back in 1988. Attorneys for Sunbelt Savings, FSB brought an adversary proceeding against him for fraud and forwarded information to the U.S. Attorney resulting in a criminal prosecution. Fuqua was vindicated in both the criminal case and the adversary proceeding, with the Bankruptcy Court granting a directed verdict in the adversary. After all this played out, Fuqua filed a state court malicious prosecution action against the lawyers in 2000. The state court granted a plea to the jurisdiction, but was reversed by the Court of Appeals.

The Supreme Court stated:

The question in this case is whether a state malicious prosecution claim is preempted by the federal bankruptcy regime simply because the claim arose out of the filing of an adversary action in a bankruptcy proceeding. We hold that under the facts of this case, Congress did not intend for such a claim to be preempted.

In a Texas trial court, Richard Fuqua alleged that Thomas Graber and Hopkins & Sutter had committed the common law tort of malicious prosecution by initiating an adversary proceeding in Fuqua's federal bankruptcy case. The petitioners argue that federal bankruptcy statutes express Congress's intent to preempt Fuqua's claim and others like it. But to hold as the petitioners suggest would require us to extract the requisite intent from congressional silence, an inference that our preemption jurisdiction does not allow. The petitioners further argue that permitting Fuqua's state malicious prosecution claim would impermissibly threaten the uniformity of federal bankruptcy law. Yet we can identify no such risk. Until Congress clearly says otherwise, preemption of Fuqua's malicious prosecution action is not warranted. Fuqua's suit should have survived Graber's plea to the jurisdiction.

Opinion, pp. 1-2.

The Supreme Court did a good job of analyzing the interplay between bankruptcy and non-bankruptcy jurisdiction. Under 28 U.S.C. Sec. 1334, bankruptcy courts and state courts have concurrent jurisdiction over matters arising in a bankruptcy case, arising under bankruptcy law or related to a bankruptcy case. Therefore, the state court would have jurisdiction over this claim, which either arose in a bankruptcy case or was related to a bankruptcy case, unless preemption applied. The Supreme Court reasoned that a generally applicable provision, such as Bankruptcy Rule 9011, did not evidence an intent to preempt another court's jurisdiction, while a "custom-built" provision, such as 11 U.S.C. Sec. 303(i) or 362(k) (sanctions for filing involuntary proceeding in bad faith and sanctions for violating the automatic stay) would. Since no "custom-built" bankruptcy provision applied to redress harm arising from a malicious adversary proceeding, the claim could be brought in state court.

This opinion helps to point out that there are at least four different vehicles for addressing a frivolous or malicious claim in bankruptcy court:

1. Sanctions under Rule 9011 (which requires following Rule 9011's procedures);
2. Sanctions under 28 U.S.C. Sec. 1927 for vexatiously multiplying proceedings;
3. Sanctions under the Court's inherent authority to punish bad faith conduct under 11 U.S.C. Sec. 105; and
4. A state court malicious prosecution action.

In the absence of an express prohibition, an aggrieved party may use any of these remedies.

What Do You Do With An Ombudsman?

Two of the new parties created by BAPCPA are the consumer privacy ombudsman and the patient care ombudsman authorized by sections 332 and 333 of title 11. In creating these positions, Congress acted to protect certain narrow constituencies deemed at risk in business bankruptcy cases. While the duties of an ombudsman are set out in the statute, the status of the ombudsman in relation to other code-created entities has yet to be fleshed out. Bankruptcy Judge Michael Lynn was faced with this issue when a patient care ombudsman sought to employ counsel and an advisor in the case of In re Renaissance Hospital--Grand Prarie, Inc., No. 08-43775 (Bankr. N.D. Tex. 12/31/08). Although no party objected to the employment, Judge Lynn wrote a thoughtful opinion about the role of the ombudsman and his authority to employ professionals. While Judge Lynn ultimately approved the employment, he tooks steps to limit the scope of the employment to avoid adding excessive administrative costs to the estate.

The Court first noted that while Congress had authorized compensation and expenses to be paid to an ombudsman, it did not provide for the ombudsman to employ professionals. As a result, the court looked at the nature of the ombudsman's role to see whether Congress had implicitly provided for this relief. The Court does a good job of explaining the roles of the various code-created entities in a chapter 11 case.

In analyzing the issues before the court, it is important to begin by noting the distinction between the role of an ombudsman as compared to that of other fiduciaries compensated (together with their retained professionals) by the estate. A trustee or debtor in possession and its professionals have the duty of preserving, protecting and maximizing the estate. A committee and its professionals serve a constituency with an economic interest in the estate. A committee will have a common interest with representatives of other economic constituencies in preserving value for creditors (and even equity owners) as well as enhancing the estate.

A patient care ombudsman, on the other hand, is concerned with a constituency whose interests do not necessarily coincide with the economic interests of other case participants. The ombudsman therefore is not concerned with the economics of the case. His very job is to ensure that his constituents--patients--are well cared for by the debtor in possession (or trustee). He may press for the debtor in possession (or trustee) to take costly measures that will deplete rather than enhance the estate and the ultimate recovery of creditors. The result is that the court and other parties cannot view a patient care ombudsman as they can a fiduciary whose job includes improving an estate's value.

One of the inherent goals in a bankruptcy case is to ensure that what is paid for from the estate provides a comparable return to the estate. Because a patient care ombudsman's cost to the estate will not be (or at least is unlikely to be) offset by any accretion of value to the estate, it is incumbent upon the court to ensure that the patient care ombudsman, while fulfilling his statutory role, does not create a serious drain on estate assets. In short, retention by an ombudsman of professionals is not consistent with the central purpose of bankruptcy in general and chapter 11 in particular: improving return to creditors and equity holders.

Memorandum Opinion, pp. 5-6.

The court concluded that "in proper circumstances and for limited purposes an ombudsman may employ professionals." The court reached this conclusion because the duties of an ombudsman include filing motions before the court. "As it is doubtful that every suitable candidate for the ombudsman role will possess not only the qualifications necessary to 'monitor the quality of patient care' but also the expertise necessary to preapre legal documents and appear in court, it seems clear that Congress must have anticipated that an ombudsman would, on occasion, have to have the assistance of counsel." Memorandum Opinion, p. 8. The Court also noted that the statute authorizes appointment of a "disinterested person" as ombudsman. Since the term "person" includes individuals, partnerships and corporations, an entity could be appointed as ombudsman. Since an entity must appear by counsel, it is appropriate for an ombudsman to employ counsel.

However, the Court limited the scope of employment of the ombudsman's counsel. The Court noted that the proposed counsel was being retained primarily for its bankruptcy expertise, while the ombudsman was required to protect and enhance the care of patients. "Counsel to an ombudsman does not require a license to generally monitor and participate in all phases of a bankruptcy case." Memorandum Opinion, p. 12. The Court defined counsel's duties as follows:

Two functions are required of the attorneys representing the Ombudsman. First, the Ombudsman must be assisted in identifying and understanding those laws intended to protect patients and those laws intended to regulate, to such end, Debtors' businesses. Second, counsel must press such motions as the Ombudsman may be required to file under Code section 333 or Rule 2015.1; additionally counsel may aid the Ombudsman in identifying and opposing relief requested by other parties which, if granted, would cause patient care to deteriorate or otherwise adversely affect patient's rights.

Memorandum Opinion, p. 12. However, the Court did not allow counsel to be compensated for preparing reports for the Ombudsman except to the extent necessary to make accurate statements about healthcare law.

The application to employ the Advisor posed a more difficult question. The proposed Advisor was the company which employed the Ombudsman. The Ombudsman proposed to hire his company to perform many of the duties of the Ombudsman himself. However, "The general rule in bankruptcy is that a fiduciary employed at estate expense will not be permitted to hire a professional to perform those duties statutorily assigned specifically to the fiduciary." Memorandum Opinion, p. 14. The Court pointed out that the U.S. Trustee could have appointed the proposed Advisor as Ombudsman rather than appointing the individual. "If the burden of serving as the patient care ombudsman in these cases is beyond the capability of an individual, an entity with greater capacity should be assigned the role rather than dividing it up through the use of an advisor." Memorandum Opinion, p. 15.

Nevertheless, the Court approved employment of the Advisor on the basis that the U.S. Trustee did not oppose the appointment and might not have considered the possibility of appointing an entity rather than an individual. However, the Court reserved the right to deny a similar request under other circumstances.

The Renaissance Hospital case is interesting because it illustrates the problem of how to make the bankruptcy system work when the Code provisions are incomplete or inadequate. The Court could have adopted a strict constructionist approach and denied employment of professionals on the basis that was not specifically authorized by the Code. On the other hand, the Court could have adopted a laissez faire approach and approved the employment on the basis that no one had objected. Instead, the Court looked within the structure of the Code to find a statutory basis for allowing the employment without giving a blank check to the professionals. While the argument that Congress must have intended something more than it made explicit can easily be abused, the Court did a good job of navigating between Code and practicality in this case.

2008 Was a Busy Bankruptcy Year for the Fifth Circuit

The Fifth Circuit has busy this year. They have been turning out bankruptcy opinions at a rate where they might consider changing the name of the court to the Fifth Circuit Court of Bankruptcy Appeals. So far I have written a dozen articles about their decisions this year. However, there are still a lot of interesting cases that I didn’t get around to. Here is a quick rundown of the best of 2008 (and one from 2007). Where I have already written about a case, I have provided the reference to the prior article. Some cases can be summed up in a sentence while others are more complicated and some are just plain baffling.

Appellate Practice
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Matter of Gadzooks, Inc., 2008 U.S. App. LEXIS 19339 (5th Cir. 2008). “Fifth Circuit Dismisses Gadzooks Appeal.” (10/2/08).
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Matter of Hilal, 534 F.3d 498 (5th Cir. 2008).

Substantial consummation of plan did not result in dismissal of appeal based on equitable mootness where debtor framed his appeal narrowly.
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Matter of S.I. Restructuring, Inc., 542 F.3d 131 (5th Cir. 2008).
“Equitable Mootness Fails to Prevent Disgorgement” (10/2/08).
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Attorney Fees

Matter of Babcock & Wilcox Company, 526 F.3d 824 (5th Cir. 2008).

Bankruptcy court did not abuse its discretion in reducing amounts billed for travel time in half.
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Automatic Stay/Discharge
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Matter of Bayhi, 528 F.3d 393 (5th Cir. 2008).

This case is not easy to follow, but is worth reading, for no reason other than the fact that Chief Judge Edith Jones dissented to vindicate the debtor’s discharge. The case begins with a husband and wife who consolidated their student loan debts into a single obligation. Under Louisiana law, liability was in solido meaning that the creditor could seek recovery of the entire debt from either party or both. The couple divorced and agreed that each would pay half of the debt. The wife continued to pay until she filed bankruptcy. Although the husband was listed as a creditor, he did not file an action to determine dischargeability under Sec. 523(a)(15).

Post-discharge, the husband filed a declaratory judgment action seeking a determination that the debt was a community obligation and thus solidary. This was agreed to. Subsequently, he filed a complaint for specific performance seeking to compel the wife to pay her share of the student loan directly to Sallie Mae. The state court granted a judgment in the husband’s favor.

The wife then re-opened her bankruptcy and sought to have the husband held in contempt for violation of the discharge. The bankruptcy court agreed, finding the pro se husband in contempt, but did not award any damages. Instead, it enjoined the husband from seeking to collect the wife’s share of the debt and vacated the state court judgment.

On appeal, Judge Wiener, writing for himself and Judge Barksdale, voted to reverse and remand, while Chief Judge Jones dissented in part. Section 524(a)(1) states that the discharge “voids any judgment at any time obtained, to the extent that such judgment is a determination of the personal liability of the debtor with respect to any debt discharged . . .” The judges disagreed among themselves as to what was a debt.

The majority judges concluded that the wife’s obligation to pay one-half of the student loan debt pursuant to the divorce decree was not a “debt.” Therefore, it could not be discharged. Since the student loan debt was not discharged, the husband’s attempt to compel the wife to pay a non-discharged debt did not violate the discharge.

Chief Judge Jones agreed that the husband should not be held in contempt because “in asserting that novel claim, (the husband) did not intentionally violate his ex-wife’s discharge order and should not be subject to civil contempt for violation of the 11 U.S.C. §524(a) discharge injunction.” However, the Chief Judge held that vacating the state court judgment was nothing more than an end run around the discharge. Judge Jones viewed the wife’s obligation vis-à-vis the husband to pay one-half of the student loan debt as a separate debt from the student loan itself. While the husband could have sought a determination that his contribution right was not discharged pursuant to 11 U.S.C. §523(a)(15), he did not and his rights were discharged.

This is a case where the dissent has the better side of the argument. While the wife’s obligation to Sally Mae was clearly not discharged, the husband’s right to compel the wife to pay her share of the debt is “an equitable remedy for breach of performance” which can be reduced to judgment and thus falls within the definition of a claim under 11 U.S.C. §101(5)(B).

However, the dissent evenhandedly provides a benefit to the creditor as well. Because the husband was asserting a novel claim, he did not intentionally seek to violate the discharge. Before a creditor can be held in contempt, he must intentionally violate a court order. Where the scope of the order is unclear, contempt is not available. The dissent pairs nicely with the Gervin opinion, in which the creditor was held not to violate the discharge by trying to collect from property it believed was subject to its judgment lien, but was actually owned by the co-debtor.
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Campbell v. Countrywide Home Loans, Inc., 545 F.3d 348 (5th Cir. 2008).

At the time that Debtors filed chapter 13, they owed 15 delinquent mortgage payments, owed for taxes and insurance advanced for a prior year and had not made any escrow payments in the current year. Rather than including the current year’s escrow shortage in the proof of claim, the creditor stated that the amount of the post-petition payment would be increased to recoup these amounts. The Bankruptcy Court found that Countrywide had violated the automatic stay, but allowed for an interlocutory appeal prior to assessing damages.

Under RESPA, Countrywide had the right to increase the debtors’ payment by the amount of any insufficiency in the escrow account. The Fifth Circuit held that the pre-petition escrow arrearage was a “claim” within the meaning of the Bankruptcy Code and that the automatic stay applied to efforts to collect that claim. However, where the creditor did not actually collect the increased amount stated in the proof of claim and did not take any affirmative steps to collect the increased amount other than including the statement in the proof of claim, the creditor had not taken an action which violated the stay.
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Matter of Gervin, No. 07-50099 (5th Cir. 11/21/08)(unpub).

The Bankruptcy Court affirmed the District Court finding that the creditor did not violate the discharge when it attempted to collect a debt from property that it believed to be subject to its judgment lien. The District Court opinion is discussed at “District Court Reverses Discharge Violation; Finds Some Violations Too Technical to Punish.” (7/23/07).
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In re Repine, 536 F.3d 512 (5th Cir. 2008).
“Fifth Circuit Answers Three Questions of First Impression on Automatic Stay.” (7/25/08).
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Avoidance Actions
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Matter of Bossart, 2008 U.S. App. LEXIS 21807 (5th Cir. 2008)(unpub).

This unpublished opinion affirmed a bankruptcy court opinion allowing a trustee to sue a company which issued an annuity to recover the annuity payment as a fraudulent transfer. The case was essentially an end run around the debtor's claim of the annuity as exempt.
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In re Entringer Bakeries, 2008 U.S. App. LEXIS 23313 (5th Cir. 2008).
“Fifth Circuit Explains Earmarking” (11/6/08)
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Matter of N A Flash Foundation, Inc., 541 F.3d 385 (5th Cir. 2008).

Where creditor was paid out of debtor’s general operating account, but debtor would have received funds subject to a construction trust fund claim subsequently, creditor did not receive more than it would have in a hypothetical chapter 7 liquidation. In a hypothetical liquidation case, the court presumes that the debtor would have preserved the trust funds and the creditor would have been paid in full.
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Constitutionality

Hersh v. United States, No. 07-10226 (5th Cir. 12/18/08)
“Fifth Circuit Relies on Constitutional Avoidance to Uphold Sec. 526(a)(4)(12/19/08)
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Dischargeability

Matter of Shaffer, 515 F.3d 424 (5th Cir. 2008).

Dentist had license revoked and was required to pay costs incurred in investigation in amount of $217,852.13. Fifth Circuit held that costs were in compensation of actual pecuniary loss and therefore did not fall within exception to discharge for fines and penalties under 11 U.S.C. §523(a)(7).
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Due Process

Matter of Waterford Energy, 2008 U.S. App. LEXIS 20972 (5th Cir. 2008)(unpub).

The Debtor owned oil and gas well in Oklahoma and was required to pay royalties to the State of Oklahoma. When it filed bankruptcy, it did not give notice to the State, but it did file a copy of its bankruptcy petition and draft plan in the real estate records. Under Oklahoma law, a certified copy of a bankruptcy petition filed in the real estate records constitutes constructive notice. However, the Fifth Circuit held that federal law rather than state law controlled on question of whether constructive notice to unknown creditors was adequate. Notice by filing in the real estate records was inadequate. Notice to unknown creditors should have been given by publication. As a result, the State did not receive notice complying with due process and its claims were not discharged.
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Equitable Subordination

Matter of S.I. Restructuring, Inc., 532 F.3d 355 (5th Cir. 2008).
“Fifth Circuit Rejects Equitable Subordination Claim With Deepening Insolvency Aspect; Insiders Not Liable for Stoking Fires of Sinking Ship.” (7/1/08).
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Exempt Property
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Matter of McClain, 516 F.3d 301 (5th Cir. 2008).

Debtor purchased an insurance policy with funds which were not disclosed on his schedules. When the insured died, the trustee claimed the policy proceeds under a constructive trust theory. The Fifth Circuit held that the trustee could have an interest in the policy if it could trace the undisclosed funds to the policy premiums and remanded the case for a trial to determine tracing and to determine what portion of the proceeds, if any, should go to the trustee.
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Matter of Peres, 530 F.3d 375 (5th Cir. 2008).

Where creditors’ meeting was continued but a new date was not announced at the meeting, time to object to exemptions did not start to run until creditors’ meeting was concluded eleven months later.
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Matter of Rogers, 513 F.3d 212 (5th Cir. 2008).
“Fifth Circuit Rules on Homestead Cap” (1/30/08).
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Matter of Soza, 542 F.3d 1060 (5th Cir. 2008).

Debtor bought an annuity the day before filing bankruptcy. Based on timing of purchase, fact that debtors retained control of funds and fact that annuity payment would have been sufficient to pay all creditors in full among other things, the Fifth Circuit found that the annuity was purchased “in fraud of a creditor” and denied the exemption based on Texas law.
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Interest Rate

Drive Financial Services, LP v. Jordan, 521 F.3d 343 (5th Cir. 2008).
“Fifth Circuit Releases Interest-Ing Opinion on Chapter 13 Interest Rates” (3/30/08).
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Judicial Estoppel

Kane v. National Union Fire Insurance Company, 535 F.3d 380 (5th Cir. 2008). “Trustee Avoids Judicial Estoppel Finding As Fifth Circuit Comes Full Circle” (7/25/08).
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Jurisdiction

Matter of Maples, 529 F.3d 670 (5th Cir. 2008)

This is a case where the published opinion sheds very little light on what happened. The opinion was published at the request of the dissenting judge and the majority goes to great lengths to say very little other than that there was no reversible error. It is necessary to read the unpublished District Court opinion to get some understanding of the case.

The Debtors owned Global Limo, Inc. Partain obtained a judgment against the Debtors and obtained a turnover order for the Debtors’ stock in the company. Partain then took possession of the assets of Global Limo. The Debtors filed bankruptcy and brought suit to set aside the turnover order as a preference. Partain, acting on behalf of Global Limo, brought a third party action against Texas State Bank alleging that it had harmed Global Limo. Somewhere there was also a claim that the Debtors and Texas State Bank had conspired to deprive Partain of his choice of counsel.

The Bankruptcy Court avoided the turnover order as a preference and denied Partain’s claims for lack of standing, since he did not have authority to act on behalf of Global Limo.

On appeal to the Fifth Circuit, the majority stated: “This case is poorly briefed, and the record is incomplete. The majority is therefore unwilling to say anything other than that the district court committed no reversible error in affirming the bankruptcy court.”

In dissent, Judge Emilio Garza argued that the Bankruptcy Court lacked subject matter jurisdiction over the claims between Partain and Texas State Bank and that the bankruptcy court had exceeded its authority in ordering the corporate assets of Global Limo brought into the bankruptcy estate of the debtors. The dissent took the majority to task for failing to consider the jurisdictional issue on the ground that the underlying claim was patently meritless. The dissent stated: “Nothing in the record suggests that TSB’s potential exposure would impact the Mapelses’ bankruptcy estate. Because this claim between third parties has no conceivable effect on the bankruptcy estate, the bankruptcy court improperly resolved this claim over which it lacked subject matter jurisdiction.” The dissent also faulted the bankruptcy court for ordering the corporate assets transferred to the estate. Although the corporate charter had been forfeited, the corporation and not its debtor shareholders still owned its assets.
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Newby v. Enron Corporation, 535 F.3d 325 (5th Cir. 2008).
“Fifth Circuit Clarifies Post-Confirmation Jurisdiction” (7/11/08).
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Property of the Estate

Matter of Seven Seas Petroleum, Inc., 522 F.3d 575 (5th Cir. 2008).

This case is the latest in a line of cases including In re MortgageAmerica Corp., 714 F.2d 1266 (5th Cir. 1983) and In re Educators Group Health Trust, 25 F.3d 1281 (5th Cir. 1994) which construe whether a cause of action belongs to the bankruptcy estate or may be asserted by individual creditors.

The Debtor owed money to unsecured bondholders. The bonds provided a formula which limited the amount of secured debt which the debtor could incur. This formula was based in part on the value of the debtor’s reserves. A consultant (Ryder Scott) calculated the reserves in an amount which proved to be highly overstated. The debtor sold $45 million in secured notes, half of which were purchased by Chesapeake. The other half were purchased by a group of investors led by the Debtor’s chairman (Hefner).

An involuntary bankruptcy was filed against the Debtor. The trustee brought various claims against Chesapeake, but dropped all claims except one seeking to re-characterize the debt as equity. All claims against Chesapeake were settled pursuant to the Debtor’s plan, which was supported by the unsecured bondholders.

The bondholders then brought a state court action against Chesapeake, Hefner and Ryder Scott alleging Conspiracy to Defraud and Aiding and Abetting Fraud. Chesapeake removed the case to the bankruptcy court. The bankruptcy court found that the claims against Chesapeake were property of the estate and had been released under the plan.

The bondholders appealed claiming that the claims belonged to them individually and were not property of the estate. The Fifth Circuit reversed and remanded. It held that the bankruptcy estate may bring claims which are typically brought by creditors outside of bankruptcy if the claims seek to recover assets which rightfully belong to the bankruptcy estate but are held by others. Thus, fraudulent conveyance claims and claims to pierce the corporate veil belong to the estate. However, claims to recover damages incurred by creditors will continue to belong to the creditors. In this case, the court found that the creditors were not seeking to recover assets belonging to the estate. As a result, the claims belonged to them and the bankruptcy court erred in dismissing the claims based on the plan.
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Sanctions and Misconduct
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Baum v. Blue Moon Ventures, LLC, 513 F.3d 181 (5th Cir. 2008).

U.S. District Judge had authority to enter pre-filing injunction preventing vexatious parties from filing litigation in any federal court, but lacked jurisdiction to enjoin state court filings.
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Cochener v. Barry, 2008 U.S. App. LEXIS 22339 (5th Cir. 2008).
“Fifth Circuit Reinstates Sanctions Award” (11/14/08).
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Matter of Pratt, 524 F.3d 580 (5th Cir. 2008).
“Fifth Circuit Clarifies Requirements of Rule 9011.” (4/8/08).
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Matter of Yorkshire, LLC, 540 F.3d 328 (5th Cir. 2008)

This is a case which is not designated for publication, but which is included in the West Reporter. Thus, it seems to be a published unpublished opinion. This case involved a business dispute between owners/managers of a business. When Knight, who was one of the managers, received notice that the other owners planned to remove him, he hired an attorney to file bankruptcy for two related entities. The bankruptcy attorney “conducted little diligence on the financial status of the entities an no diligence on their ownership and management so as to reach an informed decision as to whether a bankruptcy was warranted, and if so, who had authority to file it.” Shortly thereafter, Knight was removed from management and the new management voted to fire the attorney who had filed the bankruptcy case. After being fired by the debtor, the attorney represented Knight against the debtor. The Bankruptcy Court dismissed the cases after finding that the debtors were solvent and not in default upon their debts, but retained authority to consider sanctions. The Bankruptcy Court sanctioned both Knight and the attorney. The Fifth Circuit affirmed the Bankruptcy Court, finding that its conclusion of bad faith conduct was supported.
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Single Asset Real Estate

Matter of Scotia Pacific Company, 508 F.3d 214 (5th Cir. 2007).

Fifth Circuit considered whether debtor was a Single Asset Real Estate debtor. Test is: (1) debtor must own real property constituting a single property or project; (2) which generates substantially all of the gross income of the debtor; and (3) on which no substantial business is conducted other than the business of operating the real property and activities incidental thereto. Fifth Circuit affirmed finding that debtor conducted a substantial business on the property. Debtor employed over 60 employees and engaged in sophisticated activities such as soil conservation, road planning, design and engineering. In order to be a SARE, revenues received by the debtor must be passive rather than active.
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Standing

Matter of United Operating Company, LLC, 540 F.3d 351 (5th Cir. 2008).

Reorganized debtor lacked standing to pursue claims arising during bankruptcy, where (i) assets of estate did not revest in debtor upon confirmation and (ii) plan provided for retention of claims created under Bankruptcy Code but not common law claims.

Bankruptcy Court Limbers Up to Tackle Mental Gymnastics of Lien Avoidance

A Texas bankruptcy judge had to engage in some mental gymnastics to decide whether to avoid a lien on property exempted under the federal wildcard in In re Melissa Catherine Powell, No. 08-60204 (Bankr. W.D. Tex. 11/6/08). Powell presented some interesting facts. The debtor owned four tracts of real property. However, those properties were encumbered with a $1.1 million judgment lien. Ms. Powell had apparently been up to no good, since the judgment creditor subsequently obtained a non-dischargeable judgment against her. In the absence of bankruptcy, the debtor would have lost the three non-homestead properties. However, the debtor filed bankruptcy, claimed the property as exempt under Sec. 522(d)(1) and (5) and then sought to avoid the judgment lien as a lien impairing an exemption. While the result may raise a few eyebrows, the court faithfully followed the code sections.

The debtor was able to claim four properties as exempt because Texas allows use of the federal exemptions and each property had minimal equity. The debtor claimed total exempt equity of $7,406.43 between the four properties. The exempt values were determined based on the difference between the scheduled values and the non-judgment liens. No party objected to the exemptions, so that they became final. The debtor then moved to avoid the judgment lien as a non-purchase money lien impairing an exemption under Sec. 522(f). The creditor tried to hold the debtor to its scheduled exemption, arguing that the debtor had claimed $7,406.43 in exempt property and could not avoid the judgment lien to the extent that the equity in the properties exceeded this amount.

The Bankruptcy Court framed two issues for decision:

1. Exactly what was claimed and allowed as exempt?

2. Are the creditors, in defense of a lien avoidance motion under Sec. 522(f), foreclosed from challenging the exempt nature of the properties in question due to their failure to timely object to the Debtor's exemption claims?

The creditor's defense to the lien avoidance motion raised the question of what the debtor had claimed as exempt. Was it the property or was it a specific dollar value in equity? The court dryly noted, "Remarkably, this is an issue about which there has been some controversy."

The court pointed out that when a debtor claims an unknown amount as exempt or lists the exempt value at $1, she is putting creditors on notice that the entire value of the asset is claimed as exempt. On the other hand, when the debtor listed a specific dollar amount calculated as the difference between the scheduled value and the scheduled liens, creditors were not on notice that the debtor might claim a greater value. The court noted that there was a difference between "in kind" exemptions which apply to the entire asset and "not to exceed" exemptions which are limited to a dollar value.

The Court stated:

Section 522(d)(1) and (5) allow the Debtor to exempt her aggregate interest in the real property in question. There are not "in kind" statutes. However, when the Debtor places a value on her exemption under (d)(1) and (5) which is less than the monetary amount allowable under the statute and such value was reached by deducting the amount of debt from the value of each such listed property as set forth on Schedule A; it is clear, at least to this Court, that the Debtor's intention was to exempt the maximum allowable under the federal exemption statute. There is no intent to exempt the Properties in their entirety. Even so, this is not determinative of the issue at had as discussed below.

Slip op. at 8.

The issue is thornier because Sec. 522(f) allows the debtor to avoid a lien "to the extent that such lien impairs an exemption to which the debtor would have been entitled under subsection (b) of this section . . ." Thus, for purposes of lien avoidance, the issue is not what amount was exempted by the debtor, but what amount the debtor would have been entitled to. "For purposes of Sec. 522(f), the issue starts with the inquiry of whether we are dealing with property the debtor would have bene entitled to exempt not whether the debtor has scheduled them as such." Slip op. at 11.

Based on the "would have been entitled" language of Sec. 522(f), a debtor who under-exempts his property would be entitled to avoid the lien based on the full amount he was entitled to, while a debtor who over-exempted or claimed property which should not have been exempt at all could not resort to use of Sec. 522(f).

In the specific case, the amount actually claimed as exempt by the Debtor was $7,406.43. However, the Debtor was entitled to claim exemptions of $21,275.00 based on Sec. 522(d)(1) and (5). The lien would impair the exemption to the extent that it prevented the Debtor from realizing the value of $21,275 that she "would have been entitled" to. If there was less equity in the property than the maximum which could be claimed as exempt, then the lien "should be avoided in its entirety as the Debtor's claimed exemption is totally impaired." On the other hand, if the properties were worth more than the value of the unavoidable liens plus the Debtor's maximum exemption, then the "judicial lien would be preserved to the extent of such excess value." Although the Debtor's schedules indicated that there would not be any excess value for the lien to attach to, the court gamely offered that, "if the (creditors) would like to offer such proof, the court is amenable to holding a hearing for such purpose."

There are a number of important points to take away from this opinion.

1. Just because the Debtor is a bad person does not prevent them from using the tools available under the Code. While we frequently say that the Bankruptcy Court is a court of equity and that litigants must do equity to receive equity, that will not overcome a statutory command. In this case, the court, in discussing the creditors' claim, dropped a footnote stating, "There is no indication in the Complaint as to whether the Debtor was prosecuted for her alleged misdeeds; but, if they are true, prosecution would seem most appropriate." Where else but Bankruptcy Court would a party for whom "prosecution would seem most appropriate" prevail against the wronged party?

2. There are two types of exemptions: in-kind and not to exceed. An in-kind exemption exempts the entire property, while a not to exceed exemption just protects a dollar amount. As a result, failure to object to a "not to exceed" exemption does not make the entire property exempt unless the debtor clearly stated an intent to claim the entire asset or the asset was worth less than the allowable exemption. Therefore, if the debtor claims a $5,000 wildcard exemption on a million dollar asset, the debtor gets to keep $5,000 rather than $1,000,000.

3. Lien avoidance under Sec. 522(f) is based on what the debtor should have been entitled to exempt rather than what she actually claimed as exempt. Therefore, every lien avoidance hearing is also a hearing to determine what the exemption should have been.

Fifth Circuit Relies on Constitutional Avoidance to Uphold Sec. 526(a)(4)

In a departure from rulings by the Eighth Circuit and several lower courts, the Fifth Circuit has held that Sec. 526(a)(4), which limits the advice debt relief agencies can give potential debtors "in contemplation of" bankruptcy, passes constitutional scrutiny. Susan B. Hersh v. United States of America, No. 07-10226 (5th Cir. 12/18/08). The Fifth Circuit also found that attorneys were "debt relief agencies" and upheld the constitutionality of Sec. 527.

Section 526(a)(4) is found amongst three sections regulating the activities of "debt relief agencies." It states that a debt relief agency shall not "advise an assisted person or prospective assisted person to incur more debt in contemplation of such person filing a case under this title or to pay an attorney or bankruptcy petition preparer fee or charge for services performed as part of preparing for or representing a debtor in a case under this title." Several courts, including the Eighth Circuit, have held that this statute is an overly broad restriction on protected speech because it prohibits beneficial speech as well as abusive advice. Milavetz, Gallop & Milavetz, P.A. v. United States, 541 F.3d 785 (8th Cir. 2008).

The Fifth Circuit acknowledged that if the statute were interpreted literally, it could be problematic.

If interpreted literally and broadly, section 526(a)(4) would raise serious consitutional problems because, as Hersh suggests, it would restrict some speech that is protected by the First Amendment. The statute does not expressly qualify its restriction on advice to situations in which incurring more debt would be an abuse of the bankruptcy system. Thus, if interpreted literally, section 526(a)(4) creates a blanket restriction on attorneys advising clients to incur any debt when intending, or contemplating whether to, file for bankruptcy under any circumstances. It would prohibit some attorney advice that would not be abusive to the bankruptcy system, harmful to creditors, or harmful to debtors. Thus, interpreted literally, section 526(a)(4) may apply to speech that is protected by the First Amendment.

Slip op. at 15.

However, at this point, the Fifth Circuit took a cue from the dissent in Milavetz and noted that the constitional problem could be avoided through a narrow construction. While section 526(a)(4) could prohibit some permissible speech, it also restricts malignant speech as well. Under the doctrine of constitutional avoidance, courts will decline to hold an act unconstitutional when another legitimate construction is available. The court concluded that this was possible in the case of speech in contemplation of bankruptcy.

To avoid potential constitutional questions regarding section 526(a)(4)'s restrictions on speech, this court construes the statute to prevent only a debt relief agency's advice to a debtor to incur debt in contemplation of bankruptcy when doing so would be an abuse of the bankruptcy system. In so interpreting the statute, we avoid the constitutionality questions raised by Hersh (and those relied on by the Milavetz majority) and conclude that the statute only affects unprotected speech.

Slip op. at 19.

Having decided to avoid the constitutional issue, the Fifth Circuit took some pains to explain why its construction was plausible, noting that constitutional avoidance "is not a license for the judiciary to rewrite language enacted by the legislature." The court pointed out that the "in contemplation" phrase is frequently used to connote bad intent. The court also stated that the civil remedies for violation of the section, which include recovering damages for the benefit of the debtor and enjoining bad conduct, indicate a purpose to protect debtors from abusive advice rather than to shield them from good counsel. Finally, the court found that curbing abusive attorney practices was a major concern of BAPCPA, so that such an intent could be used to inform the statute's construction.

Milavetz and Hersh represent two different approaches to the issue of regulating attorney speech. The Milavetz decision focuses primarily on not chilling protected speech. On the other hand, the Hersh opinion seeks to protect regulation of abusive speech. With a split within the Eighth Circuit and between the Fifth and Eighth Circuits, this issue may be heading for the Supreme Court.

Republic Windows & Doors Case Illustrates Gaps in Employee Protection

Republic Windows & Doors, the Chicago company which recently closed its doors, is not a debtor in bankruptcy, at least not yet. However, it illustrates the point that when laws designed to protect employees meet secured financing, the workers can come up short.

Republic was a company which had operated since 1965. It began losing money in 2002. It tried various strategies, including raising new capital and selling assets. However, by October 2008, management knew that they were nearing the end of the road. As a last ditch effort, they presented an offer to Bank of America, their lender, to sell their note for $3.0 million on a balance of $4.5 million. Bank of America denied the request and demanded a plan for an orderly wind down. The company presented its first plan on October 16, 2008, which was turned down a few days later. The company submitted another proposal which was also rejected. Then it asked for permission to pay its employees for their vacation pay. Finally, on December 2, 2008, the company gave its employees three days notice that it would be closing.

Under the WARN Act, companies are required to give employees 60 days notice of a plant closing in many circumstances. Additionally, the employees would be entitled to a priority claim in bankruptcy for their wages up to $10,950. However, those rights are not worth much without money to pay them. The news articles don't go into detail about the lending relationship with Bank of America. However, in an asset-based lending transaction, all receivables are paid into a lockbox controlled by the bank. If the bank does not advance the money back under the loan, there is no money to operate with. In this situation, if management is not willing to divert receivables in violation of the credit agreement, the bank has the final control over whether employees are paid or not.

The fact that employees rights can be frustrated so easily has led to some creative methods to get workers paid. Some plaintiffs lawyers have sued banks under the WARN Act under the theory that they have become the employer. In the Republic Windows & Doors case, the employees have staged a sit-in at the factory to bring attention to their cause. They have managed to get prominent politicians from Rep. Luis Gutierrez to President-elect Barack Obama to plead their cause. Some have criticised Bank of America for accepting $25 billion in federal bailout money, but turning a cold shoulder toward the unpaid workers. Illinois Gov. Rod Blagojevich has ordered all state agencies to stop doing business with Bank of America until the workers are paid. However, the fact that Gov. Blagojevich was indicted on federal corruption charges today may give him less influence than he might have had otherwise.

Employee Wage Motions Still Viable

The author of the Mirant and CoServ opinions limiting critical vendor motions has written to emphasize that his prior rulings do not preclude employee wage motions in chapter 11 cases. In re Tusa-Expo Holdings, Inc., No. 08-45057 (Bankr. N.D. Tex. 11/7/08).

In Tusa-Expo, the Debtor filed a routine motion to pay employee wages to which no one objected. However, as the Court explained, the motion was a good vehicle for clarification of the court's views.

Though the Motion is unopposed, the court considers this an appropriate occasion to clarify its rulings in In re CoServ,LLC,273 B.R. 487 (Bankr. N.D. Tex. 2002) and In re Mirant Corp., 296 B.R. 427 (Bankr. N.D. Tex. 2003). In each of those cases the court set a high bar for payment of so-called "critical vendors," i.e., creditors holding prepetition unsecured claims against the debtor. Although the court carefully distinguished in CoServ between priority wage claims and general unsecured claims, as well as recognizing the particular generically critical character of claims for wages or benefits for employees, the court is concerned lest it be perceived by some that payment of prepetition claims of employees might be subject to undue scrutiny. It is important, in the court's view, that a prospective chapter 11 debtor be confident that, absent a question as to whether continuation of its operations is appropriate, prepetition wage and benefit obligations will continue during chapter 11 to be honored on a timely basis.

Memorandum Opinion, pp. 3-4.

The Court pointed out that the priority nature of wage claims set them apart from the typical critical vendor analysis. Then it went on to state that even apart from priority status, that employee claims would meet the test for payment of critical vendors under CoServ.

The Court concluded:

A central purpose of chapter 11 is to realize on a debtor's going concern value. That going-concern value is dependent in part upon the continuity and performance of the debtor's work force--something particularly true in the case at bar. The continuity and performance of a debtor's work force is, in turn, typically dependent on timely payment of wages and benefits. As claims based on prepetition wages and benefit programs almost always--as is the true of the Prepetition Employee Obligations--are entitled to priority payment under section 507(a) of the Code, unsecured creditors are not disadvantaged by early--timely--satisfaction of those claims.

Memorandum Opinion, p. 8.

There is nothing earth-shattering in this opinion. However, it is reassuring to see a court go out of its way to acknowledge the pragmatic nature of chapter 11, where the first order of business is to see that the patient survives long enough to have a chance at reorganizing. The problem with critical vendor motions was that just about every vendor could claim to be critical. In the absence of Congressional authority, there was no reason to create a de facto priority category for vendors. Since CoServ and Mirant, Congress has amended the Code to create an administrative priority category for vendors in the period immediately preceeding the petition. 11 U.S.C. Sec. 503(b)(9). These claims share some of the characteristics of employee wages claims in that they are given a high priority. However, there is a distinction in that most employees live paycheck to paycheck. If there is an interruption in pay, they are highly motivated to look for another job. Vendors, on the other hand, frequently extend credit and realize that credit risk is a cost of doing business. It will be interesting to see whether courts re-examine the critical vendor concept in light of this legislative change.

Fifth Circuit Reinstates Sanctions Award

The case of a Houston attorney sanctioned based on a brief representation of a debtor in 2001 took another turn as the Fifth Circuit reinstated the judgment of the Bankruptcy Court awarding sanctions. Matter of Cochener, No. 08-20048, 2008 WL 4681579 (5th Cir. 10/23/08). I have previously written about this case in "Brief Representation Comes Back to Haunt Attorney Six Years Later" (5/7/07) and "Sanctioned Lawyer Wins Reprieve From District Court; Court Clarifies Standards for Non-9011 Sanctions" (3/21/08).

Since I have discussed the facts extensively before, I will just summarize them briefly here. In 2001, an attorney without much bankruptcy experience filed chapter 7 for a woman who claimed few assets and no income. When questions were raised about the accuracy of her schedules at the first meeting of creditors, he decided to bring in a more experienced attorney. The new attorney realized that the debtor was heading for trouble based on incomplete schedules and statements and undisclosed transfers. He filed a motion to dismiss the case under Sec. 305(a)(1), claiming that it would be in the best interest of creditors and the debtor. He also apparently advised the debtor not to show up for the continued meeting of creditors and not to produce documents which the prior counsel had already agreed to produce. He also sent the trustee a letter in which he objected to producing documents about transfers going back more than a year on the basis that Sec. 548 only allowed a one-year look back period. Eventually he requested permission to withdraw because he had lost contact with the client. The court allowed the attorney to withdraw with the proviso that the trustee would be allowed to seek sanctions. The trustee finally got around to requesting sanctions years later.

The Bankruptcy Court awarded sanctions totaling $25,121.89 consisting of disgorgement of the $2,500.00 fee paid to the attorney and $22,621.89 to compensate the trustee for attorney's fees spent opposing the motion to dismiss and in obtaining sanctions. The sanctions were awarded under Sec. 105 and 28 U.S.C. Sec. 1927 for the reason that the trustee had not complied with the procedural requirements under Rule 9011.

The District Court affirmed the disgorgement order, but reversed the attorney's fees. The District Court concluded that to award sanctions under Sec. 105 and Sec. 1927, bad faith must be present. The District Court reviewed the various actions taken by the attorney and concluded that the only action which was sanctionable was advising the debtor not to attend the continued creditors meeting and produce documents. The court found that an attorney who advised a client not to attend the creditors' meeting had not earned his fee. Thus, the court affirmed disgorgement of the fee. The court found that only the minimum amount of sanctions necessary to deter bad conduct should be awarded and reversed the remainder of the Bankruptcy Court's award.

The Fifth Circuit concluded that the parties did not disagree on the underlying facts and that the real dispute was about the inferences to be drawn from those facts. The Fifth Circuit took a deferential approach toward the Bankruptcy Court's conclusions. It stated:

Viewing the case from the bankruptcy court's perspective, whether or not we might have drawn different inferences, we ascertain plausible record evidence to support the bankruptcy court's findings that Barry acted in bad faith, especially when he asserted that dismissal of Ms. Cochener's case was in the best interest of creditors; when he determined that he would not attend the rescheduled meeting of creditors on June 20, 2001; when he instructed the Debtor not to turn over relevant documents to the Trustee; and when he knowingly misrepresented the reach-back period for evaluation of improper transfers by the Debtor. . . . The district court's critical error seems to have been is failure to recognize that even if the bankruptcy was commenced originally as a "two-party dispute" and even if such a case might ordinarily be dismissible, the debtor has no right to such relief when she has abused the privilege afforded by bankruptcy relief. . . . The bankruptcy court acted well within its authority to enforce the integrity of the process by policing the accuracy of the debtor's schedules and representations to the court.

There are two issues worth noting here. The first relates to appellate review and the second relates to the attorney's duty to the court and his client.

On an appeal of a bankruptcy court's order, factual findings must be sustained unless clearly erroneous and legal conclusions are reviewed de novo. The question here was whether the conclusion of "bad faith" was more closely a factual finding or a legal conclusion. The Fifth Circuit found that the Bankruptcy Court's "inference" that debtor's counsel had acted in bad faith had to be upheld so long as it was "plausible." The District Court, on the other hand, appeared to make an independent determination of the conclusion to be applied to the facts. Although the Fifth Circuit did not go into much detail on this point, the result seems to be that conclusions to be drawn from the facts are reviewed much like the underlying facts themselves.

The ethical issue here concerns how the attorney managed his competing duties to his client and the court. It arguably was in the best interest of the client to extricate herself from bankruptcy before her fraudulent transfers could be uncovered. An attorney who advised his client not to file bankruptcy because of the possibility that fraudulent transfers would be uncovered would be acting ethically and giving the client good advice. However, once a bankruptcy proceeding had been filed, the attorney's duty to pursue the client's interest was limited by the attorney's duty of candor to the court. While the attorney was probably more disingenuous than dishonest, the perception that the attorney had moved from being an advocate for the client to a facilitator of the client's actions proved to be costly.