Central California Judges Give Lesson in Constitutional Law, Find that Legally Married Same Sex Couple Can File a Joint Petition

A decision by twenty Central California Bankruptcy Judges is likely to generate more heat than light[i] with its ruling that the Defense of Marriage Act is unconstitutional when applied to prevent a legally married same sex couple from filing a joint bankruptcy petition under 11 U.S.C. §302. In re Balas, No. 2:11-bk-17831 TD (Bankr. C.D. Cal. 6/13/11). You can find the opinion here. (PACER registration required).

A Gay Couple Walks Into a Courtroom

G. Balas and C. Morales were legally married in California. After experiencing numerous periods of illness, hospitalization and extended periods of unemployment, they filed for chapter 13 bankruptcy to attempt to restructure and repay their debts. Had they been named Jean and Carlos, there would have been no question that the legally married couple could file a joint petition. However, their names were actually Gene and Carlos, both males, married during a brief period when same sex marriage was legal in California.[ii] The U.S. Trustee filed a Motion to Dismiss unless they consented to severing their cases.

However, the debtors were up to the challenge. They were represented by well-respected California bankruptcy attorney Peter Lively. They were also represented by pro bono special counsel Robert Pfister with Ken Klee’s firm, Klee, Tuchin, Bogdanoff & Stern, LLP, who brought some star power to the case.

Joint Administration and DOMA

The general rule in bankruptcy is one debtor one case.[iii] However, under 11 U.S.C. §302(a), a single petition may be filed by “an individual that may be a debtor under such chapter and such individual’s spouse.” In 1996, the Defense of Marriage Act (DOMA) dictated that under federal law, the word spouse “refers only to a person of the opposite sex who is a husband or wife.” 1 U.S.C. §7. Reading the two statutory sections together, a joint petition could only be filed by a man and a woman who were husband and wife.[iv]

Filing a joint petition offers several advantages. For one thing, the couple pays one filing fee instead of two. In a chapter 13 case, that means a savings of $274. It also means paying one attorney’s fee instead of two. Filing a joint petition avoids difficult community property issues posed by separate filings. Under 11 U.S.C. §541(a)(2)(A), the bankruptcy estate of a debtor includes all community property under the sole, equal or joint management and control of the debtor.” That means that the first to file includes all joint community property. Additionally, a joint filing may influence the ability to confirm a chapter 13 plan. Assume two individuals, one with positive disposable income and one with negative disposable income. Together, they could confirm a plan based on their combined disposable income. Separately, one could not confirm a plan and the other would have to pay more. These are not huge differences, but they could be important in specific cases.

Prior to 2011, joint cases which did not involve a legally married man and a woman did not fare well. Courts had denied joint petition status to a man and his corporation,[v] In re Jephunneh Lawrence & Assoc. Chartered, 63 B.R. 318 (Bankr. D.C. 1986), a co-habiting but unmarried heterosexual couple, In re Malone, 50 B.R. 2 (Bankr. E. D. Mich. 1985), an unmarried same sex couple, In re Favre, 186 B.R. 769 (Bankr. N.D. Ga. 1995) and a same sex couple married in Canada, In re Kandu, 315 B.R. 123 (Bankr. W.D. Wash. 2004).

However, in 2011, two other courts held that legally married same sex couples could file joint petitions notwithstanding DOMA. In re Ziviello-Howell, No. 11-22706 (Bankr. E.D. Cal. 5/31/11); In re Somers, 2011 WL 1709839 (Bankr. S.D. N.Y. 5/4/11).

The Ninth Circuit and Constitutional Law

The Bankruptcy Court considered DOMA in the context of the equal protection clause of the Fifth Amendment and prior Ninth Circuit precedent. Under Equal Protection analysis, a distinction based on sexual orientation must survive heightened scrutiny, a standard greater than rational relationship. Under heightened scrutiny, a statute must be justified based on the reasons stated when it was passed rather than post hoc reasoning.

The Ninth Circuit had previously held that the military’s “Don’t Ask, Don’t Tell” policy violated the Constitution. Witt v. Department of Air Force, 527 F.3d 806 (9^th Cir. 2008). This ruling gave the bankruptcy court considerable support for its ruling.

The Bankruptcy Court’s Ruling

Given the court and the context, there was little suspense as to how the issue would be decided. The Court began its opinion with the following statement:

This case is about equality, regardless of gender or sexual orientation, for two people who filed for protection under Title 11 of the United States Code (Bankruptcy Code). Like many struggling families during these difficult economic times, Gene Balas and Carlos Morales (Debtors), filed a joint chapter 13 petition on February 24, 2011. Although the Debtors were legally married to each other in California on August 20, 2008, and remain married today, the United States Trustee (sometimes referred to simply as “trustee”) moved to dismiss this case pursuant to Bankruptcy Code § 1307(c) (Motion to Dismiss), asserting that the Debtors are ineligible to file a joint petition based on Bankruptcy Code § 302(a) because the Debtors are two males. The issue presented to this court is whether the Debtors, who are legally married and were living in California at the time of the filing of their joint petition, are eligible to file a “joint petition” as defined by § 302(a). As the Debtors state, “[T]he only issue in this Bankruptcy Case is whether some legally married couples are entitled to fewer rights than other legally married couples, based solely on a factor (the gender and/or sexual orientation of the parties in the union) that finds no support in the Bankruptcy Code or Rules and should be a constitutional irrelevancy.” Debtors’ Opp. 5:24–28. In this court’s judgment, no legally married couple should be entitled to fewer bankruptcy rights than any other legally married couple.

Opinion, p. 1-2.

The Bankruptcy Court did not have any difficulty finding that, in the specific context, DOMA would not survive rational relationship analysis, let alone heightened scrutiny.

The Court advanced the following analysis of the reasons advanced to support DOMA in Congress as applied to the specific case:

*Encouraging responsible procreating and child bearing. The couple did not have children and their ability to file a joint bankruptcy would not affect children in other relationships.

*Defending or nurturing the institution of traditional heterosexual marriage. Since the debtors were already married, allowing them to proceed with a joint bankruptcy would not affect anyone else’s marriage.

*Defending traditional notions of morality. The joint bankruptcy filing “is in no sense discernible to the Court to be a validly challengeable to morality, traditional, or otherwise, under the Fifth Amendment”.

*Preserving scant resources. “No governmental resources are implicated by the Debtors’ bankruptcy case different from the resources brought to bear routinely in thousands upon thousands of joint bankruptcy cases filed over the years[vi]”.

Opinion, pp. 12-13.

The Bottom Line

While the Balas case has attracted a lot of publicity, it is unlikely to have a lot of practical effect. First, it is limited to couples who are legally married. The Court did not allow unmarried same sex couples to file joint petitions. Therefore, the case is not a step toward requiring same sex marriage. Second, it is not clear whether courts outside of the Ninth Circuit would reach the same conclusion. The Ninth Circuit is the most liberal circuit. A more difficult test would be if a couple married in California were to move to Texas and file a joint petition. Third, allowing a joint bankruptcy petition, while desirable in some cases, is not a huge victory. What it means in this specific case is that two guys will have a little easier time proposing a plan to pay their creditors.

The case does have two interesting sidelights to it. First, it is unusual for bankruptcy courts to deal with the constitutionality of federal statutes. The Debtors’ counsel apparently provided a lot of very helpful briefing as shown by the many references to the Debtors’ Response in Opposition throughout the opinion. This shows that good briefing and research can be invaluable when the court is faced with a novel question. Second, it is unusual that twenty judges out of twenty-four in the district signed off on the opinion. This was Bankruptcy Judge Thomas Donovan’s case. There was no explanation given for why the other nineteen judges joined in. Sometimes, the judges of a district will sit en banc when considering an important issue. However, that does not appear to be what happened in this case. It seems to be highly unprecedented for other judges to sign on to a colleague’s decision on an ad hoc basis. Perhaps some of the judicial readers of this blog can shed some light on the issue.

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[i] The phrase originates from Hamlet, Act I, Scene 3 where Polonius gives his daughter Ophelia the following advice:

When the blood burns, how prodigal the soul

Lends the tongue vows. These blazes, daughter,

Giving more light than heat, extinct in both

Even in their promise as it is a-making,

You must not take for fire.

In judicial parlance, the phrase has come to refer to an argument with more passion than persuasiveness. See Sather, “Shakespeare for Lawyers: More Heat Than Light,” Am. Bankr. Inst. J. (March 1998). I am using the phrase in this context to refer to a decision which generates more controversy than practical effect.

[ii] According to the Opinion, there were 18,000 same sex marriages in California before the law was overturned by Proposition 8.

[iii] Not to be confused with the Texas Rangers maxim “one riot, one Ranger.” If you are confused over whether the phrase refers to the baseball team or the legendary law enforcement organization, you are not from Texas.

[iv] Theoretically, the man could be the wife and the woman could be the husband and still pass scrutiny under DOMA.

[v] While the man’s wife could have claimed that he was married to his job, this argument apparently was not raised.

[vi] This is actually not correct, since the clerk’s office is foregoing a filing fee of $274. However, if it is assumed that the filing fee is an accurate reflection of the cost of administering a case, then it would be a break even proposition.

Court Rules That Regulatory Actions Can Violate the Stay, Especially When You Say You Are Trying to Collect a Debt

An opinion from San Antonio Bankruptcy Judge Leif Clark examines when a claim against a non-debtor can violate the automatic stay. The short answer is: when the creditor says he is doing it to collect from the debtor. The long answer requires an examination of the interplay between 11 U.S.C. Sec. 362(a)(1) and 362(b)(4). In re Reyes, No. 10-52366-C (Bankr. W.D. Tex. 4/20/11). You can read the opinion here.

What Happened

The Reyes case arises from a real estate transaction gone bad. Josie Jones sued real estate broker Liza Reyes in state court and recovered a judgment. The Court succinctly described what happened next:

After the verdict was rendered, Jones and her lawyer, Robert Wilson, met with the debtor in a conference room at the courthouse. There, the debtor informed Wilson that they intended to file for bankruptcy. In response, Wilson, in the hearing of not only the debtor but also members of the debtorʼs family, told the debtor that he would “run them out of business by filing a complaint with the TREC (Texas Real Estate Commission) and close them down to get the money.” After the debtor filed for bankruptcy, Wilson, true to his word, filed a complaint in September 2010, on behalf of his client, with the TREC. The complaint took a number of months to prepare, and Wilson billed his client for the service. The TRECʼs procedures do not require a pre-investigation as a prerequisite to instituting such a complaint. Instead, the filing of the complaint itself necessitates an investigation by the Commission. If such an investigation results in a determination of wrongdoing on the part of the agent, and if a finding of damages is made, then the the TREC may make a monetary award to the complaining witness, and may subsequently seek reimbursement from the agent in the amount of the award. Wilson is well aware of these rules and procedures, this being one of his areas of practice.

Opinion, pp. 1-2.

The Debtors filed a Motion for Contempt against Jones and her attorney for violating the automatic stay by filing the Complaint with TREC. The Bankruptcy Court agreed with the Debtors and ruled that the stay had been violated.

The Automatic Stay By the Numbers

Among other things, the automatic stay prohibits:

(1) the commencement or continuation . . . of a judicial, administrative, or other action or proceeding against the debtor that was or could have been commenced before the commencement of the case under this title, or to recover a claim against the debtor that arose before the commencement of the case;

* * *

(6) any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case under this title.

It is clear that the respondents commenced an administrative proceeding that could have been commenced before the commencement of the case and that the claim against the Debtor arose before the commencement of the case. More difficult is the question of whether it was a proceeding to recover a claim against the debtor.

The Court answered this question in the affirmative, but only after an extensive discussion of whey the exception to the automatic stay of Sec. 362(b)(4) did not apply. Sec. 362(b)(4) allows

the commencement or continuation of an action or proceeding by a governmental unit . . . to enforce such governmental unit's police and regulatory power . . .

Notably, Sec. 362(b)(4) does not allow a private party to commence an action to enforce a governmental unit's police and regulatory power. Additionally, the Court found it significant that the TREC was required to act on the complaint.

Here, by contrast, the filing of a complaint that stated the requisite grounds for an investigation commences such an investigation, without any independent discretion on the part of the Commission. The TREC had no independent choice in the matter once that complaint was filed. The institution of an action that necessarily required further prosecution was not the mere discharge of a public duty, . . . .

Opinion, p. 8.

Further, the Court found that Ms. Jones, who lives in California, was unlikely to be motivated by a desire to protect Texas residents from unethical real estate brokers, and was more likely to be motivated by collection of money.

The Court ultimately found that the respondents were using the TREC as a vehicle to recover a claim against the debtor. Judge Clark stated:

The filing of this complaint is more correctly viewed as Wilsonʼs following up on his threats -- and his hope to recover his judgment from the debtor indirectly, by way of the TREC. Viewed that way, Jonesʼ initiation of this complaint, carefully crafted by Wilson, is better understood as the commencement or continuation of a proceeding against the debtor to collect on a prepetition debt, in violation of section 362(a)(1).

Opinion, p. 9.

What Does It All Mean?

Does collection of a judgment "from the debtor indirectly" violate the automatic stay? It is black letter law that the automatic stay does not protect non-debtors. Thus, absent the Sec. 1301 co-debtor stay, a creditor is free to proceed against a guarantor or other co-obligor after the debtor has filed bankruptcy. This raises the question of how the TREC is different from any other party who might be jointly or contingently liable on a debt of the debtor.

The Court stated that "(t)he TREC . . . does have the authority to compel payment from the debtors" but did not fully explain that statement. Under Texas law, a person who recovers a judgment against a license or certificate holder for a prohibited practice, may apply for payment from the Texas Real Estate Recovery Trust Account. Tex. Occ. Code Sec. 1101.612. The TREC may revoke a license "if the commission makes a payment from the real estate recovery trust account to satisfy all or part of a judgment against the license or registration holder " and that "a person is not eligible for a license or certificate until the person has repaid in full the amount paid from the account for the person, plus interest at the legal rate." Tex. Occ. Code Sec. 1101.655(a) and (c).

Thus, the Court is correct that the TREC could coerce repayment of amounts paid from the real estate recovery trust account by revoking the debtor's license until the amount was repaid. However, it is unclear that they could do so while the Debtor was in bankruptcy. Sec. 362(b)(4) allows a governmental unit to enforce a judgment "other than a money judgment." Thus, it seems likely that the TREC could not revoke the debtor's license for failure to repay the real estate recovery trust account. Further, Sec. 525(a) states that a governmental unit may not revoke a license based on failure to pay "a debt that is dischargeable in the case under this title."

Sec. 525(a) may provide the glue that holds the court's opinion together. The TREC may revoke a license for failure to pay a nondischargeable debt. The Texas Occupations Code provides that in order to recover from the real estate recovery fund "the person shall verify to the commission that the person has made a good faith effort to protect the judgment from being discharged in bankruptcy."

In this case, the respondents had filed a complaint to determine dischargeability but had not yet proceeded to trial. Had the respondents first obtained a nondischargeable judgment and then filed a complaint with TREC, there would have been no violation. The automatic stay terminates upon entry of the discharge and the discharge does not apply to nondischargeable debts. Here, the respondents jumped the gun. Rather than waiting until they had a nondischargeable judgment, they acted immediately to take actions which would have threatened the debtor's livelihood by threatening her license.

It was a matter of timing rather than a matter of absolute prohibition. It was also really foolish for the lawyer to tell the debtor in the hearing of multiple witnesses that he would "run them out of business by filing a complaint with the TREC and close them down to get the money."

Implications for Hot Check Cases

It is an open secret in Texas that County Attorneys' offices act as a collection agency for merchants who received dishonored checks. It is also quite clear that the automatic stay does not apply to "the commencement or continuation of a criminal action or proceeding against the debtor." 11 U.S.C. Sec. 362(b)(1). Therefore, it is clear that the County Attorney does not violate the automatic stay by filing hot check charges.

However, under the logic of Reyes, it is intriguing to ask whether the merchant who initiates hot check charges as a debt collection device could be held liable for violating the stay. The difference between subsections (b)(1) and (b)(4) may provide the answer. Sec. 362(b)(4) is limited to actions by governmental actions, while 362(b)(1) is not. Thus, if hot check charges are criminal actions, a private party may initiate hot check charges without violating the stay. They only way around that would be to say that hot check charges are not legitimate criminal actions at all, but are really debt collection actions in substance. Unfortunately, telling a state what it can and cannot criminalize probably runs afoul of the Constitution.

Poetic Justice

Way back in 1986, Judge A. Jay Cristol denied his own sua sponte motion to dismiss a chapter 7 bankruptcy case in verse. In re Love, 61 B.R. 558 (Bankr. S.D. Fl. 1986). Some 20 years later, he penned another poetic opinion, this time finding that he was not required to sua sponte dismiss a Debtor's case for failure to file the required paperwork. In re Riddle, No. 06-11313 (Bankr. S.D. Fl. 7/17/06). Although the opinion is five years old, it mysteriously appeared upon my desk today without explanation.

For your reading pleasure, I present to you the verse of Judge Cristol:

I do not like dismissal automatic,
It seems to me to be traumatic.
I do not like it in this case,
I do not like it any place.

As a judge I am most keen
to understand, What does it mean?
How can any person know
what the docket does not show?

What is the clue on the 46th day?
Is the case still here, or gone away?
And if a debtor did not do
what the Code had told him to
and no concerned party knew it,
Still the Code says the debtor blew it.
Well that is what it seems to say:
the debtor's case is then "Oy vay!"

This kind of law is symptomatic
of something very problematic.
For if the Trustee does not know
then which way should the trustee go?

Should the trustee's view prismatic
continue to search the debtor's attic
and collect debtors' assets in his fist
for distribution in a case that stands dismissed?
After a dismissal automatic
would this not be a bit erratic?

The poor trustee cannot know
the docket does not dismissal show.
What's a poor trustee to do -
except perhaps to say, "Boo hoo!"

And if the case goes on as normal
and debtor gets a discharge formal,
what if a year later some fanatic
claims the case was dismissed automatic?

Was there a case, or wasn't there one?
How do you undo what's been done?
Debtor's property is gone as if by a thief,
and Debtor is stripped but gets no relief.
I do not like dismissal automatic.
On this point I am emphatic!
I do not wish to be dramatic,
but I can not endure this static.
Something more in 521 is needed
for dismissal automatic to be heeded.

Dismissal automatic is not understood.
For all concerned this is not good.
Before this problem gets too old
it would be good if we were told:

What does automatic dismissal mean?
And by what means can it been seen?
Are we only left to guess?
Oh please Congress, fix this mess!
Until it's fixed what should I do?
How can I explain this mess to you?

If the Code required an old fashioned order,
that would create a legal border,
with complying debtors' cases defended
and 521 violators' cases ended,
from the unknown status of dismissal automatic,
to the certainty of a status charismatic.
The dismissal automatic problem would be gone,
and debtors, trustees and courts could move on.

As to this case, how should I proceed?
Review of the record is warranted, indeed.
A very careful record review,
tells this Court what it should do.
Was this case dismissed automatic?
It definitely was NOT and that's emphatic.

Judge Gargotta Writes Sweeping Opinion on Jurisdiction, Reverse Veil-piercing and Cayman Islands Law

In law school, students cope with concepts of subject matter jurisdiction, personal jurisdiction and stating a cause of action in civil procedure class. When they move on to bankruptcy class, they must try to make sense of the constitutionality of delegating jurisdiction to an Article I court when considering the Marathon Pipeline case. These are not easy issues to get your head around. Judge Craig Gargotta must have felt like he was writing a law school exam when faced with motions to dismiss in an adversary proceeding. Roberts, Trustee v. J. Howard Bass & Associates, Inc., et al, Adv. No. 10-1101 (Bankr. W.D. Tex. 2/15/11). You can find the opinion here.

Introduction

James H. Bass filed chapter 7 bankruptcy on June 3, 2009. The creditors included two judgment creditors holding claims of $5.5 million (including one that had been found to be non-dischargeable in a prior filing). Filing bankruptcy proved to be a mistake, since the court denied the debtor’s discharge and the trustee launched an adversary proceeding against nine Bass-related defendants seeking to recover assets. The defendants sought to make the adversary proceeding go away with motions to dismiss for failure to state a cause of action and for lack of jurisdiction. Among their more creative arguments was that the bankruptcy court lacked jurisdiction to hear the case because the bankruptcy jurisdiction scheme was unconstitutional.

Have We Been Working Under a Constitutionally Defective System?

In 1982, the Supreme Court found that Congress had “impermissibly removed most, if not all, of the ‘essential attributes of the judicial power’ from the Article III district court, and has vested those attributes in a non-Art. III adjunct.” Northern Pipeline Construction Co. v. Marathon Pipeline Co., 458 U.S. 50, 87 (1982). However, the defendants cited other language not actually found in the opinion for the proposition that “Congress could not vest in a non-Article III court the power to adjudicate, render final judgment, and issue binding orders in a traditional contract action arising under state law, without consent of the litigants, and subject only to ordinary appellate review.” Citing non-existent quotes from the Supreme Court is not a good way to impress the Bankruptcy Court. The defendants also argued that 28 U.S. C. §157, which referred bankruptcy matters to the bankruptcy courts was unconstitutional for the reason that it was an impermissible delegation of power to an Article I court.

The Court noted that the argument would have had some merit—if it had been made in 1982.

If this is where history ended, Defendants would be correct in stating that the bankruptcy code is unconstitutional. However, Defendants’ argument ignores approximately 30 years of subsequent history. In 1984, Congress enacted the Bankruptcy Amendments and Federal Judgeship Act of 1984 (BAFJA). One of the major changes, meant to remedy the constitutional challenges of Marathon, was 28 U.S.C. §157(b)(1) . . . .

This statutory language gave the bankruptcy courts the same broad jurisdiction as the 1978 system, but it forbade the bankruptcy courts from rendering final judgments in cases that were only “related to” the bankruptcy case.

Opinion, p. 8.

In 1987, the Fifth Circuit found the revised jurisdictional grant to be constitutional in In re Wood, 825 F.2d 90 (5th Cir. 1987). The Supreme Court cited favorably to Wood in Celotex Corp. v. Edwards, 514 U.S. 300 (1995). Not wishing to overrule the Fifth Circuit and the Supreme Court, Judge Gargotta found the jurisdictional scheme to be constitutional.

Jurisdictional to the Core?

Having found jurisdiction, the Court had to find whether it had core jurisdiction. The claims asserted by the trustee included substantive consolidation, alter-ego and declaratory judgment. Rights created by the Bankruptcy Code constitute core proceedings. Substantive consolidation arises from section 105. As a result, it is a claim created by the Bankruptcy Code and thus a core proceeding.

Alter-ego posed a more difficult question because these claims arose under state law. However, §157(b)(3) states that the fact that a claim arises under state law is not dispositive in determining core status. Because the alter ego claims would bring assets into the estate, they would have a direct effect on the liquidation of the assets of the estate under 28 U.S.C. §157(b)(2)(O).

The declaratory judgment claims arose under the Bankruptcy Code and thus were core proceedings.

Jury Trial

The next argument raised by the Defendants was that they were entitled to a jury trial and that the Bankruptcy Court could not conduct one absent consent. Although Judge Gargotta went through several pages of serious discussion, the results can be summarized as: 1) there is not constitutional right to a jury trial in an equitable action; and 2) substantive consolidation and alter ego are equitable claims.

Although Judge Gargotta went through several pages of serious discussion, the results can be summarized as: 1) there is not constitutional right to a jury trial in an equitable action; and 2) substantive consolidation and alter ego are equitable claims.

Does Texas Law Allow A Reverse Veil-Piercing Claim Against An Entity That Is Not Owned by the Debtor?

Traditional veil-piercing seeks to hold the shareholder liable for the debts of the corporation. Reverse veil-piercing is more exotic and seeks to hold a corporation liable for debts of an individual. However, in this case, the individual was not a shareholder of the corporations. Would Texas law allow reverse veil-piercing in this situation?

Judge Gargotta relied on The Cadle Co. v. Brunswick Homes, LLC, 379 B.R. 284 (Bankr. N.D. Tex. 2007) for the proposition that while ownership is traditionally a requirement for reverse veil piercing, the doctrine could also be extended to de facto ownership. Because the trustee’s complaint alleged that the debtor sought to disguise his actual control of the companies, the trustee stated a cause of action.

Can You Do Reverse Veil-Piercing on a Cayman Corporation?

One of the defendants was a Cayman Islands corporation. The defendants argued that reverse veil-piercing was not available under Cayman law. The ever-scholarly Judge Gargotta noted that the Cayman Islands generally follow British law and that the United Kingdom has recognized veil piercing for over 100 years, from Saloman vs. Saloman & Co. [1897] A.C. 22 to Adams v. Cape Industries [1990] Ch 433; 2 WLR 657; [1991] 1 All ER 929; [1990] BCC 786 Sealy 66. Thus, the trustee stated a cause of action against the Cayman corporation.

Personal Jurisdiction over the Cayman Corporation

The Cayman defendant argued that no state or federal statute allowed service on it and that it transacts no business in the U.S. and only owns assets in the Cayman Islands. The Court found that the Texas long arm statute allows service to the fullest extent provided by the Constitution. This requires minimum contacts and that exercising jurisdiction is consistent with “traditional notions of fair play and substantial justice.” The Court found that if the Cayman corporation was found to be the alter ego of the debtor, then the court would have jurisdiction over it. As a result, the court found that it had jurisdiction to determine whether the Cayman corporation was the alter ego of the debtor. This poses an interesting conundrum. If the Cayman entity is not the debtor’s alter ego, then the Court may not exercise jurisdiction over it. However, to determine whether the court has jurisdiction, it must exercise its jurisdiction. Thus, the Cayman Islands entity must appear regardless of whether there is jurisdiction. Perhaps another way to approach the problem would have been to find that the Cayman entity had minimum contacts with the United States in that it was formed with money from a United States entity and its control persons were all residents of the United States.

Substantive Consolidation

Finally, the Defendants argued that the Bankruptcy Court could not grant substantive consolidation and that substantive consolidation between a debtor and a non-debtor was improper. The argument against the applicability of substantive consolidation was unlikely to succeed given the fact that the Court had a recent opinion approving use of substantive consolidation. In re Introgen Therapeutics, Inc. 429 B.R. 570 (Bankr. W.D. Tex. 2010).

The Court was similarly unreceptive to the argument that a nondebtor could never be substantively consolidated with a debtor. While the defendants quoted from a Fifth Circuit opinion, they left out the words “under these facts.” Those words were pretty important because in Peoples State Bank v. GE Capital Corp. (In re Ark-La-Tex Timber Co.), 482 F.3d 319 (5th Cir. 2007), the debtor believed that its purchase of the ownership interest in two other entities automatically effected a substantive consolidation. The Court found that if the Trustee was successful in proving alter ego that the assets of the two non-debtor entities would be property of the estate and substantive consolidation would be moot. As a result, the Court determined that it would reserve judgment on the substantive consolidation claim.

Conclusion

After working through twenty-one pages of discussion, the Court concluded:

Having gone through the facts of the case and considered the evidence submitted by the parties, this Court finds that (1) this Court and the current bankruptcy system are constitutional; (2) Plaintiff sufficiently pled a complaint for alter-ego liability that survives the motions to dismiss; (3) this Court can exercise personal jurisdiction over Esperada for the purposes of discovery; and (4) substantive consolidation in general is permitted in the Fifth Circuit, but the issue of whether it is appropriate in this case will be reserved for later determination after discovery and a trial on the merits. For these reasons, Defendant‟s Motions to Dismiss (docket nos. 66-74) are DENIED.

Opinion, p. 21. The lesson to be learned here is that the Bankruptcy Court is fully up to the challenge of sorting through difficult procedural and jurisdictional issues. However, when raising difficult procedural and jurisdictional issues, it is important to accurately quote the cases.

Class dismissed.

Not a Good Idea to Object to Every Claim

You know that nothing good can come from an opinion which begins like this:

This is a case about an affluent debtor who sought to manipulate bankruptcy procedures to accomplish what the Code prohibits--the elimination of all of her credit card debts despite her obvious ability to repay those debts over time. The debtor, Diane Davis, obtained confirmation of a plan in which she proposed to pay her credit card debts in full. The debtor subsequently objected to every claim filed by her creditors based on their alleged failure to attach sufficient documents to their proofs of claim. The debtor withdrew several objections after the creditors responded. The Court has before it the debtor's request for a default order sustaining the remaining objections.

In re Diane Davis, No. 09-42865 (Bankr. E. D. Tex.3/31/11). p. 1. You can find the opinion here.

The Davis case is one of a debtor who tried to follow the letter but not the spirit of the law. The debtor was an above median income debtor who would not qualify for relief under chapter 7. She filed under chapter 13 but tried to avoid paying any of her unsecured debts. She scheduled all of her unsecured debts as disputed and then objected to every claim filed. If the creditor responded, she withdrew her objection. Since most of the creditors did not respond, she thought that she was home free. However, the court had other ideas.

A Few Facts

The Debtor was a single woman with gross monthly wages of $10,428 and disposable income of $3,923.92. The only debts she was delinquent upon were credit cards. She scheduled eight creditors with debts totaling $81,564. Every debt was listed as disputed with the notation "Debtor listed the balance shown on last statement; debtor not presently able to determine if balance is correct and is uncertain if trade name is correct legal creditor."

The debtor filed a plan proposing to pay $3,190 to the chapter 13 trustee for 60 months. Twelve creditors filed proofs of claim totaling$147,400.68. Because the plan proposed to pay $190,400 on claims which were less than this amount, no creditors objected to the plan and it was confirmed.

Then the debtor objected to every claim. The objections asserted that the creditors had not attached sufficient documentation to the claim and that the debtor would withdraw the objection if presented with adequate documentation. The debtor withdrew her objections to five claims after the creditors filed responses. However, the debtor sought default orders on the remaining seven claims. One of the claims that the debtor sought a default on was from Neiman Marcus. Neiman Marcus amended its claim to add documentation but did not file a response. The debtor's statement of financial affairs revealed that the debtor had been making payments on this claim prior to bankruptcy.

The court conducted several hearings on the claims objections. While the debtor was present at one hearing, she did not testify. Debtor's counsel offered a brief on why the claims should be denied but never presented any substantive grounds why the debtor did not owe the debts.

Can the Debtor Deny the Claims of the Non-Responding Creditors?

The Court's answer was "no." Failure to attach supporting documentation, without more, is not a sufficient ground for denying a claim. Judge Rhoades stated:

If an objection to a claim is raised, Section 502(b) provides that the court "shall allow the claim in such amount, except to the extent that" a grounds for disallowance provided by Section 502(b)(1)-(9) applies. (citation omitted). Thus, the Code requires us to overrule a claim objection that does not comply with Section 502(b)--even if the claimant does not appear to raise the issue.

Opinion, p. 11. Thus, the mere fact that the creditor failed to attach sufficient documentation to the claim and then failed to respond to the claims objection was not grounds for denying the claim.

Not only that, the court found that the claims did "substantially" conform to Bankruptcy Rule 3001 such that they were entitled to prima facie validity. Because the debtor did not produce evidence sufficient to rebut the prima facie validity of the claims, the creditor had no duty to respond.

An Interesting Twist

While Judge Rhoades found that the objections should be denied, she also raised the possibility that the debtor was asking for something she really didn't want.

The discharge in a chapter 13 case is different than in a chapter 7 case. (citation omitted). In a chapter 13 case, upon completion of plan payments, a debtor generally is discharged of all debts "provided for by the plan or disallowed under section 502" of the Code. (citation omitted). Section 1328(a) does not, by its terms, discharge a chapter 13 debtor of her obligation to repay claims denied solely under Bankruptcy Rule 3001.

Opinion, p. 15. Thus, had the debtor been successful in her non-substantive objections, she would not have discharged the debts.

The Ethical Obligations of the Debtor's Counsel

The Court was not amused as shown by the subheading "The Ethical Obligations of the Debtor's Counsel." The Court noted that filing the schedules and objecting to the claims, debtor's counsel

deliberately chose to (i) ignore the debtor's personal knowledge,and (ii) conduct no independent investigation prior to filing the debtor's bankruptcy schedules and claim objections."

Opinion, p. 21.

The Court went on to state:

It appears to the Court that the debtor and her counsel were motivated by the off-chance that the claimants would not respond to the objections and, consequently, that this Court would sustain the objections without substantive review. 'An off-chance does not satisfy [Bankruptcy] Rule [9011].' (citation omitted). 'This approach of throwing it against the wall and seeing what sticks is precisely the sort of conduct [Bankrutpcy Rule 9011] seeks to counter. (citations omitted).

Opinion, pp.21-22.

The Debtor's Obligation to Act in Good Faith

The Court was not any more impressed with the debtor's conduct.

Regardless of the advice the debtor may have received from her counsel regarding the claims allowance process, she has an obligation to the Court to act in good faith. To confirm a chapter 13 plan, the bankruptcy court must find, among other elements, that 'the plan has been proposed in good faith.' (citation omitted). . . Good faith in this context is not an esoteric legal concept that only lawyers and judges can understand. The question is whether the totality of the circumstances indicates that the plan is unreasonable or that the debtor is attempting to abuse the spirit of the Code. (citation omitted).

Opinion, pp. 22-23.

The Bottom Line

The Court overruled the claims objections, vacated the order confirming the plan, gave the debtor 30 days to file a new plan and scheduled a hearing to determine whether debtor's counsel violated Rule 9011.

What It Means

The chapter 13 bargain is about paying creditors in return for a discharge. The debtor had enough disposable income to pay all of the filed claims in less than sixty months. This would have been a good deal because the debtor would have been able to repay the debts without interest. However, the debtor tried to take a shortcut and eliminate all of her claims on a defect of form. The Court was right to be concerned about the good faith of this practice.

Navigating the Difficult Waters of Offers of Judgment in Bankruptcy

Offers of Judgment can be a handy device for shifting the risk of paying court costs in litigation. However, as a pair of recent opinions from Judge Leif Clark demonstrate, they can be tricky to pull off successfully. Eastman v. Baker Recovery Services, Adv. No. 08-5055-C (Bankr. W.D. Tex. 12/28/10 and 1/31/11). You can find the opinions here and here.

The Offer of Judgment Rule

Federal Rule of Bankruptcy Procedure 7068 incorporates Federal Rule of Civil Procedure 68, which states:

Rule 68. Offer of Judgment

(a) Making an Offer; Judgment on an Accepted Offer.

More than 14 days before the trial begins, a party defending against a claim may serve on an opposing party an offer to allow judgment on specified terms, with the costs then accrued. If, within 14 days after being served, the opposing party serves written notice accepting the offer, either party may then file the offer and notice of acceptance, plus proof of service. The clerk must then enter judgment.

(b) Unaccepted Offer.

An unaccepted offer is considered withdrawn, but it does not preclude a later offer. Evidence of an unaccepted offer is not admissible except in a proceeding to determine costs.

(c) Offer After Liability Is Determined.

When one party's liability to another has been determined but the extent of liability remains to be determined by further proceedings, the party held liable may make an offer of judgment. It must be served within a reasonable time — but at least 14 days — before a hearing to determine the extent of liability.

(d) Paying Costs After an Unaccepted Offer.

If the judgment that the offeree finally obtains is not more favorable than the unaccepted offer, the offeree must pay the costs incurred after the offer was made.

The rule is designed to encourage parties to make serious settlement offers early in the proceedings to avoid running up costs. If a defendant makes a reasonable offer and it is accepted, the case is over. On the other hand, if the defendant makes an offer which is not accepted and the ultimate judgment is “not more favorable than the unaccepted offer” the plaintiff must pay the defendant’s costs incurred after the offer was made.

The Eastman Case

Eastman was a particularly ugly discharge violation case. I have written about the underlying case before here. The defendants made an offer of judgment for $5,000.00 on February 27, 2009. After trial, the Court awarded $1,000.00 in statutory damages under the FDCPA plus attorney’s fees. The defendants objected to the plaintiff’s request for attorney’s fees based on the offer of judgment.

The Court rejected the defendant’s argument, finding that the offer of judgment was not “not more favorable than the unaccepted offer.”

The rule thus provides that the plaintiff must pay a defendantʼs fees if the judgment rendered fails to exceed the amount of the offer in compromise. In this case, the judgment consists of (a) the actual damages suffered, consisting of attorneysʼ fees incurred by the Plaintiff in order to enforce the discharge injunction and (b) the reasonable expenses incurred by the Plaintiff in recovering those actual damages, consisting of attorneysʼ fees incurred in prosecuting the litigation in order to obtain that recovery. (citation omitted). Thus, “costs” in the context of the rule includes the reasonable attorneysʼ fees incurred by the plaintiff in enforcing a civil contempt action, per settled case law. “[T]he judgment finally obtained must include not only the verdict of the jury but also the costs actually awarded by the court for the period that preceded the offer.” (citation omitted).

The offer in this case was made well after the Plaintiff had incurred reasonable fees for the preparation of the complaint, preparing a response to a motion to dismiss, and preparing a response to a motion for summary judgment. In addition, discovery had already taken place. The offer made was for $5,000, and was filed of record on February 27, 2009. By that point, the Plaintiff had already incurred $3,900 in fees by Alex Katzman (litigation counsel), and $4,150 in fees by Rob Eichelbaum (bankruptcy counsel) by February 27, 2009. Over $9,000 in fees were incurred by Mr. Eichelbaum from late 2007 through the end of 2008. $3,000 in fees was incurred just to convince the Defendants to withdraw the offending judgment -- and that only after the Defendants tried to use that judgment to extract a payment from the Plaintiff. Thus, the judgment, including the costs incurred to that point in time exceeded the offer in compromise. The Defendants are not entitled to recover their costs from Plaintiff under Rule 68(d).

Opinion on 12/28/10, pp. 8-9. Thus, in order to have been successful, the Offer of Judgment should have offered $5,000 plus costs incurred to date. Because the offer was for a flat $5,000.00 and the attorney’s fees incurred exceeded that amount, the offer did not meet the requirements of the rule.

Undeterred, the defendants moved for reconsideration on the basis that they had previously made an offer to settle in March 2008. The Court noted that this offer was made prior to the commencement of the litigation. The Court cited the Wright & Miller treatise for the proposition that an offer of judgment can only be made by a party defending against a claim. If litigation has not been brought, then the offer to settle is not an offer of judgment.

A Successful Offer of Judgment Case

While Eastman shows how not to make an offer of judgment, Judge Letitia Paul’s opinion in Smith v. Radoff, 2006 Bankr. LEXIS 2412 (Bankr. S.D. Tex. 2006), is an illustration of a successful use of Rule 7068. In that case, a judgment creditor obtained appointment of a receiver for the debtor’s assets some sixteen years after entry of the discharge. The receiver withdrew $44,475.79 from the debtor’s bank account.

Upon being sued, the quick-thinking defendants made separate offers of judgment to return the funds and to pay interest, costs and attorney’s fees. The plaintiff refused the offer and proceeded to trial.

At trial, the Court found that the defendants testified credibly that they were not aware of the bankruptcy discharge and had difficulty verifying it due to the age of the case (it was filed in 1987) and the debtor’s common surname.

The Court awarded interest on the seized funds at the federal judgment rate. Although the plaintiff requested attorney’s fees of $71,357.50, the court only awarded fees of $12,000.00, finding that the plaintiff had failed to mitigate damages. The Court denied all other relief to the plaintiff.

The Court then found that because the judgment was not more favorable than the offer of judgment, that the defendants were entitled to recover their costs. In subsequent proceedings, the Court awarded attorney’s fees to each of the defendants in an amount exceeding the plaintiff’s recovery. As a result, when the final judgment was entered, the plaintiff owed a small amount to the defendants. The case settled after an appeal was filed.

More on Attorney’s Fees

While both the Eastman and Smith cases found that attorney’s fees were included within the definition of costs, this is not always the case. In Marek v. Chesny, 473 U.S. 1 (1985), the Supreme Court held that attorney’s fees constitute costs whenever the underlying substantive ground for relief defines them as costs. The Advisory Committee notes to Federal Rule 54(d) listed 35 statutes which allow recovery of costs, of which at least eleven included attorney’s fees within the definition of costs. The Civil Rights Attorney’s Fees Awards Act of 1976, which was the governing statute in the Marek case, allowed attorney’s fees “as part of the costs.” As a result, the Supreme Court found that attorney’s fees could be awarded under Rule 68.

The Supreme Court’s ruling means that awards of attorney’s fees as costs under Rule 68 may be dependent upon small variations in language. For example, 28 U.S.C. §1927 allows a court to award “excess costs, expenses, and attorney’s fees.” Since costs and attorney’s fees are listed as separate items in the statute, attorney’s fees would likely not constitute costs in that context.

In Eastman, Judge Clark found that “’costs’ in the context of the rules, includes the reasonable attorney’s fees incurred by the plaintiff in enforcing a civil contempt action, per settled case law.” Opinion 12/28/10, p. 9. Unfortunately, Judge Clark did not cite to the settled case law. However, in Chambers v. NASCO, Inc., 501 U.S. 32 (1991), the Supreme Court stated that “a court's discretion to determine ‘the degree of punishment for contempt’ permits the court to impose as part of the fine attorney's fees representing the entire cost of the litigation.” While the Supreme Court was not using the term “cost” in the narrow sense of costs of court under Rule 68, this may provide some support for the proposition.

A Final Quirk

As if the law on Offers of Judgment were not difficult enough, there is a line of cases which hold that an Offer of Judgment will not result in cost shifting in a case where the defendant is the prevailing party. In re LMP Shoal Creek, LLC, 2007 Bankr. LEXIS 4659 (Bankr. W.D. Tex. 2007); In re Security Funding, Inc., 234 B.R. 398 (Bankr. E.D. Tenn. 1999). Rule 68(d) refers to “the judgment that the offeree finally obtains.” These cases hold that if the plaintiff does not recover a judgment, that Rule 68 would not apply. This appears to be a strange result, since a damage award of $1 would allow cost shifting, but a take nothing judgment would not.

Difference in Wording Dooms Bankruptcy Discrimination Claim

A debtor who was denied a job based on a bankruptcy filing found out the hard way that subtle differences in wording can make a big difference. Burnett v. Stewart Title, No. 10-20250 (5th Cir. 3/4/11). You can find the opinion here.

In September 2006, Shani Burnett filed for chapter 13 bankruptcy relief. The following year, she interviewed with Stewart Title. She was offered a job subject to a background check. When Stewart Title found out about the bankruptcy, they rescinded the offer. Burnett filed suit against Stewart Title under 11 U.S.C. Sec.525, which is titled "Protection Against Discriminatory Treatment." The Bankruptcy Court dismissed the Complaint for failure to state a cause of action and the District Court affirmed.

The Fifth Circuit as well. What would have been a good claim against a public employer failed to state a cause of action against a private employer. Section 525(a) says that a public employer may not "deny employment to, terminate the employment of, or discriminate with respect to employment against" a debtor. Sec. 525(b) states that a private employer may not "terminate the employment of, or discriminate with respect to employment against" a person who has filed bankruptcy.

The Debtor argued that refusing employment based on bankruptcy constituted "discrimination with respect to employment," one of the two clauses applicable to a private employer. The Fifth Circuit conceded that the argument might be reasonable in isolation, but failed when the two subsections were read together.

Burnett and amicus curiae contend that the act of denying employment to a person is to “discriminate with respect to employment against” that person, such that it is barred by the plain language of § 525(b). If § 525(b) were considered in isolation, Burnett’s position may have merit. However, when interpreting the meaning of a phrase in a statute, the statute must be read as a whole because “ ‘Act[s] of Congress . . . should not be read as a series of unrelated and isolated provisions.’ ” (citation omitted).

* * *

Applying . . . canons of statutory construction to § 525(b), we conclude that Congress did not prohibit private employers from denying employment to persons based on their bankruptcy status.

Opinion, pp. 2-3, 5.

The Fifth Circuit's opinion is spot on. Where one subsection expressly applies to denial of prospective employment and the second one does not, the omission must be given effect. The bottom line is that public employers may not discriminate against either existing or prospective employees based on their bankruptcy status, but private employers must only protect existing employees.

The Bankruptcy Court opinion by Judge Jeff Bohm makes an important point:

If Stewart Title had actually offered Burnett a position and if she had accepted the offer, then an employment relationship would have arisen, and any discrimination thereafter based on Burnett's bankruptcy status would have been unlawful under Sec. 525(b). (citation omitted). However, because Burnett was never formally hired and never had an employment relationship with Stewart Title, Stewart Title did not violate Sec. 525(b) by refusing to hire Burnett based on her bankruptcy status.

Memorandum Opinion, Burnett v. Stewart Title, Adv. No. 08-3239 (Bankr. S.D. Tex. 10/14/08), pp. 6-7.

While it is unfortunate that the prospective employee did not receive "protection against discriminatory treatment," the statutory wording dictated the result. Private employers may reject potential employees based on bankruptcy status.

The Early View from Inside the Borders GOB Sale

This past Saturday, I was able to combine two of my interests, books and bankruptcy, in a trip to the Borders Going Out of Business Sale. Actually, my eldest daughter demanded that I take her there. However, I was happy to indulge her and I thought it would be interesting to see what a going out of business sale looked like.

We went during the initial, orderly stage of the sale. There was still a wide selection of books available. The shelves all contained labels saying "Fixtures not for sale." The sale looked like a very successful marketing strategy. The books we bought were marked down 20-30% with an extra 10% off with a Borders card. Those prices were good, but not much less than a typical sale. Nonetheless, the store was packed with customers, so it appears that the GOB hype was successful in bringing in the purchasers even before the discounts got deep.

When we went, employee morale appeared to be pretty good. The clerks were doing a good job of moving customers through the line and were friendly. However, I did overhear a clerk telling a customer that he didn't know when the store would be closing and that the employees were the last to know what was happening. However, his tone was matter of fact rather than frustrated or angry. I imagine that after he answers the same question a hundred more times, there may be more of an edge to the response.

I plan to return to the late stages of the sale to see what whether the orderliness and calm continues to prevail as the store enters its death spiral.

Credit Slips has a good take on Borders abuse of the venue provisions of the Code. You can find it here.