BAPCPA At Three Years Old: Measuring the Statistical Impact on Texas Filings

Today is the third anniversary of the effective date of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which seemed like a good time to look at the lasting impact of this legislation on bankruptcy filings. At this point, filings remain substantially down from the period prior to adoption of the statute. In fact, BAPCPA may have eliminated over 121,000 filings in Texas over a three year period. BAPCPA has also had a smaller impact in encouraging debtors to choose chapter 13 over chapter 7. However, the fact remains that cases under both chapter 7 and chapter 13 are way down.

How to Slice the Numbers

Most bankruptcy statistics are reported based on either a calendar year or a fiscal year which coincides with a calendar month. This is not very useful for evaluating the effect of BAPCPA because its effects took place within the middle of two months. Specifically, the legislation was adopted on April 20, 2005 and took effect on October 17, 2005. During the period between adoption and the effective date, there was an historic surge in filings followed by a substantial drop-off. Thus, to accurately measure the effect of BAPCPA, it is necessary to find a "normal" period of time to compare to each of the years which began on October 17 and ended on October 16 after the effective date. Additionally, in order to gauge the true impact of the legislation, it is necessary to factor out the huge increase in filings leading up to the effective date.

To accomplish this goal, I selected the period of October 17, 2003 to October 16, 2004 as my baseline or "normal" year. In a previous article, I used the period from April 20, 2004 to April 19, 2005 as my baseline period. However, there was already evidence of increased filings during the months when Congress was debating BAPCPA so that it was necessary to step back a little further. I used the period from October 17, 2004 to October 16, 2005 as my surge period. While there was not a surge going on for all of these months, the use of an annual period made it easier to calculate the full effects of the legislation. Then I used each of the years from October 17 to October 16 as my post-BAPCPA period.

Annual Filing Rates

The following table looks at the total filing rates for the state for each of the five years being compared.



The graphics are somewhat hard to read. However, the story that the numbers tell is that in 2003-2004, there were 92,872 chapter 7 and chapter 13 filings in Texas. This surged to 135,900 in 2004-2005. In the first year after BAPCA, filings dropped to just 29,163. In the two most recent years, they have grown to 41,095 and 43,631. This means that Texas chapter 7 and chapter 13 filings had dropped 53% from the last "normal" pre-BAPCPA year of 2003-2004. This indicates that BAPCPA is having a long-term effect on filings. The decline in filings is being felt across the board. While chapter 7 filings were down 60% from the pre-BAPCPA level, chapter 13 filings were down 44% as well.

Difference in Filings Because of BAPCPA

One way to look at the numbers is to project what filings would have been under the old law and compare them to filings under the new law. I started with the 2003-2004 filings of 92,872. Over three years, it could be predicted that there would have been 278,816 filings in Texas. There were actually 113,889 filings during the three years of 2005-06, 2006-07 and 2007-08. However, to get an accurate picture, it is necessary to subtract out the excess "surge" filings from 2004-05. Most likely, many of these debtors accelerated their decision to file bankruptcy. There were 43,028 filings in 2004-05 in excess of the baseline year. When these figures are added together, they indicate a net loss of almost 122,000 cases over three years.

Predicted Three Year Filings:
278,816
Less Actual Filings:
113,889
Less "Surge" Filings:
43,028
Net Loss:
121,699

While BAPCPA was intended to encourage debtors to file chapter 13, it has resulted in a dramatic decrease in the number of chapter 13 cases filed. Chapter 13 filings in Texas during 2007-08 were 44% below their level in 2003-04. Using the same calculation, the number of chapter 13 filings lost can be estimated as follows:

Predicted Three Year Filings:
119,661
Less Actual Filings:
61,732
Less "Surge" Filings:
1,231
Net Loss of Chapter 13 Cases:
56,698

Change in Chapters Filed

Although BAPCPA resulted in a net drop in the overall number of chapter 13 cases filed, it did result in a shift in the relative percentage of each chapter of cases filed.

In 2003-04, 57% of the cases were filed under chapter 7 and 43% were filed under chapter 13. Two years later in the first post-BAPCPA year of 2005-06, this had changed to 40% chapter 7 cases and 60% chapter 13s. In the most recent year of 2007-08, the breakdown was 49% for chapter 7 to 51% for chapter 13. Thus, one effect of BAPCPA has been to make chapter 13 the more commonly used chapter, although the gap has narrowed substantially.

Bankruptcy Court Stakes Out Unique Position on Sec. 522(b)(3)(A) as Choice of Law Rule, Relies on Former State's Law Without Regard to Actual Residenc

A new decision from Bankruptcy Judge Craig Gargotta is likely to prompt discussion as the court held that a debtor could be prohibited from using federal exemptions based on the law of his prior residence even though that state's law only prohibited "residents" of the state from using the federal exemptions. In re Camp, No. 08-11056 (Bankr. W.D. Tex. 9/25/08). In so ruling, Judge Gargotta disagreed with the opinion in In re Battle, 366 B.R. 636 (Bankr. W.D. Tex. 2006) from his Western District colleague Leif Clark.

The Facts

Melvin Camp moved to Texas from Florida. Under 11 U.S.C. Sec. 522(b)(3)(A), his choice of exemptions was governed by the law of Florida because he had not resided in Texas for the requisite 730 days. Mr. Camp was a prime candidate to use the federal exemptions. His paltry possessions added up to only $24,205, but included cash of $3,100, a lot which was not his homestead valued at $4,500 and a pickup truck worth $13,750. Under the federal exemptions, he would be able to keep all of these assets.

The Debtor's lawyer had no doubt read In re Battle, which held that Sec. 522(b)(3)(A)'s mandate to apply Florida law meant to apply it exactly as written. Since Florida law prohibited residents of Florida from using the federal exemptions and Mr. Camp was NOT a resident of Florida, he should be able to claim federal exemptions and keep his property.

The Trustee objected to the Debtor's exemptions claiming that In re Battle was incorrectly decided. The Bankruptcy Court agreed with the Trustee and denied the exemption.

When Does A Statute Not Mean What It Says? When It is a Choice of Law Provision.

The Florida statute appears clear. It states that "residents of this state shall not be entitled to the federal exemptions provided in s. 522(d) of the Bankruptcy Code of 1978." Based on this language, Judge Clark's Battle opinion held that where Florida had adopted a limitation applicable to residents of Florida and Congress had deemed that the statute apply to persons who no longer resided in Florida, that the statute should be applied exactly as written--in other words, that Texans subject to Florida exemption law were not prohibited from using the federal exemptions.

Judge Gargotta acknowledged that, "At first blush, these courts' reasoning appears sound. It relies exclusively on the language of the applicable opt-out statute." Opinion, p. 4.

However, Judge Gargotta went on to consider Congress's intent in adopting these provisions and how they should be applied.

Florida has thus expressed its judgment that its residents who file bankruptcy should be restricted to claiming Florida exemptions. Congress decided when it enacted the 1978 Bankruptcy Code to honor such decisions by the states that have made them, by expressly incorporating such "opt-out" provisions by reference in Sec. 522(b)(2).

Residency restrictions in a state's exemption laws, including residency restrictions applicable to its opt-out statute, are equivalent to choice of law provisions--they address the question of what state's laws should determine the exemptions of a debtor who has moved from one state to another. (citation omitted). However, by adopting Sec. 522(b)(2) and (3)(A), congress expressed its own judgment that, in instances where a debtor moves from one state to another within 730 days before filing bankruptcy, his exemptions should be determined by the laws (including any opt-out law) of his former domiciliary state. Thus, the issue in this case (and in Battle and similar cases) arises because of the conflict between a state law choice of law provision and the federal choice of law provision contained in Sec. 522(b)(2) and (3)(A). Such conflicts are traditionally resolved by applying the doctrine of preemption. (citations omitted).

The courts deciding Battle and similar cases, however, did not address this conflict between the applicable state opt-out statute and the federal statute, Sec. 522(b)(3)(A), or the question of preemption. Instead, those courts assumed, without discussion, that Sec. 522(b)'s incorporation of each state's substantive exemption laws also incorporated the state law choice of law provisions that each state applies to its exemption laws outside of bankruptcy (e.g., the residency restriction in its opt-out statute). In doing so, those courts have effectively written out of Sec. 522(b)(3)(A) Congress's own considered policy judgment on which state's law should apply when a debtor moves before filing bankruptcy.

Opinion, pp. 4-5.

The resourceful Judge Gargotta came up with an interesting example to make his point about how literally following a state's laws could frustrate the intent of Congress. Idaho law provides that residents of Idaho are entitled to use the Idaho exemptions and that nonresidents are entitled to use the law of the state of their residence. If this provision were applied literally, a debtor who moved from Idaho to another state would automatically be allowed to use the law of the new state despite Congress's mandate to apply Idaho law.

Judge Gargotta ultimately concluded that the proper approach was to apply the laws of the prior state "as if he had not moved for purposes of determining what property he may claim as exempt." Opinion, p. 8. Indeed, he adopted the position that in applying Sec. 522(b)(3)(A), the court must disregard the reality that the debtor actually resides in the state where he lives.

For example, if thirty days before filing bankruptcy a debtor moved from Texas to Louisiana and purchased a home, Sec. 522(b)(3)(A) requires the bankruptcy court to "disregard the element of reality" of the actual state of the debtor's residence (Louisiana), and instead engage in the fiction of considering the state of his or her former residence (Texas) to be the state where he or she currently resides. If the debtor chooses state exemptions, Texas exemption laws would apply to the debtor's home and other property located within the state--in this case, within "Louisiana qua Texas." This is not, however, the extraterritorial application of Texas's exemption laws. It is not under the authority of the State of Texas that its exemption laws are being applied to property outside Texas. Rather, it is a federal choice of law statute--Sec. 522(b)(3)(A)--that has expressly provided that the exemption laws of a particular state--Texas--are applicable to a debtor who, by definition, is no longer a domiciliary of that state and so whose property is almost certainly no longer located within that state.

Opinion, p. 11.

What Does It All Mean?
This is a difficult opinion to digest. It will likely result in the death of many trees (or perhaps the consumption of many electrons) as law professors try to sort this out. Judge Gargotta acknowledged that, "(N)o other court has yet expressly held that a state residency restriction in an opt-out statute is a choice of law provision that is preempted by Sec. 522(b)(3)(A)." Opinion, p. 7.

However, despite the density of the reasoning, there is a simple logic to the result--namely, that a debtor should neither be advantaged or disadvantaged by a move within 730 days before bankruptcy. While Sec. 522(b)(3)(A) has often been viewed as a measure designed to punish debtors who move to exemption friendly states, it can also have the reverse effect. If a debtor moves from Texas with its unlimited exemption to Maryland which has no homestead exemption, the Debtor could enjoy the benefits of the Texas exemption in Maryland.

First Circuit Reverses Massive Damage Award Based on Application of Chapter 13 Mortgage Payments

Application of mortgage payments in chapter 13 is a thorny problem. Although the Debtor may not modify the terms of a mortgage on a primary residence, she may cure the arrearages while remaining current on the post-bankruptcy mortgage payments. However, if the Debtor defaults on the post-petition payments, those may be rolled into the plan as well. Thus, the mortgage company may simultaneously be receiving payments on pre-petition arrearages, current post-petition payments and post-petition arrearages. If these various payments are not posted correctly, the Debtor may face late charges and default notices which are not warranted. In one recent case, the Bankruptcy Court awarded massive damages to a debtor who received a misleading payment history, but did not suffer any other adverse actions. That award has now been reversed by the First Circuit, which found that Section 1322(b) does not impose duties on lenders. However, the First Circuit offered some suggestions on how the legal issue could be addressed in the future. In re Nosek, No. 07-2173 (1st Cir. 10/3/08).

What Happened

The Nosek case started with a $90,000 mortgage against a home in Massachusetts. After the Debtor defaulted, she filed several chapter 13 proceedings. The Debtor defaulted on her post-petition payments and entered into a stipulation with the lender to bring these amounts current. The Debtor confirmed a plan which provided for her to make her arrearage payments to the chapter 13 trustee and to make her regular payments directly to her mortgage company, Ameriquest.

The Plan did not specifically address how payments made under the plan should be credited. Apparently, Ameriquest used a dual system for recording bankruptcy payments. Under its regular accounting system, payments were applied to the oldest payment due first. If a payment was not sufficient to cover a full payment, it was held in a suspense account until it could be applied to a full payment. Ameriquest also kept a manual ledger where it tracked whether post-petition payments were being received on a timely basis.

Problems arose when Ms. Nosek sought to refinance her mortgage. In connection with her proposed refinancing, she requested a payment history. The history which she received was the general one which applied payments received to the oldest payment due. While it is not completely clear from the court's opinion, it appears that Ms. Nosek was not charged any extra fees or charges based upon the erroneous accounting. Indeed, the manual accounting (which the Debtor did not receive) showed her to be current on post-petition payments. Upon receiving the payment history, the Debtor became very distressed. This in turn distressed her attorney, who pragmatically filed a "Motion to Determine the Amount of Liens." The Bankruptcy Court ordered Ameriquest to provide the Debtor with an explantion of its accounting. When Ameriquest failed to do so, the Bankruptcy Court awarded sanctions of $500 and ordered the Debtor to file an adversary proceeding.

The Debtor filed an adversary proceeding containing multiple causes of action. At trial, the Debtor failed to prove that she had suffered any economic damages from the accounting she received. She did not show that she had been charged any unearned fees and failed to prove that she was denied her refinancing based upon the payment history. The Bankruptcy Court awarded nominal damages under RESPA and the Massachusetts Consumer Protection Act. The Bankruptcy Court also found that Ameriquest had violated the duty of good faith and fair dealing by failing to credit the payments properly. It awarded actual damages of $250,000 for emotional distress and punitive damages of $500,000. The duty of good faith and fair dealing ruling was based upon a violation of 11 U.S.C. Sec. 1322(b)(5), which allows a debtor to include provisions in a plan providing for the cure of a default.

On appeal, the District Court reversed the awards under RESPA and the duty of good faith and fair dealing, finding them to be pre-empted. It remanded for the Bankruptcy Court to consider damages under Sec. 105(a) and to reconsider its award under the Massachusetts Consumer Protection Act. On re-hearing, the Bankruptcy Court determined that the Consumer Protection Act claim was also pre-empted but awarded the same damages as before, but this time under Sec. 105(a). The District Court affirmed this judgment.

The Court of Appeals Ruling

The First Circuit reversed and directed that the judgment be vacated and the case dismissed. The main conclusion of the opinion was that Sec. 105(a) did not provide a basis for damages, since Sec. 1322(b) did not impose any duties upon the lender. The Court referred to Sec. 105(a) as a statutory contempt remedy, but pointed out that it must be used in the enforcement of another provision of the Bankruptcy Code. Since Sec. 1322(b) addresses provisions which a Debtor may include in a plan, it does not impose any duties upon creditors. The Court stated:

Ameriquest contests the bankruptcy court's conclusion that the company defied the text of Sec. 1322(b). It argues that the language of Sec. 1322(b) does not impose obligations on any party, let alone a lender. We agree. The plain language of Sec. 1322(b), relied upon by the bankruptcy court to find a violation of the code, does not impose any specific duties on a lender. It merely lists elements that a Chapter 13 debtor may include in her plan.

* * *

Because Sec. 1322(b) merely provides optional elements that a debtor may incorporate into her Chapter 13 Plan, the provision has no meaning separate and apart from the choices the Debtor makes and incorporates into her Chapter 13 Plan. In other words, to determine whether and how Nosek took advantage of the cure opportunity provided by Sec. 1322(b)(5), and whether her excercise of her cure rights was threatened by Ameriquest's accounting, we must look to the terms of Nosek's Plan itself.

Opinion, at 22, 24

The Court of Appeals found that the Plan did not contain any provisions governing accounting for payments. It merely stated that the Debtor would continue to make her regular payments and would cure the arrearage by making 60 payments of $313.52 per month. The Court found that this language did not impose any duties on the creditor.

Like the text of Sec. 1322(b), this language does not place any specific obligations on Ameriquest, accounting or otherwise. Although we agree that the statement must be read in light of the purposes of Sec. 1322(b)(5) and Chapter 13 more generally--that a debtor can sure a default by paying off her pre-petition arrearages in a reasonable amount of time--this purpose along does not change the nature of appellant's obligations in this case. The Plan language says nothing about how Ameriquest must account for pre- and post-petition payments during the course of the repayment period if payments are short, late, or not made at all. Simply put, the terms of the Plan itself do not provide the specificity required to invoke the enforcement authority of Sec. 105(a).

Opinion, page 25.

The Court also faulted the Debtor for failing to prove injury.

Although a debtor need not show proof of economic damages to establish that her cure rights have been violated, she must at least establish that her right to cure the pre-petition default provided by the Chaper 13 Plan has been impaired or threatened by the creditor's actions. Nosek's subjective fear of such impairment, based on a document prepared by Ameriquest for internal purposes only, and in the absence of any evidence that the company regarded her as in default on the basis of its accounting practices, does not suffice. Indeed, Ameriquest stated that its internal records showed that Nosek was considered current in her payment history.

Opinion, page 27.

Finally, the Court of Appeals made clear that its ruling was not an endorsement of sloppy accounting practices.

Notwithstanding these legal conclusions, we are not unsympathetic* to Nosek's predicament as a debtor seeking to satisfy the terms of her Chapter 13 Plan and stave off foreclosure of her home. Her circumstances are all too common today. Given their prevalence, it is troubling that Ameriquest had not established a more efficient and accurate way of handling the accounting issues revealed by this case at the time of trial. We fully understand the bankruptcy court's concerns about the practices that it described.

Nevertheless, the bankruptcy court's legitimate concerns did not justify the remedy that it invoked. Nosek did not demonstrate here that Ameriquest's accounting practices caused her any economic harm or threatened her right to cure her pre-petition default. Moreover, even if such threat had been demonstrated by those practices, there was no language in Nosek's Plan, as it was confirmed, or in Sec. 1322(b), that addressed how Ameriquest was to apply the payments it received from Nosek or from the Trustee. Under such circumstances, the Plan would have to be amended to prescribe the accounting practices necessary to protect Nosek's right to cure before Ameriquest could be sanctioned for a violation of an order of the bankruptcy court.

Opinion, pages 29-30.

What to Make of This

There is a saying that pigs get fat and hogs get slaughtered. Certainly the fact that the Debtor almost recovered $750,000 for failure to correctly apply several thousand dollars worth of payments and did not suffer any economic damages suggests that the Debtor, with the aid of the Bankruptcy Court, had become a hog. As distressing as this must have been for the Debtor, this particular case did not present an abuse which would shock the conscience. Indeed, this fuss could easily have been cleared up once the Debtor got Ameriquest's attention (which appears to have been a little slow in coming).

Having said all that, the Court of Appeals did a good job of keeping its eye on the ball. It focused on the plain language of the statute and the plan and pointed out what could have been done differently. For Debtor's lawyers, the message is clear: draft your plans carefully. A plan which required that payments be applied separately to arrearages and regular payments and required notice of additional fees and charges being incurred would have put more teeth in the Debtor's plan. Since many districts use form plans, this is an excellent opportunity for the bankruptcy bar to cooperatively design plan language which addresses this issue.

In a footnote, the Court of Appeals also noted that BAPCPA added Sec. 524(i), which provides that a creditor violates the discharge injunction if it willfully fails to credit payments received under a plan in the manner specified by the plan if the failure to act causes material injury to the debtor. Under this subsection, Debtor's attorneys would be well advised to seek an accounting for payments made once the plan is completed. That way, if there is a problem, it can be addressed promptly with Sec. 524(i) as an attention getter.

Vice-Presidential Candidates Debate Bankruptcy Reform

Bankruptcy reform received attention at the Vice-Presidential debate last night as viewers witnessed a gaffe from the moderator and Sen. Biden staked out a bold position on modifying home mortgages.

Moderator Gwen Ifill asked Gov. Palin about bankruptcy reform, but managed to muddle her question:

IFILL: Next question, Governor Palin, still on the economy. Last year, Congress passed a bill that would make it more difficult for debt-strapped mortgage-holders to declare bankruptcy, to get out from under that debt. This is something that John McCain supported. Would you have?

Of course, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was not passed "last year." Also, while the legislation made it more difficult to file bankruptcy in general, it did not make any substantive changes to home mortgages. It just goes to show that even smart people from PBS can get their facts wrong.

Initially both candidates dodged the question. Gov. Palin said that she would have supported the legislation at the time, but intimated that she would not support it today--and then changed the subject.

PALIN: Yes, I would have. But here, again, there have -- there have been so many changes in the conditions of our economy in just even these past weeks that there has been more and more revelation made aware now to Americans about the corruption and the greed on Wall Street.

We need to look back, even two years ago, and we need to be appreciative of John McCain's call for reform with Fannie Mae, with Freddie Mac, with the mortgage-lenders, too, who were starting to really kind of rear that head of abuse.

And the colleagues in the Senate weren't going to go there with him. So we have John McCain to thank for at least warning people. And we also have John McCain to thank for bringing in a bipartisan effort people to the table so that we can start putting politics aside, even putting a campaign aside, and just do what's right to fix this economic problem that we are in.

It is a crisis. It's a toxic mess, really, on Main Street that's affecting Wall Street. And now we have to be ever vigilant and also making sure that credit markets don't seize up. That's where the Main Streeters like me, that's where we would really feel the effects.

When Sen. Biden was asked about his support for BAPCPA, he initially gave a disjointed answer, but then dropped a bombshell.

IFILL: Senator Biden, you voted for this bankruptcy bill. Senator Obama voted against it. Some people have said that mortgage- holders really paid the price.

BIDEN: Well, mortgage-holders didn't pay the price. Only 10 percent of the people who are -- have been affected by this whole switch from Chapter 7 to Chapter 13 -- it gets complicated.

But the point of this -- Barack Obama saw the glass as half- empty. I saw it as half-full. We disagreed on that, and 85 senators voted one way, and 15 voted the other way.

But here's the deal. Barack Obama pointed out two years ago that there was a subprime mortgage crisis and wrote to the secretary of Treasury. And he said, "You'd better get on the stick here. You'd better look at it."

John McCain said as early as last December, quote -- I'm paraphrasing -- "I'm surprised about this subprime mortgage crisis," number one.

Number two, with regard to bankruptcy now, Gwen, what we should be doing now -- and Barack Obama and I support it -- we should be allowing bankruptcy courts to be able to re-adjust not just the interest rate you're paying on your mortgage to be able to stay in your home, but be able to adjust the principal that you owe, the principal that you owe. (emphasis added). That would keep people in their homes, actually help banks by keeping it from going under. But John McCain, as I understand it -- I'm not sure of this, but I believe John McCain and the governor don't support that. There are ways to help people now. And there -- ways that we're offering are not being supported by -- by the Bush administration nor do I believe by John McCain and Governor Palin.

Until recently, the Obama-Biden ticket's support for bankruptcy reform has been somewhat tepid. Earlier this year, both Sens. Obama and Biden voted for a proposal to allow bankruptcy judges to modify home mortgages, although that proposal was defeated. The Obama-Biden campaign's website, which is laden in detailed proposals does not mention modifying home mortgages in its section on Bankruptcy Reform. However, it does contain this proposal within its section titled Protect Home Ownership and Crack Down on Mortgage Fraud. No doubt this is a case of poor editing and not an attempt to confuse bankruptcy junkies.

In published accounts, Sen. Obama has championed incremental change, such as exempting military families, senior citizens, victims of national disasters and persons filing due to medical bills from credit counseling and means testing, supporting a minimum national homestead exemption for senior citizens and proposing a 120 day moratorium on foreclosures and credit reporting (although some reports have also mentioned modifying home mortgages in passing). In his acceptance speech in August, Sen. Obama mentioned reforming bankruptcy laws to protect people's pensions. Finally, just last week, Sen. Obama opposed adding bankruptcy reform to the Wall Street rescue plan.

Now that Sen. Biden stressed modifying home in the debate, the issue is likely to take on a higher profile. Thus far, the McCain-Palin ticket has railed against Wall Street greed, but has not taken a stand on bankruptcy reform (at least not that I have been able to find). It will be interesting to see whether this issue is addressed further in the upcoming debates between the presidential candidates.

Equitable Mootness Fails to Prevent Disgorgement

The Schlotzsky's case got a little woolier as the Fifth Circuit ordered that an appeal over funds disbursed from a reserve account could not be dismissed based upon equitable mootness. Wooley v. Faulkner, No. 07-50912 (5th Cir. 8/28/08).

The Schlotzsky's case involved disputes between John and Jeffrey Wooley and the Debtor. Prior to a change in management, the Wooleys (who had been officers and directors) had made secured loans to the company with the approval of the then Board of Directors. After bankruptcy, the Unsecured Creditors' Committee brought suit for equitable subordination. In an elaborate mechanism, the Wooleys received a distribution of $2,867,600 on their secured claim, but had to post a letter of credit for $2,939,200 in case the equitable subordination case went against them. Additionally, the plan created a $500,000 reserve to pay any additional secured claims allowed. After the Bankruptcy Court rendered judgment subordinating the secured claims, the Plan Administrator moved to disburse the funds in the reserve account, which the Bankruptcy Court approved. Some of the funds were used to pay the Plan Administrator's attorneys. The Wooleys appealed the adverse orders on equitable subordination and disbursement of the reserve fund.

The Fifth Circuit reversed the judgment granting equitable subordination. Wooley v. Faulker, 532 F.3d 355 (5th Cir. 2008); see "5th Circuit Rejects Equitable Subordination Claim with Deepending Insolvency Aspect," A Texas Bankruptcy Lawyer's Blog (7/1/08).

Having disposed of the first appeal, the Fifth Circuit then turned its attention to the reserve fund account. The Plan Administrator raised several arguments, but the most interesting one was equitable mootness. There are numerous instances in which equitable mootness will prevent an appeal from proceeding where a stay pending appeal is not obtained and the parties have acted in reliance on the order. In those cases, the appeal may be dismissed for equitable mootness. Plan confirmations are the type of order to which equitable mootness may apply.

The Fifth Circuit described the doctrine as follows:

'The concept of [equitable] 'mootness' from a prudential standpoint protects the interest of non-adverse third parties who are not before the reviewing court but who have acted in reliance on the plan as implemented.' The ultimate question to be decided is whether the Court can grant relief without undermining the plan and thereby, affecting third parties. For the doctrine of equitable mootness to apply, the Court must determine: "...(i) whether a stay has been obtained, (ii) whether the plan has been 'substantially consummated,' and (iii) whether the relief requested would affect either the rights of parties not before the court or the success of the plan.'

Opinion, p. 6.

At first blush, the requirements seemed to be satisfiable. The Wooleys had asked for a stay pending appeal, which was denied and the plan had been substantially consummated. The difficult question was whether the appeal would affect the rights of parties not before the court or the success of the plan. The Wooleys made a wise tactical decision to limit their appeal to seeking disgorgement only of the fees paid to the Plan Administrator's counsel. The Fifth Circuit was quick to point out that they were not seeking the return of money paid to third party creditors.

In an interesting use of a double negative, the Fifth Circuit stated that the Plan Administrator's counsel "is not a party who is not before the court." (italics in original). In other words, even though the Plan Administrator's counsel was not a formal party to the appeal, they were before the court in a very practical sense of the term. The Fifth Circuit also noted that equitable mootness should not be used to prevent the disgorgement and return to the estate of attorney's fees.

In the final analysis, the Fifth Circuit remanded the case for a determination of the additional secured claim held by the Wooleys and ordered that the Plan Administrator's attorneys disgorge their attorney's fees paid out of the reserve to the extent necessary to satisfy whatever secured claim was allowed.

Fifth Circuit Dismisses Gadzooks Appeal

Practitioners waiting for further illumination of the Fifth Circuit's Pro-Snax decision will have to continue waiting. The Gadzooks case involves whether Hughes & Luce will be compensated for nearly a million dollars worth of legal work done for an equity security holders' committee in a case where subsequent, unforeseen events negated the value of the committee's work.

The Bankruptcy Court found an exception to the requirement in Matter of Pro-Snax Distributors, Inc., 157 F.3d 422, 426 (5th Cir. 1998) that services yield “an identifiable, tangible and material benefit to the bankruptcy estate.” The District Court reversed and an appeal was taken to the Fifth Circuit.

The Fifth Circuit has now dismissed the appeal for lack of jurisdiction. Kaye v. Hughes & Luce, LLP, No. 07-10813 (5th Cir. 9/9/08). When the District Court ruled, it reversed and remanded the case to the Bankruptcy Court for further proceedings. Under 28 U.S.C. Sec. 158(d), the Fifth Circuit has jurisdiction over "final decisions, judgments, order and decrees." When a case is remanded for "significant further proceedings," the order is not final. Instead, the parties must obtain leave for an interlocutory appeal under 28 U.S.C. Sec. 1292.

Now that the appeal has been dismissed, the parties must proceed with the remand and then take the case back up the appellate chain. As a result, it is not likely that the Fifth Circuit will resolve the apparent conflict between Pro-Snax and 11 U.S.C. Sec. 330(a)(3)(C) for some time.

Update on Possible Impeachment of U.S. District Judge for Bankruptcy Fraud

There has been a new development in the case of a U.S. District Judge facing possible impeachment based in part upon his conduct as a Chapter 13 debtor. On September 10, 2008, The Judicial Council of the Fifth Circuit issued an Order and Public Reprimand in Docket No. 07-05-351-0085, In re Complaint of Judicial Misconduct Against Judge G. Thomas Porteous, Jr. under the Judicial Conduct and Disability Act of 1980. The Order publicly reprimands the Judge for conduct including perjury and violation of ethical canons, orders that no new cases be assigned to him for two years or until Congress completes impeachment proceedings and suspends his authorization to employ staff.

I previously wrote about this case last January after the Fifth Circuit recommended that Judge Porteous be referred for possible impeachment proceedings. Now the Judicial Conference of the United States has accepted the Report and Recommendation from the Judicial Conference fo the Fifth Circuit.

While the Order details substantial misconduct, the following item pertains to his personal bankruptcy case.

Judge Porteous repeatedly committed perjury by signing false statements under oath in a personal bankruptcy proceeding in violation of 18 U.S.C. Sec. 152(1)-(3), 1621 as well as Canons 1 and 2A of the Code of Conduct for United States Judges. This perjury allowed him to obtain a discharge of his debts while continuing his lifestyle at the expense of his creditors. His systematic disregard of the Bankruptcy Court's orders also implicates 11 U.S.C. Sec. 521(a)(3) and 18 U.S.C. Sec. 401(1).

Order and Public Reprimand, pp. 2-3.

While a public reprimand and suspension from receiving new cases may sound mild, the Circuit stressed that it was taking the maximum action available to it.

In issuing this Order and Public Reprimand and executing the actions contained herein, the Council is taking the maximum disciplinary steps allowed by law against Judge Porteous. Any further action to remove Judge Porteous from office and the emoluments thereof is the responsibility of Congress.

Order and Public Reprimand, p. 5.

The House Judiciary Committee has formed a task force to investigate the possible impeachment of Judge Porteous.

Practicing Law and Having a Life

This weekend, the firms that I work for hosted a celebration for the 25th anniversary of Barbara Barron and Manny Newburger practicing together, as well as the 2nd anniversary of Barron, Newburger, Sinsley & Wier, PLLC. We joined several hundred of our friends and clients (some of whom were the same people) for barbecue and country music at the Salt Lick in Driftwood, Texas. What does any of this have to do with bankruptcy? Not much directly. However, it is a reminder to heed Shakespeare’s admonition to “do as adversaries do in law, strive mightily, but eat and drink as friends.” (The Taming of the Shrew Act I, Scene 2).

Twenty-five years is a long time. While I wasn’t there for all of it, there is still a strange sensation of waking up in another time and place. Over 25 years, we have gone through the real estate bust/S & L crisis which spawned the RTC, the leveraged buyout bust which gave rise to mega-bankruptcies, credit card defaults leading to personal bankruptcy filings topping 1.6 million, Enron, bankruptcy reform and now the sub-prime mortgage crisis. During that time, newlyweds had children grow up, our hair grew thinner and our waistlines grew larger (at least mine did). The baby boomers who hoped to transform the world now look forward to retirement.

Over the years, we have met a lot of interesting people and many of them were at the festivities. Politicians and judges mingled with real estate developers, reorganized debtors and debt collectors. Lawyers, clerks and support staff drank margaritas together. However, the best story of the night was probably the entertainment (and I am not just talking about Barbara Barron gracefully two-stepping and doing the cha-cha).

The headliner for the evening was Brian Turner and His Redneck Band. Brian is proof that only in Austin, Texas can a Jewish solo practitioner pursue his dream of being a snuff-dipping country music sensation. (While Kinky Friedman is more famous, that’s only because Brian hasn’t been discovered yet). Brian represented a significant bloc of creditors in a contentious chapter 11 case that our firm handled. As we were wrapping up the case, Brian shared one of his CDs with us. His music hits traditional country music themes such as patriotism, fatherhood and failed relationships, but does so with a wry sense of humor.

With songs like “I Miss That Dog More Than You,” “If Love Is Blind Why Do You See My Faults See Clearly” and “If You Won’t Leave Me, I’ll Find Someone Who Will,” Brian harnesses a traditional country music vibe with just a little tongue in cheek. Even his tribute to his father contains the refrain, “So here’s to my dad/ who taught me all my bad habits/ some of my good ones, too/ Like to be a great dad/ believe in your country and never turn my back on you.”

I admire Brian for managing to practice law and pursue his dream as well. Let’s hope that the rest of us can find a way to harnish our dreams and creativity outside the workaday world.

Fifth Circuit Answers Three Questions of First Impression on Violation of Automatic Stay

The Fifth Circuit answered at least three questions of first impression in a recent case regarding violation of the automatic stay. In re Repine, No. 06-20807 (5th Cir. 7/22/08).

The facts of this case sound straight out of a made for TV movie, including love gone bad, prison and a renegade lawyer. Ronald Repine was married to Elizabeth Pollard Repine. Although he had made as much as $147,000 per year at one point, he was unemployed during part of the period from 2001 to 2003. He managed to get behind on his child support to the extent of $22,859. The family court sentenced him to 180 days in jail for criminal contempt and also ordered that he be held in civil contempt indefinitely until he paid the past due support and paid $2,027 to his ex-wife’s attorney Patsy Young.

Shortly after being incarcerated, Ronald did what anyone would do: he filed for chapter 13 bankruptcy. Elizabeth then retained separate counsel to represent her in the bankruptcy. Notwithstanding the automatic stay, Elizabeth made a deal with Ronald to pay the back support and get him out of jail. Ronald agreed to deed his house to Elizabeth who would be allowed to sell it and apply the proceeds to the back child support. There was just one problem: the agreement did not provide for payment of Patsy’s attorney’s fees. Elizabeth’s bankruptcy lawyer came up with a practical solution. He obtained an order from the Bankruptcy Court allowing the transfer of the house to Elizabeth and for the proceeds to be applied to the child support debt, including attorney’s fees. The order also provided that any unpaid attorney’s fees would be paid under Ronald’s Chapter 13 plan.

Elizabeth complied with her part of the deal and asked that Ronald be released from jail. However, Patsy objected because she wanted to be paid her attorney’s fees. As a result, the family court denied the motion. Shortly thereafter, Ronald completed the criminal portion of his contempt sanction and started serving the civil contempt portion. Patsy refused to submit an agreed order for Ronald’s release unless she received certified checks for her attorney’s fees. Elizabeth and Ronald then went to Bankruptcy Court to enforce the agreed order. The Bankruptcy Court ordered Patsy to appear and show cause why she should not be held in contempt for violation of the automatic stay. Despite being served with the order by a U.S. Marshall, Patsy did not appear. As a result, the Bankruptcy Court caused a warrant to be issued and Patsy was taken into custody by the U.S. Marshall’s Service.

The Bankruptcy Court ordered Patsy released but told her to stop trying to collect her attorney’s fees. Undeterred, Patsy refused to submit the order providing for Ronald’s release. Because of Patsy’s actions, Ronald was unable to attend his father’s funeral. Finally, Patsy moved to withdraw from the family law case and Elizabeth’s bankruptcy counsel substituted in. Ronald was finally released after having served about six weeks of his civil contempt sentence.

Once he got out, Ronald filed a complaint for violation of the automatic stay against Patsy. The Bankruptcy Court awarded Ronald total damages of $27,280, including $4,400 for emotional distress and $5,000 in punitive damages plus $33,720. Thus, Patsy’s efforts to collect $2,027 in attorney’s fees caused her to incur liability of $61,000.

The Court of Appeals did not have any difficulty finding that the Bankruptcy Court’s determination that Patsy had violated the automatic stay should be affirmed. While child support may be collected from property which is not property of the estate, Patsy’s demand to be paid or else Ronald could not be released from jail did not distinguish between being paid from property of the estate or non-property of the estate. Patsy just wanted to get paid and she didn’t care where the money came from. Additionally, the Court of Appeals found that Patsy’s determined refusal to submit the order agreed to by her client extended the period of Ronald’s incarceration.

When it came to damages, the Fifth Circuit plowed new ground. Section 362(k) allows punitive damages in “appropriate circumstances,” a rather indefinite mandate. The Fifth Circuit had not previously decided what constituted “appropriate circumstances” to award punitive damages. It accepted the Eighth Circuit’s standard of “egregious intentional misconduct on the violator’s part” and found that Patsy met the standard. Ignoring the Bankruptcy Court's admonition to stop collecting as well as your own client’s wishes is enough to constitute egregious intentional misconduct.

Next, the Fifth Circuit had to consider whether damages for emotional distress could be awarded for a violation of the automatic stay. This was also an issue of first impression. The Court found that a debtor seeking to recover damages for emotional distress must set forth “specific information” rather than “generalized assertions.” The Court found that testimony that he was “very upset” at what his sons would think about him being incarcerated, that it was “very traumatic” to miss his father’s funeral and that he had dreams about missing his father’s funeral and worried about it when interacting with other people all fell within the category of “generalized assertions” which would not give rise to emotional distress. As a result, the Court vacated the award for emotional distress.

Finally, the Fifth Circuit considered whether fees incurred in prosecuting an action for violation of the automatic stay were recoverable as damages. This was also an issue of first impression. The Fifth Circuit agreed that fees incurred in prosecuting an action for violation of the stay were recoverable and rejected a requirement that there be proof that the fees incurred had actually been paid.

At the end of the day, all of the damages except for $4,400 in emotional distress were affirmed.

Trustee Avoids Judicial Estoppel Finding As Fifth Circuit Comes Full Circle

Good things come in threes. Think of the first Star Wars trilogy or Lord of the Rings. Now the Fifth Circuit has completed a trilogy of cases on judicial estoppel which brings its exposition of the doctrine full circle. Kane v. National Union Fire Insurance Company, No. 07-30611 (5th Cir. 7/14/08).

Judicial estoppel “is a common law doctrine that prevents a party from assuming inconsistent positions in litigation.” In re Superior Crewboats, Inc., 374 F.3d 330 (5th Cir. 2004). The elements of judicial estoppel are: (1) the party is judicially estopped only if its position is clearly inconsistent with the previous one; (2) the court must have accepted the previous position; and (3) the non-disclosure must not have been inadvertent. In bankruptcy, the doctrine is frequently applied to prevent parties from pursuing undisclosed claims. The doctrine enforces the debtor’s duty to make full disclosure of all assets on his schedules.

The first of the recent Fifth Circuit cases was In re Coastal Plains, Inc., 179 F.3d 197 (5th Cir. 1999). In that case, the Debtor’s CEO formed a company which acquired the assets of the debtor corporation. The insider purchaser then filed suit on a claim which had not been disclosed in the schedules. The purchaser recovered $3.6 million on the undisclosed claim. The Fifth Circuit reversed on appeal, finding that accepting the argument that the claims were inadvertently left off the schedules “would encourage bankruptcy debtors to conceal claims, write off debts, and then sue on undisclosed claims and possibly recover windfalls.” In re Coastal Plains at 213.

Next came In re Superior Crewboats, 374 F. 330 (5th Cir. 2004). In that case, it was the debtor who was estopped. In that case, one of the debtors was injured prior to bankruptcy. During their chapter 13 case, they filed suit on a claim which was not listed in their schedules. After their case was converted to chapter 7, the debtors told the trustee about their claim, but represented that it was barred by limitations. As a result, the trustee abandoned the claim which the debtors continued to pursue. When the trustee learned about the case, he attempted to substitute in. However, the court granted summary judgment for the defendant.

The trend of ruling in favor of defendants continued with the lower court opinion in Kane. In Kane, the debtor filed a personal injury suit prior to bankruptcy. However, he did not list it on his schedules. Once the debtor received his discharge, the defendant moved for summary judgment based on judicial estoppel. The debtors then tried to do the right thing by asking that their bankruptcy case be re-opened so that the trustee could administer the undisclosed lawsuit. The case was reopened and the trustee asked to be substituted as real party in interest. Relying upon Superior Crewboats, the District Court granted the defendants’ motion for summary judgment and denied the trustee’s request to substitute in as real party in interest.

While Kane looked a lot like Superior Crewboats, the Fifth Circuit found an important distinction. The Court stated:

There, because the trustee had abandoned the claim, he was not the real party in interest and was not entitled to be substituted as such. Rather, following the trustee’s abandonment, the interest in the claim had reverted to the debtors, who stood to collect a windfall from the asset at the expense of the creditors. In the case before us, the Kanes’ personal injury claim became an asset of their bankruptcy estate when they filed their Chapter 7 petition. The Trustee became the real party in interest in the Kanes’ lawsuit at that point and never abandoned his interest therein.

Kane at 8.

The Fifth Circuit noted that the present case did not present any equitable concerns. Indeed, the creditors would be harmed if judicial estoppel was applied to preclude the trustee from pursuing the claims. The court quoted from a great Seventh Circuit opinion which made the obvious point:

[The debtor’s] nondisclosure in bankruptcy harmed his creditors by hiding assets from them. Using this same nondisclosure to wipe out [the debtor’s claim against the defendant] would complete the job by denying creditors even the right to seek some share of the recovery. Yet the creditors have not contradicted themselves in court. They were not aware of what [the debtor] was doing behind their backs. Creditors gypped by [the debtor’s] maneuver are hurt a second time by the district judge’s decision. Judicial estoppel is an equitable doctrine and using it to land another blow on the victims of bankruptcy fraud is not an equitable application.

Kane at 10, quoting Biesek v. Soo Line R.R. Co., 440 F.3d 410, 413 (7th Cir. 2006).

Thus, the Fifth Circuit reversed the summary judgment based on judicial estoppel and remanded to consider whether the trustee should be permitted to substitute as real party in interest (an issue which had not been considered by the district court).

In any good trilogy, things appear darkest after the second part. Here, the Superior Crewboats decision appeared to foreclose even a suit by the trustee. This was much like saying that the creditors had to be punished to protect the integrity of the system which was intended to protect the creditors, or to put it another way, it was necessary to destroy the village in order to save it.

Kane corrects this misimpression by pointing out that judicial estoppel only applies against the party who took the inconsistent position, namely the debtor; it does not apply against the trustee as the representative of the innocent creditors. Kane has an added bonus in that it encourages debtors to correct their mistakes. If the debtor omits a cause of action, but later repents, the trustee is not prejudiced. The debtor protects himself by mitigating the effects of his previous non-disclosure. The debtor also stands to benefit directly if the litigation proceeds are used to pay non-dischargeable claims or if there estate produces a surplus.

Thanks to St. Clair Newbern for the pointer on this case.

Tchaikovsky's Overture: How an Unremarkable Case Took on a Life of Its Own

Peter Tchaikovsky's 1812 Overture ends with a cannonade. Some commentators have viewed a recent opinion from Bankruptcy Judge Leslie Tchaikovsky as a cannon shot aimed at the irresponsible practices of the home mortgage industry. However, what is most remarkable about National City Mortgage vs. Hill, No. 07-4106 (Bankr. N.D. Cal. 5/28/08) is how unremarkable the opinion is.

The Opinion

In the Hill case, the debtors purchased a home for $220,000 twenty years ago. By the time that they filed bankruptcy, they had incurred debt of $683,000 against the house, including a second lien debt to National City Mortgage for $250,000. However, the debtors' combined income never exceeded $65,000.

When the debtors first applied for a loan with National City Mortgage in April 2006, they stated that their combined income was $145,716 on an annual basis. Six months later, they asked the bank to increase their Home Equity Line of Credit from $200,000 to $250,000. This time they stated their income as $190,800 on an annual basis. The bank either did not notice or did not care that the debtors were asserting that their income had increased by $45,000 per year in the span of just six months.

After the debtors filed for chapter 7 bankruptcy in April 2007, the first lienholder foreclosed and the second lien to National City Mortgage was wiped out. National City Mortgage brought a dischargeability action based on submitting a false financial statement under 11 U.S.C. Sec. 523(a)(2)(B). The court had little trouble finding that the first five elements of the claim were established. The debtors had made knowingly made a false financial statement with intent to deceive the lender. However, the court found that the element of reasonable reliance was missing.

Section 523(a)(2)(B) is unusual in that the statutory language expressly requires that reliance on a false financial statement be reasonable. This contrasts with Section 523(a)(2)(A) which states that debts based upon fraud are non-dischargeable but does not spell out the standard for reliance. The Supreme Court has said that reliance must be "justifiable" under Sec. 523(a)(2)(A), which is a lesser standard than "reasonable." Field v. Mans, 516 U.S. 59 (1995)("While the Court of Appeals followed a rule requiring reasonable reliance on the statement, we hold the standard to be the less demanding one of justifiable reliance, and accordingly vacate and remand."). Thus, Congress required a higher level of reliance on written statements of financial condition.

Judge Tchaikovsky set out the standad for reasonable reliance as follows:

Whether the creditor reasonably relied on the materially false statement under Sec. 523(a)(2)(B) is measured objectively by the degree of care exercised by a reasonably cautious person in the same transaction under similar circumstances. (citation omitted). Absent other factors, a creditor's reliance on a statement of financial condition is reasonable if it followed it normal business practices. (citation omitted). Other factors that may affect whether the creditor's reliance on its own standard lending practices is reasonable include the standards of the creditor's industry in evaluating creditworthiness, and the existence of any "red flags" that would alert the reasonably prudent lender of the possibility that the information was inaccurate. (citation omitted).

Memorandum of Decision at 8.

This was what is known as a stated income loan. According to the creditor's own guidelines, it did not require verification of income. However, it did require that an independent contractor verify that the amount stated was reasonable and that for a self-employed person that the borrower provide a copy of the borrower's business license, a copy of a bank statement showing a balance equal to 1/10 of the stated annual income or a letter from a CPA verifying the existence and ownership of the business. The Court found that the lender did not follow its own guidelines. There was no evidence that a third party contractor had verified that it was reasonable for an auto parts manager in the San Francisco Bay area (the husband) to earn $98,112 on an annual basis. While the wife submitted a letter on a CPA's letterhead with regard to her sole proprietorship, the person who signed the letter was not the CPA. Thus, the bank failed to follow its own guidelines. The Court also found that the bank ignored obvious red flags. In April 2006, the debtors claimed that Mr.Hill's income was $98,112 and that Mrs.Hill's income was $47,604. However, in October 2006, the debtors claimed that Mr. Hill's income was $67,200 (a 33% drop) and that Mrs. Hill's income was $123,600 (a 300% increase). Reasonable minds would have wondered about such a dramatic fluctuation in income, but the bank apparently did not.

In denying the complaint, the court concluded:

Based on the foregoing, the Court concludes that either the Bank did not rely on the Debtors representations concerning their income or that its relaiance was not reasonable based on an objective standard. In fact, the minimal verification required by an 'income stated' loan, as established by the Guidelines, suggestes that this type of loan is essentially an 'asset-based' loan. In other words, the Court surmises that the Bank made the loan principally in reliance on the value of the collateral: i.e., the House. If so, the Bank obtained the appraisal upon which it principally relied in making the loan. Subsequent events strongly suggest that the appraisal was inflated. However, under these circumstances, the Debtors cannot be blamed for the Bank's loss, and the Bank's claim should be discharged.

Memorandum of Decision at 13.

The Response

While the opinion was rather unremarkable, one line in it drew a lot of attention. Near the beginning of the opinion, the Court stated, "This adversary proceeding is a poster child for some of hte practices that have led to the current crisis in the housing market." Memorandum of Decision at 2. According to one blogger who wrote the day after the opinion was released, "This is a big deal, and will no doubt strike real fear in the hearts of stated-income lenders everwhere." BK Judge Rules Stated Income HELOC Debt Dischargeable, http://calculatedrisk.blogspot.com/2008/05/bk-judge-rules-stated-income-heloc-debt.html. This comment was picked up on and repeated by dozens of bloggers. The Wall Street Journal ran a story with the headine "Are borrowers free to lie?" Amir Efrati, "Are Borowers Free to Lie?," Wall Street Journal, May 31, 2008, p. B2. An article on MSN Money on June 30, 2008 amplified the story, claiming that, "In a little-noticed decision, U.S. Bankruptcy Judge Leslie J. Tchaikovsky let a California couple off the hook for debt they owed their home-equity lender because the incomes they had listed on their applications were obvious "red flags" that the lender had ignored." Liz Pulliam Webster, "Lenders create a bankruptcy monster," http://articles.moneycentral.msn.com/Banking/BankruptcyGuide/
LendersCreateABankruptcyMonster.aspx?page=1.

By this point, the focus on the legal definition of reasonable reliance had been lost. From the comments being circulated, it appeared that a crazy bankruptcy judge had declared war on the stated-income lenders, was countenancing lying by debtors and was letting borrowers off the hook for their misdeeds. One email which I received from a colleague asked me if I had heard about a case “in which the good judge held that despite the mendacity of the debtors, Mr. and Mrs. Hill (In Re Hill), National City Bank could not enforce, post petition, a home equity type of loan against the debtors post discharge.” He asked “Is this a case that you are aware of?” However, the debtors were not let off the hook. They lost their home of 20 years. What they did get was a discharge, something that debtors are entitled to if their creditors do not object or do not prove an exception to discharge.

We have been through this before. During the 1990s and early years of the 2000s, credit card lenders made a concerted effort to object to dischargeability in cases where debtors irresponsibly ran up their credit card debt. Many of these decisions focused on reliance or the lack thereof. E.g., In re Mercer, 246 F.3d 391 (5th Cir. 2001)(no reliance where creditor sent debtor pre-approved credit card);In re Eashai, 87 F.3d 1082 (9th Cir. 1996)(reliance justifiable where no red flags appeared).

In one noteworthy case, the court stated:

There is no reliance in this case. There is not even a scintilla of reliance in this case. . . .

The Plaintiff's extension of credit to the Defendant in this case was a result of their own negligent lending practices and the industry's negligent use of a faulty FICO score system which has been engineered to create the greatest amount of credit for the greatest number of working people in this country with artificially low monthly repayment requirements so that credit card companies can make the greatest amount of interest and profits possible. Losses such as this are simply a cost of doing business in such a greedy manner.

In re Akins, 235 B.R. 866, 874 (Bankr. W.D. Tex. 1999).

As long as lenders continue to make high risk loans, it is inevitable that some borrowers will default and file bankruptcy. If the loss results from the lender's own negligence, the debt will be dischargeable. This is nothing remarkable.

In Memory of Gray Byron Jolink, 1946-2008

The Central Texas bankruptcy community lost a valued friend and colleague when Gray Byron Jolink passed away unexpectedly on June 23, 2008. Gray graduated from the University of Texas Law School in 1974 and was a solo practitioner in Austin. Much of his practice involved representing the debtor in small chapter 11 cases.

Gray is survived by his mother Bette; wife Kathy; children Luke, Radkey, Georgia, Tatum and Willa; daughter-in-law Christine; brother, Dirk; sister-in-law Carol; mother-in-law Bea Cromack; grandchildren, Mason and Miles; eight nieces and nephews; and numerous other relatives and friends.

Gray’s obituary did a good job of summarizing his life. It stated:

“He was many things during his full life: pilot, photographer, attorney, birder, coach and nature lover. But the titles of which he was most proud were husband, father, grandfather, son, uncle, brother, cousin and friend.”

“He spent the last thirty years practicing bankruptcy law in Austin. His passion for the law lay in his desire to help others, and he saw his bankruptcy practice as a means to help those who struggled financially to get back on their feet.”

After Gray’s death, his colleagues shared memories of his life.

I first met Gray in the late 1980s at a hearing on a motion for relief from the automatic stay. I managed to show up after the court had already called my case and ruled without me. I located Gray in the back of the courtroom and asked him if he would object to a motion for reconsideration. He went up to the podium with me and asked the judge to let me go forward. Afterward he told me, “One of these days someone may need a favor from you. Be sure to remember when the time comes.” For a young associate, it meant a lot that a more experienced lawyer went out of his way to be nice.

Ronnie Hornberger of San Antonio said:

“Gray was one of the good guys; he was knowledgeable, gracious, easy to work with and you could always count on a hand shake deal to be honored. He truly will be missed.”

Joe Martinec recalled:

“Gray called me just about every Friday to ask ‘what are you seeing?’, at which time we would discuss the state of the Austin bankruptcy market and the crazy, outrageous or comical things the ‘young pups’ were doing. Gray was someone whose call I was always happy to take because it was almost invariably upbeat and informative. He was a great fan of history, he knew all about my distant relative being defenestrated in Prague, and he was an avid birder. I hate that I did not call him last week to tell him I had just seen a nesting pair of black-bellied whistling ducks on my brother’s stock tank. He would have told me their range, mating habits and maybe their call. I always envied Gray’s ability to get an adverse ruling or criticism without over-reacting. Most of the time, he would just chuckle and say, ‘You may be right. I’ll think about that.’ I could learn from that. He will be especially missed by those of us who are his contemporaries (a dwindling number).”

Steve Ravel said:

“I tried the first contested bankruptcy matter of my career against Gray before Judge Elliott in 1983. He was unfailingly gracious that time and every time since. When my twins were born only about 3 years after his, he went out of his way to share tips and wisdom. He coined the phrase, ‘Twins, twice as much work and four times as much fun.’”

Gray’s funeral was held at the Episcopal Church of the Good Shepherd on June 27, 2008. The church was packed to capacity as friends,family, members of his church, clients, lawyers and court staff gathered to remember him. Bankruptcy Judge Frank Monroe gave one of the eulogies. He said:

“I’m not sure that I ever met a man that enjoyed life more fully or exuded more joy in his life than Gray Jolink. Gray was a man who drew others to himself. He had a magnetic and upbeat personality. You knew instinctively that he was a person you could trust—with anything. In many ways he lived his life with the heart of a child—every new discovery was viewed with great delight and excitement.

“The last time I talked with Gray was after a Court hearing one day last week. He wanted to tell me about his experience of seeing the people who ‘danced’ on the side of the federal courthouse and the federal building. He had gone to the performance with Kathy and was obviously greatly impressed by the performance. The excitement in his eyes as he told me of his experience reminded me of a young child seeing some new wonder for the first time—not fully understanding how it could have been done but fully appreciating what he had seen.

“Gray was the consummate gentleman attorney. He was always prepared, always well mannered, polite and respectful of his fellow attorneys, the parties, the witnesses, the Court and the Court’s staff. He was unfailingly honest and forthright and always looked for a solution that would be fair to both sides. He was also an excellent litigator and cross-examiner of adverse witnesses. He was exceptionally bright, and he was an absolute joy to have in one’s courtroom.

“Gray viewed the practice of law as a profession—a way to help people—and not just a business to be run for profit, and he always conducted himself in that mode—always the gentleman.”

Judge Monroe was kind enough to type up the complete eulogy and provide me with a copy. I would be happy to send copies to anyone who asks.

Donations can be made to the Gray Jolink Memorial Fund, P.O. Box 5516, Austin, TX 78763 or to the Travis Audubon Society.

Fifth Circuit Clarifies Post-Confirmation Jurisdiction

The Fifth Circuit has written a new opinion in which it holds that once "related to" jurisdiction attaches, confirmation of the plan will not divest that jurisdiction. The opinion reconciles an apparent conflict with its holding in Craig's Stores that post-confirmation jurisdiction is limited to enforcing the plan. Newby v. Enron Corporation, No. 07-20051 (5th Cir. 7/10/08).

In the Newby case, nine actions against Enron-related parties were removed to federal court based upon "related-to" jurisdiction. Seven cases were removed prior to confirmation of Enron's plan and two were removed between plan confirmation and the plan's effective date. The cases were consolidated in U.S. District Court where they were dismissed with prejudice. The plaintiffs appealed the dismissal on the basis that the U.S. District Court lacked jurisdiction subsequent to plan confirmation.

The Fifth Circuit noted an apparent conflict in its opinions.

"We previously have stated that 'Section 1334 does not expressly limit bankruptcy jurisdiction upon plan confirmation.' (citation omitted). Other Circuits agree, holding that 'if ‘related to’ jurisdiction actually existed at the time of . . . removal” subsequent events '[can]not divest the district court of that subject matter jurisdiction.” (citation omitted). But at the same time, this Court has stated that '[a]fter a debtor’s reorganization plan has been confirmed, the debtor’s estate, and thus bankruptcy jurisdiction, ceases to exist, other than for matters pertaining to the implementation or execution of the plan.' (citations omitted). Although these statements may seem contradictory, they are easily reconciled."

Slip Opinion, at 14-15.

The Fifth Circuit clarified its holding in Craig's Stores as one relating to claims brought post-confirmation. Thus, if bankruptcy jurisdiction attaches to a claim prior to confirmation, the court retains jurisdiction over that claim post-confirmation.

"(Plaintiffs)cannot point to a single case in which we have held that plan confirmation divests a District Court of bankruptcy jurisdiction over preconfirmation claims based on pre-confirmation activities that properly had been removed pursuant to 'related to' jurisdiction. We likewise find none. Accordingly, we hold that the District Court had bankruptcy jurisdiction over the Fleming plaintiffs’ claims at the time it issued its decision dismissing them with prejudice."

Slip Opinion at 16.

5th Circuit Rejects Equitable Subordination Claim With Deepening Insolvency Aspect; Insiders Not Subordinated for Stoking the Fires of a Sinking Ship

The Fifth Circuit has ruled that insiders who “grabbed for as much as they could get” were not subject to equitable subordination where the bankruptcy court did not find sufficient harm resulting from their conduct. The court rejected a theory of damages which it equated to deepening insolvency. Matter of S.I. Restructuring, Inc., 2008 U.S. App. LEXIS 13140 (5th Cir. 6/20/08).

Background

S.I. Restructuring involved the Schlotzsky’s sandwich chain. At the time, John and Jeffrey Wooley were officers, directors and the largest shareholders of the company. In April 2003, the Wooleys made a secured loan to the company for $1 million. The company and the Wooleys were each represented by separate counsel, the transaction was approved by the company’s audit committee and board of directors and the loan was reported in the company’s SEC filings.

The company’s finances continued to deteriorate and in October 2003, it sought financing from International Bank of Commerce. IBC declined to make a loan to Schlotzsky’s, but agreed to loan the money to the Wooleys for them to loan to the company. The board of directors was given just three days notice of the meeting to approve the loan, but were provided with copies of the proposed loan documents along with emails from the company’s assistant general counsel.

In mid-2004, the Wooleys were removed as officers and directors and the company for chapter 11 shortly thereafter. The unsecured creditors committee brought a complaint for equitable subordination against the Wooleys. The bankruptcy court found that John and Jeffrey Wooley, as fiduciaries, engaged in inequitable conduct in relation to the November transaction and that their conduct conferred an unfair advantage upon them. Specifically, the court found that the Wooleys breached their fiduciary duties by: (i) presenting the loan proposal to the board as a fait accompli; (ii) by securing the loan with the “crown jewel” of the Debtor’s assets; and (iii) by securing their contingent liability as guarantors. As a result, the bankruptcy court subordinated the secured claims to the level of the unsecured creditors.

Fifth Circuit Ruling

The Fifth Circuit reversed and rendered. The Fifth Circuit characterized equitable subordination as an “extraordinary remedy” and recited the following test from In re Mobile Steel Corp., 563 F.2d 692 (5th Cir. 1977): “(1) the claimant must have engaged in inequitable conduct; (2) the misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant; and (3) equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Code.” The Court also noted an additional requirement that “a claim should be subordinated only to the extent necessary to offset the harm which the debtor or its creditors have suffered as a result of the inequitable conduct.”

Applying this test to the April 2003 transaction, the appellate court found that the bankruptcy court had not made any findings of inequitable conduct or unfair advantage. As a result, it was necessary to reverse the subordination of this debt.

When examining the November 2003 transaction, the Fifth Circuit assumed without deciding that the record supported the findings of inequitable conduct and unfair advantage. The court went on to state, “However, the bankruptcy court made no finding of harm, and the record does not support a finding that either the debtor or the unsecured creditors were harmed by the November transaction.”

The Plan Administrator argued that the securing of the loan harmed the Debtor by diminishing the pool of assets available to unsecured creditors. On a certain level, the Plan Administrator was correct. Creditors would have been better off if the Wooleys had made unsecured loans to the company. However, the Fifth Circuit did not penalize the Wooleys for protecting their own interest. Instead, the court noted that the bankruptcy court had expressly found that the debtor needed the money and that the money had been used to pay unsecured claims. The Court stated:

“Because the loan proceeds were used to pay current unsecured creditors, unsecured creditors as a class, were not harmed when the Wooleys obtained security for for the November loan. The general unsecured creditors who were paid from the proceeds of the November loan may have benefitted to the detriment of another group of unsecured creditors, but this does not mean that unsecured creditors were harmed when the Wooleys obtained security for their loan.”

The Fifth Circuit also rejected the argument that the Wooleys harmed the company by loaning it additional funds which allowed it to continue operating until its condition worsened. Although the Appellee denied that it was relying upon deepening insolvency, the court found that this was exactly what was being alleged and rejected the theory. The Court stated that, “Deepening insolvency has been defined as prolonging an insolvent corporation’s life through bad debt, causing the dissipation of corporate assets.” The Court went on to state that:

“A deepening insolvency theory of damages has been criticized and rejected by many courts. We agree with the Third Circuit Court of Appeals, which recently concluded that deepening insolvency is not a valid theory of damages. The court recognized that deepening insolvency as a measure of harm depends on how the company uses the proceeds of the loan in question and ‘looks at the issue through hindsight bias.’”

As a result, the Fifth Circuit reversed and rendered.

What About Herby’s Foods?

S.I Restructuring has some factual similarities to Matter of Herby’s Foods, 2 F.3d 128 (5th Cir. 1993), an earlier decision which upheld equitable subordination. How then to reconcile the two cases?

In Herby’s Foods, the parent company purchased the debtor less than two years before it failed. Part of the consideration was payment of a debt to another entity. In return for this payment, the parent company took a lien against the debtor’s assets. Another related entity extended a secured line of credit to the company. Another insider made unsecured advances to the company. The secured claims were not perfected until shortly before bankruptcy. During the time between the acquisition and the bankruptcy filing, unsecured claims grew from about $900,000 to $4,600,000. The unsecured creditors’ committee sought to avoid the liens as preferential, to recharacterize the loans as equity and to subordinate the insider debts to the level of equity. The bankruptcy court granted all of the relief requested. On appeal, the Fifth Circuit affirmed, finding that the requisites for equitable subordination had been established, but did not reach the issue of recharacterization.

The Fifth Circuit found that a combination of undercapitalization, failure to disclose the existence of unfiled liens and advancing funds as loans rather than capital constituted inequitable conduct. The Fifth Circuit found that unsecured creditors were harmed by the fact that the amount of unsecured debt owed to third parties increased dramatically.

“The bankruptcy court found that the Insiders’ conduct harmed Herby’s outside creditors by significantly increasing their trade credit exposure and by reducing their ultimate dividend in the liquidation. Most importantly, the court found that the Insiders had secured an unfair advantage by structuring their cash contributions to Herby’s as loans, rather than as equity capital. If the Insiders were allowed to retain their ranking as unsecured creditors, they would have gained an advantage in the priority scheme by encouraging outside creditors to increase their credit to Herby’s. Their efforts were successful; those trade creditors substantially increased their credit to Herby’s during the period in question.”

Herby’s at 134.

The Court in Herby’s accepted the “deepening insolvency” model of damages which was expressly rejected in S.I. Restructuring. However, they did not call it deepening insolvency, a term which was not in vogue in 1993. Instead, the court analyzed the case as one involving deception and trickery. The bad Insiders (referred to with a capital I in the opinion) tricked the trade creditors into advancing more credit by advancing debt rather than infusing equity, by failing to timely record their liens and by failing to adequately record the loans on the company’s books, thus giving the appearance that the company was adequately capitalized. This caused the unsecured creditors to extend trade credit. The court did not cite any evidence that creditors had relied on the company’s books. It simply found that an increase in trade debt was enough to prove harm. However, the court in S.I. Restructuring expressly rejected an argument that an increase in trade debt standing alone was evidence of harm.

Scott Ritcheson (see Acknowledgement below) suggests that Herby’s Foods is best understood as a recharacterization case which was decided based upon equitable subordination. Section 510(b) allows the court to recharacterize a debt as equity without regard to inequitable conduct, while Section 510(c) is based upon principles of equitable subordination which courts have interpreted to require proof of inequitable conduct. In the Herby’s case, the evidence of inadequate capitalization, failure to record loans on the books and failure to treat the insider loans as debts would be evidence to support a finding of recharacterization (which was one of the grounds found by the bankruptcy court but not addressed by the court of appeals). On the other hand, in S.I. Restructuring, the company was publicly traded and the transactions were approved by an audit committee of outside directors and the full board and were reported as loans to the SEC. This greater level of formality may be the factor which reconciles the two apparently contradictory opinions.

Acknowledgement

My analysis in this article was strongly influenced by an excellent paper presented by Scott Ritcheson to the Annual Meeting of the Bankruptcy Section of the State Bar of Texas on June 26, 2008 entitled “Issues and Trends in Equitable Subordination.” Anyone litigating an equitable subordination issue would benefit significantly from reading Scott’s scholarly, comprehensive article. Scott can be reached at scottr@rllawfirm.net.

On Judicial Selection

On my non-bankruptcy blog, I have written an article about the different approaches that the two presidential candidates take toward appointing judicial nominees. If you are interested in reading more, you can go to:

http://satherthoughts.blogspot.com/2008/06/presidential-campaign-reveals-different.html

Northern District of Texas Releases En Banc Opinion on Early Completion of Chapter 13 Plan

The six judges of the Bankruptcy Court for the Northern District of Texas have released an opinion on when a debtor can pay off a chapter 13 plan prior to its scheduled completion date under BAPCPA. In re Howard L. McCarthy, Jr., No. 06-40127-DML-13 (Bankr. N.D. Tex. 6/11/08). The judges ruled that absent modification of the plan to increase the payments or bad faith by the debtor, that the court must enter a discharge once payments are completed.

In the McCarthy case, the Debtor had above median income and was required to file a 60 month plan. The Court confirmed a plan providing for payments of $49,260. This payment would pay about 60% of the unsecured claims. The Debtor had to pay more than the amount of his disposable income in order to satisfy the chapter 7 liquidation test. After six months, the Debtor sold his non-exempt real estate pursuant to court order and paid the proceeds to the Trustee. The Debtor continued to make his regular monthly payments. After 21 months, he had paid $49,260 into the plan and the Trustee filed a notice of completion of payments. The Debtor then filed a motion for entry of discharge, which the Trustee opposed.

The Court found that the case did not turn on the definition of "applicable commitment period" under Section 1325(b). Instead, the Court found that the result was dictated by Sec. 1328(a).

The Court stated:

"Much of the focus of the Parties and the Amici in their briefs and at oral argument was on the question of whether the 'applicable commitment period' provided for in section 1325(b) of the Code, in Debtor's case 60 months, serves as a temporal requirement for the duration of a chapter 13 case or is simply a multiplier to be used to determine a minimum amount a debtor's plan must provide for unsecured creditors. A number of courts have struggled with this question arriving at diverse conclusions. . . . In the case at bar, however, we are not required to reach or decide that issue. Rather, the Motion poses the easier question of whether Debtor is entitled to a discharge under section 1328(a) of the Code.

* * *

"We must apply section 1328(a) in accordance with its plain meaning. . . .

"Section 1328(a)'s meaning is, in fact, plan and unambiguous. If the debtor has completed all payments under the plan, 'the Court shall grant the debtor a discharge. . . . ' (citation omitted). The use of the word 'shall' in section 1328(a) means that granting the relief is mandatory if the preconditions specified in the section are met."

Memorandum Opinion, pp. 4-5.

Having arrived at its conclusion in just five pages, the Court devoted the remainder of its opinion to replying to the Trustee's argument that deceptive debtors could use this language to slide a payment under the Trustee's door in the dead of night in order to avoid disclosing changed circumstances which would justify a modification.

The Court had two responses to this argument. First, the Court pointed out that the Marrama decision meant that "a debtor's fraudulent conduct may be addressed to prevent as well as undo a result achieved through the ordinary operation of the Code . . . " However, the Court noted that "this case is not one where money was slipped under the Trustee's door in aid of a scheme to avoid a potential plan modification." Instead, the Debtor had done exactly what was contemplated under the plan. The Debtor's Plan required the Debtor to pay a sum exceeding his monthly payments. As a result, it was clear that the Plan contemplated sale of assets. Additionally, at the time of the sale of the Debtor's property, it was clear that this pre-payment would result in the plan being paid off early. However, the Trustee did not seek to modify the plan.

Finally, the Court noted that the better procedure would be to formally request a modification of the plan to pay it off early. "The safe procedure for prepayment by a debtor under a plan is to seek approval of a plan modification under section 1329(a). If that is done, the Trustee, creditors and the court will have confidence that the prepayment is undertaken in good faith and not in anticipation of a windfall or other change in the debtor's circumstances that might otherwise bring about proposal of a Trustee's or unsecured creidtir's modification to the debtor's plan." Memorandum Opinion, p. 9.

Thus, the lesson of McCarthy is that a discharge must be granted once the payments are completed, even under BAPCPA. However, that right is balanced by the ability of the Trustee to seek a modification or to oppose discharge based upon fraud.

Sources for Free Legal Research on Texas Bankruptcy Cases

It used to be that to keep up with the latest case law, it was necessary to review the advance sheets or keep up with the latest legal journals. Of course, this required expensive subscriptions and ran weeks or months behind the release date of the opinions. Today there are many sources of free legal research released in real time.

There are three main ways to gain access to up to the minute case updates free of charge. The first is through listserves which provide case updates as they are released. The second is court websites which contain links to recent opinions. Finally, opinions can be searched through PACER.

PACER (or Public Access to Court Electronic Records) is primarily known for containing electronic docket sheets and court documents, which can be accessed for a fee of 8 cents per page. However, a relatively new addition to PACER allows free searches for written opinions. To search for opinions under PACER, go to the PACER site for a district, look for “Reports” and then click on “Written Opinions.” The opinions can be searched by date and by division. It is also possible to search for an opinion by name. A search for the Southern District of Texas Bankruptcy Court revealed that there were sixteen opinions released from May 1 to June 7, 2008. PACER is the most comprehensive source for new bankruptcy court opinions. However, the written opinions feature only goes back to April 2005 and is not searchable by keyword. As a result, it requires some patience.


Here are the best sources for opinions relevant to Texas Bankruptcy lawyers.

Supreme Court

The best source for Supreme Court updates is the Cornell Law School Supreme Court listserve. By subscribing to this free service, readers receive updates as to cases which have been granted cert and opinions released. The updates are released in real time so that it is a very good way to stay up to date on developments in the Supreme Court. The nice thing about this listserve is that it contains both summaries of the opinions and links to read the opinions themselves. This makes it easy to scan through the day’s opinions to decide which ones merit further reading.

To subscribe to this listserve, go to: http://ruckus.law.cornell.edu/mailman/listinfo/liibulletin

Fifth Circuit

The Fifth Circuit has an opinions page located at http://www.ca5.uscourts.gov/opinions.aspx. The initial page lists opinions released that day. There is also an option to do a keyword search for opinions going back to 1992.

The other nice feature of the Fifth Circuit opinions page is that they offer an opinions subscription which provides an email twice a day listing the opinions released that day and attaching copies of the published opinions. Opinions can be received in either WordPerfect or PDF format. The downside to this service is that the opinions do not come with a summary so that it is necessary to either read every opinion to figure out which ones relate to bankruptcy (which are a very small percentage) or just try to guess based on the name of the case.

District Courts

Both the U.S. District Courts for the Southern and Western Districts of Texas participate in a site sponsored by the Southern District of New York called Courtweb. The site can be accessed at: http://www.nysd.uscourts.gov/courtweb/public.htm. The opinions can be searched by keyword. Curiously, a search for the term “bankruptcy” turned up only eight opinions from the Southern District, but found 121 decisions from the Western District.

Bankruptcy Courts

Each of the four bankruptcy courts in Texas has a website. However, each district has a different approach to posting its opinions.

Northern District of Texas: www.txnb.uscourts.gov

The Northern District of Texas offers several options for opinion searching. It has a comprehensive list of opinions which can be sorted by judge, by date, by case name or by case number. One nice feature of this page is that it includes retired judges as well as current judges. While the opinions can be sorted by date released, the page does not list those dates. Thus, it is necessary to open up the opinions to find out just how recent they are. One unique feature contained on the Northern District page is that it includes an email subscription service which allows the reader to receive updates whenever new opinions are released.

Southern District of Texas: www.txs.uscourts.gov

The Southern District judges previously released opinions intended for publication on the Courtweb site and selected unpublished opinions on the Court’s website. Unfortunately, no new Southern District opinions have been added to Courtweb since July 18, 2007. As a result, PACER is currently the only way to find current Southern District Bankruptcy opinions.

Eastern District of Texas: www.txeb.uscourts.gov

The Eastern District recently unveiled a new and improved website. It includes an opinions page for its two judges. The page breaks down opinions by subject matter, date and whether they are published or unpublished. Unfortunately the page for Judge Parker is still under construction. However, litigants appearing before Judge Rhoades can browse through 76 of her opinions on topics ranging from admissions to zip codes.

Western District of Texas: www.txwb.uscourts.gov

The Western District of Texas site contains two unique features. First, the front page of its opinions section lists the ten most recent opinions by date. This makes it easy to keep up with what is current in the Western District. The page also includes a key word search. A search for the term “means test” pulled up 43 hits. The opinions only date back to April 21, 2005. However, that is still a considerable body of cases.

The courts are constantly updating their websites. As a result, it is helpful to check frequently to see what is new. I will update this article from time to time to try to keep up with new developments.

New Opinion Illustrates the Dangers of Going to Trial

Trials are unpredictable things. That's why most cases settle. A recent opinion from Austin Bankruptcy Judge Frank Monroe illustrates how a case can go astray. In MARTNKIM Dining, LLC vs. Chaney, Adv. No. 07-1082 (Bankr. W.D. Tex. 5/29/08), the defendants won the case but in the process exposed themselves to new and potentially greater legal problems.

The adversary proceeding involved a suit over sale of a restaurant. The debtor claimed that the sellers had committed fraud, including providing false financial statements. This required the court to examine the sellers'/defendants' unique accounting practices. According to the court, the sellers received 2/3 of their revenues from cash sales. These funds were deposited into the owners' personal bank account rather than the corporate account. They then "loaned" these funds back to the corporation as needed. At the end of the year, the sellers would add up the cash register tapes and report these items as income to the company's CPA. While the full amount of revenues were reported to the IRS on the company's form 1120, the cash receipts were not included on the company's sales tax return. The Court stated:

"There can be only one rational explanation for this procedure. The Chaneys did not want to, and did not, pay the sales taxes on the cash sales to the State of Texas. This is, most likely, a considerable sum of money."

Memorarndum Opinion, p. 7. The Court later estimated the amount of diverted sales taxes at approximately $100,000.

The Court also noted that the sellers paid some of their employees in cash and reported their income on form 1099 instead of paying payroll tax as required by law.

Ultimately, the Court found that the sellers/defendants had not defrauded the debtor/purchaser. The Court found that the financial statements provided were not inaccurate with regard to revenues and had not been relied upon for the expense side. As a result, the Court entered a take-nothing judgment for the defendants. However, the Court's written opinion shone an unwelcome light on the defendants' accounting practices prior to the sale. Thus, it can be said that both the plaintiff and the defendants lost.

Debt Buyers Win Respect in New Opinion

Debt buyers are not the most popular people these days. However, their role as economic scavengers was acknowledged in a recent opinion from Judge Leif Clark of San Antonio. In re Salvador Santana, No. 07-30027 (Bankr. W.D. Tex. 5/21/08).

In Santana, Portfolio Recovery Associates, LLC filed a Notice of Transfer of Claim with respect to a claim that they had acquired from Capital One in the amount of $604.19. The Debtor objected on the basis that "a third party purchasing the instrument at a very reduced cost and having [the] Bankruptcy Court enforce payment is not in the best interest of the debtor."

While the Debtor's objection was no doubt accurate (that is, that is not in the best interest of the debtor to recognize the transferred claim), this was not a valid objection.

Judge Clark recognized that a purchaser of claims was entitled to enforce the full amount of the claim regardless of what it paid. While the creditor might receive a windfall, it was also assuming the risk of default by the debtor. As a result, the benefit should accrue to the debt buyer and not the debtor.

Judge Clark wrote:

"The holder of a claim is permitted to sell the claim for less than the face amount of the claim, and the transferee is entitled to enforce the claim for its face value, even though the transferee bought the claim at a discount. In other words, the debtor is not entitled to the benefit of the discount. This is so because the discount represents the transferee's assumption of risk of payment at less than the face amount of the debt. The transferor 'cashed out' its risk of nonpayment by agreeing to accept less than face value from the transferee, but again the debtors are not entitled to the benefit of that de facto writedown. Insofar as the debtor is concerned the original debt is till owed to whomever is the current rightful owner of the obligation. the transferee 'bought' the obligation, and is now the rightful owner entitled to enforce the debt at its face value. Because this is a chapter 13 case, it is almost certain that the debt will not be paid at its face value. . . . Thus, the transferee has factored in these risks when it set the price to be paid for the claim that it purchased. To realize the benefit of its bargain, however, it needs to be able to enforce the full amount of the claim purchased. And so the law allows."

Only in bankruptcy court would a claim for $604.19 merit such a thoughtful opinion!