Fifth Circuit Report: 1st Quarter 2017

It has been a while since I have done a Fifth Circuit report.   With the new year, I am going to try to get back to chronicling each quarter's decisions from my home circuit.

Breach of contract; attorney's fees; abuse of process; malicious prosecution; sanctions; due process

Texas Capital Bank v. Dallas Roadster, Ltd. (In re Dallas Roadster, Ltd), 846 F.3d 112 (5th Cir. 1/17/17)

This case has only a tenuous connection to bankruptcy but it includes many of the types of issues that lenders and borrowers litigate.    Texas Capital Bank financed Dallas Roadster.   The DEA informed the Bank that it was investigating the Debtor for money laundering.   The DEA ultimately raided the Debtor and arrested its president.    One day prior, the Bank declared the Debtor to be in default.   After the raid, the Bank filed suit and obtained a receivership on an ex parte basis using an affidavit that contained false statements.   Dallas Roadster filed chapter 11 and got its business back from the receiver.   The state court litigation between the Bank, the Debtor and the guarantors was removed to federal court.   The Debtor confirmed a plan in which it provided for all of the Bank's claims except for attorney's fees arising from the Litigation.   

The District Court granted summary judgment against the Guarantors on their counterclaims against the Bank.  The case went to trial on the Bank's claim to recover its attorney's fees incurred in the Litigation and the Debtor's breach of contract claims against the Bank.   The District Court denied recovery to both parties.   It found that the Debtor could not recover for breach of contract because it had materially breached the contract first.   The District Court ruled that the Bank could not recover attorney's fees for defending itself against claims of wrongdoing and also used its inherent authority to sanction the Bank and deny attorney's fees.

The Fifth Circuit affirmed denial of the counterclaims and also affirmed the ruling denying the Debtor's breach of contract claims.   However, it reversed the findings against the Bank.   It found that the District Court had made an incorrect Erie guess as to how Texas courts would rule.  It also found that the District Court was permitted to sanction the Bank but had to provide it with due process before doing so.

The opinion has a good discussion of the difference between abuse of process and malicious prosecution.    A claim for abuse of process must show that process was improperly used after it was issued.   On the other hand, a claim that malice or wrongful intent caused the process to be issued the claim is one for malicious prosecution.  Because the Guarantors sued for abuse of process based on obtaining the receivership they did not have a claim.   A claim for criminal malicious prosecution must show that a person provided false information to the prosecuting party and that this party acted in reliance on the false information.    The claim by the Debtor's president that the Bank did not provide the DEA with exculpatory evidence was not sufficient to give rise to a claim for criminal malicious prosecution.

The Fifth Circuit held that the Debtor breached the loan agreements prior to the date that it claimed that the Bank breached the agreements.   The court rejected the Debtor's arguments that its breaches, which consisted of obtaining other financing without notifying the bank, were not material.   The District Court properly weighed the factors identified in Mustang Pipeline Co. v. Driver Pipeline Co., 134 S.W.3d 195 (Tex. 2004) to determine that the breaches were material.  In particular, the reporting violations deprived the Bank of benefits it had negotiated for and placed it at risk.   Because the Debtor breached first, it could not complain about the Bank's subsequent defaults.   

The Court's ruling on the Bank's claim for attorney's fees incurred in the litigation involved an "Erie guess," that is, a prediction as to how Texas courts would resolve an issue of first impression.    In Zachary Construction v. Port of Houston Authority, 449 S.W.3d 98 (Tex. 2014), the Texas Supreme Court found that a contractual provision which would insulate a party from liability based on its own misconduct was unenforceable.   The contract between the parties contained a no damages for delay provision.   However, the Port deliberately and intentionally interfered with Zachary's performance.  In that context, the Texas Supreme Court found that the Port could not use the no damages for delay provision to shield itself from liability for its own misconduct.   The District Court concluded that Texas courts would extend this ruling to the case where the lender sought to recover attorney's fees for defending itself from claims of wrongdoing.    The Fifth Circuit found that there was a material difference between using a contractual provision to shield itself from wrongdoing as opposed to recovering the cost of successfully defending itself.   

The Fifth Circuit also reversed and remanded the District Court's sanctions award against the Bank.   The District Court found that where litigation was "instigated or conducted in bad faith or there's been willful abuse of the judicial process" it could dismiss claims under its inherent authority.   The Fifth Circuit found that the District Court did have the inherent authority to dismiss claims based on vexatious litigation.   However, before doing so, it had to give notice to the party against whom sanctions were sought and give it the chance to respond.   Because the District Court issued the sanctions sua sponte, it deprived the Bank of due process and a remand was required.

Diversity jurisdiction; fraudulent transfers

Hometown 2006-1 1925 Valley View, LLC v. Prime Asset Income Management, Ltd., 847 F.3d 302 (5th Cir. 2/3/17)

This case raised issues required citizenship for diversity jurisdiction purposes and what constitutes property under the Uniform Fraudulent Transfer Act.    Hometown obtained a judgment against Prime.  Prime had been a party to three management contracts which could only be terminated upon sixty days' notice.   The other parties to the contracts terminated them without giving the required notice and Prime acquiesced.   Hometown then sued the contract counterparties in U.S. District Court on the basis that waiving the fees due during the 60 day cancellation period was a fraudulent transfer.    The District Court dismissed finding that the contracts were not "assets" which could be transferred under TUFTA.

On appeal, the Fifth Circuit considered whether diversity jurisdiction was present.   Hometown was a Texas limited liability company with one member, U.S. Bank.  Citizenship of an artificial entity other than a corporation is based on the citizenship of its members.   U.S. Bank is a citizen of Ohio.  However, U.S. Bank was trustee of a trust.   Therefore the Defendants argued that it was necessary to determine the citizenship of each of the beneficiaries of a trust.   The Fifth Circuit rejected this argument, finding that citizenship of a trust is based on the citizenship of the trustee.   Because none of the defendants were from Ohio, there was diversity.   This ruling surprised me because I assumed that the citizenship of an LLC, which is a form of company, would be based on its state of formation.  However, this is not the case.

The District Court had relied on several Seventh Circuit cases which had held that termination of a contract according to its provisions was not a transfer of an asset under the Uniform Fraudulent Transfer Act.   The Fifth Circuit said:

We agree. The rub is that the contracts here were not freely terminable. Rather, the Advisory Agreements provided for termination without cause upon sixty days' written notice.

As a result, termination of the contracts without giving 60 days' notice transferred the fees which would have been paid to the judgment debtor to the contract counterparties.   That was a transfer of property.   As a result, the Complaint stated a cause of  action and should not have been dismissed.

Diversity jurisdiction

Foster v. Deutsche Bank National Trust Co., 848 F.3d 403 (5th Cir. 2/8/17)

Homeowner sued lender and trustee in state court to enjoin a foreclosure sale.   The lender removed the case to federal court.    The district court denied a motion to remand based on lack of diversity.  It dismissed the homeowner's claims with prejudice.   The Fifth Circuit affirmed.

The Fifth Circuit agreed that the trustee was improperly joined.   It found that violation of the trustee's duties under the deed of trust would give rise to a claim for wrongful foreclosure.   However, because no foreclosure took place, this claim could not be asserted.    As a result, joining the substitute trustee as a defendant did not defeat diversity jurisdiction.   The Fifth Circuit found that Texas would not recognize a claim for attempted wrongful foreclosure.  As a result, it affirmed the dismissal of the homeowner's claims.   This left the lender free to post the property for a future foreclosure.

Denial of discharge

Chu v. Texas (In re Chu), 2017 Bankr. LEXIS 2370 (5th Cir. 2/9/17)(unpublished)

An orthodontist filed bankruptcy following accusations of Medicaid fraud.   The State of Texas filed suit to deny this discharge.   After a trial, the Bankruptcy Court denied the discharge under 11 U.S.C. Sec. 727(a)(4) and (a)(5).   The Fifth Circuit affirmed.

The Debtor argued that the State lacked standing to object to his general discharge because its debt would be non-dischargeable under 11 U.S.C. Sec. 523(a)(7).  The Fifth Circuit rejected this argument as speculation.  Because there was no final determination of the underlying claim, the State had constitutional standing to object to the global discharge. 

 The Court rejected the Debtor's argument that the Bankruptcy Court had aggregated his false statements to reach a conclusion of reckless indifference to the trust.   Instead, the Court found that the bankruptcy court was permitted to gauge the "cumulative effect of false statements." 

The Court found that the Debtor had failed to account for loss of assets.   In a personal financial statement four years before bankruptcy, the Debtor had listed assets of $75,500, including jewelry and watches.  In his schedules, he listed only $11,000 in household items, books and pictures worth $1,000 and a ring valued at $500.   Based on the Bankruptcy Court's finding that the Debtor had failed to offer a viable explanation for what happened to the assets, the Fifth Circuit affirmed the ruling that the Debtor had failed to account for assets.

 Federal Debt Collection Practices Act; turnover

United States v. Diehl, 848 F.3d 629 (5th Cir. 2/13/17)

This case involved another statute abbreviated as FDCPA, the Federal Debt Collection Practices Act.   The Court found that the FDCPA in its case did not prohibit the government from using the Texas Turnover Statute to collect a debt owed to the government.

Homestead exemption; fraudulent transfer

Wiggains v. Reed (In re Wiggains), 848 F.3d 655 (5th Cir. 2/14/17)

Debtor and spouse partitioned homestead on eve of bankruptcy to avoid limit on homestead exemption under 11 U.S.C. Sec. 522(p).   Court found that maximizing homestead was not sufficient reason to avoid partition as a fraudulent transfer.    Additionally, wife had no right to compensation under 11 U.S.C. Sec. 363(j) because entire community property interest entered estate.

Automatic Stay

Gathright v. Clark, 2017 U.S. App. 3258 (5th Cir. 2/23/17)

Automatic stay in bankruptcy did not preclude creditor from filing bad check charges.  Criminal actions are exempt from the stay.

Bankruptcy fraud

United States v. Grant, 850 F.3d 209 (5th Cir. 3/1/17)

Debtor filed five bankruptcy cases between 2008 and 2011.   In two of her cases, Debtor only disclosed one of her two social security numbers.   In another case, she failed to disclose two of her prior bankruptcies.   She was convicted on three counts of perjury and sentenced to fifteen months imprisonment..

Fraudulent transfer; damages

Galaz v. Galaz (In re Galaz). 850 F.3d 800 (5th Cir. 3/10/17)

Raul Galaz was married to Lisa Galaz.   He owned 50% of Artists Rights Foundation.   When they divorced, Lisa received 50% of Raul's 50% interest.    However, Raul transferred ARF's assets to another entity for no consideration.    Lisa filed chapter 13 bankruptcy and sued to avoid the transfer.  Julian Jackson, who owned the other 50% of ARF, sued Raul for breach of fiduciary duty.   The Bankruptcy Court ruled for Lisa and Julian awarding actual and exemplary damages. 

In the first appeal to the Fifth Circuit, the Court reversed and remanded.  The Court found that the Bankruptcy Court had no jurisdiction over the claims between Julian and Raul.   It also found that the Bankruptcy Court lacked jurisdiction to enter a final judgment on Lisa's claims against Raul.   On remand, the District Court referred the matter to the Bankruptcy Court for proposed findings and conclusions.   Based on the Bankruptcy Court's proposed findings, the District Court awarded actual and exemplary damages to Lisa.

The Fifth Circuit upheld the findings of liability.   Fraudulent intent was a question of fact reviewed under the clearly erroneous rule.   Court found that at least six badges of fraud were present.

The Fifth Circuit affirmed the award of $241,309.10 in actual damages to Lisa.   This was based on 25% of royalties received of $969,317.92 less certain reasonable expenses.    Appellants argued that the royalties should have been valued as of the time they were transferred (at which time value was negligible).   However, statute allowed the court to adjust the value "as the equities may require."   The Court also affirmed the award of $250,000.00 in exemplary damages.   Court found that factual finding that loss was caused by fraud, malice or gross negligence was not clearly erroneous.

Sanctions; All Writs Act

Carroll v. Abide (In re Carroll), 850 F.3d 811 (5th Cir. 3/13/17)

This is a sanctions case.   The Carrolls and their wholly owned company filed chapter 7 and were substantively consolidated.   The Carrolls engaged in "troublesome conduct" that "displayed (a) pattern of harassment" toward the trustee.    The Bankruptcy Court enjoined them from filing any further pleadings without court permission and awarded sanctions under 11 U.S.C. Sec. 105(a) in the amount of $49,432.  

The Court set out the standard for awarding sanctions under its inherent authority and enjoining vexatious litigants.

We begin by noting the bankruptcy court has numerous tools by which to sanction the conduct of individuals. "Federal courts have inherent powers which include the authority to sanction a party or attorney when necessary to achieve the orderly and expeditious disposition of their dockets."  "Such powers may be exercised only if essential to preserve the authority of the court and the sanction chosen must employ the least possible power adequate to the end proposed."  A court must make a specific finding of bad faith in order to impose sanctions under its inherent power.  Moreover, when sanctions are imposed under the inherent power, this court's "investigation of legal and evidentiary sufficiency is particularly probing" and this court must "probe the record in detail to get at the underlying facts and ensure the legal sufficiency of their support for the district court's more generalized finding of 'bad faith.'" 

Federal courts also have authority to enjoin vexatious litigants under the All Writs Act, 28 U.S.C. § 1651.  Moreover, under 11 U.S.C. § 105, "a bankruptcy court can issue any order, including a civil contempt order, necessary or appropriate to carry out the provisions of the bankruptcy code."  When considering whether to enjoin future filings, the court must consider the circumstances of the case, including four factors:

(1) the party's history of litigation, in particular whether he has filed vexatious, harassing, or duplicative lawsuits; (2) whether the party had a good faith basis for pursuing the litigation, or simply intended to harass; (3) the extent of the burden on the courts and other parties resulting from the party's filings; and (4) the adequacy of alternative sanctions.

  830 F.3d at 815. (internal citations omitted).

The Court had no trouble sustaining a finding of bad faith, stating,  

Appellants' suggestion that their conduct was not done in bad faith is belied by their repeated attempts to litigate issues that have been conclusively resolved against them or that they had no standing to assert and by their unsupported and multiple attempts to remove Abide as the trustee

The amount of the sanctions award was affirmed because it represented the amount of attorneys' fees incurred by the trustee in responding to the Carrolls' conduct.

Voidable preference

Tower Credit, Inc. v. Schott (In re Jackson), 850 F.3d 816 (5th Cir. 3/13/17)


 The Trustee sued to avoid a wage garnishment as a preferential transfer.   The Defendant argued that the transfer occurred when the garnishment order was issued, which was more than 90 days before bankruptcy.    The Court found that a transfer is made when it is "perfected," that is, when a judgment creditor could not obtain superior rights in the property.   However, a transfer also is not made until the debtor has rights in the property.   As a result, each time the debtor obtained wages and the garnishment lien reached those wages was a new transfer.   Therefore, the Court affirmed the judgment in favor of the trustee.

 Proof of claim; res judicata

Kipp Flores Architects, LLC v. Mid-Continent Cas. Co., 852 F.3d 405 (5th Cir. 3/24/17)

This case involved the effect of a proof of claim in subsequent litigation.   A creditor filed a proof of claim in a no-asset bankruptcy case.   No party objected to the claim.    The creditor then argued that because the proof of claim was "deemed allowed," it was res judicata in the creditor's subsequent claim against the debtor's insurance company.    The Court found that the claim did not have any preclusive effect where there was never a deadline to object to claims and adjudicating the claim would not have served a bankruptcy purpose.   

Sanctions

Armendariz v. Chowaiki, 2017 U.S. App.  LEXIS 5531 (5th Cir. 3/30/17)(unreported)

Plaintiffs sued various parties for RICO based on a fraudulent transfer action brought in U.S. Bankruptcy Court.    The District Court dismissed the suit but denied a motion for sanctions under Rule 11.    The Court did not give reasons for its denial of the sanctions motion.   The Fifth Circuit affirmed the order dismissing the suit.   However, it reversed and remanded the denial of sanctions.  The Court explained that when a court grants or denies sanctions, it must provide reasons sufficient for the reviewing court to determine the basis for the ruling.  

Supreme Court Says Structured Dismissals Must Follow Priority Scheme

In a blow to creative lawyering, the Supreme Court ruled today that a structured dismissal which allocates value contrary to the priority scheme of the Bankruptcy Code may not be approved.   Czyzewski v. Jevic Holding Corp., No. 15-649 (U.S. 3/22/17).   You can find the opinion here.

District Court Rules that Proceeds of a Texas Homestead Sold Post-Petition Lose Their Protection After Six Months in a Chapter 7 Case

Overruling a bankruptcy court decision, a District Judge in the Western District of Texas has ruled that proceeds from sale of a homestead can be recovered if not timely reinvested in a Chapter 7 case.   The Court ruled that the Frost decision applied equally in both a Chapter 13 and a Chapter 7 setting.   Lowe v. DeBerry, No. 5:15-cv-1135-RCL (W.D. Tex. 3/10/17).    The opinion can be accessed through PACER here.    The opinion raises serious questions about whether an exemption can ever be truly final.

Non-Filing Spouse Suffers Another Texas Homestead Loss

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA") capped the amount of a homestead exemption which could be claimed by a debtor that acquired a homestead within 1,215 days prior to bankruptcy.    Currently, the amount of the cap, as set by 11 U.S.C. Sec. 522(p), is $160,375 in equity per debtor.  This cap has resulted in a seismic shift in Texas where the unlimited homestead exemption is part of the State Constitution.   Now debtors' attorneys must learn how to count to 1,215 and calculate the allowable equity before filing a bankruptcy petition. However, what of the case where only one spouse files?   The short answer is that all community property enters the bankruptcy estate and that the cap is based on the one spouse that filed.   This means that the non-filing spouse can be involuntarily divested of her otherwise sacrosanct homestead interest.    The Fifth Circuit has now ruled on three different variations of this scenario and in each case, including the recent decision in Wiggains v. Reed  (Matter of Wiggains), No. 15-11249 (5th Cir. 2/14/17), which can be found here, the non-filing spouse has come up short.

Texas Supreme Court Limits Remedies for Home Equity Loan Violations

By Michael V. Baumer

Law Office of Michael Baumer

Austin, TX

This is a very long post describing some recent case law with respect to home equity litigation in Texas. These events are significant to a consumer bankruptcy practice, but if the subject is of no interest, you may want to skip it.

The Texas Supreme Court issued two opinions on May 20, 2016 regarding issues related to the home equity loan forfeiture provisions of the Texas Constitution. These opinions make significant changes to Texas case law regarding applicability and enforcement of those provisions. The first case was Garofolo v. Ocwen Loan Servicing, L.L.C., 497 S.W.3d 474 (Tex.2016) and the second is Wood v. HSBC Bank USA, N.A., 2016 WL 2993923 (Tex.2016). It is important that the cases are read in sequential order as Wood relies on Garofolo in reaching its conclusion. (All references to the Texas Constitution herein are to Article XVI, section 50(a)(6) and its subsections unless otherwise noted.)

Litigators Beware! Judge Gorsuch is a Stickler on Procedural Matters (Except When He Isn't)

This continues a series on the bankruptcy opinions of Neil Gorsuch, President Trump's nominee for the Supreme Court seat vacated by the death of Antonin Scalia.   One point which is clear is that Judge Gorsuch strongly believes that rules should be followed and is not sympathetic to arguments that procedural failures may be excused.

Did Gorsuch Expand Bankruptcy Court Referral Power?

Newly minted Supreme Court nominee Neil Gorsuch sat on the Tenth Circuit for ten years.  During that time, he signed on to eleven opinions regarding bankruptcy, which means that he wrote about bankruptcy around once a year.    None of his opinions are particularly well-known.  (In contrast, fellow finalist Thomas Hardiman authored the opinion in Official Committee of Unsecured Creditors vs. CIT Group/Business Credit, Inc. (In re Jevic Holding Corp.), 787 F.3d 173 (3rd Cir. 2015) which is currently before the Supreme Court).    However, these opinions demonstrate his crisp writing style and offer some insights into his judicial thinking.   I am going to look at one of his opinions in depth and follow up with a separate post on his remaining decisions.

Minnesota Judge Shows Disclosure Statement Wisdom

The case for The Archdiocese of St. Paul and Minneapolis, No. 15-30125 (Bankr. D. Minn.) has been an extremely contentious one.   The Debtor and the Official Committee of Unsecured Creditors have different ideas on how to compensate sexual abuse claims and have submitted competing plans.    Not surprisingly, both parties objected to the other's disclosure statement.    The orders entered by Judge Robert Kressel show remarkable wisdom about how the disclosure statement process works in the real world.    

Dismissal Ruling Full of Disney Allusions

Judge H. Christopher Mott of the Western District of Texas is known to fill his opinions with references to movies and pop songs.   His latest opinion in Xtreme Power Plan Trust v. Schindler, et al (In re Xtreme Power, Inc.), No. 16-1004 (Bankr. W.D. Tex. 12/22/16) continues this trend with allusions to Disney's Frozen, an ironic reference given the current warm weather in Austin.   

The opinion begins:

This type of lawsuit has become somewhat commonplace—directors of a now defunct corporation are sued for breach of fiduciary duties. Here, the parties are currently “Frozen” in battle—as the Defendants filed motions to dismiss under Rule 12(b)(6), echoing “Indina Menzel” to demand that the Plaintiff just “let it go.” For the most part, the Court agrees with the Defendants and will send all but a single claim to a wintery grave.

Opinion, pp. 1-2.

Following a lengthy opinion, the Court allowed a claim against four directors for breach of the duty of loyalty to proceed while concluding that "the remainder of the Complaint skates on such thin ice that it must be dismissed under Rule 12(b)(6)." 

While I do not have time for a lengthy analysis, click on the style of the case above to read it.   It is useful reading for those litigating director and officer liability claims.

Circuit Split Emerging on Dischargeability of Late Returns

There is an emerging circuit split as to whether late filed tax returns can ever be considered to be “returns.”   The issue arises because BAPCPA included a paragraph stating that a return “means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements.”    This is known as the hanging paragraph of section 523(a) because it appears following section 523(a)(19) without any other designation.

Protection for Religious Entities in Bankruptcy

This is an article that I wrote for the National Conference of Bankruptcy Judges this year.

Freedom of religion is enshrined in the First Amendment to the Constitution which protects the free exercise of religion, as well as legislation such as the Religious Freedom Restoration Act[1] the Religious Land Use and Institutionalized Persons Act of 2000[2] and the Religious Liberty and Charitable Donation Protection Act[3].   When religious and secular parties clash in bankruptcy court the constitutional and statutory protections of religion are often invoked but rarely successful.   This paper will give a brief overview of the issues.

NCBJ Report 2016: Restructuring and Bankruptcy Challenges in the 21st Century World of Not for Profits

This was the first of two educational programs sponsored by the Commercial Law League of America.   I had the privilege of appearing on a panel featuring moderator Beverly Weiss Manne, Prof.  Pam Foohey, Sam Maizel and Nancy Peterman.   Prof. Foohey and I focused on religious entities in bankruptcy, while Sam Maizel and Nancy Peterman discussed healthcare non-profits.   

Types of Cases Filed

On the church side, Prof. Foohey's research shows that 654 churches filed bankruptcy between 2006 and 2013.   The vast majority of these churches were African American congregations.    Some of the notable filings during 2016 included Carter Tabernacle Christian Methodist Episcopal Church, a 100 year old congregation in Orlando and Metropolitan Baptist Church in the District of Columbia.    Since 2004, fifteen Catholic Dioceses and religious orders have sought chapter 11 protection to resolve sexual abuse claims.   Two examples of these cases are the Diocese of Stockton which is proceeding toward a consensual confirmation following a two year mediation process and the Diocese of St. Paul and Minneapolis, MN where competing plans have been proposed by the Diocese and the Committee of Unsecured Creditors.    Finally, a handful of predominantly white mega-churches, such as the Crystal Cathedral and Great Hills Baptist Church have entered chapter 11 proceedings.   On the healthcare side, there have been at least nine hospital bankruptcies filed this year.   However, healthcare filings range from community hospitals to skilled nursing facilities.    In re Bayou Shores, SNF, LLC, 828 F.3d 1297 (11th Cir. 2016) is an example of the issues that can arise in the healthcare sector.

NCBJ Report 2016: From Detroit to San Juan--Perspectives on Municipal and Territorial Restructurings

The Commercial Law League of America held its annual luncheon at NCBJ featuring the Lawrence King Award and a keynote speech by Andy Dillon.

Bankruptcy Judge Dennis Montali received this year's King Award, joining such luminaries as Elizabeth Warren, Steven Rhodes and Gene Wedoff.   Among his accomplishments, Judge Montali sailed from San Francisco to Hawaii when he was only seventeen.    He served in the Navy.   As a practitioner, he helped to craft the emergency rule which allowed the courts to function after the Marathon decision.  He was appointed to the bench in 1993 and presided over the Pacific Gas & Electric case.   He gave a heartfelt acceptance speech in which he emphasized his commitment to treating each case as if it was his most important.

Andy Dillon was the keynote speaker.  Mr. Dillon was speaker of the Michigan House of Representatives before becoming Michigan's State Treasurer.   As Treasurer, his responsibilities included placing failing cities, including Detroit, into receivership.    More recently, he has advised Puerto Rico on its financial issues through his association with Conway McKenzie.    

NCBJ Report 2016: Hot Spots in a Cold Restructuring World: Energy and Healthcare Restructuring

This panel examined energy and healthcare reorganizations.   The unifying theme of this panel was that industries that are highly regulated, highly leveraged and lack control over their prices are prime candidates for bankruptcy.   According to the moderator, Judge Margaret Mann, the panel hoped to make its presentation relevant to practitioners regardless of whether their typical client was a gas station or dentist as opposed to a major oil producer.   Judge Mann said that these two areas are "vital to the economy and heavily regulated."

Bill Wallander explained that the energy industry was in a mess because oilprices dropped from $110 per barrel to $26, although they have recovered to $50.   He said that companies had made their plans based on being able to survive at $70-80 a barrel but that prices kept dropping.  He did add that companies that hedged were able to hold on later but that many did not have sufficient hedges.  Ana Alfanso stated that banks didn't see the drop coming either.   She stated that the crisis highlighted the problem with asset based lending.   She added that cash was a major issue because companies without cash could not drill.

NCBJ Report 2016: Broken Bench Radio

The first plenary session of NCBJ was Broken Bench Radio, a fast-paced discussion of hot topics in the form of a radio call-in show.   It covered insights from the Caesar's Entertainment case, upcoming Supreme Court decisions, recharacterization, equitable mootness, Chapter 13 updates, the CFPB and the Husky case.  

Insights From Caesar's Entertainment

James Sprayregen was the first caller in to the show.   He talked about the Caesar's Entertainment case.    He repeatedly alluded to the interesting issues that could have been decided, such as the involuntary petition filed against the company and the section 105 injunction in favor of the parent company, if only the case hadn't settled.   His best quote was "Settlement negotiations are never over and the activities in the courtroom are an extension of the settlement negotiations.

Upcoming Supreme Court Decisions

Prof.  Erwin Chemerinsky gave a brief public service announcement about two upcoming Supreme Court cases:  Czyzewski v. Jevic Holding Corp and Midland Funding, LLC v. Johnson.   The Supreme Court has granted cert in both of these cases.   Jevic is about whether a  settlement agreement resulting in a structured dismissal can violate the priority scheme under the Bankruptcy Code.   Midland Funding deals with the question of whether it is a violation of the Fair Debt Collection Practices Act to file a proof of claim that is barred by the statute of limitations.   This is an issue where the Eleventh Circuit, which says yes, is at odds with at least three other circuits.  I have a case on this issue pending before the Fifth Circuit so it is of special interest to me.

NCBJ Report 2016: The Streets of San Francisco

I am resuming my coverage of the National Conference of Bankruptcy Judges this year.   Last year the demands of work kept me off the blog.   NCBJ 2016 is taking place in San Francisco.  A few random observations.    People in San Francisco wear jackets even when it isn't cold.   There are mica specks in the sidewalk that make them glitter when the light hits them.   The Golden Gate Bridge looks incredible when it is lit up at night. 

Another observation is that San Francisco is one of the most expensive cities to live in.  I am told that a 700 square foot teardown sells for a million dollar.  However, in walking the streets, I noticed that they were teeming with milennials.    It makes me wonder where they live and how they live.

I started NCBJ wondering why I agreed to wake up at 5:00 a.m. to go running.   This year was the Seventh Annual Wake Up and Run event.   About 70 runners got to experience the darkened streets of San Francisco and the waterfront for a 5k fun run. The turnout was impressive given the early hour and the prior night's festivities.  As usual, I finished near the back of the pack but I was not alone.   It was a good way to start the conference and see some of the City.   

Arizona District Court Applies Section 1129(a)(10) on a Per Plan Basis

One challenge in confirming a chapter 11 plan is finding an impaired accepting class without counting votes of insiders as required by 11 U.S.C. Sec. 1129(a)(10).   A new opinion from the District Court of Arizona makes that job easier in cases with jointly administered debtors.   In re Transwest Properties, Inc., 2016 U.S. Dist. LEXIS 102575 (D. Ariz. 6/22/16).  

The Transwest case involved five cases that were jointly administered but not substantively consolidated.    The organizational structure consisted of a holding company, two mezzanine companies and two operating companies.   The debtors proposed a plan in which the mezzanine debtors would be dissolved and the operating companies would be owned by an investor contributing new capital under the plan.    The principal secured creditor (Lender), which had acquired the mezzanine debt during the case, voted against the plan.   Lender argued that because it held the only claim in the mezzanine debtor cases that the plan could not be confirmed under section 1129(a)(10).   The bankruptcy court approved the plan.   Lender appealed.    On the first appeal, the district court dismissed the case as equitably moot.   The Ninth Circuit reversed and sent the case back to the district court.

On remand, the District Court noted a split in authority as to whether section 1129(a)(10) applied on a per plan or a per debtor basis.   The Lender relied on two cases from the Bankruptcy Court of Delaware to argue that there had to be an accepting vote in each case.  In re Tribune, 464 B.R. 126 (Bankr. D. Del. 2011), and In re JER/Jameson Mezz Borrower II, LLC, 461 B.R. 293 (Bankr. D. Del. 2011).    The Debtors relied on cases from the bankruptcy courts for the Southern District of New York and Middle District of Pennsylvania.  In re SPGA, Inc., 2001 WL 34750646 (Bankr. M.D. Pa. 2001), In re Enron Corp., 2004 Bankr. LEXIS 2549 (Bankr. S.D.N.Y. 2004), and In re Charter Communications, 419 B.R. 221, 266 (Bankr. S.D.N.Y. 2009).   Thus, a district court in Arizona was called upon to resolve a split between East Coast bankruptcy courts.

Rather than relying on the rationales advanced by the competing bankruptcy courts, the District Court applied a plain meaning analysis.   

Here, the Court finds that § 1129(a)(10) applies on a per-plan basis. First, unlike the Tribune court, this Court finds the plain language of the statute to be dispositive. The statute states that "[i]f a class of claims is impaired under the plan, at least one class of claims that is impaired under the plan has accepted the plan" then the court shall confirm the plan if additional requirements are met. 11 U.S.C. § 1129(a)(10) (emphasis added). Thus, once an impaired class has accepted the plan, § 1129(a)(10) is satisfied as to all debtors because all debtors are being reorganized under a joint plan of reorganization.

In re Transwest Properties, Inc., at *15.  

The District Court opinion takes a perfectly defensible position.    Section 1129(a)(10) is a technical requirement.   Therefore, technical compliance should be sufficient.

Texas Supreme Court Uses "Common Sense" to Avoid Lender's Forfeiture on Home Equity Loan Violation

Texas has some of the strongest homestead protections in the country.   It was also one of the last states to allow home equity lending.   When it reluctantly amended its Constitution to allow home equity lending, it included some draconian provisions for lenders who didn't follow the rules, allowing forfeiture of principal and interest in some cases.   A lender's failure to provide a timely release after the borrower repaid the loan sparked a spirited disagreement among the Texas Justices as to whether to apply the Constitutional provision as written or to use common sense.   In a 7-2 decision, "common sense" and the lender prevailed. Garofolo v. Ocwen Loan Servicing, LLC., No. 15-0437 (Tex. 5/20/16).    You can read the opinion here and the dissent here.

What Happened

Teresa Garofolo took out a home equity loan for $159,700 in 2010.   She paid the loan off in April 2014.   While the lender recorded a release of lien, it did not provide her with a recordable release as required her loan documents.    She made demand upon Ocwen to provide her with the required paperwork.   When they failed to comply within sixty days, she filed suit in federal court seeking forfeiture of all principal and interest under the Texas Constitution.    The District Court dismissed the case.   When Ms. Garofolo appealed to the Fifth Circuit, the circuit certified two questions to the Texas Supreme Court:

 (1) Does a lender or holder violate Article XVI, Section 50(a)(6)(Q)(vii) of the Texas Constitution, becoming liable for forfeiture of principal and interest, when the loan agreement incorporates the protections of Section 50(a)(6)(Q)(vii), but the lender or holder fails to return the cancelled note and release of lien upon full payment of the note and within 60 days after the borrower informs the lender or holder of the failure to comply?

(2) If the answer to Question 1 is “no,” then, in the absence of actual damages, does a lender or holder become liable for forfeiture of principal and interest under a breach of contract theory when the loan agreement incorporates the protections of Section 50(a)(6)(Q)(vii), but the lender or holder, although filing a release of lien in the deed records, fails to return the cancelled note and release of lien upon full payment of the note and within 60 days after the borrower informs the lender or holder of the failure to comply? 

The Majority Opinion

The majority held that the Texas Constitutional provisions did not create substantive rights but merely set forth the conditions under which a creditor could have the right to foreclose a lien upon a homestead.   

Our initial inquiry is whether these terms and conditions amount to substantive constitutional rights and obligations. In concluding they do not, we first observe that section 50(a) does not directly create, allow, or regulate home-equity lending. Nowhere does it say all home-equity loans must include the constitutional terms and conditions, nor does it prohibit loans made on other terms. It simply describes what a home-equity loan must look like if a lender wants the option to foreclose on a homestead upon borrower default.

As to constitutional rights, section 50(a) creates but one: freedom from forced sale to satisfy debts other than those described in its exceptions. The delineation of home-equity lending terms and conditions serves only to set the boundaries of that constitutional right. The relevance of those terms and conditions is therefore contingent on the fundamental guarantee of section 50(a)—that the homestead is protected from forced sale “except for [a home-equity loan] that” includes the terms outlined in section 50(a)(6)(A)–(P) and “is made on the condition that” it also include the provisions set forth in section 50(a)(6)(Q)(i)–(xi). Those terms and conditions are not constitutional rights and obligations unto themselves. They only assume constitutional significance when their absence in a loan’s terms is used as a shield from foreclosure.

Majority Opinion, p. 6.   The majority went on to state that the constitutional protections did not apply because Ocwen did not seek to foreclose.

If Ocwen sought to foreclose on Garofolo’s homestead after she became delinquent in her payments, she could stand on the constitutional right to freedom from forced sale if her loan failed to include the release-of-lien requirement or forfeiture remedy. But that did not happen. Garofolo made timely payments and satisfied the balance in full. Ocwen never sought to foreclose, and there is no constitutional violation or remedy for failure to deliver a release of lien. Section 50(a) simply has no applicability outside foreclosure.

Majority Opinion, pp. 6-7.   Thus, the majority answered the first certified question "no."

It went on to answer the second question in the negative as well.   The majority said that while the loan documents contained the constitutionally required language about forfeiture of principal and interest, those provisions didn't apply to all violations of the loan documents.

Although the forfeiture remedy incorporated into Garofolo’s loan might be applicable to a lender’s failure to comply with some of her loan’s terms, it does not apply to a failure to deliver a release of lien. Accordingly, Garofolo must show actual damages to maintain her breach-of-contract claim or seek some other remedy, such as specific performance.

Majority Opinion, p. 8.  

So when would the forfeiture remedy apply?   Under the Texas Constitution, a lender must forfeit all principal and interest if it receives notice of a violation and fails to take one of the following actions within sixty (60) days:

(a) paying the owner an amount equal to any overcharge paid by the owner under or related to the extension of credit if the owner has paid an amount that exceeds an amount stated in the applicable Paragraph (E), (G), or (O) of this subdivision;

(b) sending the owner a written acknowledgment that the lien is valid only in the amount that the extension of credit does not exceed the percentage described by Paragraph (B) of this subdivision, if applicable, or is not secured by property described under Paragraph (H) or (I) of this subdivision, if applicable;

(c) sending the owner a written notice modifying any other amount, percentage, term, or other provision prohibited by this section to a permitted amount, percentage, term, or other provision and adjusting the account of the borrower to ensure that the borrower is not required to pay more than an amount permitted by this section and is not subject to any other term or provision prohibited by this section;

(d) delivering the required documents to the borrower if the lender fails to comply with Subparagraph (v) of this paragraph or obtaining the appropriate signatures if the lender fails to comply with Subparagraph (ix) of this paragraph;

(e) sending the owner a written acknowledgment, if the failure to comply is prohibited by Paragraph (K) of this subdivision, that the accrual of interest and all of the owner’s obligations under the extension of credit are abated while any prior lien prohibited under Paragraph (K) remains secured by the homestead; or

(f) if the failure to comply cannot be cured under Subparagraphs (x)(a)-(e) of this paragraph, curing the failure to comply by a refund or credit to the owner of $1,000 and offering the owner the right to refinance the extension of credit with the lender or holder for the remaining term of the loan at no cost to the owner on the same terms, including interest, as the original extension of credit with any modifications necessary to comply with this section or on terms on which the owner and the lender or holder otherwise agree that comply with this section . . . .

Texas Const. Art. XVI, Section 50(a)(6)(Q)(x).  

Garofolo argued that Ocwen could have cured the failure to provide the written lien release by paying her $1,000 under subparagraph (f).   The majority found that this would be a nonsensical cure since it would not address the actual violation.  

The unquestionably harsh forfeiture penalty is triggered when, following adequate notice, a lender fails to correct the complained-of deficiency by performing one of six available corrective measures. Ocwen argues forfeiture is simply inapplicable here because none of the six corrective measures addresses the failure to deliver a release of lien. Therefore, Ocwen could perform any or all of them yet still not correct the underlying deficiency. Garofolo argues, however, that performance of the catch-all remedy in subparagraph (f)—a $1,000 refund and an offer to refinance her loan—would have corrected the deficiency because Ocwen would have performed one of the measures required to avoid forfeiture. Of course, there was nothing to refinance—Garofolo had already paid off her loan—and a $1,000 payment would not buy her a document only Ocwen can provide. Nonetheless, Garofolo maintains that performance of subparagraph (f) was necessary to avoid forfeiture even if it completely fails to remedy or even address Garofolo’s actual complaint.

. . . Allowing lenders to avoid punishment by performing an irrelevant corrective measure at the expense of directly addressing the borrower’s complaint frustrates this intent. It follows that the six specific corrective measures exist to give lenders avenues to avoid forfeiture by fixing problems rather than furnishing technicalities that can be manipulated to avoid them.

Majority Opinion, pp. 10-11.  

In a somewhat tortured paragraph, the majority reasoned that forfeiture is triggered when a lender fails to correct the deficiency by performing one of the required acts.   If the deficiency cannot be cured by performing one of the required acts, then the forfeiture provision does not apply.

The six corrective measures each present an avenue through which a lender might actually correct a deficiency. But as this case demonstrates, these corrective measures do not speak to every manifestation of a lender’s failure to comply with its obligations. Accordingly, a lender might actually correct a deficiency but fail to do so through performance of a corrective measure. For example, if Ocwen delivered Garofolo’s release of lien within 60 days following notice, it would have actually corrected its failure to comply but would not have done so “by” performance of a constitutionally specified corrective measure. See id. Should it suffer forfeiture? Garofolo argues it should, but this view ignores that forfeiture is available only when a lender fails to correct its “failure to comply by” performance of a specific corrective measure. See id. (emphasis added). If none of those measures actually correct the lender’s failure to meet its obligations, the lender cannot correct its failure to comply “by” performing one of them, and therefore forfeiture is simply unavailable. See id. (a lender “shall forfeit all principal and interest . . . if the lender or holder fails to comply with the lender’s or holder’s obligations . . . and fails to correct the failure to comply . . . by” performing a corrective measure (emphasis added)). Accordingly, if a lender fails to meet its obligations under the loan, forfeiture is an available remedy only if one of the six corrective measures can actually correct the underlying problem and the lender nonetheless fails to timely perform the relevant corrective measure.

Majority Opinion, pp. 13-14.   Thus, the majority concluded that the forfeiture provision didn't really apply because it didn't make sense in the context of the specific default.   Instead, the majority said that Garofolo's remedy was to seek traditional breach of contract remedies or specific performance.

The Dissent

The dissenting opinion accused the majority of re-writing the law to achieve what it considered to be "common sense."

I do not agree with the Court’s answer to the Fifth Circuit’s second question, and instead conclude that the parties’ agreement expressly gives the borrower a contractual right to forfeiture of all principal and interest paid upon the lender’s “failure to correct [a] failure to comply” with its obligations under the loan. Though the Court is concerned about such a “harsh forfeiture remedy,” it is the remedy the text requires and to which both parties agreed. To reach the opposite conclusion, the Court adds words to the parties’ contract and to the Constitution’s language, and rewrites both to achieve the result it believes “common sense suggests.” Although the Court’s result may comport with “common sense,” or at least with the Court’s view of “common sense,” it is not what the parties agreed to or what the Constitution requires.

Dissent, p. 1.   The dissent found that the Constitutional language was straightforward and required forfeiture.

Consistent with the first required condition, the lender and borrower in this case agreed to a security instrument that requires the lender to give the borrower a recordable release of lien within a reasonable time after termination and full payment of the loan.  And consistent with the second condition, the agreement requires the borrower to give the lender notice of the lender’s failure to comply with an obligation, allows the lender “60 days after receipt of notice to comply with the provisions of Section 50(a)(6),” and provides that “only after lender has failed to comply, shall all principal and interest be forfeited by Lender, as required by Section 50(a)(6)(Q)(x), Article XVI of the Texas Constitution in connection with failure by Lender to comply with its obligations.”

Dissent, p. 3.   The dissent went on to say that if the default couldn't be cured by performing one of the six required cures that forfeiture was mandated rather than excused.

The Court concludes that the security instrument does not require the holder to forfeit all principal and interest unless one or more of the six corrective measures listed in subsections (a)–(f) of section 50(a)(6)(Q)(x) would “actually correct the lender’s failure to meet its obligations.” The Court then concludes that the corrective measure in subsection (f), on which the borrower relies, would not have “actually corrected” the holder’s failure to deliver the release of lien, and it would therefore be “ridiculously futile” and “irrelevant” for the holder to perform subsection (f)’s requirements.  Because the security agreement only permits forfeiture “as required by Section 50(a)(6)(Q)(x),” the Court concludes that forfeiture is not available here.  I disagree for four separate reasons: (1) subsection (f) expressly provides that it applies if the corrective measures in subsections (a)–(e) will not cure the holder’s breach, so it must apply here; (2) subsection (f) “corrects” the underlying deficiency for purposes of avoiding forfeiture and motivates the holder to timely deliver the release of lien; (3) it is not “ridiculously futile” or “irrelevant” for the holder to perform the actions subsection (f) requires; and (4) even if the holder could not “correct” its breach by performing subsection (f)’s requirements, the agreement would expressly require forfeiture, not excuse it.

Dissent, p. 4.    The dissent also appealed to Supreme Court Justice Antonin Scalia for the importance of reading the law as written as opposed to how the Court would prefer to read it.

A plain reading of the adopted language reveals the framers’ intent, but the Court rewrites this language to effectuate its own intent. The Court confuses the term “correct” with “cure,” adds the word “actually,” and renders inoperative the language that says subsection (f) applies if subsections (a)–(e) do not. The Court says “common sense suggests” its interpretation, but our assessment of “common sense” does not permit us to ignore the adopted language. ANTONIN SCALIA & BRYAN A. GARNER, READING LAW: THE INTERPRETATION OF LEGAL TEXTS 237 (2012) (noting that “judicial revision of . . . texts to make them (in the judges’ view) more reasonable” presents “a slippery slope”).

Dissent, p. 7.   The dissent also ridiculed the Court's futility analysis.

Applying its common sense, the Court concludes that lenders and holders who fail to deliver a release of lien as promised should not have to comply with subsection (f) to avoid forfeiture because paying the borrower $1,000 and offering to refinance the note would be “ridiculously futile” and “irrelevant.” Instead, the Court believes the language should permit the holder to avoid forfeiture simply by delivering the release of lien. In fact, under the Court’s construction, the lender can always avoid forfeiture when it fails to deliver a lien release, even by doing nothing at all, because the forfeiture remedy simply does not apply to a failure to deliver a release. But this is not what the text says.

In any event, the holder’s compliance with subsection (f) is not as futile or irrelevant as the Court suggests. While subsection (f) does not expressly or directly require the holder to “correct” or “cure” its failure to deliver the release of lien by actually delivering the release of lien, it serves to motivate the holder to avoid the failure in the first place, thus preventing the obligation to pay the borrower $1,000 and offer to refinance. Within sixty days of receiving notice that it has failed to deliver a release of lien, the holder must pay the borrower $1,000 and offer to refinance, or the holder is subject to forfeiture. If the holder pays the $1,000 and offers to refinance, but does not deliver the release of lien, it will avoid forfeiture but remain in breach of its obligation to deliver the release of lien.   Certainly, at that point, the borrower can sue for specific performance to obtain the release. Regardless, at a minimum, subsection (f) provides the holder a catch-all method to “correct” a failure to comply when the five other methods will not “cure” it, and by doing so motivates the holder to avoid the deficiency all together.

Dissent, pp. 8-9.   Thus, the two justices in dissent would have applied the forfeiture remedy against Ocwen.

What It Means

It makes for good theater to watch the Texas justices sparring over whether to apply plain meaning or common sense when the result would be to penalize a business interest and offer a windfall to a consumer.    It is remarkable that two justices on the all Republican court would stand for principle against a traditional Republican constituency.  

The dueling opinions also illustrate how difficult it is to apply plain meaning analysis.    Both sides made plausible arguments from the constitutional text.    However, the majority's resort to "common sense" suggests that they knew were drawing a fine distinction.

Notwithstanding the majority's tortured analysis, the opinion makes practical sense.   Failure to timely deliver a release is a minor inconvenience compared to the remedy of forfeiture of all principal and interest.    Prior to a loan being satisfied, the prospect of taking away a person's home provides a strong policy basis for imposing strict liability upon lenders who do not follow the law.   After the loan is paid, the lender no longer holds any significant power to harm the borrower.   Allowing forfeiture in this case could have chilled the market for home equity lending in Texas (although other cases allowing forfeiture have not).   As a matter of public policy, the decision was probably correct.   The big question is whether the majority had to butcher the text to get to "common sense."

Southern District of Texas Takes Itself to Task for Failure to Follow Chapter 13 Rules

In an unusual collaborative proceeding initiated by two judges from the Southern District of Texas and concluded by a third, the Court has taken the Standing Chapter 13 Trustee to task for following the guidance of the former judge and has effectively judged the system guilty.   The opinion exposes an apparent rift between the current and former judges of the district and demonstrates an activist approach to problem solving by the judiciary.     Misc. Case No. 15-701, In re:  Chapter 13 Plan Administration in the Brownsville, Corpus Christi and McAllen Divisions.    The Court's Amended Order can be found here.  

What Happened

The Southern District of Texas adopted a standard plan in 2008 which provided that when a mortgage payment was increased or decreased, the debtor's plan payment would be increased or decreased by the same amount.     This was to be done automatically without the necessity for a plan modification.  

At a hearing on December 16, 2015, Judge Marvin Isgur learned that the Standing Chapter 13 Trustee was not automatically adjusting the plan amounts, but was instead waiting for debtors to file a motion to modify.   As a result, Judge Isgur and Judge Eduardo Rodriguez issued an Order to Show Cause in  Miscellaneous Case No 15-701 on December 22, 2015.    Among other things, the Order to Show Cause stated that:

• It appears that the Chapter 13 Trustee may have made distributions to creditors and debtors with an incorrect application of the Plan.
• If the issue were only an historic issue, the Court would not issue the emergency relief contained in this Order.
• The magnitude of the errors, and the appropriate remedy (if any) for the errors is unclear.
• The Court recognizes the difficult position that this Order imposes on the Chapter 13 Trustee.  Accordingly, the Chapter 13 Trustee should not hesitate to retain counsel, directly or through her errors and omissions carrier.

The judges then issued an order which provided for an Initial Status Conference to take place approximately two weeks later.   They requested that David Jones, the Chief Judge for the District, preside over the hearing.    The judges also required that the Standing Chapter 13 Trustee and the U.S. Trustee appear.   Judge Jones handled all subsequent proceedings.

The Chapter 13  Trustee filed a response in which she stated that she had followed the direction of the former Judge who interpreted the standard plan to require that the Debtor file a motion to modify the plan if the mortgage amount changed. 

For years, at least as early as 2004, I have administered Chapter 13 Plans in accordance with Judge Richard Schmidt’s interpretation of the Plan and his direction and approval. Until his retirement on July 30, 2015, Judge Schmidt required debtors file a motion to modify in the event an increase in mortgage payment caused the plan to not timely pay out. If the debtor failed to file a motion to modify, the Trustee would file a motion to dismiss. If there was no objection filed by the debtor, the Trustee would increase the amount of the mortgage payment to reflect the new increased mortgage payment; however, the debtor’s overall payment to the Plan did not increase unless the court signed an order modifying the plan. This was the standard practice for many courts, including Judge Schmidt’s Court until his retirement.

She also submitted an affidavit from the now retired judge stating that he had in fact provided this direction.  

While the Court and the Trustee had adopted a practice "as early as 2004," the judges of the Southern District adopted a standard plan in May 2006 which took a different approach.  Under the standard plan, upon filing of a Mortgage Payment Change Notification, the Trustee was supposed to automatically increase or decrease the amount of the Debtor's payments so that the distribution to unsecured creditors remained constant.    According to Judge Jones, "(t)he effect of this change was to shift responsibility for any change in the debtor's ongoing mortgage payment from the unsecured creditors to the debtor."    However, the practice apparently followed was to put the burden on the debtor to request a modification or for the unsecured creditors to object.       

Following an initial status conference on January 11, 2016, the Court required the Standing Trustee to provide a report identifying all affected cases.     According to the Trustee's report, there were 367 open cases where Debtors had made aggregate underpayments totaling $820,843.47 and 173 open cases where Debtors had made overpayments totaling $412,881.32.   

The Trustee proposed to remedy the situation by refunding overpayments to the extent of available funds and, if this proved insufficient, to seek to recover the overpayments from creditors.   Where debtors had underpaid, the Trustee proposed (i) changing plan payments to the extent feasible, (ii) extending plans beyond sixty months; and (iii) granting hardship discharges where payments could not be made up.    According to the Court, the Trustee resisted the idea that she give notice to all affected parties and inform them that they might have claims against her.  

The Court's Order

On May 5. 2016, the Court issued its Order (which was modified slightly by an amended order the next day).    The Court began with a quote from Abraham Lincoln:

It is as much the duty of government to render prompt justice against itself, in favor of citizens, as it is to administer the same between private individuals. ABRAHAM LINCOLN, Message to Congress in special session, July 4, 1861.

What followed was a sharp critique of the administration of chapter 13 cases in the Brownsville, Corpus Christi and McAllen divisions of the Southern District of Texas, in effect, the Southern part of the Southern District.     The Court stated that "(r)esponsibility for the administration of the chapter 13 process is vested primarily in three independent parties:  the Court, the United States Trustee and the chapter 13 standing trustee."   Amended Order, page 5.   The Court did not mention the role of the debtors, creditors and their attorneys in administering the system.  However, the Court may have implicitly acknowledged the practical difficulty for someone who makes a living within the system to stand up to those tasked with its implementation.  

Judge Jones went on to state:

Based on the affidavits submitted by Ms. Boudloche and her statements to the Court during this proceeding, the Court finds that chapter 13 debtors in the Brownsville, Corpus Christi and McAllen divisions of the Southern District of Texas were intentionally treated in a manner contrary to the Uniform Plan and to other debtors in the Houston, Galveston, Victoria and Laredo divisions of the Southern District of Texas. This disparate treatment was apparently the result of communications between the Court and Ms. Boudloche and the implementation of an unwritten rule or agreement to disregard the Uniform Plan. The Court finds that Ms. Boudloche violated her duties as a chapter 13 trustee. The Court further finds that the United States Trustee violated its duties of oversight and supervision of Ms. Boudloche. Most embarrassing, the Court violated its duty to uphold the integrity and independence of the judiciary.

Amended Order, pp. 7-8.   

The Court adopted the following remedial measures in open cases with a mortgage change notice:

1.   Where the debtor had overpaid, the Court required that the trustee: (i) immediately adjust the plan; (ii) issue a refund to the debtor to the extent of available funds within fourteen days; (iii) recover any overpayments from creditors within sixty days; and (iv) failing that, the Trustee would be required to "satisfy the unpaid deficiency."

2.  Where the debtor had underpaid, the Court required the trustee to immediately file a "mortgage payment change notice" for cases with more than three months remaining.   The debtor would then be required to object within twenty-one days or be bound by the increase.    The Court also required any debtor wishing to assert affirmative relief against the Chapter 13 Trustee to file a pleading within the Miscellaneous Case within 45 days or the claim would be waived.    Once the debtor completed payments under the plan, the trustee would be required to file a Notice of Plan Completion including language stating:

In this case, the chapter 13 trustee failed to administer the debtor(s)’ plan in accordance with its terms. This failure may have resulted in a distribution to unsecured creditors that is less than what would have been received had the chapter 13 trustee properly administered the plan in accordance with its terms. If you object to the granting of a discharge or wish to assert a claim against the chapter 13 trustee, you must file a written pleading in this bankruptcy case specifically setting forth your objection or claim within 21 days of the date of this notice or any such objection or claim is forever waived.

Thus, the Court gave creditors an opportunity to object to the debtor's discharge or assert a claim against the trustee if they were shortchanged.    If creditors remained silent, the debtor's discharge would go through.

Thus, the Court's remedial procedure consisted of moving to compliance on a prospective basis while allowing parties to object or assert claims within a limited window.   If the parties chose not to upset the status quo (as they had done during the previous ten years when the plan was being ignored), the sins of the past would be laid to rest.

However, the Court did not stop there.    The Court ordered the U.S. Trustee to conduct a review of the standing trustee.   The Court stated:

The Court notes that it has listened to over 20 hours of proceedings involving Ms. Boudloche in her capacity as chapter 13 trustee. The Court encourages the United States Trustee to do the same. The Court will reserve further action pending receipt and review of the United States Trustee’s report.

Amended Order, page 10.

The Court concluded its order with an apology.

On behalf of the Bankruptcy Court, the undersigned offers its sincere apology to those debtors and their families that did not receive the justice they deserve. The Court hopes that practitioners in these divisions will share this Order with their clients and convey just how hard it is for the undersigned to publicly recognize the failure of a system that he took an oath to protect. There will be no more secret rules, unspoken practices or disparate treatment of citizens in different divisions. We are one Bankruptcy Court with a single set of written rules. All citizens within the Southern District of Texas will be treated equally and with respect.

Amended Order, page 10.

The Inquisitorial System of Justice

This case involved a judge-driven investigation.    This is a sharp contrast to the adversary system which is the norm in America.    A few words about the distinction between the adversary system and the inquisitorial system are in order.

The American system of justice is characterized by the adversary system in which the litigation is primarily driven by the parties and their advocates.   The adversary system is followed by most of the countries which inherited their legal system from England.   In contrast, most of the rest of the world follows the inquisitorial system of justice in which the Court takes the lead.    I found a good discussion of this topic in an online legal dictionary.

The inquisitorial system can be defined by comparison with the adversarial, or accusatorial, system used in the United States and Great Britain. In the Adversary System, two or more opposing parties gather evidence and present the evidence, and their arguments, to a judge or jury. The judge or jury knows nothing of the litigation until the parties present their cases to the decision maker. The defendant in a criminal trial is not required to testify.

In the inquisitorial system, the presiding judge is not a passive recipient of information. Rather, the presiding judge is primarily responsible for supervising the gathering of the evidence necessary to resolve the case. He or she actively steers the search for evidence and questions the witnesses, including the respondent or defendant. Attorneys play a more passive role, suggesting routes of inquiry for the presiding judge and following the judge's questioning with questioning of their own. Attorney questioning is often brief because the judge tries to ask all relevant questions.

The goal of both the adversarial system and the inquisitorial system is to find the truth. But the adversarial system seeks the truth by pitting the parties against each other in the hope that competition will reveal it, whereas the inquisitorial system seeks the truth by questioning those most familiar with the events in dispute. The adversarial system places a premium on the individual rights of the accused, whereas the inquisitorial system places the rights of the accused secondary to the search for truth.

The inquisitorial system was first developed by the Catholic Church during the medieval period. The ecclesiastical courts in thirteenth-century England adopted the method of adjudication by requiring witnesses and defendants to take an inquisitorial oath administered by the judge, who then questioned the witnesses. In an inquisitorial oath, the witness swore to truthfully answer all questions asked of him or her. The system flourished in England into the sixteenth century, when it became infamous for its use in the Court of the Star Chamber, a court reserved for complex, contested cases. Under the reign of King Henry VIII, the power of the Star Chamber was expanded, and the court used torture to compel the taking of the inquisitorial oath. The Star Chamber was eventually eliminated as repugnant to basic liberty, and England gradually moved toward an adversarial system.

After the French Revolution, a more refined version of the inquisitorial system developed in France and Germany. From there it spread to the rest of continental Europe and to many African, South American, and Asian countries. The inquisitorial system is now more widely used than the adversarial system. Some countries, such as Italy, use a blend of adversarial and inquisitorial elements in their court system.

http://legal-dictionary.thefreedictionary.com/Inquisitorial+System

While Bankruptcy Courts primarily function under the adversary system, section 105(a) authorizes court-led investigations such as the one in this case.    Specifically, section 105(a) provides:

No provision of this title providing for the raising of an issue by a party in interest shall be construed to preclude the court from, sua sponte, taking any action or making any determination necessary or appropriate to enforce or implement court orders or rules, or to prevent an abuse of process.

In order to satisfy due process requirements, these proceedings often begin with an order to show cause which informs the responding party of the actions being questioned and allows a response.   In re Gleason, 492 Fed. Appx. 86 (11th Cir. 2012)(unreported).    There is also an inherent tension with the Court's ability to initiate and prosecute a proceeding and remain impartial.   In the case of In re Johnson, 921 F.2d 585 (5th Cir. 1991), the Fifth Circuit reversed an order suspending a trustee where the Circuit Court found that the Bankruptcy Court should have recused itself.   This may explain why, in this particular case, Judges Isgur and Rodriguez initiated the proceeding but then referred it to Chief Judge Jones.    This was all the more important for Judge Rodriguez who had been a volume practitioner in this same court until he was appointed to replace Judge Schmidt.

The inquisitorial proceeding in bankruptcy court is a unique creature.  The ability of the Court to compel a party to appear and show cause in a proceeding where the Court initiates the action, defines its boundaries and renders a judgment is a powerful one.   There are many words that could be written about whether this type of proceeding can comply with due process or whether there are separation of powers problems when the judicial branch compels the executive branch to act.  I will leave those for another author.

Disclaimers:

I am presently representing a client in another Miscellaneous Case in the Southern District of Texas.   Nothing written here is intended to be a comment on that proceeding which involves substantially different facts and legal issues.  

In reporting on this opinion, I have relied on the publicly available record and the descriptions of the proceedings contained within the court orders.    I did not participate in these proceedings and have no personal knowledge other than what I read.  

The period for appealing the Court's order has not yet expired.   As a result, the Order is still subject to modification or reversal on appeal.

Fifth Circuit Report: First Quarter 2016

During the first quarter of 2016, the Fifth Circuit handed down some important decisions relating to bankruptcy and debt.     These include cases about how attorneys get paid from PACA proceeds, standing to object, denial of discharge, dismissal for cause, enforcing a chapter 11 plan, preferences, more fallout from the Stanford Ponzi scheme and some cases of general interest.

Click on the style of the case to go to the opinion.