The Fifth Circuit has held that proceeds from a surrendered whole-life policy are not exempt under Texas law. Trautman vs. Milligan, No. 06-50363 (5th Cir. 8/8/07). The Trautman decision relied on both interpretation of the Texas Insurance Code and policy considerations.
In Trautman, the Debtor owned an insurance policy in which he was the insured and his wife was the beneficiary. Prior to bankruptcy, he surrendered the policy and received a check for the cash value. He claimed the un-cashed check as exempt property. The Bankruptcy Court allowed the exemption, but both the District Court and the Fifth Circuit held that the property was not exempt.
The exemption turned upon statutory language which provided that “the cash value and proceeds of an insurance policy, to be provided to an insured or beneficiary” under an insurance policy issued by a life, health or accident insurance company were exempt. Texas Insurance Code Sec. 1108.051.
The Court of Appeals noted the difference between three parties to an insurance contract: the owner, the insured and the beneficiary. In this case, the husband was both the owner of the policy and the insured, while the wife was the beneficiary. The Insurance Code protects “cash value” and “proceeds” payable to an “insured” or a “beneficiary.” At first blush, there appears to be a reasonable argument for the exemption. After all, the undisputed facts were that the policy was surrendered and that the cash value was paid to the husband, who was both owner and insured. However, the Court found that the funds were paid to the husband, not as insured, but as owner. Since amounts paid to owners are not listed as exempt, the argument failed.
The Court of Appeals also noted that cash values had not always been protected from creditors. The Court surmised that the legislature allowed exemption of cash values in order to prevent creditors from seizing the value of the policy and thwarting the interest of the beneficiary. However, the Court did not feel that allowing the debtor to use a whole-life policy as a savings account free from the claims of creditors was a worthy goal. Indeed, the court noted that under the debtor’s proposed interpretation, a person could transfer funds into an insurance policy and then immediately surrender the policy and shelter the proceeds from creditors. The Court succinctly remarked that “That can’t be the law.”
This case points out an important bankruptcy planning consideration. Cash value contained within an existing insurance policy is protected by statute, while cash value in a surrendered policy is not. As a result, a financially distressed debtor will be better off waiting until after bankruptcy (and after the period for objecting to exemptions has passed) before accessing the cash value of a policy. Additionally, a debtor who needs temporary access to policy cash values will be better served by borrowing against the policy rather than surrendering it.
While the Court of Appeals was concerned about debtors fraudulently transferring their cash into an insurance policy, this possibility is addressed by the statute itself. Under Texas Insurance Code Sec. 1108.053(1), the exemption does not apply to “a premium payment made in fraud of a creditor, subject to the applicable statute of limitations for recovering the payment.”
Wednesday, August 08, 2007
Monday, July 23, 2007
District Court Reverses Discharge Violation; Finds Some Violations Too Technical to Punish
Are some violations of the discharge injunction too technical or trivial to justify enforcement? According to a U.S. District Court Judge in Texas, the answer is yes, and the holding, if correct, may highlight an important distinction between the penalties for violation of the stay and the discharge. No. SA-06-CV-0439-RF, Cadles of Grassy Meadows II, LLC v. Joyce Gervin (W.D. Tex. 11/21/06)(Royal Ferguson, D.J.).
20+ Years of Background (That’s Over a Fifth of a Century!)
The facts in the Gervin case are pretty complex and span over 20 years of time. However, a thumbnail sketch should be able to capture the essentials. Back in 1983, George Gervin was granted a 50% interest in a partnership called the 401 Group. In both 1984 and 1992, George assigned half of his interest in the 401 Group to his wife Joyce Gervin. While the 401 Group was informed of this transfer, Joyce was never formally admitted as a partner.
In 1986, he was sued by TCAP on a $2 million debt, which resulted in an agreed judgment in 1989. For nine years, TCAP and various assignees tried to chase George and succeeded in obtaining a charging order against George’s interest in the 401 Group.
George and Joyce filed for chapter 7 bankruptcy in San Antonio in 1998. The Gervins did not disclose their separate interests in the 401 Group, referring to it as community property. While the Gervins received a discharge, the Bankruptcy Court also determined that TCAP and its successor held a valid lien against George’s interest in the 401 Group.
Cadles of Grassy Meadows acquired the debt in 2000. Some four years later, on September 15, 2004, Cadles asked the Washington state court to compel the sale of the 401 Group, so that it could attach and sell George’s 50% partnership interest. On September 21, 2004, Joyce’s counsel informed Cadles that she owned a 25% interest in the 401 Group. Then on September 24, 2004, Joyce filed an action in Bankruptcy Court seeking to prevent the sale of her interest as being in violation of the discharge. She succeeded in obtaining a preliminary injunction. Notwithstanding the bankruptcy court injunction, the Washington state court entered an order compelling the sale of George’s interest in the 401 Group; however, the state court did not determine the extent of George’s interest.
Meanwhile, back in Texas, the Bankruptcy Court entered summary judgment finding that Joyce did in fact own a 25% interest in the 401 Group and that Cadles had violated Joyce’s discharge by trying to collect from her property. After a trial on damages, the Bankruptcy Court awarded Joyce $25,000 for emotional distress and $18,190 in attorney’s fees.
The District Court Ruling
Cadles was not very happy with this result and appealed. On appeal, the U.S. District Court sustained the Bankruptcy Court’s ruling that Joyce had a valid 25% interest in the 401 Group. However, it reversed the contempt judgment, finding that either there was not a violation of the discharge at all, or that the violation was so insignificant as to be unworthy of recompense.
While the Bankruptcy Court granted summary judgment that the discharge injunction had been violated, the District Court could not discern any detailed findings as to how the discharge had been violated. Indeed, Cadles contended that the Bankruptcy Court had initially intended to hold a separate hearing on the discharge violation, but instead signed an order finding the violation had occurred. This left the District Court to make its own examination.
Initially, the District Court noted that Bankruptcy Courts have the power to enforce their orders through contempt and that damages may be awarded. However, in order to find contempt, there must be an unambiguous order and an obvious violation of the order. Here, there was a prior order allowing pursuit of George’s interest in the 401 Group, but no determination of the extent of that interest. The District Court found that this made “it difficult for Cadles to assess if its actions were violating the order.” Order Granting in Part and Denying in Part, p. 17.
The Court found that this alone was sufficient to negate the finding of contempt. However, the Court went on to find that there was not an obvious violation of a court order either. In this case, Cadles sought the charging order on September 15, 2004, but did not learn about Joyce’s claimed interest in the 401 Group until September 21, 2004. Three days later, Joyce filed the adversary proceeding. Thus, when Cadles began pursuing the charging order on the 15th, it had no basis for knowing that this action would violate the discharge at the time.
The Court went on to state that even if there had been a violation, it was too minor to warrant damages. Judge Ferguson stated:
“While the Bankruptcy Code provides bankruptcy courts with the power to find a party in contempt, the code does not require such a finding. As the Supreme Court notes, ‘[the Bankruptcy Code] does not provide bankruptcy courts with a roving writ, much less a free hand. The authority bestowed thereunder may be invoked only if, and to the extent that, the equitable remedy dispensed by the court is necessary to preserve an identifiable right conferred elsewhere in the Bankruptcy Code.’ Cadle’s violation of the discharge injunction, if one existed at all, was technical, trivial, and most certainly not the kind of action contempt findings were meant to prevent.”
Order Granting in Party and Denying in Part, pp. 18-19.
Both parties were dissatisfied with the District Court’s split decision and an appeal to the Fifth Circuit is currently pending.
What is the Relevant Time Period?
There is a serious disconnect between the way in which the Bankruptcy Court and the District Court viewed the undisputed facts. The District Court essentially looked at three different time periods. First, there was the period from September 15, 2004, the date on which Cadles requested the sale order, until September 21, 2004, the date on which Joyce gave notice of her interest in the 401 Group. Because Cadles had no notice prior to this date, it could not be held charged with violation of the discharge. There was a second period from September 21, 2004 until September 24, 2004 in which Cadles knew of Joyce’s interest but did not withdraw its request. The District Court found that this inaction was either a non-violation or a technical violation. Finally, there was the period after September 24, 2004 in which the parties were litigating the issue of Joyce’s interest in Bankruptcy Court. The District Court did not consider this to be a violation.
The Bankruptcy Court did not divide its analysis into periods. However, in its Memorandum Decision on damages, No. 04-5138, (Bankr. W.D. Tex. 11/12/05), the Court was clearly considering a much lengthier period of violation. In assessing damages, the Court recounted that Joyce made 20 panicked calls to her accountant over the period of a year and that she did not sleep well for a period of two years. Memorandum Decision, p. 13. However, it is difficult to discern either a one year period or a two year period from any of the documents in the record. The earliest date on which Cadles took action was September 15, 2004. The Bankruptcy Court entered summary judgment finding that Cadles was in contempt on May 17, 2005. The Bankruptcy Court entered its Memorandum Decision on damages on November 12, 2005. Thus, the only way a period of a year or more could apply is if the Bankruptcy Court found that Cadles was in contempt for violating the discharge during the entire period from its first filing to the Bankruptcy Court’s ruling on damages. However, during all but nine days of this period the parties were litigating the extent of Joyce’s interest in the 401 Group in Bankruptcy Court. It seems likely that the Bankruptcy Court assessed damages for the period in which the parties were litigating the extent of Joyce's property interest and therefore the extent of her protection under the discharge.
What Standard Did the Courts Apply?
Although both the Bankruptcy Court and the District Court ruled on the discharge issue, neither court explicitly set out the legal standard it was applying. The Bankruptcy Court appeared to apply a strict liability standard. The unstated premise of the Bankruptcy Court ruling seems to be that because Cadles tried to levy on Joyce’s property, Cadles violated Joyce’s discharge regardless of whether Cadles had actual knowledge of Joyce’s interest and that this violation continued during the entire period in which Cadles disputed Joyce’s ownership interest in the 401 Group. The District Court, on the other hand, applied a knowing violation standard. The District Court did not charge Cadles with a duty to act until it had knowledge of Joyce’s claimed interest and therefore, knowledge that collection efforts would violate her discharge. From that point, there was a delay of a mere three days before Joyce initiated proceedings to declare her interest in the Bankruptcy Court. While Cadles proceeded subsequent to the Bankruptcy Court filing, it was careful to limit its action to proceeding against George’s interest, whatever that might be.
The difference between the courts’ rulings may well reflect their differing perspectives. The Bankruptcy Court, which deals with the automatic stay on a day in, day out basis, appeared to apply the same standard which would apply to a stay violation. By contrast, the District Court, which issues and enforces injunctions on a regular basis, applied a more conventional contempt standard. The distinction between the two is critical because the stay and the discharge, while both expressed as injunctions, have different scopes and remedies attached to them.
The automatic stay of section 362 includes a private right of action contained in §362(h). Section 362(h) allows any individual harmed by a willful violation of the stay to recover damages and allows additional relief if appropriate. A violation can be “willful” without a specific intent to violate the stay. A willful violation occurs where there is knowledge of the stay and intent to commit the act which violated the stay. Brown v. Chesnut, 422 F.3d 298 (5th Cir. 2005); Fleet Mortgage Group, Inc. v. Kaneb, 196 F.3d 265 (1st Cir. 1999).
On the other hand, there is no private right of action contained in the discharge injunction. Walls v. Wells Fargo Bank, 276 F.3d 502 (9th Cir. 2002). Instead, the discharge may be enforced under the Bankruptcy Court’s inherent contempt powers under §105. As suggested by the District Court, the civil contempt powers should not be applied where the application of the order (in this case the discharge injunction) is not clear. On the other hand, the automatic stay, which operates like a sheriff trying to maintain order in a midst of a saloon brawl, has a stricter application.
The distinction between the statutes rests on more than a simple happenstance of drafting. The automatic stay serves a broader purpose than the discharge injunction. As noted by the Fifth Circuit in Chesnut, the automatic stay is designed to protect creditors as well as debtors. The stay exists to preserve the estate, as well as to protect the debtor from collection efforts. The discharge injunction, on the other hand, exists solely to protect the debtor.
The Chesnut case provides a good counterpoint to the present one. In Chesnut, a creditor was informed that the debtor had an interest in real property titled in the name of his non-filing spouse. The creditor made a determination that this claim was erroneous and proceeded to foreclose. The U.S. District Court subsequently concluded that the creditor was correct in its assessment that the debtor lacked an interest in the property. However, the Fifth Circuit reversed, finding that the stay extended to an arguable interest in property, even if that interest was subsequently found to be lacking. The Court found that it was important to allow the Bankruptcy Court to examine the merits of the claim prior to allowing the creditor to proceed and noted the broad latitude given to the court to modify the stay upon request.
In the Gervin case, however, the creditor began by proceeding against property which appeared to be property which the Bankruptcy Court had expressly ruled was subject to the creditor’s non-dischargeable lien. Upon being informed that another party claimed an unrecorded interest in this property, the creditor paused and then amended its request to seek only the husband’s interest. This decision proved to be wise, since the interest of the other party was later validated. The important distinction here is that the creditor, faced with a possibly spurious claim, did not blindly proceed in the face of a dispute. While the creditor could be faulted for failing to immediately disclaim an interest in Joyce’s property, this delay was more technical or trivial and did not impugn the integrity of the court.
Gervin may prove to be an unusual case dependent upon unusual facts. In the typical discharge violation case, the application of the discharge is clear and the violation is obvious. However, Gervin certainly raises the possibility that some incidental violations of the discharge may not justify the invocation of the contempt power. An isolated collection letter may not be enough to suggest that the creditor is contemptuous of the authority of the Bankruptcy Court and its orders. If a violation could have been remedied by something less drastic, such as a phone call or a cease and desist letter, then perhaps resort to a full-blow adversary proceeding is premature. However, if a creditor is given fair warning that its actions violate the discharge and chooses to continue its efforts, then it would be contemptuous in both the popular and the legal sense of the word.
Disclaimer: One part of my practice involves representing creditors accused of violating the discharge. As a result, I have an interest in the arguments being advanced here. However, I do not represent the Cadle Company or its affiliates.
20+ Years of Background (That’s Over a Fifth of a Century!)
The facts in the Gervin case are pretty complex and span over 20 years of time. However, a thumbnail sketch should be able to capture the essentials. Back in 1983, George Gervin was granted a 50% interest in a partnership called the 401 Group. In both 1984 and 1992, George assigned half of his interest in the 401 Group to his wife Joyce Gervin. While the 401 Group was informed of this transfer, Joyce was never formally admitted as a partner.
In 1986, he was sued by TCAP on a $2 million debt, which resulted in an agreed judgment in 1989. For nine years, TCAP and various assignees tried to chase George and succeeded in obtaining a charging order against George’s interest in the 401 Group.
George and Joyce filed for chapter 7 bankruptcy in San Antonio in 1998. The Gervins did not disclose their separate interests in the 401 Group, referring to it as community property. While the Gervins received a discharge, the Bankruptcy Court also determined that TCAP and its successor held a valid lien against George’s interest in the 401 Group.
Cadles of Grassy Meadows acquired the debt in 2000. Some four years later, on September 15, 2004, Cadles asked the Washington state court to compel the sale of the 401 Group, so that it could attach and sell George’s 50% partnership interest. On September 21, 2004, Joyce’s counsel informed Cadles that she owned a 25% interest in the 401 Group. Then on September 24, 2004, Joyce filed an action in Bankruptcy Court seeking to prevent the sale of her interest as being in violation of the discharge. She succeeded in obtaining a preliminary injunction. Notwithstanding the bankruptcy court injunction, the Washington state court entered an order compelling the sale of George’s interest in the 401 Group; however, the state court did not determine the extent of George’s interest.
Meanwhile, back in Texas, the Bankruptcy Court entered summary judgment finding that Joyce did in fact own a 25% interest in the 401 Group and that Cadles had violated Joyce’s discharge by trying to collect from her property. After a trial on damages, the Bankruptcy Court awarded Joyce $25,000 for emotional distress and $18,190 in attorney’s fees.
The District Court Ruling
Cadles was not very happy with this result and appealed. On appeal, the U.S. District Court sustained the Bankruptcy Court’s ruling that Joyce had a valid 25% interest in the 401 Group. However, it reversed the contempt judgment, finding that either there was not a violation of the discharge at all, or that the violation was so insignificant as to be unworthy of recompense.
While the Bankruptcy Court granted summary judgment that the discharge injunction had been violated, the District Court could not discern any detailed findings as to how the discharge had been violated. Indeed, Cadles contended that the Bankruptcy Court had initially intended to hold a separate hearing on the discharge violation, but instead signed an order finding the violation had occurred. This left the District Court to make its own examination.
Initially, the District Court noted that Bankruptcy Courts have the power to enforce their orders through contempt and that damages may be awarded. However, in order to find contempt, there must be an unambiguous order and an obvious violation of the order. Here, there was a prior order allowing pursuit of George’s interest in the 401 Group, but no determination of the extent of that interest. The District Court found that this made “it difficult for Cadles to assess if its actions were violating the order.” Order Granting in Part and Denying in Part, p. 17.
The Court found that this alone was sufficient to negate the finding of contempt. However, the Court went on to find that there was not an obvious violation of a court order either. In this case, Cadles sought the charging order on September 15, 2004, but did not learn about Joyce’s claimed interest in the 401 Group until September 21, 2004. Three days later, Joyce filed the adversary proceeding. Thus, when Cadles began pursuing the charging order on the 15th, it had no basis for knowing that this action would violate the discharge at the time.
The Court went on to state that even if there had been a violation, it was too minor to warrant damages. Judge Ferguson stated:
“While the Bankruptcy Code provides bankruptcy courts with the power to find a party in contempt, the code does not require such a finding. As the Supreme Court notes, ‘[the Bankruptcy Code] does not provide bankruptcy courts with a roving writ, much less a free hand. The authority bestowed thereunder may be invoked only if, and to the extent that, the equitable remedy dispensed by the court is necessary to preserve an identifiable right conferred elsewhere in the Bankruptcy Code.’ Cadle’s violation of the discharge injunction, if one existed at all, was technical, trivial, and most certainly not the kind of action contempt findings were meant to prevent.”
Order Granting in Party and Denying in Part, pp. 18-19.
Both parties were dissatisfied with the District Court’s split decision and an appeal to the Fifth Circuit is currently pending.
What is the Relevant Time Period?
There is a serious disconnect between the way in which the Bankruptcy Court and the District Court viewed the undisputed facts. The District Court essentially looked at three different time periods. First, there was the period from September 15, 2004, the date on which Cadles requested the sale order, until September 21, 2004, the date on which Joyce gave notice of her interest in the 401 Group. Because Cadles had no notice prior to this date, it could not be held charged with violation of the discharge. There was a second period from September 21, 2004 until September 24, 2004 in which Cadles knew of Joyce’s interest but did not withdraw its request. The District Court found that this inaction was either a non-violation or a technical violation. Finally, there was the period after September 24, 2004 in which the parties were litigating the issue of Joyce’s interest in Bankruptcy Court. The District Court did not consider this to be a violation.
The Bankruptcy Court did not divide its analysis into periods. However, in its Memorandum Decision on damages, No. 04-5138, (Bankr. W.D. Tex. 11/12/05), the Court was clearly considering a much lengthier period of violation. In assessing damages, the Court recounted that Joyce made 20 panicked calls to her accountant over the period of a year and that she did not sleep well for a period of two years. Memorandum Decision, p. 13. However, it is difficult to discern either a one year period or a two year period from any of the documents in the record. The earliest date on which Cadles took action was September 15, 2004. The Bankruptcy Court entered summary judgment finding that Cadles was in contempt on May 17, 2005. The Bankruptcy Court entered its Memorandum Decision on damages on November 12, 2005. Thus, the only way a period of a year or more could apply is if the Bankruptcy Court found that Cadles was in contempt for violating the discharge during the entire period from its first filing to the Bankruptcy Court’s ruling on damages. However, during all but nine days of this period the parties were litigating the extent of Joyce’s interest in the 401 Group in Bankruptcy Court. It seems likely that the Bankruptcy Court assessed damages for the period in which the parties were litigating the extent of Joyce's property interest and therefore the extent of her protection under the discharge.
What Standard Did the Courts Apply?
Although both the Bankruptcy Court and the District Court ruled on the discharge issue, neither court explicitly set out the legal standard it was applying. The Bankruptcy Court appeared to apply a strict liability standard. The unstated premise of the Bankruptcy Court ruling seems to be that because Cadles tried to levy on Joyce’s property, Cadles violated Joyce’s discharge regardless of whether Cadles had actual knowledge of Joyce’s interest and that this violation continued during the entire period in which Cadles disputed Joyce’s ownership interest in the 401 Group. The District Court, on the other hand, applied a knowing violation standard. The District Court did not charge Cadles with a duty to act until it had knowledge of Joyce’s claimed interest and therefore, knowledge that collection efforts would violate her discharge. From that point, there was a delay of a mere three days before Joyce initiated proceedings to declare her interest in the Bankruptcy Court. While Cadles proceeded subsequent to the Bankruptcy Court filing, it was careful to limit its action to proceeding against George’s interest, whatever that might be.
The difference between the courts’ rulings may well reflect their differing perspectives. The Bankruptcy Court, which deals with the automatic stay on a day in, day out basis, appeared to apply the same standard which would apply to a stay violation. By contrast, the District Court, which issues and enforces injunctions on a regular basis, applied a more conventional contempt standard. The distinction between the two is critical because the stay and the discharge, while both expressed as injunctions, have different scopes and remedies attached to them.
The automatic stay of section 362 includes a private right of action contained in §362(h). Section 362(h) allows any individual harmed by a willful violation of the stay to recover damages and allows additional relief if appropriate. A violation can be “willful” without a specific intent to violate the stay. A willful violation occurs where there is knowledge of the stay and intent to commit the act which violated the stay. Brown v. Chesnut, 422 F.3d 298 (5th Cir. 2005); Fleet Mortgage Group, Inc. v. Kaneb, 196 F.3d 265 (1st Cir. 1999).
On the other hand, there is no private right of action contained in the discharge injunction. Walls v. Wells Fargo Bank, 276 F.3d 502 (9th Cir. 2002). Instead, the discharge may be enforced under the Bankruptcy Court’s inherent contempt powers under §105. As suggested by the District Court, the civil contempt powers should not be applied where the application of the order (in this case the discharge injunction) is not clear. On the other hand, the automatic stay, which operates like a sheriff trying to maintain order in a midst of a saloon brawl, has a stricter application.
The distinction between the statutes rests on more than a simple happenstance of drafting. The automatic stay serves a broader purpose than the discharge injunction. As noted by the Fifth Circuit in Chesnut, the automatic stay is designed to protect creditors as well as debtors. The stay exists to preserve the estate, as well as to protect the debtor from collection efforts. The discharge injunction, on the other hand, exists solely to protect the debtor.
The Chesnut case provides a good counterpoint to the present one. In Chesnut, a creditor was informed that the debtor had an interest in real property titled in the name of his non-filing spouse. The creditor made a determination that this claim was erroneous and proceeded to foreclose. The U.S. District Court subsequently concluded that the creditor was correct in its assessment that the debtor lacked an interest in the property. However, the Fifth Circuit reversed, finding that the stay extended to an arguable interest in property, even if that interest was subsequently found to be lacking. The Court found that it was important to allow the Bankruptcy Court to examine the merits of the claim prior to allowing the creditor to proceed and noted the broad latitude given to the court to modify the stay upon request.
In the Gervin case, however, the creditor began by proceeding against property which appeared to be property which the Bankruptcy Court had expressly ruled was subject to the creditor’s non-dischargeable lien. Upon being informed that another party claimed an unrecorded interest in this property, the creditor paused and then amended its request to seek only the husband’s interest. This decision proved to be wise, since the interest of the other party was later validated. The important distinction here is that the creditor, faced with a possibly spurious claim, did not blindly proceed in the face of a dispute. While the creditor could be faulted for failing to immediately disclaim an interest in Joyce’s property, this delay was more technical or trivial and did not impugn the integrity of the court.
Gervin may prove to be an unusual case dependent upon unusual facts. In the typical discharge violation case, the application of the discharge is clear and the violation is obvious. However, Gervin certainly raises the possibility that some incidental violations of the discharge may not justify the invocation of the contempt power. An isolated collection letter may not be enough to suggest that the creditor is contemptuous of the authority of the Bankruptcy Court and its orders. If a violation could have been remedied by something less drastic, such as a phone call or a cease and desist letter, then perhaps resort to a full-blow adversary proceeding is premature. However, if a creditor is given fair warning that its actions violate the discharge and chooses to continue its efforts, then it would be contemptuous in both the popular and the legal sense of the word.
Disclaimer: One part of my practice involves representing creditors accused of violating the discharge. As a result, I have an interest in the arguments being advanced here. However, I do not represent the Cadle Company or its affiliates.
Tuesday, June 26, 2007
Judge Isgur Refuses to Apply Vicarious Disqualification
Judge Marvin Isgur of the Southern District of Texas has rejected application of a per se vicarious disqualification rule in a case involving Bracewell Giuliani. No. 07-32417, In re Cygnus Oil and Gas Corporation, (Bankr. S.D. Tex. 5/29/07). In the Cygnus case, a Bracewell partner owed 100,000 shares of the debtor and has served as a director for four months during the year prior to bankruptcy. Under the language of 11 U.S.C. §101(14), the individual partner was clearly not a disinterested person entitled to be employed. If the interested status of the partner was imputed to the firm, then the firm itself would not be disinterested and could not be employed.
Judge Isgur noted that the Delaware Bankruptcy Court had applied the per se rule of vicarious disqualification. In re Essential Therapeutics, Inc., 295 B.R. 203 (Bankr. D. Del. 2003). That court found that in the “current climate of distrust of officers and directors” the corporate leadership could be subjected to interrogation for their role making it “impossible” for a firm employing such an officer or director to adequately represent the debtor’s interests.
Going out on a limb, Judge Isgur pointed out that the Ninth Circuit BAP had rejected a per se approach to vicarious disqualification. In re S.S. Retail Stores Corp., 211 B.R. 699 (9th Cir. BAP 1997). Moving on to more solid ground, the court found that the statutory language did not support the pre se rule. Judge Isgur stated:
“Rules of statutory interpretation direct the Court to ‘presume that a legislature says in a statute what it means and means in a statute what it says there.’ (citation omitted). On examination of §101(14), this Court, in accordance with the majority of circuits addressing this issue, finds that no per se rule of disqualification exists under the Bankruptcy Code. ‘Person’ is defined in §101(41) as including an ‘individual, partnership, and corporation.’ (citation omitted). The Code is unambiguous. Section 101(14) by its plain language applies to any ‘person.’ ‘Person’ specifically refers to Bracewell. McBride is the equity holder and was the Cygnus director—not Bracewell. Had Congress intended to impute a single member’s disqualification to her entire firm, it would have done so. (citation omitted). Accordingly, the Court find that based on a plain reading of the statute, Bracewell is not disqualified . . . “
Memorandum Opinion at 5.
However, the Court did not stop at this conclusion. It went on to note that under §101(14)(C), a firm could be disqualified if it possessed “an interest materially adverse to the estate . . . by reason of a direct or indirect relationship to . . . the debtor.” The firm clearly had an indirect relationship to the debtor because of the interest of its partner. However, Bracewell established that (i) its partner no longer maintained a role with the debtor, (ii) that he owned 0.3% of the debtor’s stock, (iii) that he agreed not to vote his shares, (iv) that shareholders were unlikely to receive anything from the debtor’s estate and (v) and that the former director had been “walled off” from the reorganization team. The Court found that no evidence had been presented that the firm would have a materially adverse interest based on the fact that one of its many partners had served as a director for a brief period of time.
Judge Isgur should get credit for reading the statute the way Congress wrote it. Section 101(14)(A) and (B) absolutely exclude certain specified “persons” from the definition of “disinterested person,” while Section 101(14)(C) applies to both direct and indirect relationships. Thus, the per se rule applies to direct relationships, while the “materially adverse” standard applies to indirect relationships as well. Indirect relationships require a factual inquiry, while direct relationships invoke per se disqualification. This standard is sensitive enough to identify actual conflicts (for example, if a firm employing Jeffrey Skilling had applied to represent Enron), while weeding out technical ones (as in the Cygnus Oil case).
Bracewell also gets credit for making the proper disclosures. Unlike the John Gellene case (discussed in this blog last year), Bracewell was prompt to point out its “connections” with the debtor as required by Fed.R.Bankr.P. 2014. As a result, the court was able to examine the evidence and render a decision on the front end of the case. The Cygnus case certainly provides a powerful case for the benefits of making full disclosure up front.
While Cygnus Oil certainly upholds the canon of strict statutory construction, its benefits are more likely to flow to mega-firms than small ones. In a firm where one litigation partner out of many hundreds of overall partners had been a director of the debtor, it is easy to avoid finding a materially adverse interest. However, where one out of three lawyers in a firm had been intimately involved with the debtor, disqualification would be more difficult to avoid.
As a post-script, it is worth noting that the employment rules exclude firms which fail the disinterested test, but do not require the employment of the most qualified firms. The quality of the firm employed is governed by both the open market and the court’s ability to approve the fees requested. If a firm is disinterested but mediocre, it could be hoped that an efficient market place would not employ that firm or that the court would reduce the fees awarded to that firm causing the inefficient firm to withdraw from the marketplace.
Judge Isgur noted that the Delaware Bankruptcy Court had applied the per se rule of vicarious disqualification. In re Essential Therapeutics, Inc., 295 B.R. 203 (Bankr. D. Del. 2003). That court found that in the “current climate of distrust of officers and directors” the corporate leadership could be subjected to interrogation for their role making it “impossible” for a firm employing such an officer or director to adequately represent the debtor’s interests.
Going out on a limb, Judge Isgur pointed out that the Ninth Circuit BAP had rejected a per se approach to vicarious disqualification. In re S.S. Retail Stores Corp., 211 B.R. 699 (9th Cir. BAP 1997). Moving on to more solid ground, the court found that the statutory language did not support the pre se rule. Judge Isgur stated:
“Rules of statutory interpretation direct the Court to ‘presume that a legislature says in a statute what it means and means in a statute what it says there.’ (citation omitted). On examination of §101(14), this Court, in accordance with the majority of circuits addressing this issue, finds that no per se rule of disqualification exists under the Bankruptcy Code. ‘Person’ is defined in §101(41) as including an ‘individual, partnership, and corporation.’ (citation omitted). The Code is unambiguous. Section 101(14) by its plain language applies to any ‘person.’ ‘Person’ specifically refers to Bracewell. McBride is the equity holder and was the Cygnus director—not Bracewell. Had Congress intended to impute a single member’s disqualification to her entire firm, it would have done so. (citation omitted). Accordingly, the Court find that based on a plain reading of the statute, Bracewell is not disqualified . . . “
Memorandum Opinion at 5.
However, the Court did not stop at this conclusion. It went on to note that under §101(14)(C), a firm could be disqualified if it possessed “an interest materially adverse to the estate . . . by reason of a direct or indirect relationship to . . . the debtor.” The firm clearly had an indirect relationship to the debtor because of the interest of its partner. However, Bracewell established that (i) its partner no longer maintained a role with the debtor, (ii) that he owned 0.3% of the debtor’s stock, (iii) that he agreed not to vote his shares, (iv) that shareholders were unlikely to receive anything from the debtor’s estate and (v) and that the former director had been “walled off” from the reorganization team. The Court found that no evidence had been presented that the firm would have a materially adverse interest based on the fact that one of its many partners had served as a director for a brief period of time.
Judge Isgur should get credit for reading the statute the way Congress wrote it. Section 101(14)(A) and (B) absolutely exclude certain specified “persons” from the definition of “disinterested person,” while Section 101(14)(C) applies to both direct and indirect relationships. Thus, the per se rule applies to direct relationships, while the “materially adverse” standard applies to indirect relationships as well. Indirect relationships require a factual inquiry, while direct relationships invoke per se disqualification. This standard is sensitive enough to identify actual conflicts (for example, if a firm employing Jeffrey Skilling had applied to represent Enron), while weeding out technical ones (as in the Cygnus Oil case).
Bracewell also gets credit for making the proper disclosures. Unlike the John Gellene case (discussed in this blog last year), Bracewell was prompt to point out its “connections” with the debtor as required by Fed.R.Bankr.P. 2014. As a result, the court was able to examine the evidence and render a decision on the front end of the case. The Cygnus case certainly provides a powerful case for the benefits of making full disclosure up front.
While Cygnus Oil certainly upholds the canon of strict statutory construction, its benefits are more likely to flow to mega-firms than small ones. In a firm where one litigation partner out of many hundreds of overall partners had been a director of the debtor, it is easy to avoid finding a materially adverse interest. However, where one out of three lawyers in a firm had been intimately involved with the debtor, disqualification would be more difficult to avoid.
As a post-script, it is worth noting that the employment rules exclude firms which fail the disinterested test, but do not require the employment of the most qualified firms. The quality of the firm employed is governed by both the open market and the court’s ability to approve the fees requested. If a firm is disinterested but mediocre, it could be hoped that an efficient market place would not employ that firm or that the court would reduce the fees awarded to that firm causing the inefficient firm to withdraw from the marketplace.
Wednesday, June 13, 2007
Assigned Credit Card Debt: A Problem of Paper, Electronic Images and Faith
Two recent decisions from Texas Bankruptcy Courts highlight the practical problems inherent in proving up a claim based on assigned credit card debt. However, they also illustrate the tenuous connection between trust and value in the electronic age.
The Cases
The two cases involved a common fact pattern but different outcomes. In both cases, a debtor incurred credit card debt and then filed bankruptcy. In the bankruptcy case, a third party filed a proof of claim as the assignee of the original creditor. The Debtor then objected on the basis that the entity claiming to hold the claim was unknown to it and that the documentation attached to the claim was insufficient. In In re Tran, No. 05-82180 (Bankr. S.D. Tex. 9/6/06)(Brown, Ch.B.J.) aff’d, eCast Settlement Corporation v. Tran, No. H-06-2965 (S.D. Tex. 5/14/07)(Miller, .J.) , the Court required the assignee to meet the same burden of proof which would apply to a suit on a contract in state court and the claims were denied. In In re Joe Ray Griffin, No. 06-11130 (Bankr. W.D. Tex. 5/17/07)(Monroe, B.J.), the Court allowed the claim on a finding that the underlying claim was undisputed without requiring the assignee to establish its provenance.
Lack of Evidence Dooms Tran Creditor
The Tran opinion takes a very methodical approach to the claims objection. The Court started with the question of whether the objection raised by the Debtor fell within a ground established under §502(b). The Court found that the Debtor’s objection that it did not owe any money to eCast Settlement Corporation fell within the statutory language that the claim should be allowed unless it was enforceable under any agreement or applicable law.
The Court then sought to determine who had the burden of going forward under Fed.R.Bankr.P. 3001. Under Rule 3001(f), a properly filed proof of claim is entitled to prima facie validity. If the claim is entitled to prima facie validity, the objecting party must go forward with evidence to rebut the prima facie case, at which point the burden shifts to the creditor. On the other hand, if the claim is not properly filed, it is not entitled to prima facie validity and the creditor bears both the burden of going forward with the evidence and the burden of persuasion. The Court noted that in order to be entitled to prima facie validity, a claim based on a writing must be supported by a copy of the writing or by a statement that the writing has been lost or destroyed. Fed.R.Bankr.P. 3001(c). The Court then found that under Texas law, a claim on a credit card is treated as a claim for breach of a written contract so that a copy of the written contract was necessary to give the claim prima facie validity. Since the assignee attached only a summary of a few pertinent details relating to the contract, the Court concluded that the claim was not entitled to prima facie validity and placed the entire burden on the putative claimant. The Court rejected the argument that the creditor could substitute a summary for voluminous documents on the basis that the creditor had not shown that the underlying contract was voluminous.
In this case, allocating the burden was tantamount to determining the objection. Because the creditor had the entire burden, it had to prove the existence of a contract. The Court discussed the types of evidence which could prove the existence of a contract under Texas law.
“Under Texas law, the affidavit of a custodian of the creditor’s records, whose duties include having custody and control of records related to the debtor’s account which purports to: (1) authenticate the credit card agreement documents and monthly statements; and (2) state the account balance due and unpaid, may be sufficient to prove the formation or the terms of the agreement. (citation omitted). The elements of breach of contract may be proved by introduction of debtor’s signatory reply to the bank’s predecessor in interest’s revolving credit offer; bank’s subsequent issuance of new credit cards to debtor with proof of use; monthly statements billed to debtor and debtor’s payment including a copy of a canceled check showing a payment to the bank based upon the debtor’s unique identifying revolving credit account number; admission of the debtor in debtor’s discovery responses; and subsequent absence of payment. (citation omitted). Where one bank has purchased the revolving account from another bank, the custodian of the purchaser bank’s records is competent to testify about the predecessor bank’s records in the purchaser’s possession. (citation omitted). “
Order Regarding Objection to Claims, p. 8.
Here, the creditor did not offer any of these forms of proof. Instead, the creditor sought to have the debtor prove up certain credit card statements relating to the account. The court found these statements to be insufficient to prove the existence of a contract and also insufficient to establish the Debtor’s liability to eCast. As a result, the Court denied the claims.
The Tran case was appealed to the U.S. District Court which entered an order affirming the Bankruptcy Court on May 14, 2007. The District Court opinion brought out an additional fact not apparent from the Bankruptcy Court opinion. Apparently eCast Settlement Corporation had produced general assignments from various banks to it, which did not specifically reference the Tran account. However, these assignments were excluded from evidence as hearsay.
The District Court agreed with the Bankruptcy Court that failure to attach the writing that the claims were based upon deprived the claims of their prima facie validity. The District Court noted that eCast’s “boilerplate” statement about summarizing voluminous documents might satisfy the proof of claim form but did not satisfy Rule 3001(c). The District Court also agreed with the Bankruptcy Court that failure to establish prima facie validity under Rule 3001(f) left the entire burden on eCast.
The District Court agreed that eCast had failed to satisfy its burden of proof. The Court’s discussion is very illuminating as to what evidence would have been sufficient.
“ECast had the opportunity to introduce evidence during the evidentiary hearing held June 20, 2006 before Chief United States Bankruptcy Judge Karen Brown to support its claim beyond what was attached to its proofs of claim. As discussed above, eCast introduced evidence and examined Teresa Tran at that hearing. The court found that there were several key documents, any of which could have satisfied eCast’s burden of proof had they been entered into evidence. An affidavit from the custodian of records: (i) authenticating the credit card agreement; (ii) authenticating monthly statements; or (iii) certifying the unpaid balance and balance due could have met eCast’s burden. (citation omitted). More relevant to eCast’s situation, the court found that one who has purchased an account from a bank may rely upon the custodian of the purchaser’s records to fulfill the requirements above. (citation omitted). Rather than introduce any of the types of evidence discussed above, eCast attempted to introduce general assignment agreements from three banking institutions which were excluded on evidentiary grounds. (citation omitted). The Court notes that eCast offered no witness to establish the validity of their claim as discussed above and no affidavit to authenticate documents as discussed above. Furthermore, eCast failed to offer any evidence beyond a few monthly statements—clearly insufficient on their own—to establish the existence of a contract or the amount owed under Texas law. The court proceeded a step further showing that even if eCast had established the validity of their claim, they still failed to establish the amount of their claim pursuant to Texas law.”
Memorandum and Order, pp. 11-12. The District Court approved of the Bankruptcy Court’s reasoning in this regard and thus affirmed the decision to deny the claims.
In a curious ruling, the District Court held that eCast was not required to prove that it was the assignee of the original creditors. It stated, “It was not assigned the burden to prove it rightfully acquired the claim. There are specific elements that ECast must establish to show an enforceable contract. . . . However, eCast was not required to produce assignments or transfer documents, and doing so would not alone have established a valid and enforceable claim under Texas law.” Memorandum and Order, p. 12.
Finally, the District Court ruled that eCast should not have been allowed to amend its claims to include the required proof. The Bankruptcy Court had denied an oral motion to continue the hearing on the basis that the hearing had been long scheduled. The District Court found that undue delay was a proper ground for denying a request for leave to amend.
As a result, the District Court affirmed the Bankruptcy Court in all respects.
Statements Good Enough For Griffin Creditor
The creditor in the Griffin case was able to prevail because it managed to amend its claim to point that it reached prima facie validity. In Griffin, the creditor filed a claim in the name of “B-Real, LLC/Chase Bank, N.A.” According to the court, the original claim was “woefully deficient” in that it was supported only by a summary reflecting the closing balance, but did not even include an account number. Upon receiving an objection, the creditor amended its proof of claim to attach account statements for the debt for several months prior to bankruptcy. However, it did not include any documentation showing a transfer of the debt from Chase Bank, N.A. to B-Real, LLC.
Judge Monroe found that in order for a claim filed by the original creditor to have prima facie validity, it must include the following elements:
the name and account of the debtor or debtors;
the amount of the debt;
it must be in the form of a business record or other reliable format; and
if the claim includes charges such as interest, late fees and attorney’s fees, the summary must include a statement giving a break-down of those elements.
Judge Monroe found that the account statements attached to B-Real’s claim satisfied these elements, stating “They are sufficient for all parties to assure themselves that the claim that is being asserted in the amended claim appears valid…” As a result, Judge Monroe found that the claim was entitled to prima facie validity. However, from there, the court had to decide whether the creditor asserting the claim had to prove its ownership of the claim. The Court noted that Fed.R.Bankr.P. 3001(e)(1) required evidence of transfer of the claim only if the claim is transferred after the original creditor files a proof of claim. The Court declined to impose an additional requirement not found in the rules (i.e., that a assignee who is the first person to file a claim on the account must prove the transfer). The Debtor did not produce any evidence. As a result, the court found that the prima facie validity of the claim carried the day and denied the objection.
Reconciling the Two Cases
Although the two cases arrived at different results, they share some common reasoning:
Both cases agree that a mere summary attached in support of a proof of claim is insufficient;
Both cases appear to agree that a properly proven up account statement may be sufficient for some purposes; and
Both cases agree that an assignee is not required to prove how it acquired the claim if the original creditor has not previously filed a proof of claim.
The key distinction between the two cases appears to be that in Griffin, account statements attached to the amended proof of claim were found to be adequate to give the claim prima facie validity. In Tran, the Bankruptcy Court expressly stated that “The writing required by Rule 3001(c) which must be filed with a claim in order to entitle that claim to prima facie evidentiary effect is, under Texas law, the written contract between the parties.” Because the District Court held that eCast’s “boilerplate” was not sufficient to convey prima facie evidentiary value, it did not reach the issue of what would have been adequate. However, the District Court went on to state that a business records affidavit proving up the account statement would be sufficient to satisfy the creditor’s burden of persuasion. But did the District Court really mean this? In Tran, the Debtor admitted to owing at least one of the debts in the approximate amount claimed by the creditor. An admission from the Debtor should have had the same evidentiary value as a properly proven account statement (which the District Court suggested would have been adequate). However, the District Court did not acknowledge this evidence. Thus, while the District Court opinion in Tran seems to suggest that a properly proven account statement would be adequate to prove the debt, it is not clear that the District Court intended to depart from the Bankruptcy Court’s insistence on producing the contract. As a result, the ultimate meaning of Tran is pretty murky.
Contracts, Account Statements and Faith
One summer during college, I worked in the installment loan department of a bank. My duties included typing up promissory notes and security agreements. After a loan officer personally met with the customer to execute the documents, they would come back to the installment loan department where they were kept in a vault. Under this model of credit, the obligations of the parties were easy to determine. All someone needed to do was to go to the vault and find the promissory note (assuming that I had not misfiled it). The customer’s signature appeared on the operative documents and an actual bank officer was present at the time that it was executed.
Credit cards used to be one step removed from this paradigm. Back in the old days, a person would present their credit card, which would be imprinted onto a form and signed by the customer. The credit card slip was like a miniature promissory note. Critically, it was a document signed by the customer. The charge slip would be mailed into the credit card issuer who would enter all of the charges onto a statement and send it to the customer. When the customer received the statement, he could compare it to his copies of the charge slips and dispute any items which were not correct. However, as to any other terms, such as interest or fees, he pretty much had to trust the credit card company to accurately implement the contract. While the customer may have received a copy of the contract at some point, it is unlikely that he ever kept a copy. Thus, credit cards required a higher degree of trust than a traditional promissory note.
Credit cards have continued to evolve from hard copy miniature promissory notes to electronic impulses. Today customers may or may not sign a credit card slip. If the charge statement is signed at all, it is likely to be stored as a digital image. More likely, the credit card is swiped through an electronic reader, entered into an online form or given out over the telephone. The electronic data representing the charges is stored in a computer somewhere and converted into a statement. Customers may elect to receive their statements electronically and have their payments automatically withdrawn from their bank accounts. As a result, both paper and human involvement have been greatly reduced. Credit card issuers merge, change names or sell portfolios with great frequency so that statements are likely to appear from unfamiliar parties. As a result, the element of trust or perhaps blind faith assumes a greater and greater role. The ordinary customer must have faith that the company sending out the statement indeed owns the account, that the customer’s transactions have been accurately converted into electronic data and that the issuer has accurately applied the contract.
When accounts enter charge-off or bankruptcy status, any connection to the signed promissory note sitting in a vault at the bank is long gone. Companies purchase large portfolios of accounts with minimal documentation. Accounts may change hands multiple times as they are sold and resold for progressively less. At the end of the process, the account may be reduced to a series of numbers reflecting the account number and the amount claimed to be owed. Neither the customer nor the final creditor are likely to have a copy of the original agreement or the original statements. At this point, there is little more than faith to connect the series of numbers with an actual commercial transaction that occurred at some point in the past.
The transition from paper documents to faith-based electronic data has significant consequences for the legal system. At one end of the spectrum is the original Tran opinion, which requires the creditor to produce its contract and its statements, much like the bank which could take the note out of the vault. Under this model, the debtor can scrutinize every transaction against the contract and verify that the calculations are correct. Of course, there is really no way for the debtor to know whether the document being produced as the contract bears any semblance to the original, since the customer likely did not read or retain that document. In this instance, producing the contract is a well-meaning but largely empty gesture.
Judge Monroe’s opinion in Griffin places a higher emphasis on the role of faith. The debtor receives a statement each month. Under federal law, the debtor can dispute the charges on the statement. If the debtor does not dispute the charges, then the parties have chosen to believe that the information contained on the statement is correct. The numbers on the statement become the reality for the parties regardless of what the contract actually provided. When a debtor completes her schedules, she is likely to rely on the account statements. If there is a congruence between the debt claimed and the debt scheduled, it is reasonable for the court to assume that amount is correct. If the parties have a substantive dispute, it is more likely to involve whether a charge was incurred or even whether the debtor ever opened the account. However, the parties are unlikely to litigate about interest rates or over limit fees for the simple reason that it is not practical to do so.
Assignees and Faith
The truly curious aspect of both the Bankruptcy Court opinion in Griffin and the District Court opinion in Tran is that neither court thought that it was important for the person claiming to be the creditor to prove that they actually owned the debt. Part of the standard prove-up for a promissory note is that a creditor show that they are the owner and holder of the note. However, in both of the recent cases, this element was treated as irrelevant. Indeed, only Judge Monroe sought to justify his position.
Judge Monroe relied on the fact that Rule 3001(e) required a transferee to provide evidence of the transfer if someone else had already filed a proof of claim. He stated that “this court should not impose any additional requirement on a claim transferee that does not appear in the Rules of Bankruptcy Procedure or the statute itself.” This argument fails to recognize the difference between the two circumstances. Where one creditor has already filed a claim and a second creditor also files the same claim, there must be a procedure to choose between the two competing claimants. Rule 3001(e) serves to resolve disputes between creditors.
On the other hand, when a stranger appears claiming to own the debt, the issue is whether the putative claimant is the rightful creditor or an imposter. If the legitimate creditor fails to file a claim, this should not mean that any opportunistic party should be able to step in and file a claim for their own account. Owning the claim is the central fact of being a creditor so that this should not be too much to ask.
Judge Monroe was apparently willing to take it on faith that a person in possession of the account statements was a legitimate assignee rather than an interloper. If a person claiming to be an assignee files a claim and includes copies of the account statements, there are four likely possibilities:
(1) The person is a legitimate assignee and obtained the statements from the original creditor;
(2) The person received a legitimate assignment of the claim but then assigned it on to a third party;
(3) The person hacked into the legitimate creditor’s computer and appropriated the data; or
(4) The person obtained the statements from the debtor (either through trickery or through more low tech methods such as going through the debtor’s trash).
Of these possibilities, the first is the most likely and the others are likely to be smoked out by appearance of a competing creditor. Additionally, the criminal penalties for filing a false proof of claim combined with the probability of getting caught should deter most scam artists. On the other hand, requiring a legitimate assignee to prove its ownership of the claim may cause some proper claims to be denied due to lack of documentation. As a matter of efficiency (rather than strict legal construction), using possession of the account statements as a substitute for proof of assignment will probably lead to allowance of more legitimate claims than the alternative.
The Cases
The two cases involved a common fact pattern but different outcomes. In both cases, a debtor incurred credit card debt and then filed bankruptcy. In the bankruptcy case, a third party filed a proof of claim as the assignee of the original creditor. The Debtor then objected on the basis that the entity claiming to hold the claim was unknown to it and that the documentation attached to the claim was insufficient. In In re Tran, No. 05-82180 (Bankr. S.D. Tex. 9/6/06)(Brown, Ch.B.J.) aff’d, eCast Settlement Corporation v. Tran, No. H-06-2965 (S.D. Tex. 5/14/07)(Miller, .J.) , the Court required the assignee to meet the same burden of proof which would apply to a suit on a contract in state court and the claims were denied. In In re Joe Ray Griffin, No. 06-11130 (Bankr. W.D. Tex. 5/17/07)(Monroe, B.J.), the Court allowed the claim on a finding that the underlying claim was undisputed without requiring the assignee to establish its provenance.
Lack of Evidence Dooms Tran Creditor
The Tran opinion takes a very methodical approach to the claims objection. The Court started with the question of whether the objection raised by the Debtor fell within a ground established under §502(b). The Court found that the Debtor’s objection that it did not owe any money to eCast Settlement Corporation fell within the statutory language that the claim should be allowed unless it was enforceable under any agreement or applicable law.
The Court then sought to determine who had the burden of going forward under Fed.R.Bankr.P. 3001. Under Rule 3001(f), a properly filed proof of claim is entitled to prima facie validity. If the claim is entitled to prima facie validity, the objecting party must go forward with evidence to rebut the prima facie case, at which point the burden shifts to the creditor. On the other hand, if the claim is not properly filed, it is not entitled to prima facie validity and the creditor bears both the burden of going forward with the evidence and the burden of persuasion. The Court noted that in order to be entitled to prima facie validity, a claim based on a writing must be supported by a copy of the writing or by a statement that the writing has been lost or destroyed. Fed.R.Bankr.P. 3001(c). The Court then found that under Texas law, a claim on a credit card is treated as a claim for breach of a written contract so that a copy of the written contract was necessary to give the claim prima facie validity. Since the assignee attached only a summary of a few pertinent details relating to the contract, the Court concluded that the claim was not entitled to prima facie validity and placed the entire burden on the putative claimant. The Court rejected the argument that the creditor could substitute a summary for voluminous documents on the basis that the creditor had not shown that the underlying contract was voluminous.
In this case, allocating the burden was tantamount to determining the objection. Because the creditor had the entire burden, it had to prove the existence of a contract. The Court discussed the types of evidence which could prove the existence of a contract under Texas law.
“Under Texas law, the affidavit of a custodian of the creditor’s records, whose duties include having custody and control of records related to the debtor’s account which purports to: (1) authenticate the credit card agreement documents and monthly statements; and (2) state the account balance due and unpaid, may be sufficient to prove the formation or the terms of the agreement. (citation omitted). The elements of breach of contract may be proved by introduction of debtor’s signatory reply to the bank’s predecessor in interest’s revolving credit offer; bank’s subsequent issuance of new credit cards to debtor with proof of use; monthly statements billed to debtor and debtor’s payment including a copy of a canceled check showing a payment to the bank based upon the debtor’s unique identifying revolving credit account number; admission of the debtor in debtor’s discovery responses; and subsequent absence of payment. (citation omitted). Where one bank has purchased the revolving account from another bank, the custodian of the purchaser bank’s records is competent to testify about the predecessor bank’s records in the purchaser’s possession. (citation omitted). “
Order Regarding Objection to Claims, p. 8.
Here, the creditor did not offer any of these forms of proof. Instead, the creditor sought to have the debtor prove up certain credit card statements relating to the account. The court found these statements to be insufficient to prove the existence of a contract and also insufficient to establish the Debtor’s liability to eCast. As a result, the Court denied the claims.
The Tran case was appealed to the U.S. District Court which entered an order affirming the Bankruptcy Court on May 14, 2007. The District Court opinion brought out an additional fact not apparent from the Bankruptcy Court opinion. Apparently eCast Settlement Corporation had produced general assignments from various banks to it, which did not specifically reference the Tran account. However, these assignments were excluded from evidence as hearsay.
The District Court agreed with the Bankruptcy Court that failure to attach the writing that the claims were based upon deprived the claims of their prima facie validity. The District Court noted that eCast’s “boilerplate” statement about summarizing voluminous documents might satisfy the proof of claim form but did not satisfy Rule 3001(c). The District Court also agreed with the Bankruptcy Court that failure to establish prima facie validity under Rule 3001(f) left the entire burden on eCast.
The District Court agreed that eCast had failed to satisfy its burden of proof. The Court’s discussion is very illuminating as to what evidence would have been sufficient.
“ECast had the opportunity to introduce evidence during the evidentiary hearing held June 20, 2006 before Chief United States Bankruptcy Judge Karen Brown to support its claim beyond what was attached to its proofs of claim. As discussed above, eCast introduced evidence and examined Teresa Tran at that hearing. The court found that there were several key documents, any of which could have satisfied eCast’s burden of proof had they been entered into evidence. An affidavit from the custodian of records: (i) authenticating the credit card agreement; (ii) authenticating monthly statements; or (iii) certifying the unpaid balance and balance due could have met eCast’s burden. (citation omitted). More relevant to eCast’s situation, the court found that one who has purchased an account from a bank may rely upon the custodian of the purchaser’s records to fulfill the requirements above. (citation omitted). Rather than introduce any of the types of evidence discussed above, eCast attempted to introduce general assignment agreements from three banking institutions which were excluded on evidentiary grounds. (citation omitted). The Court notes that eCast offered no witness to establish the validity of their claim as discussed above and no affidavit to authenticate documents as discussed above. Furthermore, eCast failed to offer any evidence beyond a few monthly statements—clearly insufficient on their own—to establish the existence of a contract or the amount owed under Texas law. The court proceeded a step further showing that even if eCast had established the validity of their claim, they still failed to establish the amount of their claim pursuant to Texas law.”
Memorandum and Order, pp. 11-12. The District Court approved of the Bankruptcy Court’s reasoning in this regard and thus affirmed the decision to deny the claims.
In a curious ruling, the District Court held that eCast was not required to prove that it was the assignee of the original creditors. It stated, “It was not assigned the burden to prove it rightfully acquired the claim. There are specific elements that ECast must establish to show an enforceable contract. . . . However, eCast was not required to produce assignments or transfer documents, and doing so would not alone have established a valid and enforceable claim under Texas law.” Memorandum and Order, p. 12.
Finally, the District Court ruled that eCast should not have been allowed to amend its claims to include the required proof. The Bankruptcy Court had denied an oral motion to continue the hearing on the basis that the hearing had been long scheduled. The District Court found that undue delay was a proper ground for denying a request for leave to amend.
As a result, the District Court affirmed the Bankruptcy Court in all respects.
Statements Good Enough For Griffin Creditor
The creditor in the Griffin case was able to prevail because it managed to amend its claim to point that it reached prima facie validity. In Griffin, the creditor filed a claim in the name of “B-Real, LLC/Chase Bank, N.A.” According to the court, the original claim was “woefully deficient” in that it was supported only by a summary reflecting the closing balance, but did not even include an account number. Upon receiving an objection, the creditor amended its proof of claim to attach account statements for the debt for several months prior to bankruptcy. However, it did not include any documentation showing a transfer of the debt from Chase Bank, N.A. to B-Real, LLC.
Judge Monroe found that in order for a claim filed by the original creditor to have prima facie validity, it must include the following elements:
the name and account of the debtor or debtors;
the amount of the debt;
it must be in the form of a business record or other reliable format; and
if the claim includes charges such as interest, late fees and attorney’s fees, the summary must include a statement giving a break-down of those elements.
Judge Monroe found that the account statements attached to B-Real’s claim satisfied these elements, stating “They are sufficient for all parties to assure themselves that the claim that is being asserted in the amended claim appears valid…” As a result, Judge Monroe found that the claim was entitled to prima facie validity. However, from there, the court had to decide whether the creditor asserting the claim had to prove its ownership of the claim. The Court noted that Fed.R.Bankr.P. 3001(e)(1) required evidence of transfer of the claim only if the claim is transferred after the original creditor files a proof of claim. The Court declined to impose an additional requirement not found in the rules (i.e., that a assignee who is the first person to file a claim on the account must prove the transfer). The Debtor did not produce any evidence. As a result, the court found that the prima facie validity of the claim carried the day and denied the objection.
Reconciling the Two Cases
Although the two cases arrived at different results, they share some common reasoning:
Both cases agree that a mere summary attached in support of a proof of claim is insufficient;
Both cases appear to agree that a properly proven up account statement may be sufficient for some purposes; and
Both cases agree that an assignee is not required to prove how it acquired the claim if the original creditor has not previously filed a proof of claim.
The key distinction between the two cases appears to be that in Griffin, account statements attached to the amended proof of claim were found to be adequate to give the claim prima facie validity. In Tran, the Bankruptcy Court expressly stated that “The writing required by Rule 3001(c) which must be filed with a claim in order to entitle that claim to prima facie evidentiary effect is, under Texas law, the written contract between the parties.” Because the District Court held that eCast’s “boilerplate” was not sufficient to convey prima facie evidentiary value, it did not reach the issue of what would have been adequate. However, the District Court went on to state that a business records affidavit proving up the account statement would be sufficient to satisfy the creditor’s burden of persuasion. But did the District Court really mean this? In Tran, the Debtor admitted to owing at least one of the debts in the approximate amount claimed by the creditor. An admission from the Debtor should have had the same evidentiary value as a properly proven account statement (which the District Court suggested would have been adequate). However, the District Court did not acknowledge this evidence. Thus, while the District Court opinion in Tran seems to suggest that a properly proven account statement would be adequate to prove the debt, it is not clear that the District Court intended to depart from the Bankruptcy Court’s insistence on producing the contract. As a result, the ultimate meaning of Tran is pretty murky.
Contracts, Account Statements and Faith
One summer during college, I worked in the installment loan department of a bank. My duties included typing up promissory notes and security agreements. After a loan officer personally met with the customer to execute the documents, they would come back to the installment loan department where they were kept in a vault. Under this model of credit, the obligations of the parties were easy to determine. All someone needed to do was to go to the vault and find the promissory note (assuming that I had not misfiled it). The customer’s signature appeared on the operative documents and an actual bank officer was present at the time that it was executed.
Credit cards used to be one step removed from this paradigm. Back in the old days, a person would present their credit card, which would be imprinted onto a form and signed by the customer. The credit card slip was like a miniature promissory note. Critically, it was a document signed by the customer. The charge slip would be mailed into the credit card issuer who would enter all of the charges onto a statement and send it to the customer. When the customer received the statement, he could compare it to his copies of the charge slips and dispute any items which were not correct. However, as to any other terms, such as interest or fees, he pretty much had to trust the credit card company to accurately implement the contract. While the customer may have received a copy of the contract at some point, it is unlikely that he ever kept a copy. Thus, credit cards required a higher degree of trust than a traditional promissory note.
Credit cards have continued to evolve from hard copy miniature promissory notes to electronic impulses. Today customers may or may not sign a credit card slip. If the charge statement is signed at all, it is likely to be stored as a digital image. More likely, the credit card is swiped through an electronic reader, entered into an online form or given out over the telephone. The electronic data representing the charges is stored in a computer somewhere and converted into a statement. Customers may elect to receive their statements electronically and have their payments automatically withdrawn from their bank accounts. As a result, both paper and human involvement have been greatly reduced. Credit card issuers merge, change names or sell portfolios with great frequency so that statements are likely to appear from unfamiliar parties. As a result, the element of trust or perhaps blind faith assumes a greater and greater role. The ordinary customer must have faith that the company sending out the statement indeed owns the account, that the customer’s transactions have been accurately converted into electronic data and that the issuer has accurately applied the contract.
When accounts enter charge-off or bankruptcy status, any connection to the signed promissory note sitting in a vault at the bank is long gone. Companies purchase large portfolios of accounts with minimal documentation. Accounts may change hands multiple times as they are sold and resold for progressively less. At the end of the process, the account may be reduced to a series of numbers reflecting the account number and the amount claimed to be owed. Neither the customer nor the final creditor are likely to have a copy of the original agreement or the original statements. At this point, there is little more than faith to connect the series of numbers with an actual commercial transaction that occurred at some point in the past.
The transition from paper documents to faith-based electronic data has significant consequences for the legal system. At one end of the spectrum is the original Tran opinion, which requires the creditor to produce its contract and its statements, much like the bank which could take the note out of the vault. Under this model, the debtor can scrutinize every transaction against the contract and verify that the calculations are correct. Of course, there is really no way for the debtor to know whether the document being produced as the contract bears any semblance to the original, since the customer likely did not read or retain that document. In this instance, producing the contract is a well-meaning but largely empty gesture.
Judge Monroe’s opinion in Griffin places a higher emphasis on the role of faith. The debtor receives a statement each month. Under federal law, the debtor can dispute the charges on the statement. If the debtor does not dispute the charges, then the parties have chosen to believe that the information contained on the statement is correct. The numbers on the statement become the reality for the parties regardless of what the contract actually provided. When a debtor completes her schedules, she is likely to rely on the account statements. If there is a congruence between the debt claimed and the debt scheduled, it is reasonable for the court to assume that amount is correct. If the parties have a substantive dispute, it is more likely to involve whether a charge was incurred or even whether the debtor ever opened the account. However, the parties are unlikely to litigate about interest rates or over limit fees for the simple reason that it is not practical to do so.
Assignees and Faith
The truly curious aspect of both the Bankruptcy Court opinion in Griffin and the District Court opinion in Tran is that neither court thought that it was important for the person claiming to be the creditor to prove that they actually owned the debt. Part of the standard prove-up for a promissory note is that a creditor show that they are the owner and holder of the note. However, in both of the recent cases, this element was treated as irrelevant. Indeed, only Judge Monroe sought to justify his position.
Judge Monroe relied on the fact that Rule 3001(e) required a transferee to provide evidence of the transfer if someone else had already filed a proof of claim. He stated that “this court should not impose any additional requirement on a claim transferee that does not appear in the Rules of Bankruptcy Procedure or the statute itself.” This argument fails to recognize the difference between the two circumstances. Where one creditor has already filed a claim and a second creditor also files the same claim, there must be a procedure to choose between the two competing claimants. Rule 3001(e) serves to resolve disputes between creditors.
On the other hand, when a stranger appears claiming to own the debt, the issue is whether the putative claimant is the rightful creditor or an imposter. If the legitimate creditor fails to file a claim, this should not mean that any opportunistic party should be able to step in and file a claim for their own account. Owning the claim is the central fact of being a creditor so that this should not be too much to ask.
Judge Monroe was apparently willing to take it on faith that a person in possession of the account statements was a legitimate assignee rather than an interloper. If a person claiming to be an assignee files a claim and includes copies of the account statements, there are four likely possibilities:
(1) The person is a legitimate assignee and obtained the statements from the original creditor;
(2) The person received a legitimate assignment of the claim but then assigned it on to a third party;
(3) The person hacked into the legitimate creditor’s computer and appropriated the data; or
(4) The person obtained the statements from the debtor (either through trickery or through more low tech methods such as going through the debtor’s trash).
Of these possibilities, the first is the most likely and the others are likely to be smoked out by appearance of a competing creditor. Additionally, the criminal penalties for filing a false proof of claim combined with the probability of getting caught should deter most scam artists. On the other hand, requiring a legitimate assignee to prove its ownership of the claim may cause some proper claims to be denied due to lack of documentation. As a matter of efficiency (rather than strict legal construction), using possession of the account statements as a substitute for proof of assignment will probably lead to allowance of more legitimate claims than the alternative.
Tuesday, June 05, 2007
Bad Debtors Find Limited Homestead Protection
When Congress amended the bankruptcy laws, one of its goals was to eliminate the practice of pouring money into an exempt homestead prior to filing bankruptcy. Due to the inviolability of the homestead under Texas law, this had been a time-honored practice. One Fifth Circuit opinion referred to paying off the mortgage prior to filing bankruptcy as “legitimate pre-bankruptcy planning.” Matter of Bowyer, 932 F.2d 1100 (5th Cir. 1991). The legislative history to the Bankruptcy Code noted that, “As under current law, the debtor will be permitted to nonexempt property into exempt property prior to filing a bankruptcy petition.” H.R. Rep. No. 95-595 (1977), at 361. However, two recent opinions demonstrate just how far things have changed.
For Mr. Green, Things Are Not So Serene
In In re Henry Alan Green, 2007 Bankr. LEXIS 1296 (Bankr. W.D. Tex. 4/9/07) and In re Teresa M. Green,(Bankr. W.D. Tex. 4/9/07) (Monroe, B.J.), the prediction that involuntary bankruptcy cases would be filed to attach homestead assets came to fruition. The Greens were not the most sympathetic debtors. While being sued by a relative (who subsequently recovered a judgment for over $500,000), the Greens liquidated their California assets and bought a Texas home for $1.44 million. As noted by the Court, the amount which they sunk into their new home was over three times what it would have taken to pay the judgment creditor. They then filed for chapter 7 in January 2005. The justifiably angry aunt objected to their discharge and prevailed. Under prior law, this would have resulted in a Mexican standoff where the Greens could not discharge their debts but would remain secure that their homestead was their castle.
However, then the law changed. Under the new law, it the Debtor acquires a homestead within 1,215 days prior to filing, the amount of the exemption is limited to $125,000. See 11 U.S.C. §522(p)(1)(B) and (D). As a result, the justifiably angry aunt wanted to see the Greens in bankruptcy so that the homestead property could be liquidated.
This is where some clever strategizing came in. If a debtor has 12 or more creditors, three creditors must join in hte petition; however, for less than 12 creditors, only a single petitioning creditor is required. Taken together, Mr. and Mrs Green had over twelve creditors, so that a single petitioning creditor could not institute an involuntary petition against them jointly. The petitioning creditor initiated separate cases against each of the spouses. The Bankruptcy Court rejected the argument that both debtors were liable upon each other's debts just because they were married. Instead, the court did an analysis of each debt as to each debtors. The court concluded that Mr. Green had eleven countable creditors and that Mrs. Green had eight. As a result, a single creditor could initiate the separate involuntary petitions against each of them. This opinion, like Judge Monroe’s prior opinion in In re Sadler, No. 06-10091 (Bankr. W.D. Tex. 10/18/06), contains a good discussion of how to count creditors for purposes of an involuntary petition.
The Green opinion is devoted to counting creditors for purposes of an involuntary bankruptcy petition. However, the issue of allowing the judgment creditor to access the homestead overshadows the more mundane issues written on by the court.
Debtor Snared By Sec. 522(o)
Another feature initiated by BAPCPA was the 10-year look back period for amounts invested into a homestead with intent to hinder, delay or defraud. 11 U.S.C. §522(o). In In re (Name Withheld by Request), 366 B.R. 677 (Bankr. S.D. Tex. 5/11/07)(Bohm, B.J.), Bankruptcy Judge Jeff Bohm waded through a lot of facts to deliver a 69 page opinion finding that $50,000 invested into a homestead on the eve of bankruptcy could not be claimed as exempt, while denying various other objections to exemptions.
Prior to filing bankruptcy, the Debtor sold stock which he owned and deposited $50,000 of the proceeds to his wife’s account. His wife then used these funds as the down payment for a residence in Bastrop County in her name. The Debtor and his wife then sold their existing residence. When the Debtor filed bankruptcy, he initially did not schedule the Bastrop County property, but subsequently amended his schedules and claimed it as exempt.
The Trustee objected to the exemption. At some point, Debtor’s counsel decided that the Debtor was not cooperating with her and withdrew. The Debtor represented himself at the exemption hearing.
Judge Bohm found that there were four elements to sustain an objection to exemption under §522(o).
"(1) the debtor disposed of property within ten years preceding the bankrutpcy filing; (2) the property that the debtor disposed of was nonexempt; (3) some of the proceeds from the sale of nonexempt property were used to buy a new homestead, improve an existing homestead, or reduce the debt associated with an existing homestead, or, alternatively, to buy a new principal residence used by dependents of the debtor, improve an existing principal residence used by dependents of the debtor, or reduce the debt associated with a principal residence used by dependents of the debtor; and (4) the debtor disposed of the nonexempt property with the intent to hinder, delay or defraud a creditor."
366 B.R. at 688.
The Court did not have much difficulty with the first three elements. The Debtor sold stock which was nonexempt within the year prior to the bankruptcy. $50,000 of those proceeds could be traced into the Bastrop property. Although the Debtor himself did not reside on the Bastrop property, neither the Trustee nor any creditor had challenged the property’s status as homestead. As a result, the proceeds had been used to purchase a homestead for the debtor or alternatively for his dependents, since his two minor children were living there.
In discussing intent to hinder, delay or defraud, the Court relied on a badges of fraud analysis. The Court noted thirteen possible badges of fraud based on several cases and the Texas Uniform Fraudulent Transfer Act. The Court found that eleven of these badges of fraud were present with regard to the $50,000 transfer. While the Court engaged in an extensive discussion, the facts that the Debtor sold nonexempt property at a time that he was being threatened with suit, invested those funds in exempt property in his wife’s name, promptly filed bankruptcy and failed to accurately disclose the transactions on his schedules and statement of financial affairs should have been more than enough. Interestingly enough, in finding that the Debtor “absconded,” the Court relied on testimony from the Debtor’s former counsel about his failure to appear at the 341 meeting and her difficulties in locating and communicating with him. While this testimony may indicate a problem client, it is a little bit of a stretch to construe this as absconding.
The Court rejected the Debtor’s defense that he had effectively partitioned the funds when he deposited them in his wife’s account. The provision of the Texas Constitution allowing for a partition of martial assets has an express exception for transfers made with intent to hinder, delay or defraud creditors.
Things were not all bad for the Debtor. Judge Bohm ruled in his favor with regard to an additional payment of $11,540.99 which was paid on the Bastrop property. The Court found that $2,540.49 of these funds could be traced to the earnest money which the Debtor received for sale of his existing homestead, so that that this portion of the payment did not come from nonexempt property. As to the remaining $9,000, the Trustee was unable to show the source of the funds. The Trustee had the burden to prove that the property used was nonexempt (See Fed.R.Bankr.P. 4003). Because the Trustee could not show where the funds came from, he could not show that they came from nonexempt property. As a result, the Debtor's ability to obfuscate protected him in part.
The Court granted the Trustee an equitable lien on the Debtor’s Bastrop property in the amount of $50,000 and provided that the Trustee could enforce his lien if the Debtor did not repay the funds within 120 days.
The Court also rejected an objection to purchase of consumer goods used to furnish the new residence on the eve of bankruptcy. While §522(o) refers to “real or personal property that a debtor uses as a residence or claims as a homestead,” the reference to personal property involves the residence itself (for example, a mobile home) rather than the broader category of personal property used in connection with the residence. As a result, the Trustee’s objection failed.
As an added benefit, the Court included a section on credibility of the witnesses who testified before him. Trustee Ron Summers has now been found to be a credible witness in a written opinion. The Court also found that Debtor’s original attorney Barbara Rogers was “forthright and very knowledgeable” and “a very credible witness.” Given the encounters between Houston judges and other Houston Debtor’s attorneys in some recent cases, Ms. Rogers must be relieved to have represented a difficult client and emerged with her reputation judicially affirmed.
The Bottom Line
The box score for these cases should read Creditors 2 Homesteads 0. While Judge Monroe’s case was not about the homestead per se, the decision to allow the involuntary petitions made the loss of the homestead all but inevitable. These cases also illustrate the greater danger faced by Debtors who manipulate their homesteads on the eve of bankruptcy. In the Green case, the Debtors had already lost the discharge in their initial case. In the (Name Withheld by Request) case, there is now a judicial finding that the Debtor transferred property with intent to hinder, delay or defraud creditors during the year prior to bankruptcy. As a result, it appears probable that both debtors will lose their discharge and have the value of their homestead tapped.
The recent reform legislation enacted by Congress was named the Bankruptcy Abuse Prevention and Consumer Protection Act. While the consumer protection moniker has engendered snickers of sarcasm, Congress appears to have been successful in blocking one particular abuse of the bankruptcy process. Of course, it is yet to be known whether the net cast by the amendments to §522 will catch more innocent debtors unaware of the law's complexities than unscrupulous abusers of the system.
For Mr. Green, Things Are Not So Serene
In In re Henry Alan Green, 2007 Bankr. LEXIS 1296 (Bankr. W.D. Tex. 4/9/07) and In re Teresa M. Green,(Bankr. W.D. Tex. 4/9/07) (Monroe, B.J.), the prediction that involuntary bankruptcy cases would be filed to attach homestead assets came to fruition. The Greens were not the most sympathetic debtors. While being sued by a relative (who subsequently recovered a judgment for over $500,000), the Greens liquidated their California assets and bought a Texas home for $1.44 million. As noted by the Court, the amount which they sunk into their new home was over three times what it would have taken to pay the judgment creditor. They then filed for chapter 7 in January 2005. The justifiably angry aunt objected to their discharge and prevailed. Under prior law, this would have resulted in a Mexican standoff where the Greens could not discharge their debts but would remain secure that their homestead was their castle.
However, then the law changed. Under the new law, it the Debtor acquires a homestead within 1,215 days prior to filing, the amount of the exemption is limited to $125,000. See 11 U.S.C. §522(p)(1)(B) and (D). As a result, the justifiably angry aunt wanted to see the Greens in bankruptcy so that the homestead property could be liquidated.
This is where some clever strategizing came in. If a debtor has 12 or more creditors, three creditors must join in hte petition; however, for less than 12 creditors, only a single petitioning creditor is required. Taken together, Mr. and Mrs Green had over twelve creditors, so that a single petitioning creditor could not institute an involuntary petition against them jointly. The petitioning creditor initiated separate cases against each of the spouses. The Bankruptcy Court rejected the argument that both debtors were liable upon each other's debts just because they were married. Instead, the court did an analysis of each debt as to each debtors. The court concluded that Mr. Green had eleven countable creditors and that Mrs. Green had eight. As a result, a single creditor could initiate the separate involuntary petitions against each of them. This opinion, like Judge Monroe’s prior opinion in In re Sadler, No. 06-10091 (Bankr. W.D. Tex. 10/18/06), contains a good discussion of how to count creditors for purposes of an involuntary petition.
The Green opinion is devoted to counting creditors for purposes of an involuntary bankruptcy petition. However, the issue of allowing the judgment creditor to access the homestead overshadows the more mundane issues written on by the court.
Debtor Snared By Sec. 522(o)
Another feature initiated by BAPCPA was the 10-year look back period for amounts invested into a homestead with intent to hinder, delay or defraud. 11 U.S.C. §522(o). In In re (Name Withheld by Request), 366 B.R. 677 (Bankr. S.D. Tex. 5/11/07)(Bohm, B.J.), Bankruptcy Judge Jeff Bohm waded through a lot of facts to deliver a 69 page opinion finding that $50,000 invested into a homestead on the eve of bankruptcy could not be claimed as exempt, while denying various other objections to exemptions.
Prior to filing bankruptcy, the Debtor sold stock which he owned and deposited $50,000 of the proceeds to his wife’s account. His wife then used these funds as the down payment for a residence in Bastrop County in her name. The Debtor and his wife then sold their existing residence. When the Debtor filed bankruptcy, he initially did not schedule the Bastrop County property, but subsequently amended his schedules and claimed it as exempt.
The Trustee objected to the exemption. At some point, Debtor’s counsel decided that the Debtor was not cooperating with her and withdrew. The Debtor represented himself at the exemption hearing.
Judge Bohm found that there were four elements to sustain an objection to exemption under §522(o).
"(1) the debtor disposed of property within ten years preceding the bankrutpcy filing; (2) the property that the debtor disposed of was nonexempt; (3) some of the proceeds from the sale of nonexempt property were used to buy a new homestead, improve an existing homestead, or reduce the debt associated with an existing homestead, or, alternatively, to buy a new principal residence used by dependents of the debtor, improve an existing principal residence used by dependents of the debtor, or reduce the debt associated with a principal residence used by dependents of the debtor; and (4) the debtor disposed of the nonexempt property with the intent to hinder, delay or defraud a creditor."
366 B.R. at 688.
The Court did not have much difficulty with the first three elements. The Debtor sold stock which was nonexempt within the year prior to the bankruptcy. $50,000 of those proceeds could be traced into the Bastrop property. Although the Debtor himself did not reside on the Bastrop property, neither the Trustee nor any creditor had challenged the property’s status as homestead. As a result, the proceeds had been used to purchase a homestead for the debtor or alternatively for his dependents, since his two minor children were living there.
In discussing intent to hinder, delay or defraud, the Court relied on a badges of fraud analysis. The Court noted thirteen possible badges of fraud based on several cases and the Texas Uniform Fraudulent Transfer Act. The Court found that eleven of these badges of fraud were present with regard to the $50,000 transfer. While the Court engaged in an extensive discussion, the facts that the Debtor sold nonexempt property at a time that he was being threatened with suit, invested those funds in exempt property in his wife’s name, promptly filed bankruptcy and failed to accurately disclose the transactions on his schedules and statement of financial affairs should have been more than enough. Interestingly enough, in finding that the Debtor “absconded,” the Court relied on testimony from the Debtor’s former counsel about his failure to appear at the 341 meeting and her difficulties in locating and communicating with him. While this testimony may indicate a problem client, it is a little bit of a stretch to construe this as absconding.
The Court rejected the Debtor’s defense that he had effectively partitioned the funds when he deposited them in his wife’s account. The provision of the Texas Constitution allowing for a partition of martial assets has an express exception for transfers made with intent to hinder, delay or defraud creditors.
Things were not all bad for the Debtor. Judge Bohm ruled in his favor with regard to an additional payment of $11,540.99 which was paid on the Bastrop property. The Court found that $2,540.49 of these funds could be traced to the earnest money which the Debtor received for sale of his existing homestead, so that that this portion of the payment did not come from nonexempt property. As to the remaining $9,000, the Trustee was unable to show the source of the funds. The Trustee had the burden to prove that the property used was nonexempt (See Fed.R.Bankr.P. 4003). Because the Trustee could not show where the funds came from, he could not show that they came from nonexempt property. As a result, the Debtor's ability to obfuscate protected him in part.
The Court granted the Trustee an equitable lien on the Debtor’s Bastrop property in the amount of $50,000 and provided that the Trustee could enforce his lien if the Debtor did not repay the funds within 120 days.
The Court also rejected an objection to purchase of consumer goods used to furnish the new residence on the eve of bankruptcy. While §522(o) refers to “real or personal property that a debtor uses as a residence or claims as a homestead,” the reference to personal property involves the residence itself (for example, a mobile home) rather than the broader category of personal property used in connection with the residence. As a result, the Trustee’s objection failed.
As an added benefit, the Court included a section on credibility of the witnesses who testified before him. Trustee Ron Summers has now been found to be a credible witness in a written opinion. The Court also found that Debtor’s original attorney Barbara Rogers was “forthright and very knowledgeable” and “a very credible witness.” Given the encounters between Houston judges and other Houston Debtor’s attorneys in some recent cases, Ms. Rogers must be relieved to have represented a difficult client and emerged with her reputation judicially affirmed.
The Bottom Line
The box score for these cases should read Creditors 2 Homesteads 0. While Judge Monroe’s case was not about the homestead per se, the decision to allow the involuntary petitions made the loss of the homestead all but inevitable. These cases also illustrate the greater danger faced by Debtors who manipulate their homesteads on the eve of bankruptcy. In the Green case, the Debtors had already lost the discharge in their initial case. In the (Name Withheld by Request) case, there is now a judicial finding that the Debtor transferred property with intent to hinder, delay or defraud creditors during the year prior to bankruptcy. As a result, it appears probable that both debtors will lose their discharge and have the value of their homestead tapped.
The recent reform legislation enacted by Congress was named the Bankruptcy Abuse Prevention and Consumer Protection Act. While the consumer protection moniker has engendered snickers of sarcasm, Congress appears to have been successful in blocking one particular abuse of the bankruptcy process. Of course, it is yet to be known whether the net cast by the amendments to §522 will catch more innocent debtors unaware of the law's complexities than unscrupulous abusers of the system.
Friday, May 11, 2007
Texas State Court Strikes Down Ch. 11 Litigation Trust Agreement As Void Against Public Policy
A Texas Court of Appeals has ruled that a litigation trust created under a chapter 11 plan of reorganization was void as against public policy as a “Mary Carter Agreement.” Turoff v. McCaslin, 2007 Tex. App. LEXIS 2343 (Tex. App.—Waco, 3/21/07). As a result, the court sustained a take-nothing summary judgment rendered against the plan trustee and in favor of the corporate officers and directors (D & O Defendants) and the corporate auditor who had been sued.
The Litigation Trust Agreement
ProMedCo Management Company (PMC) and its affiliates filed bankruptcy in 2000 amidst allegations that they had operated as a Ponzi scheme. On April 30, 2002, the Bankruptcy Court confirmed a plan of reorganization which provided for a Litigation Trust Agreement . The Litigation Trust Agreement was intended to provide a vehicle for pursuing claims against the D & O Defendants and the corporate auditor Arthur Andersen, as well as to allocate any proceeds recovered between the beneficiaries of the trust.
The beneficiaries of the trust were the Bank Group, the Preferred Shareholders and the unsecured creditors. The Bank Group agreed to advance $400,000 to fund the trust and would receive the first $800,000 in proceeds. The Bank Group and the Preferred Shareholders were to divide 95% of any proceeds over $800,000, while the unsecured creditors would receive 5%. Each of the parties which contributed claims to the trust released each of the other parties contributing claims.
Thus, the essence of the trust was an agreement by the Debtors, the Bank Group and the Preferred Shareholders to pool their claims for the benefit of the Bank Group and Preferred Shareholders (and to a de minimus extent the unsecured creditors) and not to sue each other. The covenant not to sue apparently protected the Bank Group from being sued by the Preferred Shareholders based on allegations that it had withheld critical information from the Preferred Shareholders at the time of their investment. Thus, rather than suing each other, the Bank Group and Preferred Shareholders agreed to combine forces and jointly pursue the D & O Defendants and Arthur Anderson under the framework of the Litigation Trust Agreement.
The D & O Defendants cried foul and filed a Motion for Summary Judgment seeking to characterize the Litigation Trust Agreement as a “Mary Carter Agreement.” Because a Mary Carter Agreement is void under Texas law, invalidating the trust would deprive the trustee of standing to pursue the claims.
Who Was Mary Carter Anyway?
The seminal Texas case on Mary Carter Agreements is Elbaor v. Smith, 845 S.W.2d 240 (Tex. 1992). In that case, the plaintiff sued three doctors and a hospital. The plaintiff then settled with two of the doctors and the hospital. Instead of dismissing out the settling defendants, these parties continued to participate in the trial where they could point the blame at the non-settling defendant. In return for this collaboration, they could be reimbursed for the amount of their settlement out of amounts recovered from the non-settling defendant. Needless to say, this was a problem, because the jury was given the impression that the case involved one plaintiff against four defendants, when in fact the real alignment was that one plaintiff and three defendants were all out to get the remaining defendant.
The Court of Appeals explained the problem with Mary Carter Agreements as follows:
“The classic Mary Carter Agreement exists when the settling defendant retains a financial stake in the plaintiff’s recovery and remains a party at the trial of the case. (citation omitted). It presents to the jury a sham of adversity between the plaintiff and a settling defendant, while these parties are actually allied for the purpose of securing a substantial judgment for the plaintiff and, in some cases, exoneration for the settling defendant. (citation omitted). These types of agreement tend to promote litigation rather than settle it and distort the trial against the nonsettling defendants. (citation omitted). And Texas does not favor settlement arrangements that tend to skew the trial process, mislead the jury, promote unethical collusion among nominal adversaries, and create the likelihood that a less culpable defendant will be hit with the full judgment. (citation omitted).”
Slip Op. at p. 4.
The Litigation Trustee pointed out that the Litigation Trust Agreement did not meet the literal definition of a Mary Carter Agreement. Critically, there was not a settling defendant who concealed the fact of settlement in return for a share of the proceeds. Instead, the potential adversaries settled out their claims well before any litigation was ever brought so that there were no sham defendants in the suit.
The Court of Appeals did not allow such a literal reading of the Texas case law to restrict it. It stated:
“(T)he law on Mary Carter Agreements in Texas has evolved to include agreements that violate the principles laid out in Elbaor even if the precise structure of the agreement does not fit the precise pattern of an agreement previously determined to be in violation of public policy. (citation omitted). A strict application of Elbaor is not necessary to find a Mary Carter Agreement.”
Id.
The Court of Appeals found that the Litigation Trust Agreement was a Mary Carter Agreement based upon the following factors:
1. The beneficiaries in the trust had a financial interest in the outcome of the litigation;
2. The beneficiaries were required to cooperate and assist with the suit;
3. The beneficiaries mutually released each other as well as four individuals employed by Goldman Sachs (one of the preferred shareholders);
4. The beneficiaries “skewed” the trial process by settling their claims between themselves and contributing their other claims to the trust; and
5. It appeared likely that less culpable defendants would be hit with the full judgment.
Thus, it seems that the Court of Appeals was offended by the fact that the Litigation Trust Agreement was essentially a joint venture between the Bank Group and the Preferred Shareholders to settle the claims between them and present a united front against the other potential defendants.
Bankruptcy Order Not So Supreme
The Court of Appeals also rejected an argument that the Supremacy Clause precluded the court from invalidating the Litigation Trust Agreement. The Court of Appeals was careful to note that the Litigation Trustee had not argued for the application of collateral estoppel or res judicata so that the court did not consider these doctrines.
The Court of Appeals stated that there were three types of pre-emption arguments: (1) where Congress has expressly pre-empted all state laws in a field; (2) where Congress has inferentially pre-empted all state laws in a field; and (3) where state law actually conflicts with federal law. The Court of Appeals analyzed the Supremacy Clause argument under the third type of pre-emption and found that it did not. According to the Court of Appeals, the issue as framed by the Litigation Trustee was whether the trial court’s summary judgment order stood as an obstacle to the execution of the Confirmation Order.
The Court of Appeals noted that the Litigation Trustee “provides no case law to support the concept that a Confirmation Order, itself, preempts a state trial court’s decision in litigation that does not relate to the bankruptcy proceeding.” The Court rejected an argument that the Bankruptcy Court’s finding that the plan was proposed in good faith and not by any means forbidden by law would prevent another court from determining that implementation of the Litigation Trust Agreement was forbidden by state law. Finally, the court noted that the purpose of the Litigation Trust Agreement, as stated in the Confirmation Order, was to “liquidate the Contributed Causes of Action.” The Court noted that one definition of “liquidate” was to determine the amount of a claim or damages. Because the Confirmation Order could not guaranty the success of the claims in state court, the state court’s order granting summary judgment liquidated the claims within the meaning of the Confirmation Order and thus implemented rather than conflicted with the Confirmation Order.
What Does It All Mean?
From the perspective of the Litigation Trust, this decision was a disaster. A structure commonly used in chapter 11 plans and specifically approved by order of the Bankruptcy Court was struck down as invalid by a state court with the result that parties who had allegedly contributed to the downfall of the debtors were able to escape liability. The result is particularly galling because the Court of Appeals really had to reach to apply the Mary Carter doctrine. Unlike a “traditional” Mary Carter Agreement, there was no sham defendant participating in the litigation and the terms of the agreement were disclosed to the world before the litigation was ever filed.
However, it may be that the problem lay with this particular litigation trust agreement and not with litigation trusts in general. Specifically, the Court of Appeals may have done rough justice by stretching state law (and this ruling does appear to be a stretch) to strike down an agreement that served only a dubious bankruptcy policy. The Litigation Trust Agreement served three constituencies:
(a) the Bank Group;
(b) the Preferred Shareholders; and
(c) the Unsecured Creditors.
Taking these in reverse order, the unsecured creditors had very little interest in the litigation. They would receive 5% of proceeds in excess of $800,000. It appears likely that the unsecured creditors were thrown into the trust as window dressing to make it appear that the trust served a valid bankruptcy purpose.
On the other hand, the Preferred Shareholders received a significant share of the trust despite the fact that they likely did not have a cognizable bankruptcy interest. Under the absolute priority rule, the interest of the preferred shareholders should have been canceled out unless the unsecured creditors received payment in full. Thus, their participation in the Litigation Trust Agreement was clearly based on their contribution of causes of action to the trust and their release of claims against the Bank Group. It can be argued that this was “new value” which would allow them to participate under the plan. However, the fact remains that they were using the bankruptcy case as a vehicle to make a deal with the Bank Group which could have been done outside of bankruptcy.
The Bank Group has the strongest claim to a share of the pie. As secured creditors of the debtors, they had the right to be paid out of causes of action asserted by the estate. However, they also had an independent interest in not getting sued. The Litigation Trust Agreement can be viewed as an agreement by the Bank Group to pay $400,000 to settle claims which could have been asserted by the Preferred Shareholders. Rather than having the money go directly to the Preferred Shareholders, the parties agreed that the money would be used to fund a joint venture between them. The complicating factor here is that it is impossible to unscramble whether the Bank Group received more value from being able to recover a share of the proceeds from the estate’s causes of action (a proper bankruptcy interest) or from not being sued by the Preferred Shareholders (a private interest). No doubt, it was the mixed nature of these interests which made the Litigation Trust Agreement appear to be beneficial, since it resolved both interests in one package.
In a perverse way, it can be argued that no substantial bankruptcy purpose was maligned by the Court’s ruling. The Bank Group paid $400,000 and received a release of claims. While they did not receive anything more, this was a risk that they took. The Preferred Shareholders were entitled to nothing under the absolute priority rule and that is exactly what they received. The unsecured creditors stood to gain very little, so that they lost very little as well.
Having said all this, it is still a bit unseemly that the D & O Defendants apparently sat back and did not challenge the plan in bankruptcy court and then attacked the validity of the structure created by the plan in state court. It could be that they didn’t know enough to raise the objection at the time or it could be that they waited to press the argument in a local state court which would be less receptive to the subtleties of federal bankruptcy law.
It is also confusing why the Litigation Trustee relied upon the Supremacy Clause, which is basically a pre-emption doctrine, when there were other arguments which could have been made. Section 1141(a) provides that the plan is binding upon the debtor, creditors, equity security holders, persons acquiring property from the debtor and persons issuing securities under the plan. It seems highly likely that the D & O defendants were either creditors or equity security holders. The Court of Appeals does not mention this section at all. As a result, it is unclear whether it glossed over the issue to get to the result it wanted or whether this argument was not made. It is also perplexing why the Litigation Trustee did not argue that the Confirmation Order had res judicata or collateral estoppel effect upon the D & O Defendants or why judicial estoppel was not urged.
Regardless of what could have or should have been argued or how the Court of Appeals should have applied the law, this case should be required reading for chapter 11 lawyers drafting litigation trust agreements in the future.
The Litigation Trust Agreement
ProMedCo Management Company (PMC) and its affiliates filed bankruptcy in 2000 amidst allegations that they had operated as a Ponzi scheme. On April 30, 2002, the Bankruptcy Court confirmed a plan of reorganization which provided for a Litigation Trust Agreement . The Litigation Trust Agreement was intended to provide a vehicle for pursuing claims against the D & O Defendants and the corporate auditor Arthur Andersen, as well as to allocate any proceeds recovered between the beneficiaries of the trust.
The beneficiaries of the trust were the Bank Group, the Preferred Shareholders and the unsecured creditors. The Bank Group agreed to advance $400,000 to fund the trust and would receive the first $800,000 in proceeds. The Bank Group and the Preferred Shareholders were to divide 95% of any proceeds over $800,000, while the unsecured creditors would receive 5%. Each of the parties which contributed claims to the trust released each of the other parties contributing claims.
Thus, the essence of the trust was an agreement by the Debtors, the Bank Group and the Preferred Shareholders to pool their claims for the benefit of the Bank Group and Preferred Shareholders (and to a de minimus extent the unsecured creditors) and not to sue each other. The covenant not to sue apparently protected the Bank Group from being sued by the Preferred Shareholders based on allegations that it had withheld critical information from the Preferred Shareholders at the time of their investment. Thus, rather than suing each other, the Bank Group and Preferred Shareholders agreed to combine forces and jointly pursue the D & O Defendants and Arthur Anderson under the framework of the Litigation Trust Agreement.
The D & O Defendants cried foul and filed a Motion for Summary Judgment seeking to characterize the Litigation Trust Agreement as a “Mary Carter Agreement.” Because a Mary Carter Agreement is void under Texas law, invalidating the trust would deprive the trustee of standing to pursue the claims.
Who Was Mary Carter Anyway?
The seminal Texas case on Mary Carter Agreements is Elbaor v. Smith, 845 S.W.2d 240 (Tex. 1992). In that case, the plaintiff sued three doctors and a hospital. The plaintiff then settled with two of the doctors and the hospital. Instead of dismissing out the settling defendants, these parties continued to participate in the trial where they could point the blame at the non-settling defendant. In return for this collaboration, they could be reimbursed for the amount of their settlement out of amounts recovered from the non-settling defendant. Needless to say, this was a problem, because the jury was given the impression that the case involved one plaintiff against four defendants, when in fact the real alignment was that one plaintiff and three defendants were all out to get the remaining defendant.
The Court of Appeals explained the problem with Mary Carter Agreements as follows:
“The classic Mary Carter Agreement exists when the settling defendant retains a financial stake in the plaintiff’s recovery and remains a party at the trial of the case. (citation omitted). It presents to the jury a sham of adversity between the plaintiff and a settling defendant, while these parties are actually allied for the purpose of securing a substantial judgment for the plaintiff and, in some cases, exoneration for the settling defendant. (citation omitted). These types of agreement tend to promote litigation rather than settle it and distort the trial against the nonsettling defendants. (citation omitted). And Texas does not favor settlement arrangements that tend to skew the trial process, mislead the jury, promote unethical collusion among nominal adversaries, and create the likelihood that a less culpable defendant will be hit with the full judgment. (citation omitted).”
Slip Op. at p. 4.
The Litigation Trustee pointed out that the Litigation Trust Agreement did not meet the literal definition of a Mary Carter Agreement. Critically, there was not a settling defendant who concealed the fact of settlement in return for a share of the proceeds. Instead, the potential adversaries settled out their claims well before any litigation was ever brought so that there were no sham defendants in the suit.
The Court of Appeals did not allow such a literal reading of the Texas case law to restrict it. It stated:
“(T)he law on Mary Carter Agreements in Texas has evolved to include agreements that violate the principles laid out in Elbaor even if the precise structure of the agreement does not fit the precise pattern of an agreement previously determined to be in violation of public policy. (citation omitted). A strict application of Elbaor is not necessary to find a Mary Carter Agreement.”
Id.
The Court of Appeals found that the Litigation Trust Agreement was a Mary Carter Agreement based upon the following factors:
1. The beneficiaries in the trust had a financial interest in the outcome of the litigation;
2. The beneficiaries were required to cooperate and assist with the suit;
3. The beneficiaries mutually released each other as well as four individuals employed by Goldman Sachs (one of the preferred shareholders);
4. The beneficiaries “skewed” the trial process by settling their claims between themselves and contributing their other claims to the trust; and
5. It appeared likely that less culpable defendants would be hit with the full judgment.
Thus, it seems that the Court of Appeals was offended by the fact that the Litigation Trust Agreement was essentially a joint venture between the Bank Group and the Preferred Shareholders to settle the claims between them and present a united front against the other potential defendants.
Bankruptcy Order Not So Supreme
The Court of Appeals also rejected an argument that the Supremacy Clause precluded the court from invalidating the Litigation Trust Agreement. The Court of Appeals was careful to note that the Litigation Trustee had not argued for the application of collateral estoppel or res judicata so that the court did not consider these doctrines.
The Court of Appeals stated that there were three types of pre-emption arguments: (1) where Congress has expressly pre-empted all state laws in a field; (2) where Congress has inferentially pre-empted all state laws in a field; and (3) where state law actually conflicts with federal law. The Court of Appeals analyzed the Supremacy Clause argument under the third type of pre-emption and found that it did not. According to the Court of Appeals, the issue as framed by the Litigation Trustee was whether the trial court’s summary judgment order stood as an obstacle to the execution of the Confirmation Order.
The Court of Appeals noted that the Litigation Trustee “provides no case law to support the concept that a Confirmation Order, itself, preempts a state trial court’s decision in litigation that does not relate to the bankruptcy proceeding.” The Court rejected an argument that the Bankruptcy Court’s finding that the plan was proposed in good faith and not by any means forbidden by law would prevent another court from determining that implementation of the Litigation Trust Agreement was forbidden by state law. Finally, the court noted that the purpose of the Litigation Trust Agreement, as stated in the Confirmation Order, was to “liquidate the Contributed Causes of Action.” The Court noted that one definition of “liquidate” was to determine the amount of a claim or damages. Because the Confirmation Order could not guaranty the success of the claims in state court, the state court’s order granting summary judgment liquidated the claims within the meaning of the Confirmation Order and thus implemented rather than conflicted with the Confirmation Order.
What Does It All Mean?
From the perspective of the Litigation Trust, this decision was a disaster. A structure commonly used in chapter 11 plans and specifically approved by order of the Bankruptcy Court was struck down as invalid by a state court with the result that parties who had allegedly contributed to the downfall of the debtors were able to escape liability. The result is particularly galling because the Court of Appeals really had to reach to apply the Mary Carter doctrine. Unlike a “traditional” Mary Carter Agreement, there was no sham defendant participating in the litigation and the terms of the agreement were disclosed to the world before the litigation was ever filed.
However, it may be that the problem lay with this particular litigation trust agreement and not with litigation trusts in general. Specifically, the Court of Appeals may have done rough justice by stretching state law (and this ruling does appear to be a stretch) to strike down an agreement that served only a dubious bankruptcy policy. The Litigation Trust Agreement served three constituencies:
(a) the Bank Group;
(b) the Preferred Shareholders; and
(c) the Unsecured Creditors.
Taking these in reverse order, the unsecured creditors had very little interest in the litigation. They would receive 5% of proceeds in excess of $800,000. It appears likely that the unsecured creditors were thrown into the trust as window dressing to make it appear that the trust served a valid bankruptcy purpose.
On the other hand, the Preferred Shareholders received a significant share of the trust despite the fact that they likely did not have a cognizable bankruptcy interest. Under the absolute priority rule, the interest of the preferred shareholders should have been canceled out unless the unsecured creditors received payment in full. Thus, their participation in the Litigation Trust Agreement was clearly based on their contribution of causes of action to the trust and their release of claims against the Bank Group. It can be argued that this was “new value” which would allow them to participate under the plan. However, the fact remains that they were using the bankruptcy case as a vehicle to make a deal with the Bank Group which could have been done outside of bankruptcy.
The Bank Group has the strongest claim to a share of the pie. As secured creditors of the debtors, they had the right to be paid out of causes of action asserted by the estate. However, they also had an independent interest in not getting sued. The Litigation Trust Agreement can be viewed as an agreement by the Bank Group to pay $400,000 to settle claims which could have been asserted by the Preferred Shareholders. Rather than having the money go directly to the Preferred Shareholders, the parties agreed that the money would be used to fund a joint venture between them. The complicating factor here is that it is impossible to unscramble whether the Bank Group received more value from being able to recover a share of the proceeds from the estate’s causes of action (a proper bankruptcy interest) or from not being sued by the Preferred Shareholders (a private interest). No doubt, it was the mixed nature of these interests which made the Litigation Trust Agreement appear to be beneficial, since it resolved both interests in one package.
In a perverse way, it can be argued that no substantial bankruptcy purpose was maligned by the Court’s ruling. The Bank Group paid $400,000 and received a release of claims. While they did not receive anything more, this was a risk that they took. The Preferred Shareholders were entitled to nothing under the absolute priority rule and that is exactly what they received. The unsecured creditors stood to gain very little, so that they lost very little as well.
Having said all this, it is still a bit unseemly that the D & O Defendants apparently sat back and did not challenge the plan in bankruptcy court and then attacked the validity of the structure created by the plan in state court. It could be that they didn’t know enough to raise the objection at the time or it could be that they waited to press the argument in a local state court which would be less receptive to the subtleties of federal bankruptcy law.
It is also confusing why the Litigation Trustee relied upon the Supremacy Clause, which is basically a pre-emption doctrine, when there were other arguments which could have been made. Section 1141(a) provides that the plan is binding upon the debtor, creditors, equity security holders, persons acquiring property from the debtor and persons issuing securities under the plan. It seems highly likely that the D & O defendants were either creditors or equity security holders. The Court of Appeals does not mention this section at all. As a result, it is unclear whether it glossed over the issue to get to the result it wanted or whether this argument was not made. It is also perplexing why the Litigation Trustee did not argue that the Confirmation Order had res judicata or collateral estoppel effect upon the D & O Defendants or why judicial estoppel was not urged.
Regardless of what could have or should have been argued or how the Court of Appeals should have applied the law, this case should be required reading for chapter 11 lawyers drafting litigation trust agreements in the future.
Tuesday, May 08, 2007
BAPCPA Allows Bad Faith Debtor To Escape Trustee Based on Failure To Make Necessary Filings
In a recent case described as “the poster child for a bad faith debtor,” the debtor was allowed to escape bankruptcy over the objection of his chapter 7 trustee because he failed to file meaningful schedules within 45 days from the petition date. In re Walter Lee Hall, Jr., No. 06-11248 (Bankr. W.D. Tex. 4/23/07). This result, according to the court, was mandated by BAPCPA.
The pro se Debtor filed his first case on May 17, 2006. He filed schedules and a statement of financial affairs, but omitted schedules E, F and G and the Form B22C Means test. However, his major offense was failure to provide his tax returns to the chapter 13 trustee. As a result, the Court concluded that the chapter 13 case had been automatically dismissed on the 46th day after the petition date based on 11 U.S.C. §521(i)(1).
The Debtor then filed a second chapter 13 case on August 15, 2006. He filed schedules which substantially consisted of the notations “TAB” and “To Be Amended.” The Debtor’s chapter 13 plan was similarly deficient. After a hearing, the Court declined to continue the stay in the second case. Among other things, the Court found that the Debtor was pursuing Chapter 13 for the purpose of frustrating his secured creditors without any legitimate hope to reorganize. While the Chapter 13 Trustee’s motion to dismiss was pending, the Debtor converted his case to Chapter 7. This time, he filed a Schedule B which listed two automobiles, but no other personal property. The 341 meeting was never completed due to the fact that the Debtor either failed to appear or invoked his 5th Amendment privilege against self-incrimination. In the course of other hearings, it became apparent that the Debtor had transferred three parcels of real property to a corporate entity he controlled.
The Court entered a Show Cause Order as to why the case should not be dismissed. The United States Trustee and the Chapter 7 Trustee appeared and requested that the case be retained, while the Debtor failed to appear. The Debtor then filed a motion requesting that the Court determine that his case had been automatically dismissed for failure to comply with the provisions of §521(a). The Debtor filed a Notice of Withdrawal of Document with respect to this motion on the day of the hearing.
At this point, the court was faced with a dilemma. There were assets which could be liquidated to pay creditors and no party was requesting dismissal of the case. However, the Court found that under Section 521(i)(1), “the case shall be automatically dismissed on the 45th day after the filing of the petition” if the Debtor fails to file the information required by Section 521(a). Under Section 521(i)(2), the court is required to enter an order reflecting that the case had been dismissed on request by a party in interest. Following the unambiguous statutory language, the court found that the Debtor was a party in interest and that the Court was required to dismiss the case based upon the Debtor’s failure to file the required documents even though the Debtor was no longer requesting dismissal. Thus, the Debtor, by the simple expedient of not meeting his obligations under Title 11, was able to receive an automatic dismissal of his case. To temper the result, the Court ordered that the case be dismissed with prejudice to refile for a period of two years. Thus, the Court would be protected from seeing this Debtor again for a period of two years. However, the Chapter 7 Trustee who was prepared to pursue the Debtor’s non-exempt and fraudulently transferred assets was left empty-handed.
This case stands in marked contrast to In re Cochener, 2007 Bankr. LEXIS 460 (Bankr. S.D. Tex. 2007)(discussed on this blog on 5/7/07). In that case, a Debtor who sought to evade her obligations under Title 11 was not allowed to dismiss her case and, in the end, both debtor and counsel were sanctioned for their efforts to evade the Chapter 7 trustee. In a perverse display of irony, the Court in that case cited it as an example of abuse justifying the enactment of BAPCPA. However, in the Hall case decided under BAPCPA, the Debtor was allowed a free pass out of bankruptcy court due to his own derelictions, while the diligent Chapter 7 Trustee received nothing. It is truly bizarre that BAPCPA allows the fortunate but dishonest debtor to escape from bankruptcy based on his own failings, when prior law would have brought him to account. Whether it was intentional or not, Congress has not done any favors for Chapter 7 Trustees.
The pro se Debtor filed his first case on May 17, 2006. He filed schedules and a statement of financial affairs, but omitted schedules E, F and G and the Form B22C Means test. However, his major offense was failure to provide his tax returns to the chapter 13 trustee. As a result, the Court concluded that the chapter 13 case had been automatically dismissed on the 46th day after the petition date based on 11 U.S.C. §521(i)(1).
The Debtor then filed a second chapter 13 case on August 15, 2006. He filed schedules which substantially consisted of the notations “TAB” and “To Be Amended.” The Debtor’s chapter 13 plan was similarly deficient. After a hearing, the Court declined to continue the stay in the second case. Among other things, the Court found that the Debtor was pursuing Chapter 13 for the purpose of frustrating his secured creditors without any legitimate hope to reorganize. While the Chapter 13 Trustee’s motion to dismiss was pending, the Debtor converted his case to Chapter 7. This time, he filed a Schedule B which listed two automobiles, but no other personal property. The 341 meeting was never completed due to the fact that the Debtor either failed to appear or invoked his 5th Amendment privilege against self-incrimination. In the course of other hearings, it became apparent that the Debtor had transferred three parcels of real property to a corporate entity he controlled.
The Court entered a Show Cause Order as to why the case should not be dismissed. The United States Trustee and the Chapter 7 Trustee appeared and requested that the case be retained, while the Debtor failed to appear. The Debtor then filed a motion requesting that the Court determine that his case had been automatically dismissed for failure to comply with the provisions of §521(a). The Debtor filed a Notice of Withdrawal of Document with respect to this motion on the day of the hearing.
At this point, the court was faced with a dilemma. There were assets which could be liquidated to pay creditors and no party was requesting dismissal of the case. However, the Court found that under Section 521(i)(1), “the case shall be automatically dismissed on the 45th day after the filing of the petition” if the Debtor fails to file the information required by Section 521(a). Under Section 521(i)(2), the court is required to enter an order reflecting that the case had been dismissed on request by a party in interest. Following the unambiguous statutory language, the court found that the Debtor was a party in interest and that the Court was required to dismiss the case based upon the Debtor’s failure to file the required documents even though the Debtor was no longer requesting dismissal. Thus, the Debtor, by the simple expedient of not meeting his obligations under Title 11, was able to receive an automatic dismissal of his case. To temper the result, the Court ordered that the case be dismissed with prejudice to refile for a period of two years. Thus, the Court would be protected from seeing this Debtor again for a period of two years. However, the Chapter 7 Trustee who was prepared to pursue the Debtor’s non-exempt and fraudulently transferred assets was left empty-handed.
This case stands in marked contrast to In re Cochener, 2007 Bankr. LEXIS 460 (Bankr. S.D. Tex. 2007)(discussed on this blog on 5/7/07). In that case, a Debtor who sought to evade her obligations under Title 11 was not allowed to dismiss her case and, in the end, both debtor and counsel were sanctioned for their efforts to evade the Chapter 7 trustee. In a perverse display of irony, the Court in that case cited it as an example of abuse justifying the enactment of BAPCPA. However, in the Hall case decided under BAPCPA, the Debtor was allowed a free pass out of bankruptcy court due to his own derelictions, while the diligent Chapter 7 Trustee received nothing. It is truly bizarre that BAPCPA allows the fortunate but dishonest debtor to escape from bankruptcy based on his own failings, when prior law would have brought him to account. Whether it was intentional or not, Congress has not done any favors for Chapter 7 Trustees.
Monday, May 07, 2007
Brief Representation Comes Back to Haunt Attorney Six Years Later
“The law has not been dead, though it has slept.” Shakespeare, Measure for Measure, Act. II, Scene ii, l. 90.
A Houston lawyer recently discovered that the passage of time was not sufficient to protect him from the consequences of actions taken in a brief representation nearly six years earlier. In re Cochener, 2007 Bankr. LEXIS 460 (Bankr. S.D. Tex. 2/6/07). The Court began its tome of an opinion with the comment that:
“In 2005, Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) to rectify perceived fraud and abuse in the bankruptcy system. . . . In the case at bar, which was initiated upon the voluntary filing of a Chapter 7 petition in 2001, the conduct of (the Debtor) and one of her attorneys demonstrates why Congress perceived that there was sufficient abuse to warrant passage of this legislation.”
That a federal bankruptcy judge would acknowledge that BAPCPA might have been a legitimate response to a problem is extraordinary enough that this case bears some scrutiny.
What Happened
The Debtor filed her chapter 7 petition on May 1, 2001, some six months after being divorced. She showed $403.00 in assets and approximately $111,000.00 in debts. The Debtor’s ex-husband informed the Trustee that the Schedules and Statement of Financial Affairs were far from accurate. As a result, the Trustee asked some searching questions and requested additional documents at the first meeting of creditors. The Debtor’s initial lawyer agreed that the documents would be produced and that the Debtor would appear for a continued creditors’ meeting.
Based on the conduct of the first meeting, the Debtor’s attorney had enough sense to realize that he was in over his head. He referred the Debtor to an attorney who was Board Certified in Consumer Bankruptcy Law and had been practicing for fifteen years. He also told the new attorney that there were allegations of concealed assets.
The new attorney apparently decided that the Debtor had made a horrible mistake in filing for bankruptcy. Even before he was formally substituted into the case, he prepared and filed a Motion to Dismiss the chapter 7 case. The motion represented that the interests of creditors would be better served by permitting dismissal and that no creditor would be prejudiced by dismissal. However, the motion did not make any factual allegations. At the same time, counsel blithely informed the trustee that based on the motion to dismiss, the Debtor would not be attending the continued meeting. The Trustee objected to the dismissal and informed the Debtor’s new counsel that attendance at the creditor’s meeting was not optional.
Nevertheless, the Debtor and her new counsel failed to attend the creditors’ meeting, which the Trustee continued yet again. The Debtor’s substitute counsel informed the Trustee that they would not be attending once again, based on the pending Motion to Dismiss. The Debtor also failed to produce any of the documents requested.
At the hearing upon the Debtor’s Motion to Dismiss, the Court apparently continued the hearing and instructed the Trustee to conduct discovery. When the Trustee requested dates for a Rule 2004 exam, Debtor’s counsel did not respond. When the Trustee noticed the exam anyway, Debtor’s counsel objected to the production requests on the basis that they went back more than one year. This was material because one of the allegations was that the Debtor had transferred property to her son more than one year before the petition, but less than the four years in which an action could be commenced under the Texas Uniform Fraudulent Transfer Act.
The Debtor failed to appear for the scheduled Rule 2004 exam and counsel contended that he had not heard from her in several weeks. Shortly thereafter, the Debtor’s second lawyer filed a motion to withdraw. At this point, he had been representing the Debtor for just over five months. The Court allowed Debtor’s second attorney to withdraw, but noted that “This order is without prejudice to any claims, ethical or otherwise, held by the Ch. 7 trustee.”
The Trustee’s counsel informed Debtor’s second attorney that he should reimburse the Trustee for the cost of responding to the Motion to Dismiss. Counsel never accepted the Trustee’s offer to make amends. This would prove to be a poor choice.
The Motion to Dismiss was eventually denied, some eleven months after it was filed. The Trustee eventually found out that the Debtor had transferred away over $90,000 in assets. The Trustee obtained a default judgment in the adversary proceeding he brought to recover these assets. Finally, several years later and after filing a forcible detainer action, the Trustee recovered two pieces of real property. The properties had been thoroughly trashed and the words “Thou Shalt Not Steal or Covet” and other similar phrases had been written on the walls. The Debtor and her son blamed this vandalism upon day laborers who did not otherwise speak English but were apparently able to quote the Bible in a foreign language.
On May 9, 2006, the Trustee’s counsel sent Debtor’s substitute counsel the first of several letters stating that the Trustee intended to seek sanctions. The third letter provided Debtor’s counsel with a proposed motion for sanctions and informed him that the motion would be filed the next day if a settlement offer was not forthcoming. Debtor’s counsel did not make a settlement offer and so the Motion for Sanctions was filed some five years after the substitute counsel had first been retained. The Court subsequently issued its own show cause order requiring the Debtor, her son and the initial attorney to show cause why they should not be sanctioned as well.
At the hearing on sanctions, it was brought out that Debtor’s second attorney was the same attorney who had been sanctioned by Judge Steen in the case of In re Thomas, 337 B.R. 879 (Bankr. S.D. Tex. 2006), which had involved false scheduling of IRS claims.
The Court’s Ruling
One of the more interesting aspects of this case was the passage of time. Although not explicitly stated by the court, claims for sanctions are apparently not subject to traditional limitations periods. In the introduction to its opinion, the Court summarily disposed of the delay issue, stating:
"The attorney . . . raises certain defenses, not the least of which is that his actions occurred in 2001, and to sanction him now after the passage of this much time is absurd and unfair. It is neither. Indeed, (counsel) has known since 2001 that the Chapter 7 trustee was very unhappy with his conduct, and ever since the Trustee's initial expression to (counsel) of misgivings about his conduct, the Trustee has repeatedly told him that he needed to reimburse the Trustee for the unnecessary legal fees and expenses which the Trustee incurred due to (counsel's) conduct. . . . Given that, in 2006, the Trustee was finally able to liquidate certain assets, the existence of which (counsel) did everything in 2001 to prevent the Trustee from uncovering , the Trustee's Motion for Sanctions is hardly absurd or untimely. Just the converse: it is reasonable and timely."
Opinion, at 2-3.
Thus, with apologies to Neil Young, sanctions, like rust, never sleep.
Having disposed of the timeliness issue, the Court concluded that Rule 9011 did not apply. Because the Trustee did not send a sanctions demand letter until May 9, 2006, some four years after the court ruled upon the motion to dismiss, counsel was never given the opportunity to withdraw the offending pleading. As a result, sanctions under this rule were not available. However, that was not the end of the inquiry.
Instead, the Court found that it could use its inherent powers under §105 to impose sanctions. On the surface, this appears to be an end run around the text of the rule. However, it is one endorsed by the Supreme Court. In Chambers v. Masco, 501 U.S. 32, 111 S.Ct. 2123, 115 L.Ed.2d 27 (1991), the Supreme Court stated that a court’s inherent power includes situations where “neither the statute nor the Rules are up to the task.” Thus, the text of Rule 9011 appears to be largely superfluous, since the court can find that the rule is not up to the task and grant relief beyond what is expressly authorized.
The Court also found that where the relief requested does not include disbarment or suspension, that proof by a preponderance of the evidence will suffice.
The Court found that counsel had engaged in five instances of sanctionable conduct: (1) he “concocted” a reason for her not to attend the first meeting of creditors and then instructed her not to do so; (2) he personally did not attend the meeting of creditors; (3) he filed a Motion to Dismiss “which included blatantly false factual and legal contentions;” (4) he wrote a letter to the Trustee’s counsel objecting to production of documents which disingenuously argued the wrong look-back period as a ground for not producing documents; and (5) he instructed the Debtor not to produce documents after prior counsel had agreed that the Debtor would do so. The Court found that sanctions were particularly appropriate because the attorney was board certified.
The Court also found that sanctions could be imposed under 28 U.S.C. §1927, which allows the court to order any attorney “who so multiplies the proceedings in any case unreasonably or vexatiously” to pay “the excess costs, expenses and attorneys’ fees reasonably incurred because of such conduct.”
The Court imposed aggregate sanctions in the amount of $25,121.89 against the Debtor’s substitute counsel, consisting of: (1) disgorgement of the $2,500 retainer paid to counsel; (2) reimbursement of the Trustee’s attorney’s fees of $6,901.25 and costs of $704.47 incurred in responding to the Motion to Dismiss; and (3) reimbursement of the Trustee’s attorney’s fees of $13,951.25 and costs of $1,064.92 incurred in prosecuting the Motion for Sanctions. The Court also imposed sanctions against the Debtor and her son in the amount of $50,000 for damage to the real properties.
In its Conclusion, the Court made the following comments which summed up its feelings about the matter:
“Lawyers occupy a special position in this country’s judicial system. Not only are they representatives of an advocates for their clients, but they are also officers of the court who bear responsibility for ensuring the integrity and fairness of our judicial system. (citation omitted). Particularly in the consumer bankruptcy system, where the clients are typically very unsophisticated about their legal duties and in desperate straits personally, attorneys must take emphatic care to encourage their clients to comply with the requirements of the Bankruptcy Code and the Bankruptcy Rules.
“In the case at bar, (Debtor’s substitute counsel) not only failed to take such care; he went out of his way to encourage the Debtor to disregard the duties imposed upon her. . . .
“At the Sanctions hearing, (Debtor’s substitute counsel) testified that ‘I believe my representation of (the Debtor) was in accordance with acceptable practice. (citation omitted). This Court strongly disagrees. (Counsel’s) gaming of the judicial process by filing a frivolous Motion to Dismiss, his instructions to the Debtor not to attend the continued Meeting of Creditors and not to produce documents which (Debtor’s original counsel) had already agreed she would produce, and his misinforming the Trustee’s counsel about the one-year look back period—all of which was done to impede the Trustee’s investigation of the Debtor’s financial affairs—was completely inimical to acceptable practice, in Houston or anywhere else.
In sum, (Counsel’s) conduct I this Court has done much to justify the passage of BAPCPA. Congress might well be pleased to know that its perception of abuse is not unfounded. Congress would probably not be pleased to learn about (Counsel’s) conduct. For his actions, he will need to immediately write a cashier’s check to the Trustee in the amount of $25,121.89.”
Opinion, at 143-145.
What Does It Mean?
The Court’s grounds for awarding sanctions raise questions about where zealous advocacy of a client ends and when obstruction of the bankruptcy process begins. The initial strategy employed by counsel sought to protect his client from the consequences of her actions. This strategy was one possible response to a difficult predicament. As noted by the Court:
“At the Sanctions hearing, (counsel) testified that his job as counsel for the Debtor, was to look out for her interests, not the interests of creditors. (citation omitted). This court agrees with (counsel) that he had a duty to look out for the Debtor’s interests. This Court disagrees with the approach that he took to do so.”
Because there is not an automatic right to dismiss a chapter 7 case, as there is in chapter 13, counsel faced the prospect that a tenacious trustee would refuse to let go of the case once allegations of fraud had been raised. That is in fact what happened. The case went south for counsel when he failed to change tactics once he became aware that the Trustee and the ex-husband were not going to allow the case to quietly go away. At this point, both his duty to the Court and his instinct for self-preservation should have created a conflict between him and his client. This conflict could only be resolved by insisting that the client cooperate with the Trustee or by making a prompt withdrawal. The fact that counsel continued to pursue a doomed strategy was not only a poor choice, but was guaranteed to earn the Trustee’s enmity and the Court’s disdain.
The Debtor in this case did not need much encouragement to behave badly. Unfortunately counsel provided, and continued to provide, that encouragement over a period of several months (at least according to the Court’s findings). A prompter attempt to make the Debtor cooperate with the Trustee probably would not have changed the Debtor’s behavior. However, it might have salvaged counsel’s reputation.
A second lesson to be learned is that Debtor’s counsel lost a valuable opportunity to quietly settle the matter. Over a period of several years, the Trustee’s counsel patiently counsel to reimburse the Trustee for his expenses in opposing the Motion to Dismiss. These quiet efforts were followed by several increasingly more insistent letters. Had counsel heeded these warnings and settled up with the Trustee, he could have limited his liability to $7,000 and avoided a 100+ page written opinion. This illustrates the rule that nearly any bad situation can be made worse by failing to address it early on.
Update:
This case was appealed to the U.S. District Court. On December 28, 2007, U.S. District Judge Sim Lake issued a Memorandum Opinion in which he affirmed the portion of the order requiring Debtor's counsel to return his retainer in the amount of $2,500, but reversed the remaining award in the amount of $22,621.89. Barry v. Sommers, No. H-07-0629 (S.D. Tex. 12/28/07). The case has now been appealed to the Fifth Circuit Court of Appeals.
On October 23, 2008, the Fifth Circuit reversed the District Court opinion and entered an order affirming the Bankruptcy Court opinion. Matter of Cochener, No. 08-20048, 2008 WL 4681579 (5th Cir. 2008).
A Houston lawyer recently discovered that the passage of time was not sufficient to protect him from the consequences of actions taken in a brief representation nearly six years earlier. In re Cochener, 2007 Bankr. LEXIS 460 (Bankr. S.D. Tex. 2/6/07). The Court began its tome of an opinion with the comment that:
“In 2005, Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) to rectify perceived fraud and abuse in the bankruptcy system. . . . In the case at bar, which was initiated upon the voluntary filing of a Chapter 7 petition in 2001, the conduct of (the Debtor) and one of her attorneys demonstrates why Congress perceived that there was sufficient abuse to warrant passage of this legislation.”
That a federal bankruptcy judge would acknowledge that BAPCPA might have been a legitimate response to a problem is extraordinary enough that this case bears some scrutiny.
What Happened
The Debtor filed her chapter 7 petition on May 1, 2001, some six months after being divorced. She showed $403.00 in assets and approximately $111,000.00 in debts. The Debtor’s ex-husband informed the Trustee that the Schedules and Statement of Financial Affairs were far from accurate. As a result, the Trustee asked some searching questions and requested additional documents at the first meeting of creditors. The Debtor’s initial lawyer agreed that the documents would be produced and that the Debtor would appear for a continued creditors’ meeting.
Based on the conduct of the first meeting, the Debtor’s attorney had enough sense to realize that he was in over his head. He referred the Debtor to an attorney who was Board Certified in Consumer Bankruptcy Law and had been practicing for fifteen years. He also told the new attorney that there were allegations of concealed assets.
The new attorney apparently decided that the Debtor had made a horrible mistake in filing for bankruptcy. Even before he was formally substituted into the case, he prepared and filed a Motion to Dismiss the chapter 7 case. The motion represented that the interests of creditors would be better served by permitting dismissal and that no creditor would be prejudiced by dismissal. However, the motion did not make any factual allegations. At the same time, counsel blithely informed the trustee that based on the motion to dismiss, the Debtor would not be attending the continued meeting. The Trustee objected to the dismissal and informed the Debtor’s new counsel that attendance at the creditor’s meeting was not optional.
Nevertheless, the Debtor and her new counsel failed to attend the creditors’ meeting, which the Trustee continued yet again. The Debtor’s substitute counsel informed the Trustee that they would not be attending once again, based on the pending Motion to Dismiss. The Debtor also failed to produce any of the documents requested.
At the hearing upon the Debtor’s Motion to Dismiss, the Court apparently continued the hearing and instructed the Trustee to conduct discovery. When the Trustee requested dates for a Rule 2004 exam, Debtor’s counsel did not respond. When the Trustee noticed the exam anyway, Debtor’s counsel objected to the production requests on the basis that they went back more than one year. This was material because one of the allegations was that the Debtor had transferred property to her son more than one year before the petition, but less than the four years in which an action could be commenced under the Texas Uniform Fraudulent Transfer Act.
The Debtor failed to appear for the scheduled Rule 2004 exam and counsel contended that he had not heard from her in several weeks. Shortly thereafter, the Debtor’s second lawyer filed a motion to withdraw. At this point, he had been representing the Debtor for just over five months. The Court allowed Debtor’s second attorney to withdraw, but noted that “This order is without prejudice to any claims, ethical or otherwise, held by the Ch. 7 trustee.”
The Trustee’s counsel informed Debtor’s second attorney that he should reimburse the Trustee for the cost of responding to the Motion to Dismiss. Counsel never accepted the Trustee’s offer to make amends. This would prove to be a poor choice.
The Motion to Dismiss was eventually denied, some eleven months after it was filed. The Trustee eventually found out that the Debtor had transferred away over $90,000 in assets. The Trustee obtained a default judgment in the adversary proceeding he brought to recover these assets. Finally, several years later and after filing a forcible detainer action, the Trustee recovered two pieces of real property. The properties had been thoroughly trashed and the words “Thou Shalt Not Steal or Covet” and other similar phrases had been written on the walls. The Debtor and her son blamed this vandalism upon day laborers who did not otherwise speak English but were apparently able to quote the Bible in a foreign language.
On May 9, 2006, the Trustee’s counsel sent Debtor’s substitute counsel the first of several letters stating that the Trustee intended to seek sanctions. The third letter provided Debtor’s counsel with a proposed motion for sanctions and informed him that the motion would be filed the next day if a settlement offer was not forthcoming. Debtor’s counsel did not make a settlement offer and so the Motion for Sanctions was filed some five years after the substitute counsel had first been retained. The Court subsequently issued its own show cause order requiring the Debtor, her son and the initial attorney to show cause why they should not be sanctioned as well.
At the hearing on sanctions, it was brought out that Debtor’s second attorney was the same attorney who had been sanctioned by Judge Steen in the case of In re Thomas, 337 B.R. 879 (Bankr. S.D. Tex. 2006), which had involved false scheduling of IRS claims.
The Court’s Ruling
One of the more interesting aspects of this case was the passage of time. Although not explicitly stated by the court, claims for sanctions are apparently not subject to traditional limitations periods. In the introduction to its opinion, the Court summarily disposed of the delay issue, stating:
"The attorney . . . raises certain defenses, not the least of which is that his actions occurred in 2001, and to sanction him now after the passage of this much time is absurd and unfair. It is neither. Indeed, (counsel) has known since 2001 that the Chapter 7 trustee was very unhappy with his conduct, and ever since the Trustee's initial expression to (counsel) of misgivings about his conduct, the Trustee has repeatedly told him that he needed to reimburse the Trustee for the unnecessary legal fees and expenses which the Trustee incurred due to (counsel's) conduct. . . . Given that, in 2006, the Trustee was finally able to liquidate certain assets, the existence of which (counsel) did everything in 2001 to prevent the Trustee from uncovering , the Trustee's Motion for Sanctions is hardly absurd or untimely. Just the converse: it is reasonable and timely."
Opinion, at 2-3.
Thus, with apologies to Neil Young, sanctions, like rust, never sleep.
Having disposed of the timeliness issue, the Court concluded that Rule 9011 did not apply. Because the Trustee did not send a sanctions demand letter until May 9, 2006, some four years after the court ruled upon the motion to dismiss, counsel was never given the opportunity to withdraw the offending pleading. As a result, sanctions under this rule were not available. However, that was not the end of the inquiry.
Instead, the Court found that it could use its inherent powers under §105 to impose sanctions. On the surface, this appears to be an end run around the text of the rule. However, it is one endorsed by the Supreme Court. In Chambers v. Masco, 501 U.S. 32, 111 S.Ct. 2123, 115 L.Ed.2d 27 (1991), the Supreme Court stated that a court’s inherent power includes situations where “neither the statute nor the Rules are up to the task.” Thus, the text of Rule 9011 appears to be largely superfluous, since the court can find that the rule is not up to the task and grant relief beyond what is expressly authorized.
The Court also found that where the relief requested does not include disbarment or suspension, that proof by a preponderance of the evidence will suffice.
The Court found that counsel had engaged in five instances of sanctionable conduct: (1) he “concocted” a reason for her not to attend the first meeting of creditors and then instructed her not to do so; (2) he personally did not attend the meeting of creditors; (3) he filed a Motion to Dismiss “which included blatantly false factual and legal contentions;” (4) he wrote a letter to the Trustee’s counsel objecting to production of documents which disingenuously argued the wrong look-back period as a ground for not producing documents; and (5) he instructed the Debtor not to produce documents after prior counsel had agreed that the Debtor would do so. The Court found that sanctions were particularly appropriate because the attorney was board certified.
The Court also found that sanctions could be imposed under 28 U.S.C. §1927, which allows the court to order any attorney “who so multiplies the proceedings in any case unreasonably or vexatiously” to pay “the excess costs, expenses and attorneys’ fees reasonably incurred because of such conduct.”
The Court imposed aggregate sanctions in the amount of $25,121.89 against the Debtor’s substitute counsel, consisting of: (1) disgorgement of the $2,500 retainer paid to counsel; (2) reimbursement of the Trustee’s attorney’s fees of $6,901.25 and costs of $704.47 incurred in responding to the Motion to Dismiss; and (3) reimbursement of the Trustee’s attorney’s fees of $13,951.25 and costs of $1,064.92 incurred in prosecuting the Motion for Sanctions. The Court also imposed sanctions against the Debtor and her son in the amount of $50,000 for damage to the real properties.
In its Conclusion, the Court made the following comments which summed up its feelings about the matter:
“Lawyers occupy a special position in this country’s judicial system. Not only are they representatives of an advocates for their clients, but they are also officers of the court who bear responsibility for ensuring the integrity and fairness of our judicial system. (citation omitted). Particularly in the consumer bankruptcy system, where the clients are typically very unsophisticated about their legal duties and in desperate straits personally, attorneys must take emphatic care to encourage their clients to comply with the requirements of the Bankruptcy Code and the Bankruptcy Rules.
“In the case at bar, (Debtor’s substitute counsel) not only failed to take such care; he went out of his way to encourage the Debtor to disregard the duties imposed upon her. . . .
“At the Sanctions hearing, (Debtor’s substitute counsel) testified that ‘I believe my representation of (the Debtor) was in accordance with acceptable practice. (citation omitted). This Court strongly disagrees. (Counsel’s) gaming of the judicial process by filing a frivolous Motion to Dismiss, his instructions to the Debtor not to attend the continued Meeting of Creditors and not to produce documents which (Debtor’s original counsel) had already agreed she would produce, and his misinforming the Trustee’s counsel about the one-year look back period—all of which was done to impede the Trustee’s investigation of the Debtor’s financial affairs—was completely inimical to acceptable practice, in Houston or anywhere else.
In sum, (Counsel’s) conduct I this Court has done much to justify the passage of BAPCPA. Congress might well be pleased to know that its perception of abuse is not unfounded. Congress would probably not be pleased to learn about (Counsel’s) conduct. For his actions, he will need to immediately write a cashier’s check to the Trustee in the amount of $25,121.89.”
Opinion, at 143-145.
What Does It Mean?
The Court’s grounds for awarding sanctions raise questions about where zealous advocacy of a client ends and when obstruction of the bankruptcy process begins. The initial strategy employed by counsel sought to protect his client from the consequences of her actions. This strategy was one possible response to a difficult predicament. As noted by the Court:
“At the Sanctions hearing, (counsel) testified that his job as counsel for the Debtor, was to look out for her interests, not the interests of creditors. (citation omitted). This court agrees with (counsel) that he had a duty to look out for the Debtor’s interests. This Court disagrees with the approach that he took to do so.”
Because there is not an automatic right to dismiss a chapter 7 case, as there is in chapter 13, counsel faced the prospect that a tenacious trustee would refuse to let go of the case once allegations of fraud had been raised. That is in fact what happened. The case went south for counsel when he failed to change tactics once he became aware that the Trustee and the ex-husband were not going to allow the case to quietly go away. At this point, both his duty to the Court and his instinct for self-preservation should have created a conflict between him and his client. This conflict could only be resolved by insisting that the client cooperate with the Trustee or by making a prompt withdrawal. The fact that counsel continued to pursue a doomed strategy was not only a poor choice, but was guaranteed to earn the Trustee’s enmity and the Court’s disdain.
The Debtor in this case did not need much encouragement to behave badly. Unfortunately counsel provided, and continued to provide, that encouragement over a period of several months (at least according to the Court’s findings). A prompter attempt to make the Debtor cooperate with the Trustee probably would not have changed the Debtor’s behavior. However, it might have salvaged counsel’s reputation.
A second lesson to be learned is that Debtor’s counsel lost a valuable opportunity to quietly settle the matter. Over a period of several years, the Trustee’s counsel patiently counsel to reimburse the Trustee for his expenses in opposing the Motion to Dismiss. These quiet efforts were followed by several increasingly more insistent letters. Had counsel heeded these warnings and settled up with the Trustee, he could have limited his liability to $7,000 and avoided a 100+ page written opinion. This illustrates the rule that nearly any bad situation can be made worse by failing to address it early on.
Update:
This case was appealed to the U.S. District Court. On December 28, 2007, U.S. District Judge Sim Lake issued a Memorandum Opinion in which he affirmed the portion of the order requiring Debtor's counsel to return his retainer in the amount of $2,500, but reversed the remaining award in the amount of $22,621.89. Barry v. Sommers, No. H-07-0629 (S.D. Tex. 12/28/07). The case has now been appealed to the Fifth Circuit Court of Appeals.
On October 23, 2008, the Fifth Circuit reversed the District Court opinion and entered an order affirming the Bankruptcy Court opinion. Matter of Cochener, No. 08-20048, 2008 WL 4681579 (5th Cir. 2008).
Wednesday, April 25, 2007
Mother-Daughter Debacle Plays Out in Waco; Family Debts Determined to Be Dischargeable
“Traditionally, trials of family conflicts often involve emotion and controversy, yet are short on reason, logic and admissible evidence. These adversary proceedings share these traits.” Thus, began Judge Larry Kelly’s Memorandum Opinion in which he sought to sort out the tangled mother-daughter disputes in Rose Douso Petro v. Irene E. Holland, et al, Adv. No. 06-6001, 06-6002 and 06-6004 (Bankr. W.D. Tex. 1/12/07). This opinion is significant both because it was one of Judge Kelly’s final opinions prior to retirement (after 20+ years on the bench) and because it offers an object lesson in the difficulty in translating informal family dealings into legal proceedings.
Some Background
In better times, Irene Holland was married to Scottie Holland and Irene’s parents advanced money to her. These borrowings were later documented in a promissory note in the amount of $305,000 in 1988. The debt was evidenced by a note which was payable on November 1, 1993 or when the Hollands sold a piece of property they owned in San Antonio. Seven years later, the Hollands sold the San Antonio property but neglected to pay off the note. According to Irene’s mother Rose Petro, they also failed to inform her of the sale. Rose contended that she did not learn of the sale until spring 2002, some 14 years after the date of the loan and seven years after the sale.
In the spring of 2003, the Hollands sold a residence they owned in Hawaii for $1.6 million. Around the same time, they divorced. In connection with the divorce, the Hollands agreed that Rose would receive $286,568.53 out of the sales proceeds to be paid on her note. Judge Kelly noted that there is no explanation for why they chose this amount rather than the full face amount of the note (although apparently this is what Irene believed was owing). The Title Company issued the check payable to Rose, but wrote it in care of Irene. It is not explained why the check went to Irene. However, a lot of subsequent litigation could have been avoided if the check had gone straight to Rose. In apparent violation of the divorce agreement, Irene returned the check to the title company and requested that it be voided. In its place, she requested that four new checks be issued. One of the four checks was issued to Rose in the amount of $110,000 and was received by Rose. In a development which would become important later, Irene contended that Rose gave her permission to do this.
Rose was not happy when she found out what had happened. In June 2004, she sued Irene, Scottie and the title company in District Court in Bell County. The state court found that it lacked jurisdiction over the title company and dismissed all claims against it. Irene engaged Waco attorney John Montez and filed bankruptcy during the October 2005 bankruptcy rush. At this point, adversary proceedings began to get filed left and right. Rose removed the state court litigation to bankruptcy court where it was assigned Adv. No. 06-6001. She then filed a complaint against Irene seeking to except her debt from discharge under Sec. 523(a)(2), (4) and (6) and objecting to Irene’s general discharge under Sec. 727(a)(2)-(5). This became Adv. No. 06-6002. Scottie filed his own adversary proceeding based on breach of the Agreement Incident to Divorce, which was docketed as Adv. No. 06-6004. Prior to trial, Scottie settled his claims against Irene as well as Rose’s claims against him. Thus, the sole issues which remained for trial were Rose’s claims against Irene.
The Trial
Prior to trial, it appeared as though Irene had not gone out of her way to repay the note to her parents. However, it was unclear whether this would translate into a non-dischargeable debt.
Before determining whether the debt was non-dischargeable, the court had to decide whether there was even an enforceable debt. The promissory note was due within four years after the property sold. Since the property was sold on March 29, 2000, the deadline to file suit would have expired on March 29, 2004, approximately three months before suit was actually filed. The court found that Irene had not fraudulently concealed the sale of the property from her mother and that her mother knew about the sale by 2002. As a result, the court concluded that the original debt was barred by limitations. However, under Texas law, a debt barred by limitations can be revived by a written agreement signed by the obligor. Even though Rose was apparently unaware of the terms of the Agreement Incident to Divorce, the Court found that Rose was a third party beneficiary of this agreement and that it was sufficient to revive the debt. Thus, but for Irene and Scottie’s agreement to provide for Rose in their divorce, the debt would have been unenforceable and the court’s opinion would have been much shorter.
Having overcome the limitations defense, Rose still needed to prove one of the grounds for non-dischargeability which she alleged.
Fraud
The court had no trouble dispatching the fraud ground under Sec. 523(a)(2). There was simply no evidence that Irene had made a false representation at the time that the note was executed or that Rose had relied upon any false representation. Since Rose did not know about the Agreement Incident to Divorce, it was not possible for her to rely upon this agreement as a false representation. While Irene very likely made a false representation to Scottie, she wisely resolved her dispute with him.
This illustrates an important distinction between “fraud” in the popular sense and the legal sense. If I make a promise to pay you with the best of intentions and then later make a capricious and whimsical decision not to pay, even though I had the ability to do so, you would feel defrauded. However, legally this constitutes nothing more than a breach of contract. The essence of fraud is a false representation made with bad intent which is relied upon by the other party to their detriment. If the representation is originally made with good intent, all the subsequent bad faith in the world will not transform the original representation into fraud. Thus, where the original promise is made honestly and there is subsequent bad conduct, the plaintiff must be able to show a subsequent false representation which they relied upon.
In a series of informal dealings over a lengthy period of time, such as in this case, proving anyone’s intent at the outset is nearly impossible.
Fraud or Defalcation in a Fiduciary Capacity
Fraud or defalcation in a fiduciary capacity under Sec. 523(a)(4) did not present much difficulty either. A fiduciary under federal law requires a much higher standard than under state law. A federal fiduciary must be akin to a trustee. The mother-daughter bond simply does not rise to this level. Judge Kelly found that there were no other factors, such as control over Rose’s finances, which would give rise to a fiduciary relationship. An argument could have been made that the Agreement Incident to Divorce imposed trustee-like duties upon Irene with respect to the cashiers check which was later voided. However, this claim would have likely failed based on Irene’s unrebutted testimony that Rose gave her permission to use the funds.
Embezzlement
The claim for embezzlement failed for the reason that the funds from the real estate closing were never property of Rose. In order for embezzlement to take place, there must be an appropriation of another person’s property for the debtor’s benefit with fraudulent intent. Here, Irene exercised control over a cashiers check made payable to Rose. However, once again, the popular wisdom parts company with the legal test. Under Texas law, a cashier’s check remains the property of the person who purchased it until it is delivered. Judge Kelly found that because the check for $286,568.53 was never delivered to Rose, it was never her property. Thus, while it looks bad that Irene canceled out the check and didn’t give the funds to Rose, it didn’t constitute embezzlement.
Willful and Malicious Injury
Finally, Judge Kelly found that the claim for willful and malicious injury under Sec. 523(a)(6) failed. Of all the claims, this one appeared to have the greatest chance of success. If the court had believed that Irene had voided the cashiers check from the real estate closing for the purpose of harming Rose, then the court might have been able to find willful and malicious injury. However, Irene testified at trial that she had oral permission from Rose to void the check. This testimony came out on direct examination from Rose’s attorney and was not rebutted. As a result, the testimony stood without contradiction and was accepted by the court. The result might have been different on a claim by Scottie, since he was certainly harmed by the failure to pay Rose. However, he had already settled with Rose and Irene prior to trial.
Conclusion
This case shows why the bankruptcy discharge is an imperfect screen for unethical or immoral behavior. Some observers would probably conclude that Irene behaved badly, or at least selfishly. Despite the fact that she had received a huge sum of money from her parents and signed a written promise to pay, she always found other things to spend her money on when she had the opportunity. Her conduct in agreeing to repay her mom out of the Hawaii sales proceeds and then voiding the check appears to constitute double dealing. Thus, it could be argued that good lawyering and weak laws helped Irene escape her just desserts.
However, a counter argument can be made that this was much ado about nothing. Irene’s parents did not treat the “loan” like a business transaction. They apparently advanced funds first and documented the transaction later. According to Irene, the note was never intended to be collected, but would be used to adjust the sisters’ share of the inheritance later. As found by Judge Kelly, the note would have been barred by limitations and become unenforceable were it not for Irene and Scottie’s decision to include it in the Agreement Incident to Divorce. While the decision to void the cashier’s check looks bad, the unrebutted testimony about verbal consent supports an inference that the mother may have initially approved the transaction and then changed her mind.
This case is a good example of why informal dealings based on trust make for bad legal cases. Rose could have protected herself if she had tried to enforce the note when it matured or when she found out about the sale of the San Antonio property. She did not do so, perhaps hoping that her daughter would eventually do the right thing. Or perhaps she never intended to enforce the note at the time it came due and only changed her mind after the fact. The Court had an unenviable job in trying to sort all the sort out the mother-daughter brawl. However, the resulting opinion provides a good primer on the law of dischargeability.
Some Background
In better times, Irene Holland was married to Scottie Holland and Irene’s parents advanced money to her. These borrowings were later documented in a promissory note in the amount of $305,000 in 1988. The debt was evidenced by a note which was payable on November 1, 1993 or when the Hollands sold a piece of property they owned in San Antonio. Seven years later, the Hollands sold the San Antonio property but neglected to pay off the note. According to Irene’s mother Rose Petro, they also failed to inform her of the sale. Rose contended that she did not learn of the sale until spring 2002, some 14 years after the date of the loan and seven years after the sale.
In the spring of 2003, the Hollands sold a residence they owned in Hawaii for $1.6 million. Around the same time, they divorced. In connection with the divorce, the Hollands agreed that Rose would receive $286,568.53 out of the sales proceeds to be paid on her note. Judge Kelly noted that there is no explanation for why they chose this amount rather than the full face amount of the note (although apparently this is what Irene believed was owing). The Title Company issued the check payable to Rose, but wrote it in care of Irene. It is not explained why the check went to Irene. However, a lot of subsequent litigation could have been avoided if the check had gone straight to Rose. In apparent violation of the divorce agreement, Irene returned the check to the title company and requested that it be voided. In its place, she requested that four new checks be issued. One of the four checks was issued to Rose in the amount of $110,000 and was received by Rose. In a development which would become important later, Irene contended that Rose gave her permission to do this.
Rose was not happy when she found out what had happened. In June 2004, she sued Irene, Scottie and the title company in District Court in Bell County. The state court found that it lacked jurisdiction over the title company and dismissed all claims against it. Irene engaged Waco attorney John Montez and filed bankruptcy during the October 2005 bankruptcy rush. At this point, adversary proceedings began to get filed left and right. Rose removed the state court litigation to bankruptcy court where it was assigned Adv. No. 06-6001. She then filed a complaint against Irene seeking to except her debt from discharge under Sec. 523(a)(2), (4) and (6) and objecting to Irene’s general discharge under Sec. 727(a)(2)-(5). This became Adv. No. 06-6002. Scottie filed his own adversary proceeding based on breach of the Agreement Incident to Divorce, which was docketed as Adv. No. 06-6004. Prior to trial, Scottie settled his claims against Irene as well as Rose’s claims against him. Thus, the sole issues which remained for trial were Rose’s claims against Irene.
The Trial
Prior to trial, it appeared as though Irene had not gone out of her way to repay the note to her parents. However, it was unclear whether this would translate into a non-dischargeable debt.
Before determining whether the debt was non-dischargeable, the court had to decide whether there was even an enforceable debt. The promissory note was due within four years after the property sold. Since the property was sold on March 29, 2000, the deadline to file suit would have expired on March 29, 2004, approximately three months before suit was actually filed. The court found that Irene had not fraudulently concealed the sale of the property from her mother and that her mother knew about the sale by 2002. As a result, the court concluded that the original debt was barred by limitations. However, under Texas law, a debt barred by limitations can be revived by a written agreement signed by the obligor. Even though Rose was apparently unaware of the terms of the Agreement Incident to Divorce, the Court found that Rose was a third party beneficiary of this agreement and that it was sufficient to revive the debt. Thus, but for Irene and Scottie’s agreement to provide for Rose in their divorce, the debt would have been unenforceable and the court’s opinion would have been much shorter.
Having overcome the limitations defense, Rose still needed to prove one of the grounds for non-dischargeability which she alleged.
Fraud
The court had no trouble dispatching the fraud ground under Sec. 523(a)(2). There was simply no evidence that Irene had made a false representation at the time that the note was executed or that Rose had relied upon any false representation. Since Rose did not know about the Agreement Incident to Divorce, it was not possible for her to rely upon this agreement as a false representation. While Irene very likely made a false representation to Scottie, she wisely resolved her dispute with him.
This illustrates an important distinction between “fraud” in the popular sense and the legal sense. If I make a promise to pay you with the best of intentions and then later make a capricious and whimsical decision not to pay, even though I had the ability to do so, you would feel defrauded. However, legally this constitutes nothing more than a breach of contract. The essence of fraud is a false representation made with bad intent which is relied upon by the other party to their detriment. If the representation is originally made with good intent, all the subsequent bad faith in the world will not transform the original representation into fraud. Thus, where the original promise is made honestly and there is subsequent bad conduct, the plaintiff must be able to show a subsequent false representation which they relied upon.
In a series of informal dealings over a lengthy period of time, such as in this case, proving anyone’s intent at the outset is nearly impossible.
Fraud or Defalcation in a Fiduciary Capacity
Fraud or defalcation in a fiduciary capacity under Sec. 523(a)(4) did not present much difficulty either. A fiduciary under federal law requires a much higher standard than under state law. A federal fiduciary must be akin to a trustee. The mother-daughter bond simply does not rise to this level. Judge Kelly found that there were no other factors, such as control over Rose’s finances, which would give rise to a fiduciary relationship. An argument could have been made that the Agreement Incident to Divorce imposed trustee-like duties upon Irene with respect to the cashiers check which was later voided. However, this claim would have likely failed based on Irene’s unrebutted testimony that Rose gave her permission to use the funds.
Embezzlement
The claim for embezzlement failed for the reason that the funds from the real estate closing were never property of Rose. In order for embezzlement to take place, there must be an appropriation of another person’s property for the debtor’s benefit with fraudulent intent. Here, Irene exercised control over a cashiers check made payable to Rose. However, once again, the popular wisdom parts company with the legal test. Under Texas law, a cashier’s check remains the property of the person who purchased it until it is delivered. Judge Kelly found that because the check for $286,568.53 was never delivered to Rose, it was never her property. Thus, while it looks bad that Irene canceled out the check and didn’t give the funds to Rose, it didn’t constitute embezzlement.
Willful and Malicious Injury
Finally, Judge Kelly found that the claim for willful and malicious injury under Sec. 523(a)(6) failed. Of all the claims, this one appeared to have the greatest chance of success. If the court had believed that Irene had voided the cashiers check from the real estate closing for the purpose of harming Rose, then the court might have been able to find willful and malicious injury. However, Irene testified at trial that she had oral permission from Rose to void the check. This testimony came out on direct examination from Rose’s attorney and was not rebutted. As a result, the testimony stood without contradiction and was accepted by the court. The result might have been different on a claim by Scottie, since he was certainly harmed by the failure to pay Rose. However, he had already settled with Rose and Irene prior to trial.
Conclusion
This case shows why the bankruptcy discharge is an imperfect screen for unethical or immoral behavior. Some observers would probably conclude that Irene behaved badly, or at least selfishly. Despite the fact that she had received a huge sum of money from her parents and signed a written promise to pay, she always found other things to spend her money on when she had the opportunity. Her conduct in agreeing to repay her mom out of the Hawaii sales proceeds and then voiding the check appears to constitute double dealing. Thus, it could be argued that good lawyering and weak laws helped Irene escape her just desserts.
However, a counter argument can be made that this was much ado about nothing. Irene’s parents did not treat the “loan” like a business transaction. They apparently advanced funds first and documented the transaction later. According to Irene, the note was never intended to be collected, but would be used to adjust the sisters’ share of the inheritance later. As found by Judge Kelly, the note would have been barred by limitations and become unenforceable were it not for Irene and Scottie’s decision to include it in the Agreement Incident to Divorce. While the decision to void the cashier’s check looks bad, the unrebutted testimony about verbal consent supports an inference that the mother may have initially approved the transaction and then changed her mind.
This case is a good example of why informal dealings based on trust make for bad legal cases. Rose could have protected herself if she had tried to enforce the note when it matured or when she found out about the sale of the San Antonio property. She did not do so, perhaps hoping that her daughter would eventually do the right thing. Or perhaps she never intended to enforce the note at the time it came due and only changed her mind after the fact. The Court had an unenviable job in trying to sort all the sort out the mother-daughter brawl. However, the resulting opinion provides a good primer on the law of dischargeability.
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