Tangled Financial Web Allows Assets to Escape Trustee's Reach

A recent opinion by Bankruptcy Judge Craig Gargotta demonstrates the problems arising from the use of cash management systems and also provides an object lesson in why lawyers should have more than a passing knowledge of accounting concepts. In Ingalls v. SMTC Corporation, No. 06-1283 (Bankr. W.D. Tex. 9/11/09), the bankruptcy trustee sought to recover millions of dollars in inter-corporate transfers. After a two week trial, the court issued a 94 page opinion denying all relief.

The case was precipitated when SMTC Manufacturing of Texas filed a chapter 7 petition after divesting its assets. While the debtor paid all of its current trade debt, it also made numerous transfers to insiders leaving it unable to pay a sizeable debt on its lease.

The transfers challenged by the trustee fell into four categories:

1) Payments to the parent company’s affiliates in North Carolina and Mexico;

2) Expense reallocations which increased the Texas company’s share of expenses;

3) Approximately $41 million transferred to the holding company through a cash management system; and

4) Transfer of the debtor’s fixed assets to affiliates.

The Corporate Structure and Cash Management System

To understand the case, it is necessary to understand the relationship between the debtor and its affiliated companies, their cash management system and the companies’ secured debt.

The corporate structure consisted of a parent company, SMTC Corporation, which owned a holding company, HTM Holdings, Inc. HTM owned the operating companies, including SMTC Manufacturing of Texas.

The companies used a cash management system which centralized their funds. Prior to March 2002, the operating companies would deposit funds into their operating accounts which would be swept into a zero balance account maintained by the holding company. The funds in the zero balance account would be applied to the holding company’s debt to Lehman Brothers. As funds were needed by the operating companies, they could either be paid from funds deposited into the operating account that day or funds advanced from the Lehman Brothers loan. Beginning in March 2002, Lehman Brothers required that all funds be deposited into a lockbox account so that the only funds available for operations came from the Lehman Brothers loan.

Lehman Brothers provided a revolving credit line to the holding company which was used to fund the operating companies. The parties kept track of how much money was paid to and paid from each of the operating companies. This number was their portion of the debt. However, each of the operating companies guaranteed the entire debt and pledged their assets. To the extent that any operating company paid more than its individual balance on the loan, it had a right of contribution against the other operating companies.

While the Texas company initially enjoyed a period of rapid growth, it ran into trouble in 2002. In mid-2002, SMTC Texas laid off about half of its employees and moved its manufacturing operations to Mexico. The cost of labor in Mexico was $3.00 per hour compared to $19.00 in Texas. However, even this was not enough to allow the debtor to meet Dell’s pricing demands so that it eventually dropped (or disengaged from) Dell as a customer. After that, it lost Alcatel as a customer and corporate decided that it was time to close the doors. The debtor surrendered its leased facilities in May 2003 and filed chapter 7 in December 2004. Significantly, the other affiliated companies continued to operate and did not file bankruptcy. The chapter 7 trustee looked at all of the transfers out of SMTC and cried foul, leading to a fraudulent transfer complaint.

Was There A Transfer?

The first major issue which the court had to consider was whether there had been any “transfers” at all. Under the Texas Uniform Fraudulent Transfer Act (TUFTA), the definition of a transfer excludes “property to the extent it is encumbered by a valid lien.” The defendants argued that no “transfers” occurred because:

1) Each individual asset transferred was worth less than the amount of the total debt: and

2) Because the debtor was liable for the entire Lehman debt, its collective assets had no equity.

The court ruled against the asset by asset approach. It found that if there was equity in the debtor’s collective assets that transfer of individual assets from that pool would be deemed to be made from the unencumbered portion of the assets rather than the encumbered ones.

This made it necessary to determine whether there was equity in the debtor’s collective assets, raising some difficult accounting issues. The difficulty arose because of the interplay between the following facts:

1) The debtor’s assets were greater than its share of the Lehman Brothers loan at some points in time;

2) The debtor had guaranteed the entire Lehman Brothers loan, which far exceeded its assets; and

3) The SMTC family of companies was making all of their payments n the Lehman Brothers loan, although there were some covenant defaults.

This raised the question of what portion of the Lehman Brothers debt should be accounted for on the debtor’s balance sheet. The trustee argued that the debtor’s obligation on the Lehman Brothers debt was a contingent obligation which did not belong on the balance sheet because of the low probability that the debtor would be called upon to perform. The defendants argued that the entire amount should be included because the debtor was unconditionally liable.

The court agreed that the debt was a contingent liability. However, whether a contingent liability should be stated on the debtor’s balance sheet depended on the likelihood that the contingency would occur and that it would affect the debtor’s balance sheet. A contingent liability could be shown on the balance sheet if the contingency was likely to occur, could be referenced in a footnote or could be omitted entirely if the contingency was unlikely to occur.

The court found that the appropriate way to measure the contingent liability was to apply a percentage to the likelihood that the guaranty would be called upon and multiply that percentage by the amount of the debt. The trustee argued that the appropriate percentage was 0% based on the fact that the SMTC companies had not defaulted upon the debt and that the debt was later paid off. The court rejected this argument because the SMTC companies had defaulted under their loan covenants and that the debt was only paid off through a restructuring in which Lehman Brothers accepted stock in partial satisfaction. Because the possibility that the debtor would be called upon to satisfy the guaranty was greater than 0% and the trustee did not advance an alternate number, the court refused to exclude the debt as a contingent liability.

However, that was not the end of the inquiry. Even though the debtor could be called upon to pay the entire debt, it had a right to contribution from its co-debtors. This was an asset which needed to be added to the balance sheet. The court assumed that the value of the right of contribution was equal to the portion of the debt which exceeded the debtor’s individual account. This may have been a leap of faith, since the court did not analyze the ability of the other companies to pay their portions. However, given that the debt was retired without payment from SMTC Texas, it may have been a reasonable conclusion. The net result was that for determining the debtor’s equity in its assets, the court examined the value of the debtor’s assets minus the amount of the debtor’s portion of the Lehman Brothers loan. The result of this analysis was that the debtor had equity in its assets until March 2003. Once the debtor reached the no equity stage, it could transfer its assets away without risk because they had no net value and were not “transfers” under TUFTA.
The effect of the court’s ruling was to exclude the transfer of the fixed assets and $3.9 million of the cash transferred through the cash management system.

Note that the result would not be the same in an action brought under 11 U.S.C. §548. The definition of “transfer” under the Bankruptcy Code does not exclude encumbered property. 11 U.S.C. §101(54). Thus, it is possible to bring a fraudulent conveyance action to recover a fully encumbered piece of property under the Bankruptcy Code, while the same transfer would not be covered under the Texas statute.

Fraudulent Conveyance Analysis

Under the Texas statute, like the Bankruptcy Code, a transfer can be avoided as a fraudulent conveyance if it is made “with actual intent to hinder, delay or defraud any creditor” or if it was made for less than reasonably equivalent value while insolvent. Actual intent can be shown through direct evidence or through badges of fraud. TUFTA, unlike the Bankruptcy Code, legislatively defines eleven badges of fraud. The badges of fraud are:

1. The transfer was to an insider;

2. The debtor retained possession or control of the property transferred after the transfer;

3. The transfer or obligation was concealed;

4. Before the transfer was made or obligation incurred, the debtor had been sued or threatened with suit;

5. The transfer was of substantially all the debtor’s assets;

6. The debtor absconded;

7. The debtor removed or concealed assets;

8. The value of the consideration received by the debtor was reasonably equivalent to the value of the asset transferred or the amount of the obligation incurred;

9. The debtor was insolvent or became insolvent shortly after a substantial debt was incurred;

10. The transfer occurred shortly before or after a substantial debt was incurred; and

11. The debtor transferred the essential elements of the business to a lienor who transferred the assets to an insider of the debtor.

Tex. Bus. & Com. Code §24.005(b).

The list of badges of fraud raises several interesting issues. First, the issues of solvency and reasonably equivalent value are included in the badges of fraud. Thus, it would make sense to determine these issues first, since a positive finding on these two elements would eliminate the need to determine the other nine badges of fraud. The other implication is that since solvency and reasonably equivalent value are just two of eleven badges of fraud, a transfer can be fraudulent even though the debtor was solvent at the time or received reasonably equivalent value. The second interesting question is how many badges of fraud are enough. The meticulous Judge Gargotta noted that the presence of “many” badges of fraud “will always make out a strong case of fraud” and that four or five have been found to be sufficient in some cases. On the other hand, one badge of fraud is not enough. Once a sufficient number of badges of fraud are established, then the burden shifts to the transferee to establish some “legitimate supervening purpose.”

Analysis of Actual Intent to Hinder, Delay or Defraud

Judge Gargotta chose to do the more difficult analysis of intent to hinder, delay or defraud first. His decision on these issues effectively decided the constructive fraud issue as well.

The Judge rejected the trustee’s arguments regarding direct evidence of fraudulent intent. The Trustee contended that emails discussing the possibility of bankrupting the Texas company and “walking away” from the lease combined with failure to produce board minutes where these options were discussed was proof that the corporate parent intended to defraud the lessor. The trustee also argued that the debtor hindered the lessor when it failed to make several payments on the lease when it had the cash to do so. The court was not moved by this evidence. Discussing the option of bankrupting the company and walking away from the lease did not go one step further and establish intent to transfer the assets away. The court did not give any particular significance to failure to produce the board minutes, refusing to draw an inference that the minutes would have been harmful.

This led to a discussion of badges of fraud. As a preliminary matter, Judge Gargotta had already determined that the debtor was insolvent throughout the relevant period. As a result, one badge of fraud and half of the constructive fraud analysis had already been decided. It was not contested that the transfers were made to insiders, so that a second badge of fraud was present. However, at this point, the trustee hit a wall as the court failed to find any additional badges of fraud.

Badge 1: Transfers were made to insiders. This badge was not disputed.

Badge 2: The debtor retained possession or control of the property transferred. This badge was not present.

Badge 3: The transfer or obligation was concealed. All of the transactions were recorded on the debtor’s books. The transfers were all properly documented. As a result, this badge was not present.

Badge 4: Before the transfer was made, the debtor had been threatened with suit. The debtor was not sued until after it shut down in May 2003.

Badge 5: The transfer was of substantially all the debtor’s assets. Collectively the transfers were of substantially all the debtor’s assets. However, individually none of them were. Furthermore, because the Texas statute excluded fully encumbered assets from the definition of “transfer,” the final series of transfers were not considered. As a result, when the last transfer which could be considered to be a transfer was made, the debtor still had assets left, defeating this badge.

Badge 6: The debtor absconded. This was another badge implicated by the definition of transfer. Because the only “transfers” which could be considered were those occurring prior to March 2003, this badge did not apply because the debtor was still operating its business at this time.

Badge 7: The debtor removed or concealed assets. This badge is similar to badge 3. However, instead of concealing transactions, it relates to concealing assets. However, the result is the same. Since the debtor accounted for all of the transfers in its records, it did not conceal assets.

Badge 8: Reasonably equivalent value. I will return to this badge.

Badge 9: The debtor was insolvent or became insolvent. The court found this issue was present.

Badge 10: The transfer occurred or the obligation was incurred shortly before or shortly after a substantial debt was incurred. The only major debt which the debtor had was its lease. This was incurred on September 1, 2001. All of the disputed transfers occurred during 2002 and 2003. As a result, this badge was not present.

Badge 11: The debtor transferred the essential assets of the business to a lienor who transferred the assets to an insider of the debtor. This was not present.

Based on the definition of transfer and facts which were not seriously contested, the most badges of fraud that could be established was three. Thus, the whole case boiled down to reasonably equivalent value.

Reasonably Equivalent Value

1. The Trustee challenged $104,646.00 in payments to SMTC Charlotte from February 2002 to June 2002 and $37 million to SMTC Mex/SMTC Chihuahua from February 2002 to February 2003.

While these transfers were substantial, the defendants established that the SMTC companies transferred their manufacturing operations from Texas to Mexico to take advantage of lower wages. However, Dell continued to place orders with SMTC Texas, which then filled them with product purchased from SMTC Mex and SMTC Chihuahua. The Debtor added a mark-up to the product purchased from Mexico before it sold it to Dell. The defendants produced invoices, bills of lading and other documents to establish that the transfers to the affiliated companies were for payment of product actually purchased which the debtor sold for a profit. Thus, this group of transfers was factually shown to be for reasonably equivalent value.

2. The Trustee challenged approximately $2 million in expense reallocations between the debtor and the corporate office.

The defendants established that the expense reallocations were based on recommendations from the companies’ accountants and were reasonable. Thus, this set of transactions was supported by reasonably equivalent value.

3. The Trustee challenged $37 million in funds which were upstreamed to the holding company by the cash management system.

This looked to be the trustee’s strongest claim. Between January 2002 and December 2003, the Debtor transferred $41 more to the holding company than it received back. This seemed to be a simple cash in cash out analysis showing a net transfer without reasonably equivalent value. However, this was a case where the complexities of the cash management system worked against the trustee. The court concluded that the trustee’s expert only considered transactions running through the debtor’s bank account and not transactions reconciled at the corporate level. Because many inter-corporate transactions were handled through reconciliations, the court found that an analysis of the bank statements only was insufficient to show whether the debtor received reasonably equivalent value.

The Court stated:

The Trustee has not provided the Court a complete picture that explains specifically why reasonably equivalent value was not received. What the ZBA Master Bank Reconciliation demonstrates is that the $41.1 million figure that was derived solely by analyzing the bank accounts does not accurately reflect the payments made to SMTC Mex or any of the other affiliates on behalf of the Debtor via intercompany transfers. The Trustee failed to account for this reconciliation in his explanation as to what effect these transactions would have on reasonably equivalent value. He therefore has not proved the absence of reasonably equivalent value by a preponderance of the evidence.

Opinion, p. 70.

With this finding, the trustee’s case was doomed.

Why It’s Hard To Be The Trustee

This was a difficult case for the trustee. He was faced with a debtor which had transferred all of its assets to affiliates (although it also paid $3.9 million to trade creditors). However, the case turned into a battle of the accountants. The trustee starts off at a disadvantage in a battle of experts because the trustee usually starts off without any cash to pay experts. In this particular case, the trustee sought to employ an accountant on a contingent fee basis. Unfortunately, this violated the disciplinary rules governing accountants in Texas and the court disqualified the expert. The trustee then had to retain another accountant to testify based on the first accountant’s compilations. The court did allow the first accountant to testify as a fact witness. Thus, the defendant had access to its own expert accountant which it retained as well as the defendants’ management, while the trustee had to start over with a new expert who was looking in from the outside.

Concluding Thoughts

SMTC illustrates the difficulties arising from inter-related companies with a common cash management system. The SMTC companies succeeded in walling off SMTC Texas and allowing it to fail. Despite the fact that many of the assets were transferred to affiliates, it was extremely difficult to unscramble the companies’ finances. The court successfully worked through the issues related to contingent liabilities and rights of contribution. However, it found that the trustee’s expert had failed to account for all of the value provided to the debtor. The result was not based on knowing the answer, but on uncertainty resulting from the inability to fully deconstruct the companies’ intertwined finances. While the defendants may have prevailed in any circumstance, the complexity of the arrangement was certainly an assisting factor for the defense.

Fifth Circuit Goes All In On Hanging Paragraph

Joining several other courts, the Fifth Circuit has ruled that the entire debt created by a purchase money transaction is protected from modification under the hanging of section 1325(a). The decision overrules several lower court decisions which had limited or denied protection to claims which included non-purchase money components. Matter of Dale, No. 08-20583 (5th Cir. 9/8/09). The opinion can be found here.

In the Dale case, the debtor traded in a vehicle with negative equity, which amount was rolled into the purchase of a new vehicle. The amount financed also included a gap insurance premium, taxes and fees and an extended warranty. The debtors filed bankruptcy less than one year later. The bankruptcy court ruled that the portions of the debt for negative equity and other items not related to the physical vehicle were not purchase money debts and could be modified in a chapter 13 plan. The district court reversed.

Under the hanging paragraph, the debtor may not apply the valuation provisions of section 506 to limit the secured portion of a claim to the collateral's value "if the creditor has a purchase money security interest securing the debt that is the subject of the claim" and the collateral was a motor vehicle purchased within 910 days of the petition. Because the term "purchase money security interest" is not defined by Title 11, the Fifth Circuit looked to the use of the term under the Uniform Commercial Code. It explained:

The parties agree that the relevant state law is that of Texas. In Texas, a “purchase-money security interest” in goods is defined as a security interest in goods that are “purchase-money collateral,” and “purchase-money collateral” is in turn defined as goods that secure a “purchase-money obligation.” TEX.BUS. & COM. CODE § 9.103. Texas defines “purchase-money obligation” as “an obligation . . . incurred as all or part of the price of the collateral or for value given to enable the debtor to acquire rights in or the use of the collateral if the value is in fact so used.” Id. The definition of “purchase-money obligation” thus contains two prongs: (i) the price of the collateral, and (ii) value given to enable the debtor to acquire rights in or use of the collateral.

Opinion at 7.

Official Comment number 3 to Sec. 9.103 explains that the "price" of the collateral and "value given to enable" includes items such as "sales taxes, duties, finance charges, interest, freight charges, costs of storage in transit, demurrage(???), administrative charges, expenses of collection and enforcement, attorney's fees, and other similar obligations." Thus, because the concept of value given to enable the debtor to acquire rights in the collateral is broader than just the purchase price of the vehicle under the UCC, the same analysis applies under the hanging paragraph.

Once the Circuit reached this conclusion, the rest was easy. The debtor could not have acquired rights in the collateral without incurring the entire debt. While the debtor could have purchased a vehicle without an extended warranty, the debtor could not have purchased a vehicle with an extended warranty without paying for the warranty. Similarly, the debtor could have purchased a new vehicle without trading in his old vehicle. However, under Texas law, a dealer cannot accept a vehicle in trade without paying off the existing lien. Thus, if the debtor wishes to trade in an old vehicle with negative equity, paying off that negative equity is part of the amount which must be paid to acquire rights in the vehicle.

In making its ruling, the Fifth Circuit agreed with the Fourth, Tenth and Eleventh Circuits as well as the highest court in New York. In re Price, 562 618 (4th Cir. 2009); In re Ford, 2009 WL 2358365 (10th Cir. 8/3/09); In re Graupner, 537 F.3d 1295 (11th Cir. 2008); In re Peaslee, 13 N.Y.3d 75 (2009)(the New York court was answering a certified question from the Second Circuit). While the result is counter-intuitive, it follows a counter-intuitive state law definition so that the definition is consistent between state and federal courts.

Texas Chapter 11 Filings Continue to Soar

Texas chapter 11 filings continue to soar, with second quarter 2009 filings nearly triple the level from the same quarter in 2008. Filings in each of Texas's four districts were greater than in any of the previous five quarters.

Statewide, there were 430 new chapter 11 cases filed from April 1, 2009 to June 30, 2009. During the same period in 2008, there were only 152 cases filed.

Leading the state was the Western District of Texas with 176 new chapter 11 cases. This contrasts with less than 20 filings per quarter in each of the first three quarters of 2008. The Western District numbers were boosted by the filing of 121 cases related to Crescent Real Estate. However, when these cases are backed out, the Western District still had 55 additional cases, which would be a recent high for the district.

To place the Western District of Texas numbers in perspective, the Clerk's office has a summary of annual filings since 1993. See here. During the period from 1993 to 2008, the Western District had a low of 79 chapter 11 cases in 2006 and a high of 246 in 1993. In one day, the Western District had more chapter 11 filings than for the entire years of 1999, 2000, 2005, 2006, 2007 and 2008. The 228 cases filed during the first half of 2009 are greater than any year's annual totals except for 1993 when there were 246 filings. However, this record will likely be eclipsed by the end of the year.

The Northern District of Texas followed with 134 cases compared to just 57 during the same quarter of 2008. The Southern District of Texas reported 93 new chapter 11s, while the Eastern District of Texas had 27 new cases.

Judge to Investment Bankers: Pigs Get Fat and Hogs Get Their Employment Denied

Eye-popping professional fees have become more commonplace as larger and larger firms enter bankruptcy. However, one judge has drawn the line at a request to employ two investment banking firms with guaranteed upfront fees of $1 million to supplement the two valuations already obtained in the case. The opinion contains equal amounts outrage at the professionals' chutzpah and measured analysis of the record required to justify employment under 11 U.S.C. Sec. 328 in light of Pro-Snax. While the judge's colorful language is startling in its boldness, it offers substantial guidance in distinguishing between a routine application to employ and an extraordinary one and the record necessary to meet the higher burden. In re Energy Partners, Ltd., No. 09-32957 (Bankr. S.D. Tex. 7/28/09). The opinion is here.

The Lead-Up to the Opinion

Energy Partners, Ltd. is a publicly traded company which filed chapter 11 in Houston this year. The Debtor obtained a valuation which showed no value for equity. An equity holder offered a valuation schowing substantial value for equity and this valuation was included in the disclosure statement. At the point that the disclosure statement had been approved, the Equity Committee and the Unsecured Noteholders' Committee wanted to hire their own investment bankers rather than using the existing valuations.

The Equity Committee sought to employ Tudor Pickering for compensation including: (a) a $500,000 non-refundable advisory fee; (b) an extended engagement fee of $100,000 per month if its services were still required as of September 1, 2009: (c) a fee of $25,000 per day for any day in which its employees were required to testify; and (d) reimbursement of expenses. Employment was sought under Sec. 328, so that the fees could not easily be re-examined based on the actual results in the case.

The Unsecured Noteholders' Committee sought to engage Houlihan Loukey on the following terms: (a) an upfront non-refundable fee of $500,000; (b) a non-refundable fee of $100,000 for August 1-15, 2009; (c) a non-refundable fee of $100,000 for August 16-31, 2009; and (d) reimbursement for out of pocket expenses. This employment was also sought under Sec. 328.

In contrast, the Debtor's investment banker, Parkman Whaling, charged the relatively modest fee of $75,000 per month with no upfront fee. (While this is not insignificant, it always helps to be the party with the lowest bill when trying to get compensated).

Bank of America objected on the grounds that: (a) the fees were too high; (b) the fees were non-refundable; (c) the fees were to be paid from Bank of America's cash collateral; and (d) the proposed payments violated the budget in the cash collateral order. The Unsecured Creditors' Committee objected as well. The Debtor did not object, but expressed concern about the $25,000 per day fee expert witness fee.

The Court heard from three witnesses at the employment hearing: a representative from each investment banking firm and a member of the Equity Committee.

The Court orally denied the applications for employment and followed up with its memorandum opinion.

The Opinion

The introduction to Judge Bohm's opinion sets the tone for what follows:

Oblivious to recent congressional and public criticism over executives of publicly-held corporations who are paid monumental salaries and bonuses despite running their companies into the ground, two investment banking firms now come into this Court requesting that they be employed under similarly outrageous terms. They do so because two committees in this Chapter 11 case have filed applications to employ these investment banking firms to perform valuation services even though two other independent firms have already performed similar valuations. These investment bankers, who wish to have their fees and expenses paid out of the debtor's estate, have sworn under oath that they will render services only if they immediately receive a nonrefundable fee aggregating $1.0 million. This Court declines the opportunity to endorse such arrogance. The purse is too perverse.

The committees' request to hire the most expensive investment bankers at virtually nondisgorgable and astronomically high fees is tantamount to a debtor chartering a private jet to travel to a meeting ofcreditors. While this hypothetical debtor may well need transportation in order to attend the meeting, just as the committees in the case at bar may legitimately believe they each need an independent valuation consultant, both have requested the most inordinately expensive means by which to achieve their objectives. To approve such a request runs contrary to a fundamental principle of bankruptcy: that a debtor and all professionals associated with the case should act with a measure of frugality in order to preserve the estate's assets and thereby maximize the chances for a successful reorganization.

Memorandum Opinion, pp. 1-2.

Section 328 & Pro-Snax

Section 328 allows the court to employ a professional "on any reasonable terms and conditions of employment, including on a retainer, on an hourly basis, on a fixed or percentage basis, or on a contingent fee basis." The court may allow different compensation only "if such terms and conditions prove to hae been improvident in light of deelopments not capable of being anticipated at the time of the fixing of such terms and conditions." Thus, if the court approves employment under Section 328 on a non-refundable, flat fee basis, as proposed here, the court would be relatively powerless to change the fee absent something incapable of being anticipated. Thus, if the investment bankers wrote their valuation in crayon on a Big Chief tablet or showed up for court but slept through the proceedings, both of those possibilities were capable of being anticipated and would not allow a change in the fees. On the other hand, if the bankruptcy court sunk into the Gulf of Mexico preventing the hearing from taking place, that would probably be something not capable of being anticipated.

Judge Bohm noted that courts have identified the following factors for determining whether to approve employment under Section 328:

(1) whether terms of an engagement agreement reflect normal business terms in the marketplace; (2) the relationship between the Debtor and the professionals, i.e., whether the parties involved are sophisticated business entities with equal bargaining power who engaged in an arms-length negotiation; (3) whether the retention, as proposed, is in the best interests of the estate; (4) whether there is creditor opposition to the retention and retainer provisions; and (5) whether, given the size, circumstances and posture ofthe case, the amount ofthe retainer is itselfreasonable, including whether the retainer provides the appropriate level of "risk minimization," especially in light ofthe existence of any other "risk-minimizing" devices, such as an administrative order and/or a carve-out.

Memorandum Opinion, p. 19, (quoting In re Insilco Techs., Inc., 291 B.R. 628, 633 (Bankr. D. Del. 2003).

The Court also noted that some courts have imposed specific requirements for investment bankers, quoting the following language from an opinion in the District of Massachusetts which relied upon an opinion from the Southern District of New York:

Any investment banker/advisor retention application submitted to this court must present the scope and complexity of the assignment, its anticipated duration, expected results, required resources, the extent to which highly specialized skills may be needed and the extent to which they have them or may have to obtain them, projected salaries ofparticipating professionals, billing rates and prevailing fees for comparable engagements, current retentions in bankruptcy by the retained firm, and any estimated lost opportunity costs due to time exigencies ofthe job. In addition, the actual retention agreement between the investment banker/advisor and the client must be attached to the retention application and, the party retaining the professional must describe the process by which the financial banker/advisor has been selected. This latter requirement is aimed specifically at offsetting what we perceive as a lack of competitiveness in the selection process. Finally, the application must explain how the investment banker/advisor will eliminate, or at least reduce, the duplication of effort[s] .... We liken our requirements to a financial impact statement on the estate. Only with an advance picture of the job to be accomplished will we be able to measure the results (or lack thereof) achieved.

Memorandum Opinion, pp. 30-31, quoting In re High Voltage Engineering Corp., 311 B.R. 320,333-334 (Bankr. D. Mass. 2004).

On top of all this, Judge Bohm noted the requirement in the Fifth Circuit that a professional generate a tangible, identifiable and material benefit to the estate in order to be compensated. This stems from the Fifth Circuit's Pro-Snax decision. In the context of a Section 328 application, Judge Bohm found that the applicant must show in advance that they will provide a tangible, identifiable and material benefit.

Given all of these requirements and the scant record, it was highly improbable that the applications would withstand objection. However, Judge Bohm entered a lengthy analysis as to why the factors were not met. Among other things, the applicants failed to prove that their rates reflected normal business terms in the market. The only evidence of market conditions consisted of the fact that the debtor's investment bankers were willing to work for $75,000 per month, while the two committees' advisors wanted $500,000 upfront in order to begin work. Judge Bohm was particularly offended by the $25,000 per day expert witness fee, noting that many Americans performing valuable services, such as military policemen and nurses, make that much money in a year. He found that the terms and conditions were insufficiently spelled out. One of the firms completely failed to spell out the terms of what it would do in its engagement agreement. They also failed to explain why a non-refundable fee was necessary to obtain a qualified professional. Additionally, the Court noted the opposition from creditors and the fact that the upfront fees would shred the cash collateral order. (Note: This is a very abbreviated summary of the factors discussed in the opinion).

The Conclusion

After all these pages of analysis, Judge Bohm, channeling Howard Beale*, proclaimed:

At some point, this Court must draw the line between what is reasonable and what is not. To quote the Fifth Circuit: "'[W]hen a pig becomes a hog it is slaughtered. '" (citation omitted). "As the finder of fact, the bankruptcy court has the primary duty to distinguish hogs from pigs." (citation omitted). Although the Fifth Circuit expressed this sentiment under a different set of facts than those in the case at bar,this Court sees good reason why this maxim applies here with equal force. These two investment banking firms have become hogs. Indeed, the investment bankers in the case at bar appear to have embraced the outlook expressed by Michael Douglas's character, Gordon Gekko, in the film Wall Street that "Greed-for lack of a better word-is good. Greed is right. Greed works. That may be how Wall Street views the world, but it is not how this Court sees things. In this Court, Greed is not good; Greed is wrong; and Greed does not work. Rather, the Court refers the parties to the words of Frederick Douglass, a prominent and compelling figure in American history who knew something about hard work: "People might not get all they work for in this world, but they must certainly work for all they get."

The exorbitant fees requested by Houlihan Lokey and Tudor Pickering are similar to the "appearance fees" which certain of the world's top athletes-for example, Tiger Woods-are able to command. However, unlike Tiger Woods, whose presence does guarantee a financial benefit at any event where he appears, neither of these two investment banking firms introduced any testimony or exhibits guaranteeing some benefit to the estate in this case. They expect to be paid an appearance fee for simply showing up-not only do they not guarantee success; they do not even guarantee they will work a minimum number of hours in order to try to achieve success. This Court will therefore not approve the payment of their requested "appearance fees." Tudor Pickering is not Tiger Woods. Nor is Houlihan Lokey.

Memorandum Opinion, pp. 37-38.

After the employment under Sec. 328 was denied, the investment bankers indicated that they would be willing to be employed under the traditional Sec. 330 standards. The Court confirmed the Debtor's plan on August 3, 2009.

How Did This Happen? What Does It Mean?

The Memorandum Opinion makes the court's strong feelings quite clear. In retrospect, it seems obvious that the committees and the investment bankers badly misread what would fly. How did this happen? Part of the answer lies in the unusual nature of the case. This was the case of a publicly traded company which went from filing to plan confirmation in just 90 days, an accomplishment that GM and Chrysler achieved only by shortcutting the plan process. This was a case with three committees: an Unsecured Creditors' Committee, an Unsecured Noteholders' Committee and an Equity Committee. It is natural for a committee to want to hire a professional. After all, a committee without a professional is like a combatant who brings a knife to a gun fight. It would be a daunting task given the fact that the investment bankers would be coming in after the debtor's expert had done its work with only a short time to prepare their own. Given the circumstances, it seems likely that the investment bankers felt justified in asking for a premium rate and the committees felt like they had few other options. In the hustle and bustle of a case, it is easy to get tunnel vision and lose sight of what a transaction looks like to the outside world. In this case, the usual way of doing things ran smack into a brick wall of a judge requiring strict compliance.

So what does this all mean? Were these investment bankers a new incarnation of Gordon Gekko? Will this opinion deter big cases from filing in Houston? In the words of Dr. Ian Malcolm**, nature will find a way. Notwithstanding Judge Bohm's strong language about greed, it is still possible to get employed and compensated in Houston. This opinion gives some good guidelines as to what needs to be proven. If these standards look too difficult, it is not necessary to rely on Sec. 328. Applicants might also keep in mind that they are appearing before a bankruptcy judge who works long hours and earns $160,000 per year. When the fees for a month's work start adding up to a multiple of the judge's annual salary, you need to have a really good story as to why you are the Tiger Woods of your profession.

*--Howard Beale was the character in the movie Network who proclaimed, "I'm mad as hell and I'm not going to take it anymore."

**--Dr. Ian Malcolm was the chaos theory mathematician in Jurassic Park.

Credit Slips Blogger Cited in Opinion

Blogging can be as personal as Ranger fans venting about why Glen Sather (no relation) must go or as mundane as someone's vacation photos. However, some legal blogs succeed in putting out thoughtful analysis in real time. One of the best legal blogs is Credit Slips. That's why I was so pleased to see Credit Slips blogger Stephen Luebben cited in the recent opinion by Judge Robert Gerber in In re General Motors Corp., 2009 Bankr. LEXIS 1687 (Bankr. S.D. N.Y. 7/5/09). Prof. Luebben was cited with regard to the multiple meanings of the word "interest" in different contexts.

The Court went on to explain his reference to a blog as follows:

Blogs are a fairly recent phenomenon in the law, providing a useful forum for interchanges of ideas. While comments in blogs lack the editing and peer review characteristics of law journals, and probably should be considered judiciously, they may nevertheless be quite useful, especially as food for thought, and may be regarded as simply another kind of secondary authority, whose value simply turns on the rigor of the analysis in the underlying ideas they express.

In re General Motors Corp., at 85, n. 96.

Another recent blog citing was in In re Gulf Coast Oil Corp., 404 B.R. 407 (Bankr. S.D. Tex. 2009)(quoting Wall Street Journal Bankruptcy Beat).

It's nice to know that the judges are out there reading.

Rule Amendment Proposes to Allow Objections to Exemptions After Conversion

The Committee on Rules and Practice has recommended that the Judicial Conference approve a series of changes to the Federal Rules of Bankruptcy Procedure. One proposal is to amend Rule 1019 to allow a new period of time to object to exemptions when a case is converted from chapters 11, 12 or 13 to chapter 7. Currently, if creditors fail to object to an exemption in a reorganization case and the case is later converted to chapter 7, the chapter 7 trustee does not have an opportunity to object unless the debtor amends their exemptions. However, the rule would not apply if: (i) the case was originally filed as a chapter 7 and the period for objecting to exemptions expired or (ii) a plan was confirmed more than one year prior to conversion. If approved by the Judicial Conference, the rule will be transmitted to the Supreme Court for adoption.

Fifth Circuit Holds That Projected Disposable Income Should Reflect Reality

In a new opinion, the Fifth Circuit ruled that the calculation of "projected disposable income" in a chapter 13 plan is not merely a mechanical calculation and may take note of events "reasonably certain" to occur. Matter of Nowlin, Non. 08-20066 (5th Cir. 7/17/09). In doing so, the Fifth Circuit sided with the Eighth and Tenth Circuits and rejected a decision from the Ninth Circuit.

Nowlin involved an above median income debtor whose means test form indicated that she could pay $38.67 per month, but whose schedules I and J indicated that she could pay $195.64. The Debtor proposed a plan to pay $195.00 per month for 60 months. The only problem was that the Debtor had a 401k loan which would pay off in two years, which would free up $947.30 per month. The Trustee objected on the basis that the Debtor was not including all of her "projected disposable income" based on the money which would be freed up in the future. The Debtor responded that all she had to do was take the number listed on the means test and multiply by 60.

The Fifth Circuit held that "projected disposable income" was something more than just a mechanical computation and could take other events into account.

We are persuaded that the independent definition of “projected” adds to the phrase’s overall meaning. The term “projected,” not defined in the statute, means “[t]o calculate, estimate, or predict (something in the future),based on present data or trends.” (citation omitted). In view of this definition, with which Nowlin agrees, we interpret the phrase “projected disposable income” to embrace a forward-looking view grounded in the present via the statutory definition of “disposable income” premised on historical data. The statutorily defined “disposable income” is the starting point—it is presumptively correct—from which the bankruptcy court projects that income over the course of the plan. Under this interpretation, the statutory definition of “disposable income” is integral to the bankruptcy court’s decision to confirm or reject a Chapter 13 debtor’s proposed plan.

Opinion, pp. 6-7.

The Court's two holdings were as follows:

Thus, we hold that a debtor’s “disposable income” calculated under § 1325(b)(2)and multiplied by the applicable commitment period is presumptively the debtor’s “projected disposable income” under § 1325(b)(1)(B), but that any party may rebut this presumption by presenting evidence of present or reasonably certain future events that substantially change the debtor’s financial situation.

Opinion, p. 12.

We hold that a bankruptcy court may consider reasonably certain future events when evaluating a Chapter 13 plan for confirmation under § 1325. Some events may be too speculative, such as the fluctuation of an investment market during the plan’s term and its impact on the debtor’s budget. Other events are much more certain, as in this case where the debtor will pay off a debt at a date certain. If the event is less than reasonably certain to occur, amendment under 11 U.S.C. § 1329 is the appropriate way to proceed if a party wishes to change the plan.

Opinion, p. 14.

While Nowlin was a defeat for the debtor in the specific case, it also offers the possibility of mitigating an unusually harsh result from the means test. In its opinion, the Fifth Circuit noted that if the debtor's six month average income was higher than his current income due to a change in job, this was something which could be factored in. Additionally, if it was reasonably certain that an expense would increase, for example, if the debtor had received notice that his rent would increase in six months, the means test could be adjusted there as well.

The Fifth Circuit has established a workable framework for making the means test conform to reality. The means test provides the presumptive starting point. If changes have already occurred or are "reasonably certain" to take place, they may be accounted for in confirmation of the initial plan. On the other hand, if the effect of a future occurrence cannot be predicted with reasonably certainty, the remedy is to file for a modification of the plan under section 1329.

Ninth Circuit Joins Consensus: 401k Loans Not Deductible As Secured Debt Under Means Test

Joining what has become the consensus position, the Ninth Circuit has held that payments on a 401k loan may not be deducted under the chapter 7 means test. Egebjerg v. Anderson, 2009 U.S. App. LEXIS 11651 (9th Cir. 5/29/09). The opinion highlights a major inconsistency in the way that BAPCPA treats retirement plan loans.

The Ninth Circuit ruled that a loan from a retirement plan was not a debt and therefore was not a secured debt which could be deducted on line 42 of the means test. The crux of the ruling is found in the following language:

The reasoning behind these decisions is straightforward. Egebjerg’s obligation is essentially a debt to himself — he has borrowed his own money. (citation omitted). Egebjerg contributed the money to the account in the first place; should he fail to repay himself, the administrator has no personal recourse against him. (citation omitted). Instead, the plan will deem the outstanding loan balance to be a distribution of funds, thereby reducing the amount available to Egebjerg from his account in the future. (citation omitted). This deemed distribution will have tax consequences to Egebjerg, but it does not create a debtor creditor relationship.

Opinion, pp. 6386-87.

In my view, this is an area where the law has gone astray. I recently received a loan from my 401k plan. The document which I signed was entitled "Loan Agreement, Note and Pledge." In pertinent part, the document stated:

For value received the Borrower agrees to pay the Lender the amount of $________ principal and interest at an annual interest rate of ______%. The length of the loan shall be ___ months. Payment shall be made to the Trustee of the Plan in the amount of $_______ Semi-Monthly beginning ______ and ending _______. Prepayment of the unpaid principal and accrued interest may be made by the Borrower at any time without penalty.

Pledge to secure this loan: Borrower hereby irrevocably pledges his/her vested account balance under the Plan in satisfaction of any unpaid balance and associated costs due and payable upon default.

Thus, there is a Lender, a Borrower, a promise to pay and a security interest. The fact that the security interest is in funds contributed to a retirement plan should not make a difference. While the funds in the retirement plan originated from my contributions, they are no longer under my dominion and control. If I buy 1 share of Berkshire Hathaway and then borrow money secured by that stock, I have in essence borrowed my own money; my money has just taken the form of Berkshire Hathaway stock instead of cash. The pledge of the stock allows me to keep my money in the form of the stock while having access to it through the intermediary of the bank. The analogy of a pledge of stock is particularly appropriate, since I have the assets in my 401k plan invested in mutual funds.

Besides ignoring the form and substance of the transaction, the consensus position is inconsistent with the manner in which 401k loans are treated elsewhere by BAPCPA. BAPCPA included three provisions specifically aimed at protecting retirement plan loans. Section 362(b)(19) provides that retirement plan loans are not subject to the automatic stay, thus allowing their continued collection in a bankruptcy case. Section 523(a)(18) provides that a "debt" owed to a retirement plan is non-dischargeable, thus protecting a debtor from tax liability resulting from discharge of the loan. Finally, Section 1322(f) provides that a retirement plan "loan" may not be altered by a chapter 13 plan and may not be included in calculation of the debtor's disposable income. There are two important points here. The first is that since the Code refers to these obligations as "debts" and "loans" in other places, why would they not be a debt or a loan under the means test? Secondly, the purpose of the chapter 7 means test is to identify debtors who can afford to pay their debts under a chapter 13 plan. Therefore, it makes logical sense to interpret the chapter 7 means test in light of what would be deductible in a chapter 13 case.

Unfortunately, it looks like the train has left the station on this issue and the Ninth Circuit's position does reflect a consensus among courts. As a result, this may be an issue requiring a legislative fix.

Circuit Court Denies Claim For Lack of Supporting Documentation

The 10th Circuit has ruled that a trustee's objection to an assigned proof of claim should be sustained based on lack of supporting documentation even though the debtor scheduled a similar claim. In re Kirkland, No. 08-2017 (10th Cir. 7/14/09). The opinion can be found here.

In Kirkland, the debtor scheduled a debt in the amount of $5,004 for a credit card account ending in 2787. NextBank, N.A./B-Line, LLC filed a proof of claim in the amount of $5,328.19 for a credit card account ending in 2787, but did not include any supporting documentation. The chapter 7 trustee objected to the claim. Neither the trustee nor the creditor offered any evidence at the hearing, although the creditor asked the court to take judicial notice of the debtor's schedules. The Bankruptcy Court sustained the objection, finding that the creditor had failed to prove up its claim. In re Kirkland, 361 B.R. 199 (Bankr. D.N.M. 2007). The Bankruptcy Appellate Panel reversed. In re Kirkland, 379 B.R. 341(10th Cir. BAP 2007).

The 10th Circuit held that the Bankruptcy Court was correct in denying the claim. It stated:

The bankruptcy court appropriately determined that because B-Line bore the burden of proof for its claim and failed to meet its burden, its claim was disallowed. See In re Kirkland, 361 F.3d at 205. The plain language of the bankruptcy Code and its associated procedural rules support the court’s ruling. The Bankruptcy Code provides that “[a] creditor . . . may file a proof of claim.” 11 U.S.C. § 501(a). Because the code does not define “proof of claim,” we look to the Federal Rules of Bankruptcy Procedure. “A proof of claim is a written statement setting forth a creditor’s claim. . . . [It] shall conform substantially to the appropriate Official Form.” Fed. R. Bankr. P. 3001(a). The relevant form is Official Form 10, which requires a claimant to “[a]ttach redacted copies of any documents that support the claim, such as promissory notes, purchase orders, invoices, itemized statements of running accounts, contracts, judgments, mortgages, and security agreements.” Fed. R. Bankr. P. Official Form 10. Form 10 also instructs a claimant that “[i]f the documents are not available, please explain.” Id. When a proof of claim is executed and filed in accordance with the provisions of Rule 3001 (including Official Form 10), it “constitutes prima facie evidence of the validity and amount of the claim.” Fed. R. Bankr. P. 3001(f).

B-Line has failed to produce a single document to support its proof of claim. B-Line has also failed to explain its failure to provide supporting documentation. Although the bankruptcy court took judicial notice of the Debtor’s appended schedules of unsecured creditors, it correctly determined that the schedules were of no evidentiary value against the Trustee. Therefore, B-Line has failed to present “prima facie evidence of the validity and amount of the claim.” Id. In response to the Trustee’s objection, the bankruptcy court held an evidentiary hearing. Even then, B-Line produced no evidence in support of its claim and no explanation for its failure to do so. On this record, we conclude that the bankruptcy court appropriately disallowed B-Line’s claim. Had the bankruptcy court allowed B-Line’s claim despite B-Line’s failure to provide either supporting evidence or an explanation for its failure to provide supporting evidence, the burden would have improperly rested with the Trustee to disprove an unsubstantiated claim. (citation omitted).

Opinion, at 5-6.

The Court of Appeals' reasoning can be summarized as follows:

1. A properly filed proof of claim is entitled to prima facie validity.

2. A claim without supporting documentation is not a properly filed proof of claim and is not entitled to prima facie validity.

3. The trustee is not estopped by the debtor's schedules.

4. If a claim is not entitled to prima facie validity and is not supported by competent evidence, the claim must be denied without the necessity for the objecting party to offer any proof.

This is an issue which has been percolating through the lower courts for some time now. See On Gunslingers, Presumptions and Burdens of Proof and Assigned Credit Card Debt: A Problem of Paper, Electronic Images and Faith. However, this appears to be the first Circuit Court opinion to weigh in on the effect fo failure to attach documentation to a credit card claim. However, the ruling may be of primary benefit to trustees, since the trustee was not estopped by the debtor's schedules. If the objection had been brought by a debtor, the result might have been different.

More About Judge Sotomayor and Bankruptcy

Supreme Court nominee Sonia Sotomayor’s questionnaire completed for the Senate Judiciary Committee contains a mind-numbing 173 pages of details about the prospective justice. If you need to know who she gave a speech to in 1993 or which single-sex club she belonged to until recently, this is the place to look. However, the questionnaire also contains some information of interest to bankruptcy practitioners.

First, Judge Sotomayor has seen the inside of a bankruptcy courtroom. When asked to name the ten most significant cases that she litigated, Judge Sotomayor included In re Van Ness Auto Plaza, Inc., a case in which she represented Ferrari North America, Inc. in the bankruptcy of one of its franchisees. As an attorney, Judge Sotomayor successfully opposed the debtor’s attempt to assume the franchise agreement while rejecting contracts to sell vehicles to customers. Thus, the prospective Justice is not only a wise Latina who came up from the projects, but also a defender of Ferrari purchasers.

Second, this Supreme Court term has not been kind to Judge Sotomayor. While Ricci v. Destefano received more media attention, Judge Sotomayor was also part of the panel whose decision was reversed in the only major bankruptcy case of the term. In Johns-Manville Corp. v. Chubb Indemnity Insurance Co., 517 F.3d 52 (2nd cir. 2008), the Second Circuit ruled that the bankruptcy court’s jurisdiction to enter a channeling injunction in the Johns-Manville bankruptcy case did not extend to claims arising from the insurance company’s conduct as opposed to the debtor’s conduct. The court found that the jurisdiction issue could be raised when the insurance company sought to enforce the bankruptcy court’s order even though it had not been challenged on direct appeal. The Supreme Court reversed, finding that the jurisdictional challenge was an improper collateral attack on the bankruptcy court’s order. Travelers Indemnity Company v. Bailey, 2009 U.S. LEXIS 4537 (June 18, 2009). Thus, Judge Sotomayor was on the losing side of a major bankruptcy precedent.

Fifth Circuit Allows Ownership Expense on Paid For Vehicle

The Fifth Circuit has held that a debtor may claim an ownership expense on the chapter 7 means test even if the debtor does not have a loan or lease payment. In re Tate, No. 08-60953 (5th Cir. 6/10/09). In the Tate case, the debtors owned two paid for vehicles. If they were allowed to claim a vehicle ownership expense under the means test, their monthly disposable income was $137.66, just under the threshold of $166.67 where their case would be deemed to be abusive. A Bankruptcy Court in Mississippi dismissed the case on the Trustee's motion, a decision which was upheld by the District Court.

However, when the matter reached the Fifth Circuit, the Court concluded that "the debtors should have been able to deduct the transportation ownership deduction under the plain language" of the statute. The Fifth Circuit noted a split between courts following the "plain language" approach and the Internal Revenue Manual test. The Court described the two approaches as follows:

Both approaches start from the text of the statute, which states in part, "The debtor's monthly expenses shall be the debtor's applicable monthly expense amounts specified under the National Standards and Local Standards." (citation omitted). The approaches differ, however, in how they read the word "applicable" in the above sentence.

Courts following the "plain language" approach read the word "applicable" to refer to the selection of an expense amount from the Local Standards that relates to the geographic area in which the debtor resides and the number of vehicles the debtor owns. (citation omitted). Under the plain language approach, the vehicle ownership deduction that "applies" to a debtor is the one that corresponds to his geographic region and number of cars regardless of whether that deduction is an actual expense. (citation omitted). . . .

Courts following the IRM approach conclude that the vehicle ownership deduction is not allowed if the debtor has no debt payment. These courts reach this result by reading the word "applicable" to modify "monthly expense" amounts so the debtor can deduct this expense if he has a "relevant" ownership expense. (citation omitted). In other words, under this approach, if the debtor has no debt or lease payment related to a vehicle, he cannot take the ownership deduction because it is not applicable or relevant to him. This interpretation is called the IRM approach because the courts following it use the methology of the IRM as an interpretive guide for applying the means test. (citation omitted). Under this approach, courts look not only to the Local Standards but also to how the IRS uses the Local Standards in its revenue collection process. Under the IRM, if a taxpayer has no car payment, the taxpayer is only entitled to the vehicle operation expense, not the ownership deduction.

Opinion, pp. 4-5.

In adopting the plain language approach, the Fifth Circuit sided with the Seventh Circuit, which is the only other circuit court to address the issue. In re Ross-Tousey, 549 F.3d 1148 (7th Cir. 2008).

As I see it, the plain language approach is preferable for at least three reasons. First, it is always best to follow the plain language of the statute. Any time that courts bend a statute to arrive at the result that Congress may have intended, they stray into legislating rather than judging. Second, following the Internal Revenue Manual poses a separation of powers issue. While it is bad enough that BAPCPA relies on a standard promulgated by the executive branch to determine eligibility for bankruptcy, at least the National and Local Standards purport to be based on objective factors. However, allowing the IRS to shade those standards through the IRM effectively allows an executive branch agency to amend the statute, which is an obvious problem. Finally, allowing an ownership expense recognizes reality. A car is a depreciating asset. Even if a debtor does not have a debt payment, the trade-in value of the vehicle is going down. Thus, a prudent debtor who does not have a car payment would still be saving for the downpayment on a replacement vehicle. Allowing an ownership expense only for debtors with a car payment penalizes the debtor who keeps a car for the long term as opposed to the person who trades for a shiny, new car every year.

Supreme Court Grants Cert in Attorney Speech Case

The Supreme Court has granted certiorari in Milavetz, Gallop & Milavetz, P.A. v. United United States, 541 F.3d 785 (8th Cir. 2008), cert granted, 2009 U.S. LEXIS 4277 (6/8/09). The Milavetz case held that the provision in BAPCPA preventing attorneys from advising debtors to incur debt in contemplation of bankruptcy was an unconstitutional restriction on the right to free speech under the First Amendment. Although it is not in direct conflict, the Fifth Circuit took a somewhat different tack on this issue, finding that the statute was not facially overbroad and reserving the issue of whether it could be overbroad as applied in a specific case. Hersh v. United States, 553 F.2d 743 (5th Cir. 2008). Thus, the Eighth Circuit said that the statute was unconstitutional on its face, while the Fifth Circuit held that a constitutional challenge would have to wait until there was an actual case where an attorney was punished for providing advice contrary to the statute.

Milavetz also had two other rulings, finding that attorneys were Debt Relief Agencies and finding that the mandatory disclosures (i.e., "We a Debt Relief Agency") was constitutional. Most courts have agreed with these conclusions.

Milavetz had one interesting sidenote. The Commercial Law League of America, a professional group, which represents the interests of creditors, filed an amicus brief in support of the plaintiffs' position. Thus, this is a case where a creditor's trade group spoke up for the speech rights of debtor's lawyers.

The order granting certiorari did not limit itself, so that it appear that the Supreme Court will take up all three issues.

Supreme Court Decides One Case and Hints At Result in Another

While many continuing legal education conferences consist of regurgitations of things you already know, every once in a while, you gain an insight which makes it all worthwhile. Today at the State Bar of Texas Bankruptcy Section Bench-Bar Conference, I was fortunate enough to hear Nashville Bankruptcy Judge Keith Lundin tie together today's decision in Travelers Indemnity Co. v. Bailey, 557 U.S. ___ (6/18/09) with the decision to grant cert in Espinosa v. United Student Aid Funds,Inc., 545 F.3d 1113, as amended at 553 F.3d 1193 (9th Cir. 2008), cert granted, 2009 U.S. LEXIS 4361 (U.S. 6/15/09). The common link between the two cases is whether bankruptcy court orders which could have been objected to are subject to collateral attack when they are not. In Travelers, the Supreme Court held that a bankruptcy court injunction contained in a confirmation order was not subject to collateral attack. Judge Lundin suggested that the Supreme Court might be signalling a similar result in Espinosa, a case involving a chapter 13 confirmation order.

20 Year Old Order Trumps in Travelers

The Travelers case arose out of the Johns-Manville bankruptcy case. In return for contributing $770 million to a trust created by the plan of reorganization, Mansville's insurers received the benefit of an injunction preventing suits against them. Over a decade later, plaintiffs started suing Travelers for withholding information about the dangers of asbestos or conspiring with Manville to conceal the dangers of asbestos. Many of these suits accused Travelers of acting wrongfully in its own capacity rather than as Mansville's insurer.

Travelers agreed to settle with some of the plaintiffs in return for an order from the Bankruptcy Court clarifying that the suits were barred by the original 1986 order. The Bankruptcy Court granted the clarifying order, finding that the direct suits against Travelers were encompassed by its original order.

On appeal, the Second Circuit reversed. It held that it was not enough to look to the terms of the prior order. Instead, it was necessary to deteermine whether the order was within the subject matter jurisdiction of the Bankruptcy Court. Concluding that the Bankruptcy Court did not have subject matter jurisdiction to enjoin suits against a non-debtor insurance company based on the insuror's own misconduct, the Second Circuit reversed.

On writ of certiorari, the Supreme Court reversed the Second Circuit and reinstated the Bankruptcy Court's order. The Supreme Court stated:

If this were a direct review of the 1986 Orders, the Court of Appeals would indeed have been duty bound to consider whether the Bankruptcy Court had acted beyond its subject-matter jurisdiction. (citation omitted). But the 1986 Orders became final on direct review over two decades ago, and Travelers' response to the Circuit's jurisdictional ruling is correct: whether the Bankruptcy Court had jurisdiction and authority to enter the injunction in 1986 was not properly before the Court of Appeals in 2008 and is not properly before us.

Opinion of the Court, p. 10.

Travelers Ruling Hints At Espinosa Result

While this ruling is significant, it also suggests that direction that the Supreme Court might take in a case in which it granted certiorari earlier this week. In Espinosa v. United Student Aid Funds, Inc., a chapter 13 debtor included several provisions in its plan related to student loans:

1. It provided that the student loan claim would be paid in the amount of $13,250;

2. It provided that "The amounts claimed by the United Student Loan Aid Funds, Inc., et. al. for capitalized interest, penalties, and fees shall not be paid for the reasons that the same are penalties and not provided for in the loan agreement between the Debtor and the lender."

3. It provided that amounts not paid under the plan would be discharged.

The creditor also received a notice stating that if it did not agree with the treatment provided for its claim under the plan, that it was under an obligation to object.

United Student Aid Funds, Inc. filed a claim for a higher amount, but did not object to the plan. After the debtor completed its plan and received a discharge, United began intercepting the Debtor's tax refunds. Espinosa sought to hold United in contempt, while United sought a determination that the plan could not discharge its student loan debt. The Bankruptcy Court ruled that the plan controlled and that the student loan debt was discharged.

On appeal, United claimed that the plan could not discharge the debt because the Debtor did not file an adversary proceeding seeking a hardship discharge. The Ninth Circuit disagreed, stating:

(W)hen the creditor is served with notice of the proposed plan, it has a full and fair opportunity to insist on the special procedures available to student loan creditors by objecting to the plan on the ground that there has been no undue hardship finding. Rights may, of course, be waived or forfeited, if not raised in a timely fashion. This doesn't mean that these rights are ignored, or that a judgment that is entered after a party fails to assert them conflicts with the statutory scheme or is somehow invalid.

Espinosa, at 1118.

The Ninth Circuit rejected an argument that United did not receive due process.

It makes a mockery of the English language and common sense to say that Funds wasn't given notice, or was somehow ambushed or taken advantage of. The only thing the creditor was not told is that it could insist on an adversary proceeding and a judicial determination of undue hardship. But that's less a matter of notice and more of a tutorial as to what rights the creditor has under the Bankruptcy Code--a long-form Miranda warning for bankers. If that were the standard for adequate notice, every notification under the Bankruptcy Code would have to be accompanied by Collier's Treatise, lest the creditor overlook some rights it might have under the Code.

Esinosa, at 1121.

On motion for rehearing en banc, the Ninth Circuit found it necessary to add some additional authority to its opinion. One of its insertions referred to a treatise written by Judge Keith Lundin, stating:

Rather, we agree with Judge Lundin that "Pardee and Andersen stand soundly for the better-reasoned principle that notice of how the Chapter 13 plan affects creditors' rights is all that the Constitution, the Bankruptcy Code and the Bankruptcy Rules require to bind creditors to the provisions of a confirmed plan under § 1327(a)." Keith M. Lundin, Chapter 13 Bankruptcy § 229.1 (3d ed. 2000 & Supp. 2004)."

553 F.3d at 1196.

Judge Lundin makes an interesting point. If the confirmation injunction in Travelers was valid regardless of whether the Bankruptcy Court arguably exceeded its subject matter jurisidction, wouldn't it follow that an order confirming a chapter 13 plan would be entitled to similar respect even if the debtor failed to comply with the procedural niceties for commencing an adversary proceeding.

Will Espinosa Extend the Reach of Shoaf?

The outcome in Espinosa will have significant repercussions in the Fifth Circuit. The Fifth Circuit has three opinions holding that a provision in a plan cannot determine the allowance of a claim or the secured status of the claim. In re Taylor, 132 F.3d 256 (5th Cir. 1998)(chapter 11 plan could not establish amount of responsible person liability at $0); In re Howard, 972 F.2d 639 (5th Cir. 1992)(chapter 13 plan could not reduce amount of secured claim to $500); In re Simmons, 765 F.2d 547 (5th Cir. 1985)(no res judicata effect for chapter 13 plan which erroneously listed claim as unsecured). The Fifth Circuit has held that this trio of cases is an exception to the general rule contained in Republic Supply Co. v. Shoaf, 815 F.2d 1046 (5th Cir. 1987) that unobjected to provisions in a plan are enforceable based on res judicata. Since the rationale in the Simmons trio was that additional procedural requirements were required to affect a claim, an opinion upholding Espinosa could undermine these precedents.

Chapter 11 in Texas: Introduction to the 2008 Cases

Enron filed in the Southern District of New York. However, there are still chapter 11 cases being filed in Texas. During 2008, there were a total of 701 chapter 11 cases filed in Texas. This will be the first of a series of posts examining the Class of 2008. In future posts, I hope to look at who filed, who represented them and how many were successful.

Where Do Texas Chapter 11s File?

In this post, I will look at something more basic: where did the cases file. The answer is that more chapter 11 cases are filed in big cities than in small towns. While there is nothing surprising about the fact that more chapter 11s were filed in Dallas or Houston than in Lubbock, it is interesting that some large metropolitan areas attract a disproportionate number of cases.

The cases were distributed among the four districts of Texas as follows:

Southern District of Texas--271
Northern District of Texas--249
Western District of Texas---102
Eastern District of Texas----79

Of the cases filed in Texas, 663 originated within Texas and 38 were filed by out of state debtors. During 2007 (which is the most recent year available), the population of Texas was 23,904,380. That means that on average, there was one chapter 11 filed for every 36,055 residents. However, that does not mean that every county with at least 36,055 residents could claim a chapter 11 of their very own. Indeed, some 29 counties with at least this much population, including Midland and Taylor did not have any cases. Instead, the cases were skewed toward the larger counties.

The 20 largest counties gave rise to 589 filings for an 89.7% share of the total cases originating from Texas. These counties only contain 71% of the state's population. Thus, it appears that the large counties get a disproportionately large share of the filings compared to the state at large. This is not true across the board. The county with the lowest ratio of residents to filings was humble Camp county. This county had seven filings (all related to Pilgrim's Pride) and a population of 12,557 for a rate of one chapter 11 case for every 1,794 residents.

When the filings per population are compared between the 20 largest counties, there is a definite bias in favor of the Dallas/Fort Worth and Houston megaplexes.

The term Ch.11PP refers to Chapter 11 cases filed per population. A low number means that more cases were filed than would be predicted by the population, while a high number indicates the reverse.

While there is not a complete correlation, counties in the D/FW and Houston area, including Collin, Dallas, Denton, Harris and Tarrant, a a lower Ch.11PP rate (meaning had more cases than would be predicted strictly by population) than the rest of the state. However, some of the outlying counties in the Houston megaplex, including Fort Bend, Montgomery, Brazoria and Galveston counties, had fewer cases than would be expected. The border counties did not show a clear trend. Webb and Cameron counties had higher filing rates, while El Paso, Bexar and Hidalgo counties were in the bottom group. Rounding out the less than expected group were Travis, Nueces, Jefferson and Bell Counties (although Travis was just about average, one of the rare occasions that designation will be applied to the capital of Keeping It Weird).

Why?

Why do cases flock toward some localities and avoid others? Access to judges may be part of the answer. Harris County has four resident judges, while Dallas county has three. On the other hand, Lubbock County, Jefferson County and El Paso County all share judges with other divisions. However, this does not explain Bexar County, which has two resident judges but a low filing rate. Access to the chapter 11 bar may be a factor. Many of the counties which had lower rates of filings were outliers from major metropolitan areas. Montgomery, Fort Bend, Brazoria and Galveston Counties are all part of the Houston megaplex with lower than expected filing rates. If most of the chapter 11 lawyers are located in Houston, individuals and small businesses in outlying areas might be deterred from hiring a lawyer in the big city. Another possibility may be that the types of business prevalent in an area might influence the filing rate. For example, areas with high amounts of agriculture (Lubbock, Nueces) seem to be lower in filings. Suburban areas have very inconsistent results, with Denton, Collin and Williamson Counties ranking high and Ft. Bend, Montgomery and Brazoria counties ranking low.

If you would like a copy of the chart which is easier to read, please send an email to ssather@bnpclaw.com.

Coming Attraction

The next installment of the Class of 2008 will look at the flameouts, the cases that were dismissed or converted in the first 90 days. Although I have not done the research yet, I suspect that paying the filing fee in installments may be an indicator that a case is on rocky ground. I am amazed at just how many cases there are in this category.

Another View on Chrysler

The Chrysler deal has now closed, proving that it is possible to do a multi-billion dollar asset sale on an expedited timetable when the U.S. government is your DIP lender and is directing the pace. I am still scratching my head at the ease with which this deal went through. In the realm where I practice, an attempt to sell the debtor's assets to a purchaser selected by management for a small fraction of the secured debt would not only be denied, but would likely be followed by a motion for sanctions. However, when you are dealing with a debtor whose failure could send nuclear shock waves across the economy, it may be that the strict legalities give way to more pragmatic considerations.

Here is a pragmatic analysis from guest-blogger Steve Roberts.

How about this.

If the government did not step in, Chrysler would shut down and go into liquidation and the senior lenders with $6.9 billion in debt would be paid less than the $2 billion or 29 cents on the dollar the government is offering them.

So the government is using your and my money to bail out the lenders along with everyone else. But holdouts among the lenders are screaming that their constitutional and statutory rights are being violated because inferior claims are getting more.


Lets look at that. Who do we, the taxpayers, need if there is any chance for us to get our money back? The the supply chain and the workers. Without them there is no bailout and the senior lenders would get less. So New Chrysler cuts the unions into the deal and assumes the supply contracts with the suppliers to maintain the supply chain.

The Indiana pension funds, who are the last holdouts among the senior lenders, say that the government is hurting the teachers and state employees of Indiana with this bailout, so let's examine that. The fund managers for these funds bought Chrysler debt in or after 2007 and paid 43 cents on the dollar for it, betting that Chrysler would survive. They were wrong. They did not lose money because the government stepped in. They lost money because they lost on the risk they took.

These fund managers have said publicly in this case that they will settle for 50 cents on the dollar, a neat 7 cent profit. And since the government will not use your and my money to bail these fund managers out for their miscalculation, they are appealing the approval of the sale to the 2nd Circuit on an emergency basis.

They must be betting that the government will pay them more if they win and are willing to take the risk that the government will not let the bailout fail.

Since Steve wrote this analysis, both the Second Circuit and the Supreme Court refused to block the sale and it has now closed.

However, I think it highlights what an unusual case this is. Chrysler was not a meaningful player in its own bankruptcy. Instead, the case tested how much the treasury was willing to pay to avoid the collateral damage from a Chrysler failure. The senior lenders (or at least the holdouts) were not banks which had lent money directly to the debtor, but rather speculators who had bought the debt in the hopes of making of a profit. As Steve correctly points out, the objecting creditors, having seen that the government was in the bailout business, wanted a bailout of their own investment decision. The government stood firm and was backed up by the courts.

What I really want to know is how can I use this precedent in my next single asset real estate case?

The Bankruptcy Opinions of Sonia Sotomayor

Yesterday President Obama nominated Second Circuit judge Sonia Sotomayor to take David Souter's place on the Supreme Court. As a District Court Judge in the Southern District of New York and as a Judge on the Second Circuit Court of Appeals, Judge Sotomayor has come across bankruptcy issues from time to time. However, few of her opinions are the stuff that casebooks are made of.

Big Bankruptcies: Routine Opinions

One consequence of sitting in New York is that Judge Sotomayor has written opinions in some major cases,such as Adelphia, Bethlehem Steel, Eastern Airlines, R.H. Macy & Co. and Worldcom. In In re Adelphia Communications Corporation, 544 F.3d 420 (2nd Cir. 2008), she affirmed the confirmation of a bankruptcy plan which transferred claims being asserted by an Equity Committee to a plan trust. The problem was that the Equity Committee, which was far out of the money, had confused derivative standing to pursue claims on behalf of the estate with ownership of the claims themselves. As Judge Sotomayor stated:

We do not mean to trivialize, but only to place in context, the role of the derivative plaintiff. It serves "with the approval and supervision of a bankruptcy court" and shares the "labor" of litigation with the debtor-in-possession. (citation omitted). Contrary to the Equity Committee's arguments, however, it does not usurp the central role of the court or debtor in overseeing and managing the estate's legal claims.

In Official Committee of Unsecured Creditors v. Securities and Exchange Commission, 467 F.3d 73 (2nd 2005), an interesting provision of Sarbanes-Oxley came into play. The SEC brought claims on behalf of defrauded investors, which the debtor settled. The SEC then proposed its plan for distributing those funds to the investors. The Unsecured Creditors Committee didn't like the SEC's plan (which was separate from the plan of reorganization in the case). Judge Sotomayor held that the Official Committee of Unsecured Creditors had standing to appeal, even though it was not a party to the SEC action, but ruled against them on the merits. In another Worldcom appeal, she held that the confirmed plan of reorganization barred pursuit of a discharged claim. In re Worldcom, Inc., 546 F.3d 211 (2nd Cir. 2008).

In another case, the judge ruled that employee benefits earned by an employee over the course of his employment but payable when he was discharged during the bankruptcy were not entitled to administrative claim status because the right to payment had accrued pre-petition. In re Bethlehem Steel Corporation, 479 F.3d 167 (2nd Cir. 2007).

As a district court judge, she ruled on an appeal concerning whether a tax assessed post-petition and payable under an unexpired lease which was later rejected was entitled to administrative priority. She affirmed the ruling of the Bankruptcy Court which had found it to be an administrative claim. In re R.H. Macy & Co., 1994 U.S. Dist. LEXIS 21364 (S.D. N.Y. 2004). The most interesting thing about this opinion is that it consists of a transcript of her discussion with counsel on the record before she made her ruling. She displays a bit of humanity when she apologizes to counsel for her delay in ruling and acknowledges some unfamiliarity with the bankruptcy issues.

THE COURT: How are you counsel? I must apologize for the delay in addressing this case. There is no excuse other than the press of life in general in the court-house. You have also presented me with interesting issues, so once I did turn my attention to it, it has not been easy for me to resolve.

I have a series of questions for those of you who are bankruptcy lawyers. I would like to have you educate me and focus me a little bit.

In the Eastern Airlines case, the Bankruptcy Court approved a comprehensive settlement between the Debtor and the Airline Pilots Association. A group of dissident pilots objected to the settlement and appealed. Judge Sotomayor found that the settlement was not an abuse of discretion. Nellis v. Shugrue, 165 B.R. 115 (S.D. N.Y. 1994).

International Insolvency

Judge Sotomayor has also had a passing acquaintance with international insolvency cases. In In re Board of Directors of Telecom Argentina, S.A., 528 F.3d 162 (2nd Cir. 2008), she affirmed the decision to recognize a foreign proceeding under former Section 304. In Petition of Alison J. Treco and David Patrick Hamilton as liquidators of Meridien International Bank Ltd., 205 B.R. 358 (S.D. N.Y. 1997) and Allstate Insurance Company v. Hughes, 174 B.R. 884 (S.D. N.Y. 1994) she affirmed the granting of a Section 304 injunction to protect the assets of a foreign debtor.

Dischargeability of Debts

Judge Sotomayor has written several opinions dealing with dischargeability of marital obligations. In re Maddigan, 312 F.3d 589 (2nd Cir. 2002)(attorney's fees incurred in connection with support claim were nondischargeable under Section 523(a)(5)); Beier v. Beier, 1995 U.S. Dist. LEXIS 1702 (S.D. N.Y. 1995)(granting summary judgment on non-dischargeability was inappropriate when there were issues of fact)

She also ruled that in determining the dischargeability of a claim arising under a settlement agreement, it was appropriate to look to the facts surrounding the underlying claim. In re DeTrano, 326 F.3d 319 (2nd Cir. 2003).

In European American Bank v. Benedict, 1995 U.S. Dist. LEXIS 10051 (S.D. N.Y. 1995),Judge Sotomayor ruled that the deadline to file a complaint to determine dischargeability could not be extended after the expiration of the deadline.

Other Rulings

In re Millenium Seacarriers, Inc., 419 F.3d 83 (2nd Cir. 2005)(bankruptcy court's jurisdiction over property of the estate wherever located included jurisdiction to extinguish maritime liens).

Harris v. Albany County Office, 464 F.3d 263 (2nd Cir. 2006)(dismissing appeal based upon failure to provide designation of record on appeal and transcript was abuse of discretion where debtor was not given opportunity to cure defect first)

Beightol v. UBS Painewebber, Inc., 354 F.3d 187 (2nd Cir. 2004)(no appeal from order denying motion to abstain)

In re New Haven Projects Ltd. Liability Co., 225 F.3d 283 (2nd Cir. 2000)(where Section 505 gave bankruptcy court discretionary authority to redetermine tax liability it was not error for bankruptcy court to decline to exercise that authority).

In re Seatrain Lines, Inc., 198 B.R. 45 (S.D. N.Y. 1996)(debtor's action against insurer which denied indemnification post-petition was core proceeding so that reference would not be withdrawn).

Royal American Insurance Co. v. McCrory Corporation, 1996 U.S. Dist. LEXIS 5552 (S.D.N.Y. 1996)(bankruptcy court erred in refusing to lift stay to pursue suit against debtor's insurance carrier despite fact that claimant had failed to file a timely claim against debtor).

In re St. Johnsbury Trucking Company, Inc., 191 B.R. 22 (S.D. N.Y. 1995)(Negotiated Rates Act of 1993 was constitutional as applied in bankruptcy, but issue would be certified for interlocutory appeal).

First Fidelity Bank, N.A. v. Eleven Hundred Metroplex Associates, 190 B.R. 510 (S.D. N.Y. 1995)(order for use of cash collateral reversed where debtor made absolute assignment of rents)

In re Friedman & Shapiro, Inc., 185 B.R. 143 (S.D. N.Y. 1995)(disciplinary proceeding against attornrey by state bar could not be removed based upon law firm's pending bankruptcy).

Kuntz v. Pardo, 160 B.R. 35 (S.D. N.Y. 1993)(litigant whose appeal was dismissed for failure to designate record did not demonstrate excusable neglect entitling him to reinstatement of appeal)

The Bottom Line

In ten years as a circuit court judge, Judge Sotomayor has authored 232 opinions, twelve of which have concerned substantive bankruptcy issues. In eleven out of twelve cases, she affirmed the lower courts. Remarkably, her six year record as a district court judge contains many bankruptcy rulings. Her bankruptcy opinions appear to be competently written, although none jump out as having changed the face of the law.

For another perspective on the Sotomayor nomination, go to The Case Against Sonia Sotomayor: Arch-Conservative .

Lawyers, Guns and Money

"Send lawyers, guns and money."--Warren Zevon (1978).

A new opinion out of San Antonio (home to the Alamo) contains the elements of lawyers, guns and money in a decision about exempting firearms. In re Wilkinson, No. 07-50189 (Bankr. W.D. Tex. 4/10/09). While I enjoyed the analysis, I don't think I would have arrived at the same conclusion. (Of course, I don't wear a black robe, so whether I agree or disagree is somewhat academic).

Dr. Wilkinson had guns. Lots of guns. Some of them could shoot. Others were mounted on the wall with brass plates describing them. The Debtor sought to keep two guns under the firearms exemption, but also sought to keep the mounted guns as home furnishings. The trustee cried foul, arguing that "firearms are firearms and cannot be claimed under another category such as 'home furnishings.'"

The Debtor's first shot (pun intended) was to point to a statute which said that antique or curio guns manufactured before 1899 were not guns. Texas Penal Code Sec. 46.01. This was a nice try, since the creative debtor's lawyer found a statute which said that the mounted guns were not legally firearms. However, this shot was easily deflected by the judge. The Penal Code dealt with guns which could not be possessed by felons. Since guns which cannot go bang are not inherently dangerous in the hands of a felon, their possession should not be criminalized. However, the statute didn't really answer the question of whether antique firearms mounted on plaques should be excluded from the definition of firearms under an exemption statute.

Next, the court considered the definition of firearm in common parlance. The court noted that:

Notably, none of these definitions excludes antique firearms or guns from the definition of what constitutes a firearm. None of these definitions requires that the item be in working order to constitute a firearm.

Opinion, p. 11.

The Court then went on an interesting historical analysis which demonstrated that guns have not always been sancrosanct in Texas. The Court noted that in Choate v. Redding, 18 Tex. 579 (1857), the Texas Supreme Court bemoaned the fact that there was no exemption for guns in Texas. This was especially troubling because Texas law required that every able-bodied man bring a gun in connection with their militia service. (This was back in the good old days when gun ownership was not only allowed but mandated!) Thus, if a creditor levied upon a debtor's non-exempt gun and he was called up for militia service, the debtor could be punished for showing up disarmed.

The lackadaisical legislature did not allow a gun to be exempted until 1870 and tardily expanded this exemption to two guns in 1973. The court concluded that because the legislature had to be dragged kicking and screaming to allow even two guns to be exempted that it would not allow more than that to be exempted under the guise of home furnishings.

I find the historical analysis interesting. I had always thought that the exemption for two guns was meant to allow Pa to shoot one gun out the front door while Ma defended the back of the house. Since the exemption for two guns did not come around until 1973 when the risk of marauding indians was substantially diminished, this assumption was probably incorrect. Hopefully none of my clients who I told this story to will ask for their money back.

However, I think that the court was asking the wrong question. The Debtor sought to exempt the mounted firearms as home furnishings rather than as firearms. Thus, the relevant question should be whether a mounted gun which doesn't go bang could be considered to be a home furnishing. A home furnishing is something that is used to furnish a home. (While I don't have any authority for this proposition, it is based on the close proximity between home and furnishing in the statute). Texans are granted great leeway in deciding how they will furnish their homes. They may decide to decorate their homes with tasteful artwork bought in galleries in Santa Fe and Taos or they may decide to build elaborate displays of Lone Star beer bottles and photographs of road kill. Likewise, both a display case containing pre-Columbian pottery and a collection of sweatstained tshirts from the Capital 10,000 neatly mounted in a shadow box could be a home furnishing. How you furnish your home is largely in the eyes of the beholder.

In my mind, whether a gun is exempt as a gun or a home furnishing depends on how it is actually used. If it is kept in a gun safe with suitable ammunition nearby, it is only exempt as a firearm or possibly as a tool of the trade in the case of a law enforcement officer. On the other hand, if it is mounted and the wall and doesn't go bang, then it is probably being used as an adornment or decoration and thus would fit the definition of a home furnishing. Just because the same item could potentially be exempted under one category should not prohibit it from being claimed under another applicable provision. Function, not origin, should determine the appropriate category for exemption. The mounted firearms seem an easy case to me. The harder case would be the debtor who decorated the inside of his closet with $60,000 worth of gold bullion. If the interest in decorating with gold arose on the eve of bankruptcy and the gold was not prominently displayed to visitors, that would probably not be a real home furnishing.