A judge judging himself: judicial recusal

Judges are in high demand for continuing education seminars. Astute conference planners will often schedule a judges' panel at the end of the day to insure full attendance. If the judge is outspoken, or at least colorful, so much the better. However, what happens when the outspoken judge displays displeasure with your client's industry and you have a similar matter pending before him? If you file a motion for recusal, you could find yourself in the interesting position of having the judge judge himself. That is what happened in the case of In re Wilborn, 401 B.R. 848 (Bankr. S.D. Tex. 2009) in which Wells Fargo sought to recuse Judge Jeff Bohm over comments he made at a CLE conference. After a lengthy analysis, Judge Bohm concluded that the movant had not met his burden and that he had "an affirmative duty not to recuse himself."

The Seminars

At issue were presentations made at two conferences, the State Bar of Texas Advanced Consumer Bankruptcy Conference and one held at the LSU Law School. The motion was based on written materials and oral statements made at the two conferences. However, it turns out that Judge Bohm was not the author of written materials for either forum. In the first case, Judge Bohm was a substitute for Judge Marvin Isgur, who authored in the materials. In the second case, Judge Elizabeth Wall Magner presented a powerpoint which she prepared after which Judge Bohm spoke.

In his Dallas discussion, Judge Bohm began with a rather straightforward discussion of construction of Bankruptcy Rule 2016 and 11 U.S.C. Sec. 1322(b)(2) as they relate to post-petition fees and charges assessed by mortgage creditors. The positions articulated by Judge Bohm, namely, that Rule 2016 applies to mortgageholder fees, that Sec. 1322(b)(2) does not preclude review of the reasonableness of fees and that Sec. 105 allows redress for debtors charged unreasonable fees were not anything that he hadn't ruled previously.

However, the judge did not stop there. He proceeded to lecture both debtor's lawyers and creditors about practices in the industry. Speaking to debtor's lawyers, he said "if you are zealously representing your client, then you want to focus like a laser beam, it seems to me, on what some creditors are doing in terms of charging your clients after they have filed a petition." He also suggested that debtor's lawyers to write a monthly letter to the creditors' attorney stating:

Dear attorney for home lender in chapter 13, I am writing you this letter to inquire as to whether your client is charging any fees and expenses now that my client has filed for bankruptcy. Please advise. Because if I find out that you are and you haven't disclosed it, I'm going to scream bloody murder in bankruptcy court.

I think you ought to send that letter once every month. that might get the attention of some creditors' lawyers. And it might--and I say might get the attention of some lenders.

401 B.R. at 855.

Judge Bohm was just warming up. In closing, he got on his soapbox and articulated the following:

Why do I cite these newspapers to you? Freddie Mac, Fannie Mae, AIG and the Lehman Brothers. I don't think I cited Washington Mutual, but I'll cite them. What are they all? They're all creditors. I used to represent creditors. I used to be a banker before I went to law school. Well, I am finding since I've been on the bench on the creditors' side is that we've got a culture going of arrogance and hubris. We have forgotten how to be thorough and how to pay attention to detail, and it's coming home to roost in spades.

I mean, think about it folks, Freddie Mac and Fannie Mae, FDR would be turning over in his grave if he could see those institutions today. The directors, the dispute that's going on right now is, are we going to pay the two presidents of these institutions golden parachutes of millions of millions of dollars? This, for while they were head of their ships, ran aground.

We've got AIG going belly up. By the way, Freddie Mac and Fannie Mae, the institutions that are about buying loans portfolios for loans that never should have been made. That's why I say we've got--we have lost the need--the paying attention to detail.

* * *

I'm policing my docket. You're going to get more opinions, at least from me, and I assume the true--same will be true for at least Judge Isgur and Judge Magner. We want to see the I's dotted and T's crossed, and if they're not, then as I've said, 105 sanctions will be--will be used.

I hate to end on that kind of note, but given where we are with a lot of the institutions that I just cited, I don't know how else to express my frustration with some--not all, of the mortgage lenders in my court. I wish to emphasize that I--I think highly of most, virtually all, of the attorneys who appear in my court these days, so I don't want you to leave this seminar thinking that I am upset with you, but do please convey to your clients tht I feel very strongly that the rules and the statutes need to be complied with.

401 B.R. at 857-58.

The Dallas conference did not single out Wells Fargo. However, one slide in Judge Magner's powerpoint did:

Wells Fargo manages 7.7 million loans. If only one $15 fee were charged per year on each loan, its revenue would be $115 million.

401 B.R. at 859.

Meanwhile, Judge Bohm was presiding over a class action sought brought against Wells Fargo alleging that it charged improper fees in chapter 13 bankruptcy cases. Judge Bohm's candor apparently made Wells Fargo feel that he had targeted a bulls eye on them. They filed a motion to recuse. However, as noted by Judge Bohm, a motion to recuse "is committed to the discretion of the targeted judge." This leaves the judge in the unusual position of sitting as trier of fact with regard to his own impartiality.

The Ruling

In his ruling, Judge Bohm discussed several legal principles applicable to disqualification:

1) Under 28 U.S.C. Sec. 455(a), a judge "shall disqualify himself in any proceeding in which he is presiding in which his impartiality might reasonably be questioned."

2) The movant must establish that a judge is not qualified by clear and convincing evidence.

3) "(A) judge's comment is disqualifying only if it connotes . . . a closed mind on the merits of the case."

4) Recusal based on bias may be based on "a danger that the judge will rely on an extrajudicial source for his rulings" or "where the judge displays such a high degree of favoritism or antagonism as to make fair judgment impossible."

These principles appear to be in conflict. The statute speaks in terms of situations in which "his impartiality might reasonably be questioned." This language, particularly in its use of the words "might" and "reasonably" suggests a low standard, one in which the mere appearance of partiality is sufficient to bring about disqualification. However, the requirement of proof by clear and convincing evidence (which must be established to the judge being questioned) and the requirement of a closed mind on the particular case set a very high bar. Indeed, it might be suggested that a motion for recusal should never be necessary, since the conduct demanding recusal should be so obvious to the judge that he should have voluntarily removed himself prior to any motion being filed.

Judge Bohm continued with a very thorough analysis of what comments made outside of the courtroom would merit recusal. Generally, comments made to legal education seminars on general legal issues are permissible, while statements to a newspaper about the merits of a pending case are not. Since Judge Bohm did not single out Wells Fargo or talk about any specific pending case, much less the Wellborn v. Wells Fargo case, recusal was not appropriate.

How Educational Do You Want Your CLE To Be?

Given that recusal requests are addressed to the judge sought to be recused and that judges are given wide latitude, the result in this case is not particularly surprising. The larger question is, should judges be speaking so freely about issues that will come up in their courtrooms? Should they be so blunt, including giving advice to one side about what they should be doing to zealously represent their clients?

With one limited exception, I say preach on Brother Bohm. I say this as an attorney who is more likely to appear in front of His Honor as a creditors' lawyer than representing a debtor. In fact, I fully expect that I will appear in front of him on one of his hot button issues. It is just a question of when.

When I appear in front of a judge, I want to know as much as possible about his thinking. I am going to study his rulings and talk to attorneys who have appeared in front of him. If I'm going to listen to him speak at a conference, I don't want to hear namby-pamby platitudes. I want to hear the good stuff. I want to hear the good stuff because it is useful intelligence.

On the other hand, it does give me pause when the judge starts dictating letters for debtor's lawyers to use, especially when the debtor's lawyer is invited to scream bloody murder to the bankruptcy court. It almost comes off as a wink, wink, nudge, nudge, follow this procedure and I will sock it to the mortgage company. The issue of disclosure of post-petition fees and charges is a legitimate one and one which is being addressed by amended Rule 2016. It is a bit unseemly for the judge to be encouraging lawyers to engage in guerilla tactics rather than looking for a systemic response. However, beyond that, the judge did not talk about cases currently pending before him or call out lawyers he was unhappy with. Indeed, he went so far as to express his respect for the bar.

On balance, the benefit of getting inside the judge's head is worth more to me than the risk that he will engage in cheerleading for the other side. I won't always agree with Judge Bohm, but I will always find him passionate and informative.

Whom do you trust when interpreting a trust?

Update: On June 15, 2011, the Fifth Circuit entered a ruling finding that the Trustee was entitled to 50% of the corpus of the trust. Roberts v. McConnell, No. 10-50462 (5th Cir. 6/15/11). You can read the Fifth Circuit opinion here.

Trusts are interesting things. They are a way to transfer property without completely letting go. One reason to transfer property in trust is to see that the beneficiary receives the benefit of the trust property instead of his creditors. Of course, the bankruptcy trustee has just the opposite incentive. The trustee would like to bust the trust and distribute the proceeds to creditors. When trust provisions are unclear, it can make for an interesting exercise as Judge Craig Gargotta discovered in Roberts v. McConnell, Adv. No. 09-1011 (Bankr. W.D. Tex. 11/3/09).

In this case, Mary McConnell set up a trust for her grandson. The trust allowed the beneficiary to withdraw funds from the trust according to a graduated schedule based on the beneficiary's age, but only if "the Settlor of this Trust (or each Settlor, if more than one) is then deceased." The grandmother passed away in September 1997. At that time, the grandson could have withdrawn 33% of the trust. However, several months later, his mother made a contribution to the trust which she repeated during six additional years.

The debtor filed for bankruptcy in 2004. At that time, he was 37 years old. At that time, he would have been entitled to one-half of the trust if the Settlor (or Settlors if more than one) were deceased. In 2009, the bankruptcy trustee brought suit against the trustee of the trust seeking to recover the entire corpus for the benefit of the bankruptcy estate. The trustee of the trust moved to dismiss.

The issues that the court faced were:

1) Was the term settlor limited to the person who initially created the trust or did it extend to the mother as well?
2) If the mother was deemed to be a settlor, could the trustee at least recover the funds which the debtor was entitled to withdraw for a brief period prior to his mother's initial contribution?

Under the Texas Property Code, the term settlor is defined as the person who creates the trust. However, the Trust defined settlor as anyone who contributed property to the trust. Under the Texas Property Code, the specific language of the trust controlled over the definition of settlor contained within the Property Code. The parenthetical language (or each Settlor if more than one) suggested that there could be additional settlors. Thus, the trustee could not recover the full amount of the trust, since there was still a settlor alive.

However, this gave rise to a second question: could the mother, by becoming a settlor, unvest the debtor's right to make a withdrawal? Recall that when the debtor's grandmother passed away, she was the sole settlor of the trust and he could withdraw one-third of the value of the trust at that time. Had bankruptcy not intervened, one could imagine the unpleasant conversation which might transpire when the son learned that his legacy was now out of reach due to this mother's decision to add to the trust. In this case, the bankruptcy trustee was just making the argument which the son would likely have made, namely, it's not fair.

In trying to determine the intent of the settlor, the court found it significant that the trust imposed two different requirements for withdrawing funds from the trust: reaching a specified age and the prior death of all settlors. The court found an intent for both benchmarks to be present at any time that a withdrawal was requested.

The court's result seems to be a natural reading of the language of the trust. However, it is not hard to imagine how these provisions could be used to reach a twisted result. Imagine that the grandmother had two grandsons, one of whom always wrote his thank you notes timely and never forgot his grandmother's birthday. The other grandson was an ungracious lout who stole spare change from his grandmother's purse and never had a kind word, let alone a thank you. The grandmother decides to create a trust for one of the grandsons but not the other. The grandmother passes on and the ungrateful grandchild learns that he has been passed over. Upon learning of the trust provision, he contributes $10 to his brother's trust so that he can never access the trust funds. In this scenario, could the ungrateful grandson keep his favored brother from ever accessing the trust? Would the likelihood that the sinister grandson would encounter an unfortunate accident go up? These would make for good law school exam questions. Fortunately Judge Gargotta didn't have to reach these questions. (Congratulations to new law clerk Sarah Darnell on her first opinion).

Update #1: Eric Taube advises that this opinion is being appealed.

Update #2: Alert grammarians Pat Autry and Fay Gillham pointed out that my headline should have read "Whom do you trust when interpreting a trust?" instead of the original "Who do you trust when interpreting a trust?" I did some research and found out that they were correct.

According to wikiHow, who is used as the subject of a sentence or phrase while whom is used as the object of a verb. This still left me scratching my head, so I read further on. If the answer to the question is he, then who is correct, while if the answer to the question is him, then it is whom. Thus, the answer to the question would be "I trust him to interpret a trust" indicating that whom was the correct way to begin the sentence.

Judge Seeks Creditors' Attention With Discharge Violation Ruling

A Fort Worth bankruptcy judge sent an unmistakable message to Bank of America and a collection agency in a recent opinion on violation of the discharge: clean up your procedures or pay up. McClure v. Bank of America, Adv. No. 08-4000 (Bankr. N.D. Tex. 11/23/09).

What Happened

The debtors owned a business named Qualico. Like many entrepreneurs, they obtained financing through credit card accounts, which they personally guaranteed. When the business failed, both the company and its owners ended up in chapter 7. The McClures listed several debts owed to Bank of America in their schedules.

Shortly after the McClures received their personal discharge, Bank of America referred two of their accounts to a collection agency. Bank of America did not dispute knowing about the discharge and the opinion is silent as to any explanation for why discharged debts were referred to a collection agency. To compound the confusion, two different Bank of America debts were referred to two different collectors within the same firm.

Upon receiving the accounts, the collection agency, CFG, sought to do a bankruptcy scrub on the accounts. However, the information received from Bank of America was not very helpful. Placed in the social security number field was the tax ID number for the corporation. A search under this number did not turn up the corporation's bankruptcy and no search was done on the individual.

At the fatal moment before the first collection call was placed, Bank of America knew about the discharge, but the collection agency was blissfully ignorant.

The first collector was merely trying to collect upon the corporate account and was not aware that there was a guaranty. However, that did not stop him from telling the individual debtor that someone was headed to his house and that they would be filing suit against him that day. When the collector stopped to take a breath, the terrified debtor informed him of his bankruptcy, which was duly entered into the system. This stopped collection on account #1. However, it did not provide notice to the collector on account #2. He sent the debtor a letter and made a phone call, which no doubt unnerved the debtor who had already provided the agency with his bankruptcy information.

Who Violated the Discharge?

All of the collection activity which took place violated the discharge. However, to hold a creditor liable for contempt, there must be actual notice of the order being violated. Thus, under these facts, who committed a knowing violation: BOA, CFG, Collector #1 and/or Collector #2? Liability as to BOA was easy. They admitted knowledge of the discharge at the time that they referred the debts out for collection. Collector #1 did not know about the discharge at the time he made his threatening call. Neither did Collector #2. However, the collection agency committed a knowing violation when Collector #2 contacted the debtor even though the actual collector did not.

Here's how the court reached this conclusion. The court did not impute knowledge from the principal to the agent. Additionally, the court did not hold the collection agency liable for negligently performing the bankruptcy scrub. However, once Collector #1 received notice of the discharge, that put the agency on notice. Although Collector #2 could not be held liable for information which never reached him, the agency could be held liable for his unknowing actions. Thus, you have the paradox that neither collector knew about the discharge at the time he undertook the collection actions. However, once the entity knew about the discharge, it could not allow its employee to remain in the dark.

Damages

Damages are always a difficult issue in these cases. While attorney's fees are available, they are poor compensation to the debtor. Mental anguish is hard to prove. In this case, the debtor's doctor testified, but the court found the evidence to be inconclusive. (The court did, however, state that it did not "consider the line between being an aggressive agent and a bully to be so fine that CFG cannot service its clients without resort to such crude scare tactics"). However, the court did not stop there. It stated:

The McClures have, however, expended substantial time and effort in prosecuting this lawsuit. Without the willingness of aggrieved debtors to prosecute violations of the discharge injunction of section 524(a)(2), such violations would go unchecked by the court. The Code has as one of its underlying purposes providing a fresh start to a discharged debtor. (citation omitted). If violations of the discharge injunction go unpunished, creditors will lack the necessary incentive to avoid violating the law, and an underlying purpose of the Code will be undermined. In order to ensure that debtors are not hesitant to prosecute violations of the discharge injunction, they should be awarded actual damages to compensate them for the time and effort they have to expend in the process. In this case, the court awards the McClures $2,500.00 in actual damage for the time and effort they expended in proscuting this adversary proceeding, for which BOA and CFG will be jointly and severally liable.

Memorandum Opinion, pp. 12-13.

(The court also took pains to note that it had not been requested to assess damages under the Fair Debt Collection Practices Act and that such damages would not have been available in any event, since this was a business debt).

The Court also awarded $79,839.14 in attorney's fees. The defendants complained that the debtor's attorney was piling on. However, the court was quick to justify the large award, stating:

CFG and BOA questioned the high cost of attorney services based on want of harm to the McClures. First, the need to encourage enforcement of the discharge injunction counsels against too great parsimony in assessing fees. Second, the refusal of CFG to acknowledge error--and a pre-trial dispute between CFG and BOA over responsibility for the violation of the injunction--added to the cost of the attorneys. Had the two defendants accepted responsibility for their conduct early in this adversary proceeding, the cost of the McClures' counsel would have no doubt been much lower.

Memorandum Opinion, p. 13, n. 27.

However, the final relief awarded was the most interesting. The court awarded conditional sanctions payable to the registry of the court based on the defendants' apparent lack of concern with the law. The Court stated:

(T)he court finds that the actions of BOA and CFG in violating the discharge injunction were sufficiently egregious to warrant sanctions. By failing to adopt measures sufficient to prevent violations of the discharge injunction and then willfully violating the discharge injunction, BOA and CFG have demonstrated a lack of concern for the law. The injunction of section 524(a)(2) and that provided by section 362(a), which in the McClures' case the former replaced (citation omitted), are at the heart of bankruptcy protection. (citation omitted). It is only by reason of these provisions that the court is able to ensure debtors the interim protection promised by the filing of a petition and the true fresh start that a discharge is supposed to bring. To protect its own authority as well as to give debtors the relief Congress intended, a bankruptcy court must act promptly and firmly to stop conduct violative of section 362(a) or 524(a)(2) and to prevent future breach of those provisions. This is particularly important when, as is true of BOA and CFG, the entity violating the stay deals with millions of consumers, many of whom will be in bankruptcy cases; BOA's and CFG's procedures for ensuring compliance with the law must be seamless.

The court, therefore, concludes that it is both reasonable and necessary to sanction BOA and CFG in order to deter BOA and CFG from violating any discharge injunction in the future. See 11 U.S.C. Sec. 105(a).

The court hereby sanctions BOA in the amount of $100,000.00, payable to the registry of the court, and sanctions CFG in the amount of $50,000, also payable to the registry of the court. Each sanction will be suspended and need not be paid if, within 90 days of the entry of this memorandum opinion, by affidavit either the President or General Counsel of each company submits to the court new procedures his or her company has adopted to prevent future violations of any discharge injunction.

Memorandum Opinion, pp. 14-15.

The court's three-fold remedy addressed three different needs. First, the debtors received a small award to vindicate them for having to seek redress from the court. Debtors' counsel received a large award to compensate him for having to pursue the case. Judge Michael Lynn presides over large cases, such as Pilgrim's Pride, and is no doubt used to seeing large fee requests. When compared to the fees charged in mega-cases, the hard-working debtors attorneys' fees likely seemed quite reasonable. Finally, the court saved the largest award as an incentive to fix the problem. The court did not grant the debtor a windfall, but did not overlook the seriousness of the failure either. By ordering a payment to the registry of the court unless procedures were changed, the court took a stand on behalf of the integrity of the larger bankruptcy process and on behalf of other debtors who might be harmed in the future.

This opinion offers some practical advice to counsel defending parties accused of violating the discharge. If there is a clear-cut violation, as there was here, acknowledge liability promptly. The real battle will be over damages, which are difficult for the debtor to establish. A prompt offer of judgment may avoid a large award and an embarassing written opinion later. Further, when there has been a breakdown of procedures as happened here, the time to address those procedures is immediately. The opinion never answered the question of why Bank of America referred two discharged debts to a collection agency. The failure to answer this question may have informed the urgency of the court's insistence that "procedures for ensuring compliance with the law must be seamless."

Debtor Gets Mortgage Claim Denied. Now What?

I am in New York for the Commercial Law League conference, so it is appropriate to blog about a case from the Southern District of New York. While the Southern District of New York is known for its multi-billion dollar cases, a recent case highlights a consumer issue faced by courts nationwide. In (Name Withheld by Request), Case No. 09-22261 (Bankr. S.D. N.Y. 9/29/09), the Debtor's lawyer became frustrated with inconsistent information received from a mortgage servicer and filed an objection to claim. The mortgage servicer's submissions raised more questions, leading to denial of the claim. However, the bigger question is what denial of the claim means for the debtor.

A Proof of Claim Walks Into A Bankruptcy

In this chapter 13 case, PHH Mortgage filed a proof of claim on the debtor’s mortgage. PHH stated that it was the secured creditor. The proof of claim attached the following documents:

(a) a one-page itemization;
(b) pages 9 through 16 of a document identified as New York--Single Family . . . Fannie Mae/Freddie Mac UNIFORM INSTRUMENT MERS;
(c) a 4 page Fixed/Adjustable Rate Rider; and
(d) 16 pages out of a 24 page mortgage showing MERS as mortgage holder and Mortgage World Bankers, Inc. as lender.

In response to an inquiry from the Debtor’s attorney, PHH stated that it was the servicer and that US Bank as trustee for a securitization trust was the actual creditor. This was the first problem. The person who filed the claim was not the holder of the claim, but the agent for an undislosed principal.

The Debtor objected to the claim, arguing that the servicer lacked standing to file the claim and that the proof of claim did not demonstrate a complete chain of title from the originator to the securitization trust.

The Creditor Digs Itself In Deeper

In response to the objection, PHH Mortgage filed an affirmation of counsel, an affidavit and a memorandum of law. These documents created more problems for the purported creditor. The affirmation of counsel attached an Assignment of Mortgage from MERS to US Bank. The document was executed by Tracy Johnson as Assistant Vice-President of MERS. (MERS is Mortgage Electronic Recording Service, which exists to serve as a nominee for mortgage holders and allow mortgages to be transferred without the necessity of a formal assignment. In other words, MERS acts as nominee of whoever holds the mortgage.). It also included a power of attorney authorizing PHH to act on behalf of US Bank. The second affidavit was signed by Tracy Johnson, this time as Assistant Vice-President of PHH.

The Memorandum of Law stated that:

The ownership of the Note and Mortgage were subsequently transferred to US Bank. An Assignment of Mortgage was not executed at the time of the transfer. PHH intends to submit documentation to show that US Bank now has the beneficial interest in the Note and Mortgage by virtue of the pre-existing transfer of this loan. In addition, the documentation will demonstrate that PHH is still authorized to file the Proof of Claim as the loan servicing agent for US Bank.

Memorandum, p. 3.

Unfortunately, PHH did not obtain the documentation. The following exchange took place at the hearing on the claims objection:

THE COURT: . . . what is the evidence of the transfer of the mortgage to US Bank?

MR. ______: All I have is PHH’s representations, Judge.

THE COURT: By the woman who also appears to be working for MERS and who isn’t here.

Transcript, pp. 15-16.

The Ruling

In the end, the Court expunged the claim. The Court’s findings are summarized as follows:

1) The documentation attached to the claim was incomplete and did not identify the holder of the note. Recall that the claim included pages 9 through 16 from one document and 16 pages out of 24 pages of another. The Court this selective attachment of partial documents to be suspicious, since the omitted pages would have identified the holder of the debt. As a result, the Court found that the claim was not entitled to prima facie validity.

2) The Court did not accept the affiant as a custodian of records, apparently due to the fact that the same person claimed to be custodian of records for two different entities and because the affidavit was contradictory.

3) The Note contained a stamp indicating that it was transferred from the securitization trust to the servicer, PHH. As the court stated, "To my knowledge of how these securitized mortgage nonte/trusts are structured, it doesn't make sense and it's not explained anywhere in the affdavit as to how it would make sense that it would be transferred to the servicer of the trust, the note would be transferred to the servicer of the trust. That's an odd thing for me to accept." Transcript, p. 24.

4) There was no evidence of assignment of the mortgage to the purported creditor other than the uncorroborated statement of the servicer.

As a result, the Court stated:

You know what, what I will say is this, the owner of the mortgage as far as I can see and the owner of the note has not filed a proof of claim in the case. That’s what I’ve found. Someone filed a proof of claim who’s not been able to establish that they hold the note and the mortgage.

Transcript, pp. 24-25.

What Does This Mean?

Consider what this means. There is someone somewhere who holds a mortgage upon the debtor’s home. That person is not the person who filed the claim. As a result, the true creditor is somewhere outside of the bankruptcy case. A secured creditor can choose to remain outside of the bankruptcy process, in which case the lien will ride through unaffected. The real creditor may appear at some point and ask to lift the stay. If not, at the end of the case, the debtor will receive a discharge from her personal liability but will still be subject to the lien. Of course, if the creditor is never able to prove up its paperwork, then at some point, the lien would be barred by limitations.

Ignoring What We Know To Be True

This leads to the second important point. Complete, consistent documentation matters. The claim was expunged based on incomplete documentation which failed to identify the holder of the note and the mortgage. The affidavits submitted compounded the problem because the same person claimed to be custodian of records for two different entities. The lawyer for PHH forthrightly acknowledged the problem when he stated:

I agree with you, Judge. I think that the reality is that . . . we’re ignoring what we know to be true because we can’t get our hands on the documents.

Transcript,pp. 16-17.

That is a powerful admission. If the creditor’s lawyer cannot get his hands on the documents, where are they? This case started with an originator who advanced actual money which allowed the debtor to purchase a home. For years prior to bankruptcy, the debtor made payments to a servicer. These payments were accepted. The debtor received statements of account. There was never a question raised as to whether the right person was being paid. It was only when the bankruptcy case was filed that questions were raised about proper paperwork.

This raises an interesting question. Was the right person being paid prior to bankruptcy? One possibility is that PHH’s lawyer is correct and that “we’re ignoring what we know to be true because we can’t get our hands on the documents.” The other possibility is that somewhere along the line, there has been a disconnect between the party entitled to payment and the party receiving payment. In this instance, the aggrieved party would be the true holder of the note and mortgage. If the phantom real holder doesn’t complain that its funds are being diverted, what is the debtor’s right to complain? If the debtor’s loan has been lost somewhere in a securitization black hole, does that mean that the debtor gets a free house? This case points out a difficult tension between acknowledging “what we know to be true” and putting the creditor to its proof.

Dispatches from a Hangdog Bankrupt

This morning I was listening to KUT, our local public radio affiliate, when I heard the story of a rare book dealer who filed for bankruptcy in Austin. His story is told in a series of dispatches which appear on McSweeneys.net, which you can access here. My favorite story (which was featured on the KUT show and can be found in episode 4) was about the Travis County Constable who wept when the debtor's girlfriend invited her in for coffee as she was serving papers on him. My second favorite was the story of the debtor's interview with his attorney about how to value his cat on the schedules. While the attorney is referred to by the pseudonym Mr. H, you can pretty well figure out who it is, since there are not many male consumer bankruptcy lawyers in Austin whose last name starts with H (and no, it is not Pat Hargadon). The dispatches convey a lot of interesting information and capture the human element of failure poignantly. It is well worth your reading.

Anonymity and Cyber-Bullying

This is somewhat off-topic. However, as a blogger, I am interested in cases about blogging. Recently, I have come across coverage of two cases dealing with people who wanted to say mean things on-line under the cloak of anonymity. One case involved postings which were merely libelous and nasty, while another involved a determined campaign of cyber-bullying against two female law students.

Skanks of NYC

The current issue of the Federal Lawyer has an excellent article by Michael Tonsing entitled "A Fashion Model, a Mean-Spirited Name-Calling Detractor, a Blog, and at Least Four Teachable Moments," The Federal Lawyer (October 2009), p. 10. It is the story of a blogger who wrote five posts about a fashion model under the title "Skanks of NYC." The author also included some sexually suggestive photos of the model. The model, Liskula Cohen, sued Google to find out the identity of the blogger. The trial judge in New York granted this request over Google's objection. The outed blogger turned out to be another woman, who then sued Google for giving up her IP address. In an interesting case of chutzpah, the attorney for the outed blogger compared the right to hurl anonymous insults to the authors of the Federalist Papers who wrote under pseudonyms (but whose identities were well known). Mr. Tonsing concludes his article with a great pun: "Anonymity is not guaranteed. Proceed at your own risk in Cyberia. When is a door not a door? When it's ajar."

Auto-Admit

The other case, which I discovered from Prof. Nancy Rapoport's blog, is much darker and more disturbing. A website called AutoAdmit bills itself as "the most prestigious law school discussion board in the world." www.AutoAdmit.com. Two Yale law school students were subjected to a vicious smear campaign on the site. Some 39 different anonymous posters using names such as pauliewalnuts, Cheese Eating Surrender Monkey and Sleazy Z started a campaign which began with sexually explicit comments and escalated to statements suggesting that the women be raped and killed. According to a Complaint filed in United States District Court:

Two women who have done nothing except work hard in school and show promise of making contributions to society have been targeted because of their appearance and out of spite to be the subject of a campaign of pornographic abuse. Hiding behind pseudonyms and the smug assumption that their carefully-aimed hostility can pass as merely juvenile misconduct, the defendants have worked assiduously to harm the plaintiffs, for the sheer joy of destruction. Plaintiffs, whose character, intelligence, appearance and sexual lives have been thoroughly trashed by the defendants, now seek redress by bringing this action for damages and injunctive relief.

Complaint, Doe v. Unknown Defendants, Case No. 307CV00909, U.S. District Court for the District of Connecticut, p. 1.

The statements made on the discussion board, which were outrageous in their vulgarity, are set forth in detail in the complaint. Some of the tamer comments suggested that one of the students had bribed her way into Yale Law School and was having a lesbian affair with the Dean of Admissions, included anti-Semitic slurs about the students, stated that one of them had herpes and had numerous postings about the manner in which the posters wanted to have forced sex with them. The campaign went so far as to send anonymous emails to faculty of Yale Law School and a firm where one of the students had a summer clerkship suggesting that she would harm the reputation of both the Law School and the law firm.

The two students fought back, hiring Reputation Defender, which is an internet public relations firm, and filing suit in United States District Court. In the District Court suit, the plaintiffs sent subpoenas to the internet service providers of the anonymous posters seeking their identity. One such anonymous person, who went by the moniker AK47, sought to quash the subpoena. In an interesting opinion, U.S. District Judge Christopher Droney found that:

The forgoing principles and decisions make clear that Doe 21 has a First Amendment right to anonymous Internet speech, but that the right is not absolute and must be weighed against Doe II’s need for discovery to redress alleged wrongs. Courts have considered a number of factors in balancing these two competing interests. This balancing analysis ensures that the First Amendment rights of anonymous Internet speakers are not lost unnecessarily, and that plaintiffs do not use discovery to “harass, intimidate or silence critics in the public forum opportunities presented by the Internet.”

Ruling on Defendant John Doe 21's Motion to Quash Plaintiff's Subpoena and Motion to Proceed Anonymously, Doe v. Unknown Defendants, Case No. 3:07CV909 (D.Ct. 6/13/08). After weighing various factors, the Court concluded that the subpoena should not be quashed.

As a result of discovery, the Plaintiffs concluded that one of the posters was Matthew C. Ryan, an undergraduate student at the University of Texas. Other identities were discovered, but kept quiet during settlement negotiations. When names started to be named, settlements came quickly. Left unanswered was what motivated the attacks in the first place.

In a bizarre sidenote, one of the libelled students is now the defendant in an action brought by a former employee of Auto-Admit. While attending law school, Anthony Ciolli worked for Auto-Admit as chief educational director. In their campaign to get Auto-Admit to take down the offending posts, the students and Reputation Defender publicly named Ciolli as administrator of the site and stated that he had refused to remove the postings. Ciolli was also named as a defendant in the initial lawsuit. Curiously, neither Auto-Admit nor its owner were named as defendants. Ciolli claimed that he had no control over the discussion board. However, when news of the scandal spread, a law firm rescinded its employment offer to him. While much of Ciolli's suit was dismissed on jurisdictional grounds or for failure to state a cause of action, it remains pending in the U.S. District Court in Philadephia.

Conclusion

The internet is a remarkable forum for the expression of ideas. Anyone can become their own publisher with a minimum of effort and can do so anonymously. However, anonymity can be a cloak for abuse. In the case of the Yale Law School students, they were subjected to nothing less than a gang rape of their reputations and psyches. It seems like a bit of an understatement to point out that online defamers are not the modern day equivalent of the authors of the Federalist Papers. In these cases, the outing of the anonymous authors was a good thing.

I choose to write under my own name and photo. I also don't write anything that I would be embarassed to have my mother read. For some time now, I have moderated comments on my bankruptcy blog. Besides filtering out comments which are really ads for male enhancement products, I have rejected several comments which made personal attacks on judges and litigants mentioned in my posts. As they used to say on Hill Street Blues, "Let's be careful out there."

Random Thoughts from the National Conference of Bankruptcy Judges--Day 3

Today was the final day of the NCBJ annual meeting. Two interesting things today. Heard a good discussion of Rule 2019 and the highlight of the conference, Supreme Court Associate Justice John Paul Stevens.

Rule 2019

I had never thought too much about Rule 2019. I knew that it was out there and that it required creditors to make some kind of disclosure, but that was about it. Judge Robert Gerber had an interesting take on the Rule. Under its current version, it requires any entity or committee (other than an official committee) representing multiple parties to file a verified statement of (1) the name and address of each person represented, (2) the nature, amount and date of acquisition of the claim (if the claim was acquired within one year before the petition date), (3) the pertinent facts and circumstances of the employment of the entity, (4) with reference to the time of the employment of the entity, the organization or the formation of the committee, the amounts of claims owned by the entity, the members of the committee, the times when acquired, the amounts paid and any sales or other disposition thereof. An amendment to the rule is being considered which would require disclosure of all interests of the committee members, but would not require disclosure of the price paid unless specifically ordered by the court.

As Judge Gerber noted, this Rule is most often honored in the breach. This raises the question of why. Part of the reason, according to Judge Gerber, is that parties are unlikely to throw rocks at each other if it would mean that they would have to comply with the rule also. As the judge noted, in big cases, the major fight is between groups of creditors rather than between the debtor and creditors. He observed that he spends his time refereeing disputes between hedge funds. The other reason is unfamiliarity.

The Rule dates back to the 1930s when ad hoc committees would appear in cases claiming to represent creditors, but actually controlled by insiders. Thus, the Rule ensured that parties dealing with an ad hoc committee knew whether it was a legitimate representative of creditors or a front for the insiders.

In modern practice, and especially under the proposed amended rule, disclosure would require disclosure of the underlying interest of entities participating in an entity. "People's private agendas matter," said the judge. In the modern world of hedge funds, a creditor may claim to hold $500,000,000 of bonds but hold a put to sell back $450,000,000, thus inflating their actual claim. If a creditor is shorting the debtor's stock, it could have an incentive to sink the reorganization while claiming to act as a creditor.

Justice John Paul Stevens

The conference came to its conclusion with a conversation with John Paul Stevens. There was a certain symmetry to this. In the CLLA's opening breakfast, Paul Begala talked about how he had named his son John Paul in honor of the Pope and how President Clinton had introduced him to His Holiness. The conference ended with another John Paul, this one the senior justice on the Supreme Court, having served since 1975. Justice Stevens will turn 90 this year. However, he was the picture of vitality, which he attributed to marrying a beautiful dietician (as well as playing tennis three times a week, golfing regularly and swimming in the ocean). He appeared genial and courtly in his bowtie (which he said that he wears because he never learned how to tie a regular tie).

Two bits of baseball trivia. In 1932, he attended a world series game at Wrigley Field where he saw Babe Ruth point to the outfield and then slam out a homerun. Some years later, he threw out the first pitch at Wrigley Field, a feat that meant more to his grandchildren than his service on the Supreme Court.

He used his own experience in the navy to subtly critique Justices who take a strictly literal approach of statutes and the constitution. While he was serving in naval intelligence, a dispatch came through indicating a Japanese battleship was in an unexpected location. The previous officer of the watch sent out the alarm. Then a duplicate version of the message came through, indicating that the original message had been garbled and that it was just a routine communique from a Japanese personnel officer on a base on an island. His point was "In communications there can be garbles." He said this was useful in trying to figure out "Could (Congress) possibly mean what they appear to say." Of course, in law, you don't have the advantage of a duplicate communique appearing in non-garbled form, so that the analogy didn't completely work.

He said that oral argument is more likely to change the way that a justice analyzes a case, although sometimes it will change his position. He suggested that the purpose of petitions for rehearing was to let the defeated lawyer blow off steam, while saying that dissents let the unsuccessful lawyer know that someone listened to him.

Justice Stevens said that he didn't think there was a good chance for televising oral arguments. He stated that whenever you put television in, it changes things.
He noted that since cameras were added to confirmation hearings for Supreme Court nominees, Senators spent more time making speeches, delaying the actual questioning significantly.

When asked about rumors of his impending retirement, he said, "I don't know the answer either."

On the use of foreign law, he pointed out that state law was foreign law and that no one saw anything untoward about looking at persuasive opinions from state court judges. He added that if an English judge or a European judge wrote something persuasive, he would consider it. However, he did not consider himself bound by foreign law.

His final advice to lawyers was:

"You will be practicing for a long time. There will be temptations to take a short cut here or there. You will be appearing before the same judge over and over. The biggest asset is to earn the respect of the bar and the judiciary."

Final Thoughts

It was a good conference. As you can see from these posts, I heard a lot that I found interesting. I met some judges. I saw some shows. Not a bad way to spend three days.

Random Thoughts From The National Conference of Bankruptcy Judges--Day 2

The most interesting programs I attended yesterday concerned consumer issues in the Post-BAPCPA world and real estate issues. I attended several other informative presentations (including a lunchtime history of the Constitution from former Judge Kenneth Starr), but will focus on these two in the interest of length.

Consumer Issues

I started Tuesday off with Post-BAPCPA Case Update for Consumer Practitioners. The two most interesting issues here were standing and the proposed amendments to the Bankruptcy Rules affecting claims. This one was enjoyable because there were many bankruptcy judges in attendance who contributed to the discussion, including the Hon. Eugene Wedoff, Joan Feeney, Keith Lundin, Brenda Rhoades, Eileen Hollowell and Sheri Bluebond. (They weren't all there at the same time. I repeated this program).

Standing Issues

The standing debate arises when a servicer, debt buyer or some other party files a proof of claim or motion to lift stay. As an initial matter, Sec. 501 provides that a creditor may file a proof of claim, while Sec. 362(d) provides that a party in interest may file a motion for relief from stay. Party in interest is broader than creditor, so that the party in interest language would allow a mortgage servicer to file a motion for relief. However, the disparity is equalled out by Rule 3001(b), which allows an authorized agent to file a proof of claim. A servicer would qualify as an agent.

The next issue is whether the person filing the motion or claim actually owns it. This issue applies to debt buyers and securitization trusts among others. Judge Wedoff argued that on a motion for relief from stay, it is the creditor's burden to show lack of equity. This entails showing that the person is the creditor and the amount of the debt. Not answered was what happens when the party in interest seeks relief for cause. Since the entire burden is on the debtor, does the movant have to prove that they are the actual creditor?

This gave rise to a vigorous debate in both iterations of this presentation that I attended. One view was that a motion for relief from stay is simply relief from an injunction, so that issues of standing could be determined in state court. The counter view was that especially in Western states with non-judicial foreclosure, there is no court review so that lifting the stay was tantamount to disposing of the property. This places the burden on the debtor to seek an injunction against foreclosure in state court.

Another debate had to do with assignees and proofs of claim. Whose interest should be protected when there is an issue regarding ownership of the claim? Is it the debtor or the original holder of the claim? If the original creditor is given notice of the bankruptcy case and a purported assignee files the only claim on that debt, it is safe to assume that the claimant actually holds the claim. On the other hand, when an assignee files a motion for relief from stay, the debtor has a direct interest in whether the person seeking relief is authorized to do so.

These issues are exemplified by cases involving MERS and securitization trusts. MERS is a national clearinghouse for mortgage assignments. The creditor names MERS as the nominee for the trustee under the deed of trust. Thus, if the mortgage is assigned, MERS continues to act as nominee for whoever the current trustee happens to be. The problem arises when MERS files a motion for relief from automatic stay. MERS does not hold the note. It is merely the nominee of the trustee under the deed of trust. Several courts have held that this does not give them standing to file a motion for relief from stay. Securitization trusts also give rise to a problem. Mortgages are put into pools with an indenture trustee. However, in one case which was mentioned, the entity contributing the mortgage loan to the trust was never the holder. There was simply a gap in title.

New Claims Opinion

One of the judges from New Hampshire mentioned the October 19 decision from the First Circuit BAP in In re Plourde, which can be found here. I have not had a chance to review this opinion in detail, but apprently it held that failure to file a claim in the proper form deprived it of prima facie validity, so that the creditor was only entitled to priority as a late filed claim. Not quite sure how they got to that result. It will likely go up to the First Circuit.

Proposed Rules Changes

The other interesting discussion concerned the proposed amendments to Bankruptcy Rule 3001(c) and Bankruptcy Rule 3002.1. The changes to Rule 3001(c) would require more documentation on a claim, including the most recent account statement on a credit card account, an itemized statement of interest, fees, expenses and charges, a statement of the amount necessary to cure an arrearage on a secured claim and an escrow account analysis if applicable. What is really significant about this amendment is that it states that the consequence of failing to provide this information on the claim is that the creditor would be precluded from using this information in any hearing "unless the court determines that the failure was substantially justified or is harmless." Furthere, the court may award sanctions in addition to or in lieu of exclusion of evidence. This is a huge change. Under the current rule, failure to properly document a claim deprives it of prima facie validity, but the creditor can still prove up its claim in a hearing. This rule would effectively provide that failure to properly document the claim means that it may be denied. Some of the speakers suggested that this was not too severe because the creditor could always amend the claim. However, in the Southern District of Texas, Judge Jeff Bohm has held that a creditor may not amend its claim without leave of court once it has been objected to. The rule is also huge because it allows sanctions for filing an improperly documented proof of claim. Under current law, sanctions may be awarded under Rule 9011 which has a safe harbor provision or under the court's inherent authority, which requires a finding of bad faith. Allowing sanctions for filing an improperly documented claim and nothing more is a quantum change.

Proposed Rule 3002.1 would require creditors with a security interest in the debtor's principal residence to file notice of certain charges and changes in payment amounts. If the payment amount changes post-petition due to an adjustment in the interest rate or the escrow amount, notice must be filed 30 days before the payment amount changes. The notice must be given in the same form applicable under non-bankruptcy law. Additionally, a creditor must file a notice of all fees, expenses or charges incurred post-petition as a supplement to its proof of claim. This notice must be filed within 180 days after the charges are incurred. The debtor and the trustee would then have one year to object to the charges. Additionally, the trustee would be required to file a statement indicating that the final payment necessary to cure an arreage on the mortgage has been made. All of these notices can be challenged in court. Failure to give the required notice would bar the charges.

These rules changes are open for comment at www.uscourts.gov/rules until February 16, 2010. If approved, they will go into effect on December 1, 2011.

Real Estate Issues

From there, I went on to the panel discussion on real estate issues moderaed by Prof. Mechele Dickerson from the University of Texas Law School. First up, was a summary of the state of the market from Ronald Greenspan with FTI Consulting. The residential real estate market has hit bottom and is on the upswing in all major markets except Detroit and Las Vegas. However, it had a steep decline, going from 1.7 million housing starts in 2005 to only 500,000 in 2009. Part of the reason that homes sales are recovering is the fact that the government is guarantying 80% of the new mortgages being made. One note of concern is that the level of vacant homes has risen from its typical rate of 1.0% to 2.5%, meaning that houses are sitting empty and subject to vandalism, blight, etc.

The outlook for commercial real estate is much darker. Commercial real estate did not peak until the first quarter of 2008 and has dropped precipitously. Sales ae down by 75%. Default rates have increased from 0.5% to 4.0%. Mr. Greenspan indicated that the commercial fundamentals could continue to go down for another three years.

The panel highlighted three recent real estate cases of interest. In Tousa, Inc., the bankruptcy court recently held that encumbering the property of one group of subsidiary companies to pay off the debts of a different subsidiary was a fraudulent conveyance. The opinion is some 180 pages long.

The panel opined that the Ninth Circuit BAP's opinion in Clear Channel has proven to be less problematic than anticipated. The Clear Channel opinion overruled approval of a Sec. 363 sale over the objection of a dissenting junior lienholder. It held that Sec. 363(f)(3), which allows sales free and clear of liens if the sales price exceeds the aggregate value of all liens refers to the total dollar amount of the lien, not the Sec. 506(b) value. Thus, you could not cut off the junior lienholder based on the argument that the lien was completely underwater. One case subsequent to Clear Channel allowed a sale under similar circumstances based on Sec. 363(f)(5) which allows sale free and clear of liens if the creditor could be forced to accept a monetary satisfaction "in a legal or equitable proceeding." In the specific case, Washington law allows a junior lienholder to be cut off in a foreclosure action, thus satisfying the section. The panel speculated about whether cramdown under chapter 11 would be "a legal or equitable proceeding" under the section.

The recent case of General Growth Properties illustrates what happens when you have a large number of single purpose entities with a central cash management system. The lenders required that each entity have an independent director to keep them bankruptcy remote. However, the debtor simply replaced the independent director on the eve of bankruptcy without notice to the lender or the independent director being replaced. The court noted that the independent director's duty was to the entity rather than to the lender. The court refused to dismiss the bankruptcy cases of solvent debtors who were current upon their debts. The lenders argued that the cases had been filed in bad faith because the debtors were current and had not sought to negotiate with the creditor. The creditor also argued that reorganization was futile because they would not agree to any reorganization plan proposed by the debtor. Of course, this undercut their argument that the debtors should have negotiated with them. The court rejected the motions to dismiss.

The case also raised the issue of whether you could use income from one debtor to pay the expenses of another pursuant to a central cash management system. The court analyzed the issue as one of adequate protection and found that the creditor was adequately protected by the value of the collateral. The panel raised the question of whether the lending could have been challenged as a transaction not in the ordinary course of business. If the cash negative debtors were having to borrow money from the cash positive debtors and were not able to get DIP financing, then the financing would presumably be on less than market terms. Thus, the transaction would not be in the best interest of the lending entity regardless of whether the lender was adequately protected.

Another issue raised by aggregations of single asset real estate debtors is whether there must be an impaired accepting class in each case or simply one impaired accepting class under the plan. Sec. 1129(a)(10) references the plan. An unreported opinion in the Enron case says that you need one impaired accepting class overall rather than in each case.

Another interesting isssue discussed was a springing guaranty. This is a guaranty which only comes into force if the debtor files bankruptcy. Obviously, it is intended as a poison pill to deter bankruptcy filings. The question raised was whether this violated public policy by giving principals of the debtor an incentive to violate their fiduciary duty by not filing bankruptcy to protect their personal financial interest.

Random Thoughts from the National Conference of Bankruptcy Judges--Day 1

I am in Las Vegas for the National Conference of Bankruptcy Judges. The conference promises 2 1/2 days of events combining leading speakers and some frivolity.

I started off Monday by attending the Commercial Law League of America's breakfast with Paul Begala. Begala attended the University of Texas Law School around the same time that I did, but went on to work in the Clinton White House shortly thereafter. He is speaking on the topic Politics in America Today: Too Important to Be Left to the Politicians. However, it should have been titled Will Obama Crash and Burn. One of his central points was that presidents enter office with high expectations and high approval ratings, but inevitably run into scandals and reality which drag their approval ratings down. Some, like Presidents Reagan and Clinton recover, while others, like Jimmy Carter and George H.W. Bush do not. Begala's thesis is that some presidents succeed despite the unpopularity of their foibles. While Americans did not like Iran-Contra and the Monica Lewinsky affair, they liked Ronald Reagan and Bill Clinton. The key, according to Begala, is a belief in American Exceptionalism, the conviction that America is a place which, as de Tocqueville reported early on, contains unlimited opportunities. Reagan (morning in America) and Clinton (the Man from Hope) got this. Begala believes that Obama gets this also. As a matter of fact, his point is how can anyone go from being the grandson of a Kenyan goatherder whose father deserted him to president of the United States without believing in the promise and the magic of America. He contrasts this with a conversation he had with his haughty French brother in law who became suddenly silent when asked when France would elect a President of Algerian or Moroccan descent.

Upon entering the main hall, my first thought is that I am in a cavern. The speakers are way off in the distance. Most of the audience crowds around the back, leaving plenty of room up front for this willing to walk half a mile or so.

Barbara Houser, the incoming president of the NCBJ, gives a preview of next year's conference in New Orleans. When I think of Judge Houser, I think of serious, sober analysis. However, the promotional video shows the wild side of Judge Houser, speeding around New Orleans in what looks like a go cart, wearing a Saints jersey, eating beignets and wandering down Bourbon street in a feathery Mardi Gras mask. It is nice to know that even judges can have fun. (I will try to get the video for a future blog).

From there, the next topic is Obamanomics and the Future of Bankruptcy. Of course, as the panel later makes clear, Obama's key policies regarding economic stimulus and recovery are largely a continuation of the Bush administration's. First up is former Sen. Gordon Smith, who paints a picture of dire consequences when the demographic Tsunami of entitlements hits. If I heard him correctly, he said that at some point in the future, the gap between tax revenues and entitlement payments will equal the gross national product. He posits that the federal government will shift costs down to the states which will not have the ability to print money or engage in endless deficit spending. He wonders aloud whether the bankruptcy code will need to be amended to allow states to file for bankruptcy.

The panel which follows discusses the meaning of the Chrysler and GM cases. The economist on the panel argues that reorganization should be faster, more like a sale. The panel asks whether the current practice is a signal that the chapter 11 process is no longer viable.

Another panelist makes the point that BAPCPA has caused bankruptcies to fall and defaults to rise, which will lead to bankruptcies increasing. Currently 3% of prime mortgages and 14% of subprime mortgages are in default.

The economist addresses the problem of home foreclosures. She posits that lenders foreclose too often because they only consider their own costs and not the larger costs to society (kids having to change schools, vacant homes, property values crashing). Of course, like any good economist, she has a on the one hand this and one the other hand that approach. The current program of relying on voluntary modifications leads to too few modifications, while allowing cram-down in chapter 13 would lead to too many (i.e., people who could have paid their loans given a little time will be able to modify when they don't really need to).

Later in the day, I learn about the different types of recessions. Apprently, there are bathtub recessions, V recessions and hockey stick recessions. We are in a bathtub recession, which involves a steep slide followed by a long trough and a steep recovery. According to the speaker, we have reached the bottom of the bathtub and will stay there for at least three years.

The panel on chapter 11 bemoaned the fact that while we are seeing an uptick in chapter 11s, we are not seeing true reorganizations. Reorganizations today consist of 363 sales, orderly liquidations and cases with significant litigation which will pay off in a short period of time. Another change is that bankruptcy is now part of the process, rather than the focus of the process. In other words, bankruptcy is a tool used to implement a strategy developed ahead of time, rather than the means where the strategy is developed.

Another change is that almost every case of consequence runs the risk of administrative insolvency due to high amounts of leverage leading to the need for a speedy resolution.

One of the speakers argued that we have shifted from a rehabilitation process to a retribution process. Where there is risk, there is failure. He argued that we should give debtors a chance to reorganize after failure rather than penalizing them.

I learned a new term: fulcrum security. These are the secured creditors who stand to win or lose big time depending on the sucess of the reorganization. They are either first lenders who are undersecured or junior lenders. They are more like equity than secured creditors in that they are willing to take greater risks to try to achieve greater rewards. Some creditors in this category go into the case with a loan to own mentality.

Outrageous Creditor Behavior Leads to Small Damage Award

A debtor's suit against an abusive creditor seemed to have all the right elements: outrageous facts, creative legal theories and a sympathetic judge; but lacked just one thing, damages. Shane Eastman v. Baker Recovery Services, Adv. No. 08-5055 (Bankr. W.D. Tex. 10/15/09). The opinion can be found here.

The Facts

Based on the opinion from Bankruptcy Judge Leif Clark, the facts were pretty outrageous. A debtor filed a no-asset chapter 7 case and received a discharge. He inadvertently omitted a credit card that had been used by his ex-wife when they were still married. That account was sold to a debt buyer, who then filed suit against someone else named Shane Eastman in California. When the debt buyer realized that he had sued the wrong Shane, instead of dismissing his case, he had Texas Shane served with process in the California action.

At this point, the debtor's lawyer wrote to the creditor's lawyer and informed him that he was violating the discharge. The debtor, believing that his lawyer's letter had done the trick, did not answer. The debt buyer apparently didn't think the discharge applied to him, so he took a default judgment against the debtor in the California action without notice to the debtor.

The debtor learned about the judgment some time later when his security clearance with the Air Force was revoked. The debtor's lawyer demanded that the judgment be released. The creditor refused to do so unless he was paid $2,500 for his trouble. The debtor then had his bankruptcy case reopened. According to the judge, "It was the reopening of the case that finally motivated Baker to abandon his efforts to extort some payment out of Eastman in exchange for releasing the judgment." The use of the word "extort" gives some insight into the judge's view of the situation. The debtor got his security clearance back some five months after it had been revoked. However, during this period, he missed out on a potential opportunity for a career-advancing placement with a general.

The discouraged debtor believed that the episode had soured his chances for advancement in the Air Force and resigned several months later, some 11 years into his military career.

Creative Causes of Action

The creditor committed the following bad acts at a minimum:

1. He filed suit on a discharged debt;
2. He sued a consumer in a state where he did not reside;
3. He took a default judgment after being notified of the discharge; and
4. He demanded payment for releasing the judgment on the discharged debt.

These facts were pretty serious. Therefore, they justified more than just a simple action for violation of the discharge. The debtor's lawyer sued for violation of the discharge, violation of the Fair Debt Collection Practices Act, violation of the Texas Debt Collection Act, violation of the Texas Deceptive Trade Practices Act and tortious infliction of emotional distress.

The Bankruptcy Court allowed the debtor to proceed with all of these causes of action, finding that the bankruptcy discharge does not preempt other claims arising out of violation of the discharge.

The Court found liability on three out of five claims. With some understatement, the Court held that, "It is obvious to this Court that the Defendants violated Sec. 524(e) of the Bankruptcy Code." Although the Defendants claimed that the debtor was precluded from urging the discharge violation based on his failure to plead this as an affirmative defense in the California suit, the judge didn't buy it.

The Fair Debt Collection Practices Act prohibits a debt collector from making a "false, deceptive or misleading representation or means in connection with the collection of any debt." The Court followed Judge Easterbrook of the Seventh Circuit in ruling that "A demand for immediate payment while a debtor is in bankruptcy (or after the debtor's discharge) is 'false' in the sense that it asserts that money is due, although, because of the automatic stay (11 U.S.C. Sec. 362(a)) or the discharge injunction (11 U.S.C. Sec. 524), it is not." Thus, it was clear that the debt buyer and his lawyer had violated the FDCPA.

The Texas Debt Collection Act has a similar provision prohibiting the use of a "fraudulent, deceptive or misleading representation . . . misrepresenting the character, extent or amount of a consumer debt or misrepresenting the consumer debt's status in a judicial or governmental proceeding." The court found that filing suit on a discharged debt fell within this provision and thus found liability under the TDCA.

The TDCA also provides that a violation is considered to be a deceptive trade practice under the Texas Deceptive Trade Practice Act. However, to recover under the DTPA, a person must be a "consumer." Since the debtor never sought to acquire goods or services from the debt buyer, he did not qualify as a consumer under the DTPA and could not take advantage of that statute's remedies.

The court also found that the defendants were not liable for tortious infliction of emotional distress. To recover under this theory, the debtor would have needed to show that the defendant's actions were taken for the primary purpose of causing emotional distress. While the debt buyer's actions were outrageous, they were aimed at collecting the debt rather than inflicting emotional distress.

The Relief Granted

Having prevailed under three theories, the big question was what relief could be granted. The debtor sought to recover (i) actual damages, statutory damages and attorney's fees under the FDCPA; (ii) actual damages and costs and attorney's fees under the TDCA; (iii) economic damages and treble damages under the DTPA; and (iv) damages for the infliction of emotional distress. The debtor apparently did not seek damages for contempt for violation of the discharge injunction.

Because the court ruled against the plaintiff on the DTPA and tortious infliction of emotional distress, the best possible recovery for the plaintiff was under the FDCPA for statutory damages, actual damages and attorney's fees. The court awarded statutory damages of $1,000 as provided by the FDCPA and held that the debtor was entitled to recover attorney's fees. However, the court ruled that the debtor did not prove an entitlement to actual damages.

The debtor's primary theory of damages was that the judgment destroyed his Air Force career when his security clearance was withdrawn and he lost the opportunity to work for the general. The debtor presented evidence of what he would have earned if he had stayed with the Air Force and been promoted to Chief Master Sergeant. The court found that this fell within the category of "special damages," meaning damages that are of such an unusual nature that they would vary from individual to individual. In order to recover special damages, they must be specifically pled and may not be "too remote, uncertain, conjectural, speculative or contingent." This was a difficult burden for the debtor to meet. He acknowledged that promotion to Chief Master Sergeant was difficult to obtain. He also acknowledged that he did not apply for the position with the general because he was told not to bother. Because the debtor voluntarily left his position with the Air Force, it was impossible to tell whether he would have made Chief Master Sergeant and therefore impossible to award damages. He also failed to provide any evidence of his mental state as a result of the defendants' actions, so that he could not recover for emotional distress. Because these were the only items of damage pled, he was not able to recover for actual damages.

Final Lessons

This is a hard case. The creditor's actions were clearly outrageous. The judge was clearly offended. However, the only relief that the debtor received was the court's finding that the debt had in fact been discharged, $1,000 in statutory damages and reimbursement for his attorney's fees. Thus, his victory was more symbolic than substantial.

The defendants did not escape unharmed. They have the stigma of a finding from a federal judge that they violated the law. They also will have to pay both their own attorney's fees (which likely were substantial given that they hired a former bankruptcy judge to defend them) as well as the plaintiff's fees. However, it could have been much worse.

The bottom line is that good liability facts do not always translate into good damage facts. It seems unmistakably clear that loss of a security clearance would cloud a military career. But how does that translate into damages? In this case, the plaintiff had to prove what would have happened over nine years of a future military career that the plaintiff walked away from. Because there was no guaranty that he would have achieved his career goals with the Air Force, the damage theory did not work. There was clearly a lost opportunity. But how do you value a possibility? The harm was quite real to the debtor. However, the true damage of lost hopes and aspirations was too intangible to value.

IRS Loses Out on Inheritance Bait and Switch

While the government has many powers, the Fifth Circuit recently decided that the IRS had no remedy when proceedings in a Louisiana state court deprived it of the benefits it was supposed to receive under a confirmed chapter 11 plan. The opinion can be found here. United States v. Lewis, No. 08-30964 (5th Cir. 10/1/09).

When Caroline and Nelson Hunt filed chapter 11 in the 1980s, they owed over $100 million in non-dischargeable taxes. As part of their plan, they agreed that any inheritance received by Caroline would go to the IRS. Caroline was the niece of Turner Hunt Lewis, who was in his 70s, childless and intestate at the time. This meant that if he died, his estate would be divided between his three nieces and nephews. His estate was ultimately worth $16.5 million.

However, when Mr. Lewis was on his deathbed some 13 years later in 2002, his nephews petitioned the state court in Louisiana for an inderdictment, which is like a guardianship. With the approval of the Louisiana court, they created a trust in which the share of the estate which would have gone to Caroline went to her children. The nephews acknowledged that they did this with Caroline's blessing for the purpose of keeping her share out of the hands of the IRS. The IRS was not given any notice of the proceedings.

Some years later, the IRS sued in federal court to set aside the trust. The District Court granted summary judgment against the IRS. In an unusually brief and blunt published opinion, the Fifth Circuit dispensed with the government's contentions.

The effect, and presumably the intent, of this course of action was to pass the estate to family who had no such tax obligation. Its legality is challenged here. The government has filed this federal suit claiming that the curators’ course of action was in fact contrary to Louisiana state law and that we should protect its rights by striking down the trust provision in favor of Caroline’s descendants and awarding Caroline the money she should have inherited, to be remitted to the I.R.S. according to the 1989 agreement.

We confess the considerable difficulty of understanding the basis under which this claim proceeds. In answering this question, we note what the United States has not alleged. The United States has not argued that any party committed tax fraud or violated any other specific internal revenue law with relation to the Turner Hunt Lewis Trust. The United States does not argue that Caroline or Nelson Hunt violated their agreement with the I.R.S. In essence, the government asks that we sit as a general court of review for a seven year old Louisiana district court trust law decision because it has the ultimate effect of redirecting the path of funds to a path beyond the reach of the federal government.

But the government has no claim to money that Caroline Hunt did not inherit, and the state court judgment decided no right of the government. Rather, it decided the authority of Lewis’s representatives to dispose of his property. Had Turner Hunt Lewis omitted Caroline Hunt from his will, the government would have had no recourse. His representatives did omit her. If their decision was effective, the matter ends. And a solemn judgment of a Louisiana state court with jurisdiction over the interdiction approved the omission of Caroline Hunt and is unchallenged. We see no reasoned basis for our authority to review that judgment and the I.R.S. offers none.

The government’s creditor relationship with the interdiction and state court judgment raises questions of standing and failure to state a claim. These issues are here not easily disentangled. Congress has given the I.R.S. access to federal courts to collect taxes, and – while this case pushes the outer limits of that license – we will reach the merits and affirm the district court’s rejection of the government’s claim. Ultimately, the government is unable to demonstrate any entitlement to the disputed moneys by virtue of its contract with Caroline Hunt.

Memorandum Opinion, pp. 3-4.

A concurring opinion noted that under Louisiana law, an affected party could have sought annulment of the judgment within one year of discovery if it was obtained through "ill practices." Having failed to utilize the remedy created by state law, the government was without a remedy in federal court.

The opinion is remarkable in that the Fifth Circuit panel chose to publish an opinion whose discussion did not cite any cases, statutes or rules (although the concurrence did reference the Louisiana annulment procedure). This could be seen as a public rebuke to the government both for pursuing a meritless claim and for failing to protect its interest.

While the precedential value of this opinion is minimal, it offers several practical lessons. The first is that state court judgments matter. Far too many debtors wait until after an adverse judgment has been rendered to seek bankruptcy relief. By that time, it may be too late. Once a judgment has been rendered in state court, it can only be challenged in state court no matter how badly it smells. The second lesson is to be careful in drafting plans and agreements. In this case, the expectation was that Caroline would receive an inheritance which would go to the government. However, there were many ways that expectation could have been thwarted. Caroline could have predeceased her rich uncle, he could have prepared a will excluding her or he could have lost the money in a casino. The fact that the nephews used a suspect, last minute move to divert the inheritance did not change the fact that the original promise was rather illusory to begin with.

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.