Texas Lawyer Escapes Sanction

In politics, it is sometimes said, what did the president know and when did he know it. As it turns out this analysis is helpful in determining whether a lawyer should face sanctions under Rule 9011 as well. In the case of In re Dernick, No. 18-32417 (Bankr. S.D. Tex. 5/22/20), the fact that "there [we]re a fair number of complex and confusing details at play" was enough to prevent the motion in question from being objectively frivolous.

What Happened

Two individuals filed Chapter 11 and hired  lawyer AA (not his real initials).  AA filed a Motion to Disqualify law firm FG from representing one of their creditors, Dernick Encore, LLC. The motion alleged that FG had previously represented the Debtors in substantially related matters and were in possession of relevant confidential information.

Dernick Encore responded and said that FG had not represented the Debtors and that the prior representations were not substantially related to FG's current representation of Dernick Encore. 

After a two day evidentiary hearing, the Court denied the Motion and allowed Dernick Encore to file an application for fees and costs. Dernick Encore sought to recover fees of $101,704.00. The Debtors objected that the Court lacked sufficient authority for fee shifting. The Court then issued a Show Cause Order for the Debtors and lawyer AA to show cause why they had not violated Rule 9011(b).

Subsequently, the Debtors retained new counsel and lawyer AA withdrew. 

The Court conducted a hearing on the Order to Show Cause over the course of three days. 

While the Show Cause Order was under advisement, the Debtors, Dernick Encore and several other parties went to mediation and reached a settlement. Following approval of a motion to compromise, the Debtors were released from the Show Cause Order. That left the issue of whether lawyer AA was subject to sanctions.

The Court's Ruling

The Court concluded that because Derrick Encore had not filed a Motion for Sanctions, that the Court could not order lawyer AA to pay Derrick Encore's attorneys' fees. However, the Court still had power to award sanctions under Rule 9011 and its inherent authority. If this is confusing, it is because it is. Rule 9011 authorizes sanctions in two contexts. First, there are party initiated sanctions which require a safe harbor notice. Second, there are Court initiated sanctions which are triggered by an order to show cause which must describe the specific conduct which the respondent is alleged to have committed. Apparently the relief which can be granted with regard to Court-initiated sanctions are different than when sanctions are party-initiated.

This brought the Court to the merits of whether lawyer AA had violated Rule 9011(b). The Court stated that a pleading could violate Rule 9011 if it met one of the four subsections of Rule 9011(b), which the Court described as the frivolousness clause or objective component and the improper purpose or subjective component.

 In order to avoid violation of the frivolousness clauses, the lawyer must (i) perform a reasonable preliminary investigation and (ii) conclude that the legal papers filed are grounded in "both a nonfrivolous legal theory and well-founded factual contentions and/or denials that, at a minimum, have a reasonable possibility of having evidentiary support after further investigation and discovery."  The court's inquiry "should focus on the merits of the motion gleaned from the facts and law known or available to the attorney at the time of filing."  Opinion, p. 11.

Failure to conduct a reasonable investigation will not protect the attorney even if he had a good faith belief that the motion was sound. Reasonableness depends on "the time available for investigation, whether Mr. [AA] had to rely on Debtors for information as to the underlying facts, whether the Motion was based on a plausible view of the law, and may depend on the extent to which factual development necessitates discovery."  Opinion, p.. 12.

In order to disqualify an attorney there must be (i) a prior representation and (ii) a substantial relationship between the prior representation of the Debtors and the current representation of Dernick Encore.

FG had represented the Debtors previously in connection with their status as minority shareholders of a company called Cinco Resources, Inc. However, FG's engagement letter stated that it was limited to filing answers for the minority shareholders and would be completed once the answers were filed. It also stated that continued work would be contingent on timely payment of their invoices (which did not happen). To further complicate things, another one of the minority shareholders asked FG to perform various tasks related to other companies and to bill the matter to the Cinco Resources Minority Shareholder matter.  Dernick Encore paid the bill for the other services rendered.

Attorney AA concluded that FG had continued to represent the minority shareholders (including the Debtors) through 2015. The Court stated:

The Court finds credible Mr. [AA]’s testimony that his review of the record before him raised reasonable concerns about [FG]’s scope of representations with respect to Debtors. While the Court carefully combed through the trial record and found certain points where Mr. [AA] could have been more investigative in his inquiry before filing his Motion, the Court’s job is not to direct counsel on how to prosecute their motions. Rather, the Court is guided by Rule 11 and Rule 9011, which cautions that sanctions run the risk of chilling zealous and creative advocacy, as well as potentially meritorious claims that circumstances make difficult to prove. In reviewing the record, the Court notes that there are a fair number of complex and confusing details at play, especially regarding Debtors’ numerous businesses, Debtors’ dealings with CRI and DRI, and Debtors’ dealings with various law firms, either individually or through their companies. Taking the record in toto, the Court is not convinced that Mr. [AA]'s Motion was objectively frivolous. The interrelatedness of Debtors’ companies and the timing of representations would certainly give any competent attorney pause, and the Court does not find that Mr. [AA]'s Motion approached frivolous levels under Rule 9011(b).

Opinion, pp. 16-17. The Court also found that the motion was not filed for an improper purpose. The Court reasoned that if the motion was objectively nonfrivolous, it could not have been filed for a subjectively improper purpose. This raises the question of whether the improper purpose test adds anything to the rule beyond the objective test. 

Thus, Judge Rodriguez declined to impose sanctions under his Show Cause Order.

What Does It Mean?

I see at least three takeaways from this case.

The first is that if a party wants to recover its attorneys fees, it should send a safe harbor letter (which must include a copy of the proposed motion). Had Dernick Encore sent a safe harbor letter, the Debtors might have reconsidered going ahead with their disqualification motion. Instead, the company incurred over $100,000 in legal fees which it was unable to recover.

The second is that the initial investigation is crucial. Here, lawyer AA reviewed enough documents to constitute a reasonable inquiry. Had he merely relied on his clients' word, he might likely have lost. While bankruptcies move quickly, asking the client for documentation (and then actually reviewing that documentation) is good defense for the lawyer, particularly when the motion is likely to be contentious. 

Finally, it takes a thoughtful judge to deny relief on his own order to show cause.

Hat tip to Matt Garcia for sending me the opinion.

Note: I did not use the name or initials of the lawyer in question. Publicizing an order granting sanctions can be a further punishment to the lawyer. However, where sanctions were denied, there is no good reason in publicizing the name of someone who was not sanctioned.

 

Third Circuit Allows Third Party Release on "Exceptional" Facts

Third party releases have long been a controversial feature of certain chapter 11 plans. They are neither specifically allowed nor prohibited by the plain language of the Bankruptcy Code. This has led courts to reach differing results. There are two important principles at play in these cases. On the one hand, bankruptcy exists to provide relief to debtors. On the other hand, bankruptcy plans are intended to provide the greatest possible return to creditors. If granting releases makes the plan possible, this is in the best interest of creditors.

The Third Circuit waded into this debate to answer a very limited question:  does Article III permit non-consensual third party releases? The Court's answer, at least in the specific case before it, was yes. In re Millenium Holdings II, LLC, 945 F.3d 126 (3rd Cir. 12/19/19). 

A Case Study in How Judges Determine Witness Credibility

When a judge hears from multiple witnesses, he or she must make a decision on how much weight to give to what each witness says. Bankruptcy judges frequently make their credibility decisions a part of their opinions. This is both helpful to the parties and increases the likelihood that fact findings will not be found to be clearly erroneous on appeal.

Judge H. Christopher Mott's opinion in Adv. No. 18-1091, Kansas City Southern Railway v. Chavez, which can be found here is a good illustration on how judges assess credibility. For more background on the case, you can read my prior post here.  During the trial, Judge Mott heard testimony from thirteen witnesses, some of whom testified live and some of whom testified by deposition.  I have listed the witnesses below and have quoted Judge Mott's credibility findings.

A Story of Lawyers Behaving Badly

Here, the Court grapples with an inheritance—the latest chapter of a litigation odyssey that began over a decade ago in a different domain.

Adv. No. 18-1091, Kansas City Southern Railway Company vs. Luz Chavez vs. Rosenthal & Watson, P.C. (Bankr. W.D. Tex. 1/31/20), p.1.  The opinion can be found here.

To the outsider, proceedings in bankruptcy court may seem like lawyers talking in incomprehensible jargon while the judge looks down from on high staring Sphinx-like until called upon to make a ruling. However, there is a part of trial work that applies to bankruptcy as well and that is telling stories. The lawyers each spin their tales through arguments, witnesses and exhibits. The judge then takes the raw material the lawyers have given him and fashions it into his own tale.  This case is a tragic tale of clients and some lawyers who failed to serve them well.

Note: on the cold light of the digital page, as drafted by the judge and his clerks, the story takes on clear heroes and villains. In this post, I do not seek to judge the parties, the judge has already done that. Instead, I am re-telling a story that I heard from a judge and found compelling.

Bankruptcy in a Time of Coronavirus

As confirmed cases of the Covid-19 virus climbed across the country, bankruptcy courts and the U.S. Trustee's office have been seeking ways to adapt to the new normal.  This post will look at how the court system has rolled out its disaster preparedness through the lens of the Bankruptcy Courts for the Western District of Texas, Southern District of Texas and District of Delaware.

Here is a timeline of announcements from the Courts with a few random anecdotes thrown in.  All of the standing orders and announcements can be found on the respective websites of their courts.

Congress to Expand Small Business Eligibility Limits to $7.5 Million

On March 25, 2020, the U.S. Senate passed the Coronavirus Aid, Relief and Economic Security Act” (CARES Act). The House is expected to pass the bill today. One provision of the bill increases the eligibility limits for small business debtors from $2.7 million to $7.5 million. The amendment will only apply to cases commenced after its effective date and will be subject to a sunset provision after one year.

Since many more businesses will be eligible to file under the small business provisions, it is worthwhile to review the pluses and minuses of falling within Subchapter V.  Subchapter V, which is titled Small Business Debtor Reorganization consists of 11 U.S.C. Sec. 1181-1195.

Supreme Court Set to Hear Passive Stay Violation Case

Seeking to resolve a 5-3 split among the Courts of Appeals, the Supreme Court will consider whether a creditor which passively retains property of the estate violates the automatic stay.  Case No. 19-357, City of Chicago v. Fulton. The Second, Seventh, Eighth, Ninth and Eleventh Circuits have ruled that retaining possession or control of property of the debtor violates the stay. The Third, Tenth and D.C. Circuits have held that passive retention of property is not an "act" to exercise control over property of the estate.