After just sixteen days on the bench, Austin Bankruptcy Judge Craig Gargotta has penned his first opinion. In Ingalls vs. Cunningham, Adv. No. 06-1236 (Bankr. W.D. Tex. 10/16/07), Judge Gargotta considered whether a creditor which filed an arguably usurious claim could take advantage of Texas's usury cure provision when it amended the claim to delete the offending charges. Judge Gargotta concluded that it could.
In this case, the creditor filed an initial claim for $89,280 on November 19, 2005. On April 24, 2007, the Trustee sought to amend an existing adversary proceeding to include a claim for usury. Ten days later, the creditor objected to the motion and filed an amended claim for $32,041.66 which eliminated the offending charges. The parties entered an agreed order which allowed the amendment but preserved the defendant's right to challenge the usury claim.
On defendant's motion to dismiss, the court considered whether the creditor's amended claim was sufficiently timely to constitute an allowable cure under the Texas Finance Code. Texas has two separate usury cure provisions. If the creditor discovers the usury violation, Texas Finance Code Sec. 305.103 allows the creditor to correct the violation within 60 days from "the date the creditor actually discovered the violation" by giving notice to the obligor. A second section, Texas Finance Code Sec. 305.006, applies when the obligor discovers the violation. It requires the obligor to give the creditor 60 days notice prior to filing suit or filing a counterclaim. During the 60 day period, the creditor may correct the violation in the same manner as under Sec. 305.103 (that is, by giving notice to the debtor).
In this case, the court found that Sec. 305.006 applied because this case involved a suit by the debtor's chapter 7 trustee. The court found that the trustee's motion for leave to amend constituted notice to the obligor of the usury violation triggering the 60 day period to cure. The court found that amending the proof of claim to exclude the allegedly usurious charges consituted an adequate cure. Because the creditor filed its amended claim well within the 60 day cure period, it was not subject to being sued for usury. As a result, the court granted the motion to dismiss.
This case raises several practice points. The first is that a proof of claim in a bankruptcy case can constitute a demand for usurious interest. As a result, alert debtors and trustees should scrutinize the claims filed to see if there are claims which could be asserted. Second, the two usury cure provisions appear to work independently. If a creditor discovers the usury, it has 60 days to cure the violation. However, if the creditor fails to do so, it has a second 60 day period once it receives notice from the obligor. Thus, although Texas has "draconian" usury penalties, a prudent creditor has an easy means to avoid liability if it acts promptly.
Wednesday, October 24, 2007
Monday, October 22, 2007
Court Protects Homestead Proceeds But Leaves Open Question on Tardy Objections
Texas has one of the most generous homestead exemptions in the country. However, a quirk in the law allows an exemption in homestead proceeds to be lost due to the passage of time. San Antonio Bankruptcy Judge Leif Clark recently found a creative solution to the problem created by an obstreperous creditor seeking to outlast the debtor and preclude reinvestment of the proceeds from sale of a homestead. In re Bading, No. 06-52750 (Bankr. W.D. Tex. 9/22/07). However, the opinion raises the question of why Judge Clark had to work so hard when Supreme Court precedent provided a simpler alternative.
The Vanishing Exemption and Absolute Protection of Exempted Property
Most exemption statutes are limited by the type and value of the property to be claimed as exempt, but are not limited as to time. Thus, exempt property will keep its status so long as it retains its exempt character. However, a sale or other transformation of the exempt property will usually cause it to lose its exempt character. The Texas homestead exemption extends not only to a homestead owned and occupied by the debtor, but to the proceeds from sale of a homestead as well. Tex. Prop. Code §41.001(c). The proceeds exemption is one which is limited by time. It lasts for the lesser of six months or until the debtor acquires another homestead. The purpose of the proceeds exemption is to give the debtor a limited period of time in which to acquire a new homestead. As a result, the statute creates a vanishing exemption. Homestead proceeds which were fully protected five months and 29 days after sale of the home become cash subject to claims of creditors after six months and one day.
This vanishing exemption creates a potential conflict between state and federal law in the bankruptcy context. According to 11 U.S.C. §522(c), “property exempted under this section is not liable during or after the case for any debt of the debtor that arose, or that is determined under section 502 of this title as if such debt had arisen, before the commencement of the case” (with certain exceptions). Thus, the Bankruptcy Code gives exempted property absolute protection from pre-petition claims.
This absolute protection is implemented in two ways. First, the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure provide a limited time in which to object to exempt property. 11 U.S.C. §522(l); Fed.R.Bankr.P. 4003(b). If the property is claimed as exempt and the exemption is not timely challenged, the property remains exempt regardless of whether it would have been subject to a valid objection. Taylor v. Freeland & Kronz, 503 U.S. 638 (1992). Second, the property’s exempt status is determined as of the petition date using the “snapshot” approach. Matter of Zibman, 268 F.3d 298 (5th Cir. 2001).
A Fading Snapshot
While the Zibman decision recognized the “snapshot” approach, it also noted that like a bad Polaroid, the picture could fade. According to the Fifth Circuit:
“(T)he law and facts existing on the date of filing the bankruptcy petition determine the existence of available exemptions but . . . it is the entire state law applicable on the filing date that is determinative. Courts cannot apply a juridical airbrush to excise offending images necessarily picture in the petition-date snapshot.”
Zibman at 304.
Thus, Zibman teaches that where conditions exist on the petition date which would limit the exemption, the snapshot approach does not eliminate those limitations. However, it seems important to the Fifth Circuit’s analysis that the condition must exist as of the petition date. In the Zibman case, the debtors had sold their homestead approximately two months prior to bankruptcy. Thus, the snapshot on the petition date revealed an exemption which had just four months remaining in the absence of reinvestment. Since the debtors had moved to another state, reinvestment was not a possibility.
In the Zibman case, the Trustee obtained an order extending the time to object to exemptions until after the six month reinvestment period expired. When the debtor failed to purchase a new homestead, the trustee objected and was sustained by the Fifth Circuit. Thus, although the exemption was still valid on the petition date, it was a limited exemption and was defeated by the timely filed objection.
Although the Trustee benefitted from an extension of time in Zibman, the court noted that the debtor could benefit from one as well. In a footnote, the Court noted that although the debtors could have requested tolling of the six month period, they failed to do so.
Bading Determines Calculation of Six Month Period
In Judge Clark’s Bading decision, the court examined how to calculate the six month period in the face of creditor obstruction. The debtor owned two contiguous lots which made up her homestead. Prior to bankruptcy, Gulfside Supply, Inc. recorded an abstract of judgment against the debtor. Under Texas law, an abstract of judgment creates a lien against all real estate owned by the debtor in the county, but does not attach to a homestead. Since the debtor only owned a homestead, the abstract of judgment should have been a nullity. However, as noted by the Bankruptcy Court, “title companies are notorious cowards.” When the creditor refused to release the lien, the debtor was put to a Hobson’s choice to either pay off the invalid lien or risk losing the ability to sell the property.
In this case, the debtor found a middle ground. It reached an agreement with the creditor to release its lien from one of the two tracts. The sale of the first lot closed on December 4, 2006 and the debtor received proceeds of approximately $142,000. The debtor did not reinvest these proceeds out of fear that acquiring a new homestead would void the exemption on the second tract.
Instead, the debtor then filed bankruptcy on December 29, 2006 and filed a motion to avoid lien on the second tract. The motion to avoid lien was granted. However, at this point, the debtor was faced with a timing dilemma. The creditor, which had not objected to the debtor’s exemptions, contended that it was not required to file an objection until after the property lost its exempt character and that the six month clock had begun to run on the sale of the first tract. Under the creditor’s position, there was only one month in which to complete the sale of the second tract and invest the proceeds from both tracts in a new homestead. To avoid this problem, the debtor, relying on the Zibman dicta, filed a motion to toll the reinvestment period.
After a hearing, the Bankruptcy Court came to three important conclusions:
1) The fact that Gulfside failed to file a timely objection to exemption was irrelevant. The court stated:
“Gulfside responds that a creditor should not be required to file a ‘conditional objection’ based on what might happen after the close of the time allowed for objection to exemptions, on pain of those exemptions being allowed as a matter of law under section 522(l). The court agrees with Gulfside on this issue. Were the rule otherwise, then trustees and creditors alike would have a duty to object in every proceeds case, just to make sure they preserved their rights. That strikes the court as an unnecessary formality, and one that is difficult to square with the rationale employed by the Fifth Circuit in Zibman to reach its result.”
Bading, slip op., p. 6, n. 5.
2) The six month clock did not begin to run until the second tract was sold.
The six month clock is triggered by sale of “a” homestead, not part of the homestead. Here, the debtor had a single purchaser for both parts of the homestead. The closing of the sale of the complete homestead was delayed by the creditor’s unjustified refusal to release its lien. As a result, there was not a sale of “a” homestead until the second closing, so that the six month clock did not begin to run until that date.
3) If the single sale theory did not work, the court found that equitable tolling would apply.
The court noted that both Texas law and the Zibman opinion held open the possibility that the six month period to reinvest could be tolled. Tolling is an equitable principle. Where, as here, the creditor delayed the debtor’s ability to sell through its refusal to release an invalid lien, there were sufficient grounds to toll the six month reinvestment period.
Thus, the net result was that the debtor was able to sell her homestead free of the offending judgment lien and the creditor’s stall tactics failed to achieve their desired result.
Invoking Avril Lavigne
Judge Clark’s reasoning is elegant and avoided an obvious injustice. However, it raises an obvious question: “Why do you have to make things so complicated?”* Judge Clark would never have had to reach the issues of unitary homestead sales or equitable tolling if he had simply followed Taylor v. Freeland & Kronz and ruled that failure to timely object to the claimed exemption ended the inquiry.
Judge Clark justified his failure to deem the objection waived on two grounds:
1) Practicality; and
2) Fealty to the Fifth Circuit’s reasoning in Zibman.
The practical argument questions the reasonableness of requiring conditional objections in cases involving homestead proceeds. The most reasonable response to this argument is: So what? Cases involving exemptions of homestead proceeds are relatively rare. In order to have a case involving proceeds, the sale must have taken place pre-petition. The deadline to object to exemptions occurs 30 days after the conclusion of the first meeting of creditors. Fed.R.Bankr.P. 4003(b). While the creditors’ meeting must be commenced 20-40 days after the filing of the petition, Fed.R.Bankr.P. 2003(a), there is no rule as to when the meeting must be concluded. As a result, the trustee may simply continue the meeting to a date after the conclusion of the six month reinvestment period. If that isn’t satisfactory, a creditor could move to extend the time to object or could file a conditional objection. All of these solutions are easy to accomplish. Since proceeds cases are unusual, it is reasonable to require trustees and creditors to take these nominal steps to preserve their rights rather than to argue that Supreme Court precedent should be disregarded.
The rationale of the Zibman opinion offers offers little support to the tardy creditor. In that case, the trustee obtained an order extending the time to object to exemptions. The trustee filed his objection within that time period. As a result, Zibman should not be construed as authorizing out of time objections. Indeed, the Zibman rationale simply recognizes that the debtor’s right to exempt proceeds may depend on events happening after the petition date. This is not an invitation to ignore the rules requiring timely objections to exemptions.
Finally, allowing untimely objections to exemptions based on events occurring after the petition date would lead to absurd results. Under Taylor v. Freeland & Kronz, which is an intellectual cousin to Republic Supply Co. v. Shoaf, 815 F.2d 1046 (5th Cir. 1987), failure to file a timely objection to exemption allows the debtor to retain the claimed property regardless of whether the debtor had a colorable claim of exemptions in the first place. If Zibman is read as allowing untimely objections, it means that a conditional claim to exemption of homestead proceeds would receive less protection than a debtor’s attempt to exempt a stack of gold bullion or a herd of Ethiopian hog-nosed goats** as his homestead. The legal system would be seriously out of joint if it accorded greater rights to the frivolous than the conditionally correct. The entire concept of statutes of limitation assumes that creditors must be diligent to protect their rights. If a creditor is unable to focus its attention on a claim which will be resolved in less than six months, the court should not create a judicial do-over for it.
*--This is the refrain from a recent song by semi-punk songstress Avril Lavigne.
**--A rare form of livestock found only in Bastrop County. Apologies to Joe Martinec and Eric Borsheim. For the full story of the Ethiopian hog-nosed goats, write to me at ssather@bnpclaw.com.
The Vanishing Exemption and Absolute Protection of Exempted Property
Most exemption statutes are limited by the type and value of the property to be claimed as exempt, but are not limited as to time. Thus, exempt property will keep its status so long as it retains its exempt character. However, a sale or other transformation of the exempt property will usually cause it to lose its exempt character. The Texas homestead exemption extends not only to a homestead owned and occupied by the debtor, but to the proceeds from sale of a homestead as well. Tex. Prop. Code §41.001(c). The proceeds exemption is one which is limited by time. It lasts for the lesser of six months or until the debtor acquires another homestead. The purpose of the proceeds exemption is to give the debtor a limited period of time in which to acquire a new homestead. As a result, the statute creates a vanishing exemption. Homestead proceeds which were fully protected five months and 29 days after sale of the home become cash subject to claims of creditors after six months and one day.
This vanishing exemption creates a potential conflict between state and federal law in the bankruptcy context. According to 11 U.S.C. §522(c), “property exempted under this section is not liable during or after the case for any debt of the debtor that arose, or that is determined under section 502 of this title as if such debt had arisen, before the commencement of the case” (with certain exceptions). Thus, the Bankruptcy Code gives exempted property absolute protection from pre-petition claims.
This absolute protection is implemented in two ways. First, the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure provide a limited time in which to object to exempt property. 11 U.S.C. §522(l); Fed.R.Bankr.P. 4003(b). If the property is claimed as exempt and the exemption is not timely challenged, the property remains exempt regardless of whether it would have been subject to a valid objection. Taylor v. Freeland & Kronz, 503 U.S. 638 (1992). Second, the property’s exempt status is determined as of the petition date using the “snapshot” approach. Matter of Zibman, 268 F.3d 298 (5th Cir. 2001).
A Fading Snapshot
While the Zibman decision recognized the “snapshot” approach, it also noted that like a bad Polaroid, the picture could fade. According to the Fifth Circuit:
“(T)he law and facts existing on the date of filing the bankruptcy petition determine the existence of available exemptions but . . . it is the entire state law applicable on the filing date that is determinative. Courts cannot apply a juridical airbrush to excise offending images necessarily picture in the petition-date snapshot.”
Zibman at 304.
Thus, Zibman teaches that where conditions exist on the petition date which would limit the exemption, the snapshot approach does not eliminate those limitations. However, it seems important to the Fifth Circuit’s analysis that the condition must exist as of the petition date. In the Zibman case, the debtors had sold their homestead approximately two months prior to bankruptcy. Thus, the snapshot on the petition date revealed an exemption which had just four months remaining in the absence of reinvestment. Since the debtors had moved to another state, reinvestment was not a possibility.
In the Zibman case, the Trustee obtained an order extending the time to object to exemptions until after the six month reinvestment period expired. When the debtor failed to purchase a new homestead, the trustee objected and was sustained by the Fifth Circuit. Thus, although the exemption was still valid on the petition date, it was a limited exemption and was defeated by the timely filed objection.
Although the Trustee benefitted from an extension of time in Zibman, the court noted that the debtor could benefit from one as well. In a footnote, the Court noted that although the debtors could have requested tolling of the six month period, they failed to do so.
Bading Determines Calculation of Six Month Period
In Judge Clark’s Bading decision, the court examined how to calculate the six month period in the face of creditor obstruction. The debtor owned two contiguous lots which made up her homestead. Prior to bankruptcy, Gulfside Supply, Inc. recorded an abstract of judgment against the debtor. Under Texas law, an abstract of judgment creates a lien against all real estate owned by the debtor in the county, but does not attach to a homestead. Since the debtor only owned a homestead, the abstract of judgment should have been a nullity. However, as noted by the Bankruptcy Court, “title companies are notorious cowards.” When the creditor refused to release the lien, the debtor was put to a Hobson’s choice to either pay off the invalid lien or risk losing the ability to sell the property.
In this case, the debtor found a middle ground. It reached an agreement with the creditor to release its lien from one of the two tracts. The sale of the first lot closed on December 4, 2006 and the debtor received proceeds of approximately $142,000. The debtor did not reinvest these proceeds out of fear that acquiring a new homestead would void the exemption on the second tract.
Instead, the debtor then filed bankruptcy on December 29, 2006 and filed a motion to avoid lien on the second tract. The motion to avoid lien was granted. However, at this point, the debtor was faced with a timing dilemma. The creditor, which had not objected to the debtor’s exemptions, contended that it was not required to file an objection until after the property lost its exempt character and that the six month clock had begun to run on the sale of the first tract. Under the creditor’s position, there was only one month in which to complete the sale of the second tract and invest the proceeds from both tracts in a new homestead. To avoid this problem, the debtor, relying on the Zibman dicta, filed a motion to toll the reinvestment period.
After a hearing, the Bankruptcy Court came to three important conclusions:
1) The fact that Gulfside failed to file a timely objection to exemption was irrelevant. The court stated:
“Gulfside responds that a creditor should not be required to file a ‘conditional objection’ based on what might happen after the close of the time allowed for objection to exemptions, on pain of those exemptions being allowed as a matter of law under section 522(l). The court agrees with Gulfside on this issue. Were the rule otherwise, then trustees and creditors alike would have a duty to object in every proceeds case, just to make sure they preserved their rights. That strikes the court as an unnecessary formality, and one that is difficult to square with the rationale employed by the Fifth Circuit in Zibman to reach its result.”
Bading, slip op., p. 6, n. 5.
2) The six month clock did not begin to run until the second tract was sold.
The six month clock is triggered by sale of “a” homestead, not part of the homestead. Here, the debtor had a single purchaser for both parts of the homestead. The closing of the sale of the complete homestead was delayed by the creditor’s unjustified refusal to release its lien. As a result, there was not a sale of “a” homestead until the second closing, so that the six month clock did not begin to run until that date.
3) If the single sale theory did not work, the court found that equitable tolling would apply.
The court noted that both Texas law and the Zibman opinion held open the possibility that the six month period to reinvest could be tolled. Tolling is an equitable principle. Where, as here, the creditor delayed the debtor’s ability to sell through its refusal to release an invalid lien, there were sufficient grounds to toll the six month reinvestment period.
Thus, the net result was that the debtor was able to sell her homestead free of the offending judgment lien and the creditor’s stall tactics failed to achieve their desired result.
Invoking Avril Lavigne
Judge Clark’s reasoning is elegant and avoided an obvious injustice. However, it raises an obvious question: “Why do you have to make things so complicated?”* Judge Clark would never have had to reach the issues of unitary homestead sales or equitable tolling if he had simply followed Taylor v. Freeland & Kronz and ruled that failure to timely object to the claimed exemption ended the inquiry.
Judge Clark justified his failure to deem the objection waived on two grounds:
1) Practicality; and
2) Fealty to the Fifth Circuit’s reasoning in Zibman.
The practical argument questions the reasonableness of requiring conditional objections in cases involving homestead proceeds. The most reasonable response to this argument is: So what? Cases involving exemptions of homestead proceeds are relatively rare. In order to have a case involving proceeds, the sale must have taken place pre-petition. The deadline to object to exemptions occurs 30 days after the conclusion of the first meeting of creditors. Fed.R.Bankr.P. 4003(b). While the creditors’ meeting must be commenced 20-40 days after the filing of the petition, Fed.R.Bankr.P. 2003(a), there is no rule as to when the meeting must be concluded. As a result, the trustee may simply continue the meeting to a date after the conclusion of the six month reinvestment period. If that isn’t satisfactory, a creditor could move to extend the time to object or could file a conditional objection. All of these solutions are easy to accomplish. Since proceeds cases are unusual, it is reasonable to require trustees and creditors to take these nominal steps to preserve their rights rather than to argue that Supreme Court precedent should be disregarded.
The rationale of the Zibman opinion offers offers little support to the tardy creditor. In that case, the trustee obtained an order extending the time to object to exemptions. The trustee filed his objection within that time period. As a result, Zibman should not be construed as authorizing out of time objections. Indeed, the Zibman rationale simply recognizes that the debtor’s right to exempt proceeds may depend on events happening after the petition date. This is not an invitation to ignore the rules requiring timely objections to exemptions.
Finally, allowing untimely objections to exemptions based on events occurring after the petition date would lead to absurd results. Under Taylor v. Freeland & Kronz, which is an intellectual cousin to Republic Supply Co. v. Shoaf, 815 F.2d 1046 (5th Cir. 1987), failure to file a timely objection to exemption allows the debtor to retain the claimed property regardless of whether the debtor had a colorable claim of exemptions in the first place. If Zibman is read as allowing untimely objections, it means that a conditional claim to exemption of homestead proceeds would receive less protection than a debtor’s attempt to exempt a stack of gold bullion or a herd of Ethiopian hog-nosed goats** as his homestead. The legal system would be seriously out of joint if it accorded greater rights to the frivolous than the conditionally correct. The entire concept of statutes of limitation assumes that creditors must be diligent to protect their rights. If a creditor is unable to focus its attention on a claim which will be resolved in less than six months, the court should not create a judicial do-over for it.
*--This is the refrain from a recent song by semi-punk songstress Avril Lavigne.
**--A rare form of livestock found only in Bastrop County. Apologies to Joe Martinec and Eric Borsheim. For the full story of the Ethiopian hog-nosed goats, write to me at ssather@bnpclaw.com.
Wednesday, October 17, 2007
Creditor Trust Fails to Revive Claims Brought by Debtor; Creditors Found to Have Derivative Standing Only
While plan trusts have many uses, overcoming res judicata is not one of them. In Medlin, Trustee v. Wells Fargo Bank, N.A., Adv. No. 04-5041 (Bankr. W.D. Tex. 7/31/07), the Bankruptcy Court considered whether claims contributed to a plan trust by investors could overcome a prior take nothing judgment entered in a suit by the debtor’s trustee. In this case, the motto try, try again proved unavailing.
In the initial action, Len Blackwell, Chapter 11 trustee for the Inverworld debtors brought claims against Wells Fargo Bank, N.A. and Wells Fargo Bank of Texas, N.A. Pursuant to a Cash Management Services Agreement, the claims were referred to arbitration. The arbitration resulted in a take nothing judgment.
Subsequently, the cases proceeded to confirmation. The plan allowed for creditors to contribute their claims to an investor claim trust. The investor claim trust then brought its own claims. Although the reference was withdrawn, the Bankruptcy Court retained preliminary matters. The Bankruptcy Court was asked to consider whether the creditor claims were barred by res judicata.
Drawing an analogy to Orson Welles who proclaimed that Gallo Wineries would sell no wine before its time, the Bankruptcy Court noted that this issue was now ripe for decision since a new opinion by the Delaware Supreme Court resolved the issue. In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, __ A.2d __, 2007 WL 1453705 (Del. Sup. 5/18/07), the Delaware Supreme Court held that creditors of an insolvent firm could assert breach of fiduciary claims; however, such claims were derivative claims just like those which could be asserted by shareholders. Because the creditor claims were derivative of the company’s claims, they were barred by res judicata based on the prior adverse ruling against the company. Thus, even though both the company and the creditors were allowed to assert clams, they were not considered to be separate parties for purposes of res judicata.
The derivative nature of these breach of fiduciary duty claims raises an interesting race to the courthouse problem. Because multiple parties have standing to pursue the same claim, it is possible that the first party to file might be the least qualified to pursue the claim or might have an actual incentive to sandbag the claims. For example, if debtor's management chooses to pursue claims against other members of management, it is possible that they might pursue the claims for the purpose of eliminating them. Thus, if management puts on a weak case and loses, the creditors would be barred. The same logic would seem to apply if management pursued the claims and then settled them on behalf of the company. There is some protection where the party sabotaging the claims is part of the debtor's management. In that case, the disingenuous pursuit of breach of fiduciary claims could give rise to new breach of fiduciary claims against the parties who caused the prior claims to be lost. However, if the claims are pursued by a small third party creditor who simply lacks the resources to put on a good case, there is no similar protection. Indeed, it is possible that a friendly creditor could bring claims for the express purpose of allowing them to go down to defeat. In that case, the creditor would not have a pre-existing fiduciary duty to the company (although it might acquire one by virtue of pursuing the claims)and its failure would bind both the debtor and its creditors.
In the initial action, Len Blackwell, Chapter 11 trustee for the Inverworld debtors brought claims against Wells Fargo Bank, N.A. and Wells Fargo Bank of Texas, N.A. Pursuant to a Cash Management Services Agreement, the claims were referred to arbitration. The arbitration resulted in a take nothing judgment.
Subsequently, the cases proceeded to confirmation. The plan allowed for creditors to contribute their claims to an investor claim trust. The investor claim trust then brought its own claims. Although the reference was withdrawn, the Bankruptcy Court retained preliminary matters. The Bankruptcy Court was asked to consider whether the creditor claims were barred by res judicata.
Drawing an analogy to Orson Welles who proclaimed that Gallo Wineries would sell no wine before its time, the Bankruptcy Court noted that this issue was now ripe for decision since a new opinion by the Delaware Supreme Court resolved the issue. In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, __ A.2d __, 2007 WL 1453705 (Del. Sup. 5/18/07), the Delaware Supreme Court held that creditors of an insolvent firm could assert breach of fiduciary claims; however, such claims were derivative claims just like those which could be asserted by shareholders. Because the creditor claims were derivative of the company’s claims, they were barred by res judicata based on the prior adverse ruling against the company. Thus, even though both the company and the creditors were allowed to assert clams, they were not considered to be separate parties for purposes of res judicata.
The derivative nature of these breach of fiduciary duty claims raises an interesting race to the courthouse problem. Because multiple parties have standing to pursue the same claim, it is possible that the first party to file might be the least qualified to pursue the claim or might have an actual incentive to sandbag the claims. For example, if debtor's management chooses to pursue claims against other members of management, it is possible that they might pursue the claims for the purpose of eliminating them. Thus, if management puts on a weak case and loses, the creditors would be barred. The same logic would seem to apply if management pursued the claims and then settled them on behalf of the company. There is some protection where the party sabotaging the claims is part of the debtor's management. In that case, the disingenuous pursuit of breach of fiduciary claims could give rise to new breach of fiduciary claims against the parties who caused the prior claims to be lost. However, if the claims are pursued by a small third party creditor who simply lacks the resources to put on a good case, there is no similar protection. Indeed, it is possible that a friendly creditor could bring claims for the express purpose of allowing them to go down to defeat. In that case, the creditor would not have a pre-existing fiduciary duty to the company (although it might acquire one by virtue of pursuing the claims)and its failure would bind both the debtor and its creditors.
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