Thursday, December 31, 2009

Contempt Upheld for Injunction Not Yet Reduced to Writing

In one more chapter of the Gary Bradley bankruptcy, the Fifth Circuit Court of Appeals upheld a finding of contempt against the Lazarus Exempt Trust based upon conduct occurring between the court's oral pronouncement of an injunction and its reduction to writing. Matter of Gary Bradley, No. 08-50587 (5th Cir. 11/11/09).

When Gary Bradley filed bankruptcy, his trustee, Ronald Ingalls, sought to recover properties held by the Lazarus Exempt Trust. Prior to trial, the Court had issued an injunction preventing the Trust from dissipating assets held or controlled by the trust. This injunction expired at the conclusion of the trial. In order to avoid a gap period between expiration of the preliminary injunction and entry of a judgment, the Trustee, the IRS and the FDIC filed a Joint Motion to Maintain Status Quo Pending Final Ruling in Adversary Proceeding.

At the hearing on the motion, the attorney for the Lazarus Exempt Trust acknowledged that there were plans underway to dispose of certain property. The Court orally pronounced an injunction which was narrower than the one requested by the moving parties. The written order was not entered until 27 days later. Meanwhile, Bradley Beutel, the Trustee of the Lazarus Exempt Trust carried out a sale of property and disbursed the funds. He sought to have the Bankruptcy Court ratify the transfers, but the court denied the motion.

After that, the Bankruptcy Trustee sought to hold Beutel in contempt both personally and in his capacity as trustee. The Court made a finding of civil contempt and ordered Beutel and the Trust (which now had a new trustee) to repay $317,953.53. Beutel's personal liability was settled, leaving only the issue of the liability of the trust.

Tommy Thompson, the successor Trustee of the Lazarus Exempt Trust appealed, contending that he could not be held in contempt for violation of an oral injunction. The Fifth Circuit distinguished two Seventh Circuit cases in which oral pronouncements were deemed unenforceable on the basis that in those cases a written order was never entered. In contrast, in this case, a written order was entered in conformity with the oral ruling, the Trustee of the Trust was aware of the ruling and considered himself bound by it (as shown by his motion seeking ratification) and his conduct violated a central tenet of the ruling. As a result, the Court stated that:

The question we face is not whether the bankruptcy court acted properly to create an effective, appealable order. It is whether Beutel's manifestly improper actions can render him liable for contempt.
Opinion, p. 11.

The court stated that the first step was to consider whether the order was civil or criminal. The court found that the fact no imprisonment was involved was not dispositive. Instead, it noted that criminal contempt is intended to punish the contemnor and vindicate the authority of the court, while civil contempt is intended to compel compliance with an order or compensate another party for the contemnor's violation. Imprisonment can be used in connection with either civil or criminal contempt, the distinction being whether the imprisonment is for a fixed term or can be remitted based upon compliance with the court's order. Monetary sanctions can also constitute either civil or criminal contempt. If awarded to punish, they are criminal, while if awarded to compensate, then they are civil. In this case, the court found that the Bankruptcy Court's award constituted remedial civil contempt.

Ironically, the Court found that if the case had involved criminal contempt, it would have been clear that violation of an oral ruling would be permissible, since the federal criminal contempt statute includes violation of a court's "command." However, the question was closer in the civil contempt analysis. The elements of civil contempt are: "(1) that a court order was in effect, and (2) that the order required certain conduct by the respondent, and (3) that the respondent failed to comply with the court's order." Opinion, p. 14.

In conclusion the court stated:

We see no reason why the civil contempt power, as generally recognized in our courts, should not reach Beutel’s conduct. As discussed above, the power is broad and pragmatic, reaching where it must—consistent with prudent court management and due process—to prevent insults, oppression, and experimentation with disobedience of the law. Beutel’s shell game with the proceeds of Trust property is the type of conduct contempt targets, and there is no doubt that he received adequate notice and opportunity to be heard at all stages of the proceedings. His conduct had the effect of frustrating not only the injunction, but also the trial on the merits, by diverting funds from Trust entities that the bankruptcy court would later rule belonged to the bankruptcy estate. The district court found—not clearly erroneously—that Beutel intentionally avoided the injunction hearing because he intended to sell Trust assets and distribute the proceeds in a manner that he expected the court to prohibit. On top of this, the bankruptcy court provided clear notice of the commands that Beutel violated, and which the bankruptcy court later reduced to writing and entered. The bankruptcy court found—also not clearly erroneously—that Beutel knew about the “oral injunction” and considered himself bound. Nonetheless he consummated the transaction as planned and then falsely claimed he had not known about the court’s command. With proper procedures, this conduct could support a criminal contempt conviction. Thompson provides no reason why the result should be different merely because the contempt finding made Beutel
liable to the opposing party rather than imposing a fine payable to the court. We hold that the civil contempt power reaches Beutel’s conduct despite the fact that it occurred before the written injunction was in force.
Opinion, pp. 16-17.

While the Fifth Circuit's conclusion is unremarkable, it contains a good discussion of civil contempt. Indeed, it is unclear what the contempt proceeding gained the Bankruptcy Trustee. The Bankruptcy Court found that the assets disposed of were property of the estate. The contempt ruling merely required the trust to repay the value of assets of the bankruptcy court which it disposed of. It seems that the Trustee could have reached the same result without the necessity of a contempt proceeding.

Nevertheless, the opinion drives home the point that Bankruptcy Courts are federal courts and that their pronouncements--whether reduced to writing or not--should be taken seriously.

Dispute Between Partners Leads to Mandatory Subordination

In Matter of Seaquest Diving, L.P., No. 08-20516 (5th Cir. 8/12/09), the Fifth Circuit considered whether a state court judgment based on a dispute between partners was subject to mandatory subordination under 11 U.S.C. Sec. 510(b) because it arose from the recission of a purchase or sale of a security of the debtor. The court found that mandatory subordination applied.

The dispute arose from formation of Seaquest Diving, L.P. S & J Diving, L.P. contributed assets valued at $6 million in exchange for Class A shares, while three individuals received Class B shares in return for sweat equity and industry contacts. Litigation ensued within two months of the venture's formation. After two settlement agreements failed to close, a judgment was entered in favor of S & J in the amount of $2,742,014. Six days later, Seaquest filed for chapter 11.

Seaquest sought to subordinate the S & J judgment based on Sec. 510(b). The Bankruptcy Court agreed, finding that the state court judgment was an adjudication of recission of the LP and LLC agreements and that therefore, the claim must be subordinated pursuant to 11 U.S.C. Sec. 510(b).

Under Sec. 510(b), "a claim arising from recission of a purchase or sale of a security of the debtor or of an affilate of the debtor, for damages arising from the purchase or sale of such a security . . . shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security . . . ." While equitable subordination, requires a finding of wrongdoing by a creditor, mandatory subordination enforces the principle that "creditors are entitled to be paid ahead of shareholders in the distribution of corporate assets." Thus, an equityholder cannot be elevated to the level of an unsecured creditor by virtue of an unwinding of the securities transaction.

After an extensive analysis, the Fifth Circuit held that the state court judgment was in fact a recission claim. Judge DeMoss wrote:

For purposes of § 510(b), we may “look behind” the state court judgment to determine whether the S&J claim “arises from” the rescission of a purchase or sale of a security of SeaQuest. (citation omitted). The Supreme Court has approved of this practice when construing other provisions of the bankruptcy code. (citation omitted). We reject S&J’s argument that “the equitable nature of a claim is lost once it is converted to a . . . judgment.” If the court could not look behind the judgment, then subordination of a rescission or tort claim based on securities fraud (which clearly falls within the purview of § 510(b)) would depend upon whether the claimant obtained a pre-petition judgment on the claim. We doubt that Congress intended such a result, which is contrary to the text and legislative history of the statute. For purposes of § 510(b), a “claim” includes a judgment. (citation omitted). The fact that a claim has been reduced to a judgment does not deprive the court of the ability to look behind that judgment to determine whether it “arises from” a rescission of a security of the debtor.

The pre-petition judgment in this case was based on breach of the October 3 Settlement Agreement. This agreement stated that “the asset contribution and transaction agreement [ACTA] will be rescinded such that Sea[Q]uest and S&J Diving will retain all of its [contributed] assets,” S&J will no longer be a limited partner of SeaQuest LP, and Jones will no longer be a member of SeaQuest LLC. The $3,100,000 “asset sales agreement,” which was never consummated, was dependent upon the return of these contributed assets, and the payment of $2,300,000 in overhead expenses was characterized as a “reimbursement” of S&J’s capital contribution. By structuring the transaction as a rescission rather than a redemption, S&J immediately realized the benefit of recouping a significant portion of its capital contribution rather than sharing those assets pari passu with other unsecured creditors during SeaQuest’s bankruptcy.

Opinion, pp. 19-20.

In this case, the fact that the parties described the transaction as a recission and that it was a recission in substance meant that the judgment claim enjoyed no greater priority than held by an equity holder.

Wednesday, December 30, 2009

Judges Examine the Murky Standing of MERS

This year we have learned a lot about the mortgage industry. We have learned about mortgage securitization trusts who couldn't find the note. There have been more cases about debtors emerging from chapter 13 only to be hit with years of undisclosed fees and charges. Earlier this year, I wrote about the problems faced by a firm who claimed that their legal technology system would not let them speak directly to their client. However, one of the big trends this year was courts asking "Who is MERS and why are they filing motions for relief from the automatic stay?"

During 2009, I was able to find at least five opinions from across the country holding that MERS lacked standing to file a motion for relief from automatic stay. In re Wilhelm, 407 B.R. 392 (Bankr. D. Ida. 7/7/09); In re Fitch, 2009 Bankr. LEXIS 1375 (Bankr. N.D. Ohio 5/28/09); In re Mitchell, 2009 Bankr. LEXIS 876 (Bankr. D. Nev. 3/31/09), aff'd sub. nom., Mortgage Electronic Registration Systems, Inc. v. Atkerson, No. 2:09-CV-00673 (D. Nev. 12/8/09); In re Sheridan, 2009 Bankr. LEXIS 552 (Bankr. D. Ida. 3/12/09); In re Jacobsen, 402 B.R. 359 (Bankr. W.D. Wash. 3/6/09).

That raises the question:

Who is MERS?

According to the MERS website:

MERS was created by the mortgage banking industry to streamline the mortgage process by using electronic commerce to eliminate paper. Our mission is to register every mortgage loan in the United States on the MERS® System.

Beneficiaries of MERS include mortgage originators, servicers, warehouse lenders, wholesale lenders, retail lenders, document custodians, settlement agents, title companies, insurers, investors, county recorders and consumers.

MERS acts as nominee in the county land records for the lender and servicer. Any loan registered on the MERS® System is inoculated against future assignments because MERS remains the nominal mortgagee no matter how many times servicing is traded. MERS as original mortgagee (MOM) is approved by Fannie Mae, Freddie Mac, Ginnie Mae, FHA and VA, California and Utah Housing Finance Agencies, as well as all of the major Wall Street rating agencies.

The concept of MERS is simple. Lenders designate MERS as the mortgagee of record. MERS keeps track of who holds the mortgage. So long as mortgages are assigned to another MERS member, there is no need to file an assignment of mortgage. This eliminates the risk that a subsequent holder will fail to record a document in the county deed records. It also means that the real party in interest does not appear in the public record. Essentially MERS serves the function of outsourcing the assignment of mortgages.

The Problem

The difficulty arises when a borrower files bankruptcy and the lender needs to file a motion for relief from automatic stay. The file is sent to an attorney. It includes a promissory note payable to an entity long out of the picture,a mortgage in favor or MERS as nominee and a pay history provided by a servicer. Which of these three parties is the proper party to request relief from the stay? Some attorneys have chosen MERS as the movant. According to the courts who addressed the issue during 2009, that was the wrong answer.

The problem arises because MERS is the holder of the mortgage. However, a mortgage is merely collateral for a debt. It is not the debt itself. MERS acts as nominee for the mortgagee. However, it does not act as holder of the note, or even as servicer of the note. Thus, several courts have concluded that MERS lacks standing to seek relief from the stay.

The Latest Word

The District Court of Nevada recently considered 18 cases in which MERS had filed a motion for relief from stay, but was found not to be the real party in interest. The District Court upheld this ruling stating:

A motion for relief from stay is a contested matter under the Bankruptcy Code. (citation omitted). Bankruptcy Rule 7017 applies in contested matters. Rule 7017incorporates Federal Rule of Civil Procedure 17(a)(1), which requires that "[a]n action must be prosecuted in the name of hte real party in interest." (citation omitted).

Since MERS admits that it had no beneficial interest in the note in this case at the time the motion was filed, but was moving "Solely as Nominee," MERS must at least provide evidence of its alleged agency relationship. (citation omitted). An agent for the purpose of bringing suit is "viewed as a nominal rather than a real party in interest and will be rquired to litigate in the name of his principal rather than his own name." (citation omitted). This is particularly important in the District of Nevada where the Local Rules of Bankruptcy Practice require parties to communicate in good faith regarding resolution of a motion for relief from stay before it is filed. (citation omitted). The parties cannot come to a resolution if those with a beneficial interest in the note have not been identified and engaged in conversation.

In the context of a motion for relief from stay, the movant, MERS, in this case bears the burden of providing that it is a real party in interest. (citation omitted). Initially, a movant seeking relief from stay may rely upon its motion. However, if a trustee or debtor objects based upon standing, the movant must come forward with evidence of standing. (citation omitted).

The only evidence presented to the Bankruptcy Court that it acted on behalf of the current owner(s) of the beneficial interest in the note was MERS' assertion that the current note holder is a MERS member, because "the loan at issue is regiatered to a MERS member. (citation omitted). MERS asserts that if the loan is sold to a party to that is not a member of MERS then the loan is "deactivated from the MERS system." (citation omitted). MERS thus argued to the Bankruptcy Court that since a loan has not been deactivated, it must remain in the hands of a MERS member that it has agency to act for. However, given the admitted failure of MERS to follow its policies in the cases that were withdrawn, relying heavily on its policy of deactivating loans now in the hands of non-members to establish agency carries little weight.

The only direct documentary evidence provided by MERS in the present case was the deed of trust indicating that MERS had been identified as "beneficiary" and that it had been named nominee for the original lender. (citation omitted). Since MERS provided no evidence that it was the agent or nominee for the current owner of the beneficial interest in the note, other than the fact that the loan had not been deactivated from the MERS system, it has failed to meet its burden of establishing that it is a real party in interest with standing. Accordingly, the order of the Bankruptcy Court must be affirmed.

This holding is limited to the specific facts and procedural posture of the instant case. Since the Bankruptcy Court denied the Motion without prejudice, nothing prevents Appellant from refiling the Motion in the Bankruptcy Court and providing the evidence that it admits should be readily available in its system. The Court makes no finding that MERS would not be able to establish itself as a real party in interest had it identified the holder of the note or provided sufficient evidence of the source of its authority.
Mortgage Electronic Registration Systems, Inc. v. Atkerson, supra, Order, pp. 4-5.

What It Means

This particular ruling is very narrow. MERS failed to demonstrate that was a real party in interest under Rule 7017. While the court stated that MERS could establish that it was a real party in interest if it identified the current holder of the note and provided sufficient evidence of authority. However, since MERS acts solely as nominee for the holder of the mortgage, it might not be able to meet the required burden of proof, since it does not act as agent for the holder of the note. The better practice seems to be for the holder of the note to file the motion. However, in doing so, it must prove that MERS is its nominee. Thus, it is possible that the attempt to simplify has actually served to complicate.

Monday, December 21, 2009

Interesting Opinion on Privilege and Work Product

Most bankruptcy lawyers abhor discovery disputes, both because they consume valuable time and because of the fear of offending the court. As a result, it is easy to get rusty on some of the finer points of privilege and work product law. An interesting opinion from Judge Leif Clark provides a good primer on how those concepts apply in bankruptcy court. Osherow v. Vann, Adv. No. 08-5006 (Bankr. W.D.Tex. 4/10/09).

This was a case where debtors filed chapter 11 and employed forensic accountants to investigate preference and transfer claims. Additionally, Creditors' Committee counsel prepared a report for the benefit of the Committee. The Plan created a Litigation Trust, which was deemed to be the successor in interest of both the Debtor and the Creditors' Committee. The Liquidating Trust was required to hire both Debtor's counsel and the Committee counsel on its behalf.

The Litigation Trustee received two reports: a report prepared by the Debtor's forensic accountants (the A & M Report) and a report prepared by Committee counsel (the H & B Report). The A & M Report had been shared among the Debtor, the Committee and the Lenders, while the H & B Report had only been disclosed to members of the committee prior to appointment of the Litigation Trustee.

When the Litigation Trustee sued some former insiders, they decided that it would be advantageous to see the two reports. The Litigation Trustee opposed disclosure, arguing that the reports were subject to attorney-client and work product privilege. The Preference Defendants claimed that the Trustee could not assert attorney-client privilege as to the H & B Report because it was prepared for the Committee, not the Trustee and because it had not been kept confidential. They also argued that it was not work product because it was not prepared in anticipation of litigation. As to the A & M Report, they contended that a report prepared by accountants was not subject to privilege and that the A & M Report was not kept confidential. They also argued that they would suffer an undue hardship if they did not have access to the reports.

Thus, the issues teed up were:

1. Can attorney-client privilege transfer from a DIP and a Commitee to a Litigation Trustee?
2. How confidential do you have to keep a document to avoid waiving privilege?
3. Can a report prepared by the Debtor's accountants fall under the attorney-client privilege?
4. Are reports prepared prior to plan confirmation and prior to litigation prepared in anticipation of litigation?
5. Can the defendant claim undue hardship if they have to re-create the analysis contained in the rerports?

The 41 page opinion contains a very thorough discussion that I will not repeat in depth here. Suffice it to say that:

1. The privilege does follow the cause of action. Thus, a chapter 11 plan can assign not only the transfer claims, but the attorney-client privilege protecting those claims as well.
2. A Creditor's Committee can have a privilege with regard to claims which it was not specifically authorized to pursue.
3. While disclosure to third parties normally waive the privilege, this does not apply to disclosures to accountants or other professionals hired to assist the attorney. This applies even if the professional is employed by the client (that is, the debtor)rather than by the attorney. ". . . disclosure to firms, such as A & M, when they are acting as 'interpreters' between client and lawyer do not result in a waiver of the attorney client privilege."
4. The common interest doctrine allowed the Debtor and the Committee to share privileged information without waiver of the privilege.
5. Work product must be prepared in anticipation of litigation and may be disclosed if a party shows that it has a substantial need for the materials to prepare its case and cannot, without undue hardship, obtain their substantial equivalent by other means.
6. "Opinion work product, which is the mental impressions, conclusions, opinions, or legal theories of lawyers or other representative of the party that is in litigation, has 'almost absolute protection.'"
7. The reports were prepared in anticipation of litigation, even though the DIP and the Committee no longer existed, since the Litigation Trustee was their successor in interest.
8. The fact that the defendants would have to dig through 300 boxes of documents did not constitute a compelling need to see the reports. "That is a dog that won't hunt. The fact that the defendants would prefer to work off the opponents' work product hardly makes the case for 'undue hardship.' It is not a hardship that the defendants have to do their own work."

Thus, the reports were protected by both attorney-client privilege and the work product privilege. Judge Clark's opinion makes a good resource for researching these issues and unlike attorney work product, this is a case where you may work off Judge Clark's work product.

Case Makes Good Point About State Turnover Receivers

An opinion from Judge Craig Gargotta reaches the rather unremarkable conclusion that it was appropriate to dismiss a chapter 7 case filed for a corporation which had no assets and only one significant creditor. In re Gaston Premier Homes, Ltd., No. 09-11903 (Bankr. W.D. Tex. 11/18/09).

Gaston involved a case where a creditor obtained a judgment against the debtor and then obtained a turnover order which appointed a state court receiver. When the state court receiver started digging into transactions between the debtor and its principal, the debtor filed a chapter 7 petition. The receiver and the judgment creditor sought to have the case dismissed. The court dismissed the case under 11 U.S.C. Sec. 305 which allows the court to dismiss a case if it is in the best interest of creditors. This holding is unremarkable because it appears that the case was filed to frustrate the receiver rather than to obtain an equitable division of the debtor's assets.

More interesting is an argument which the court rejected. The state court receiver argued that his appointment divested management of the ability to file a bankruptcy proceeding. Important to the court's decision was the fact that this receiver was appointed pursuant to a turnover order for the benefit of a single creditor rather than being appointed as a receiver for the benefit of all the company's creditors under Tex. Civ. Prac. & Rem. Code Chapter 64.

The court stated:

The Receiver in the instant case was not appointed under the Receivership Chapter (Ch. 64) of the Texas Civil Practice & Remedies Code. He was appointed under the Texas Turnover Statute, in an order itself styled "Order for Turnover Relief", to take possession of the leviable property of the Debtor in order to satisfy the judgment of a particular creditor: the other Movant, Richard Johnson. Thus, the Receiver is acting to collect available property for one purpose: to pay one creditor, Richard Johnson. Movants themselves admit this in paragraph 9 of their Motion.

The Debtor has the better argument. To begin with, the Receiver in this case has been appointed for the benefit of Richard Johnson, not the creditors. There has been no case law provided to the Court that suggests that a receiver in this context abrogated the Debtor's ability to file bankruptcy. . . . The better reasoned cases hold that the ability to file bankruptcy is a function of federal, not state law. The Receiver in this instance cannot preclude a remedy under fderal law--there is nothing in the state turnover statute that allows for it.
Opinion, pp. 10-11.

The Bankruptcy Court makes a legitimate point. There is a world of difference between a Turnover Receiver appointed under Texas Civil Practice & Remedies Code Sec. 31.002 and a receiver appointed under Texas Civil Practice & Remedies Code Chapter 64. A Turnover Receiver is basically a collection agent for a judgment creditor. A Turnover Receiver is generally appointed on an ex parte basis with a minimal bond. There are no statutory qualifications for a turnover receiver.

On the other hand, a receiver appointed under Chapter 64 must be a citizen and a qualified voter and may not be a party, attorney or other person interested in the action for appointment of a receiver. A Chapter 64 receiver's bond must be "good and sufficient." (Bond of $100 for business grossing $70,000 per month was not "good and sufficient." Harmon v. Schoelpple, 730 S.W.2d 376 (Tex.Civ.App.--Houston[14th Dist.], 1987, no writ). Additionally, a Chapter 64 receiver for immovable property may not be appointed without notice.

The difference between the two types of receivers is that a Chapter 64 receiver is more like a bankruptcy trustee while a Turnover Receiver is simply an extension of the judgment creditor. It is important to note that a Turnover Receiver cannot prevent a debtor from seeking relief under the Bankruptcy Code.

Sunday, December 06, 2009

Discharge by Declaration: What Chapter 13 Lawyers Can Learn From Chapter 11

This is a paper which I presented to the ABI Winter Leadership Conference on December 4, 2009. I wrote this before the oral argument in Espinosa which is discussed in today's other post.

I. Introduction

Chapter 11 and Chapter 13 share many similarities in text and structure. Developments under one chapter are likely to influence cases under the other. This term the Supreme Court will consider “discharge by declaration” in Espinosa v. United Student Aid Funds, Inc., 545 F.3d 1113, as amended by, 553 F.3d 1193 (9th Cir. 2008), cert. granted, 2009 U.S. LEXIS 4361 (2009). The case illustrates the tension between finality and form as the competing principles of res judicata and due process conflict. Chapter 11 has a substantial body of case law dealing with the binding effect of a confirmed plan which may guide the Supreme Court’s deliberations.

II. Res Judicata

Chapter 11 cases can involve millions or even billions of dollars in assets and claims. Chapter 13 cases, on the other hand, are subject to strict debt limits. While chapter 11 plans feature hundreds of pages of dense legalese, chapter 13 involves large numbers of cases with relatively short plans. Regardless of the chapter, creditors must wade through large amounts of paper to ensure that their rights are protected.

In Chapter 11, there has been a lively debate over whether a plan may release or enjoin actions against non-debtors. In re Continental Airlines, 203 F.3d 203 (2nd Cir. 2000)(discharge of non-debtors not allowed absent unusual circumstances); In re Metromedia Fiber Network, Inc., 416 F.3d 136 (2nd Cir. 2005)(non-debtor release only allowed when “important to a debtor’s plan”); In re Dow Corning Corporation, 280 F.3d 648 (6th Cir. 2002)(non-debtor release only appropriate in “unusual circumstances”); In re Ingersoll, Inc., 562 F.3d 856 (7th Cir. 2009)(limited release allowed when essential component of plan); Matter of Specialty Equipment Companies, Inc., 3 F.3d 1043 (7th Cir. 1993)(consensual release permissible); In re Lowenschuss, 67 F.3d 1394 (9th Cir. 1995)(bankruptcy court lacks power to confirm plan which discharges non-debtor).

In Chapter 13, there is a controversy over “discharge by declaration” where a plan declares that a debt, such as a student loan, will be found to be discharged. In re Banks, 299 F.3d 296 (4th Cir. 2002)(no discharge by declaration); In re Ruehle, 412 F.3d 679 (6th Cir. 2005)(same); In re Hanson, 397 F.3d 482 (7th Cir. 2005)(same); Espinosa v. Student Aid Funds, supra (discharge by declaration permissible when not challenged); In re Meersman, 505 F.3d 1033 (10th Cir. 2007)(no discharge by declaration). While these strategies may fail if challenged at the confirmation hearing, they are sometimes overlooked. When they are discovered after the confirmation order has become final, res judicata will determine whether the order stands.

The doctrine of res judicata prevents a party from re-litigating a matter which has been previously decided. As the Supreme Court stated in a case involving release of a guarantor in a reorganization proceeding under the Bankruptcy Act:

Courts to determine the rights of parties are an integral part of our system of government. It is just as important that there should be a place to end as that there should be a place to begin litigation. After a party has his day in court, with opportunity to present his evidence and his view of the law, a collateral attack upon the decision as to jurisdiction there rendered merely retries the issue previously determined. There is no reason to expect that the second decision will be more satisfactory than the first.

Stoll v. Gottlieb, 305 U.S. 165, 172, 59 S. Ct. 134, 138, 83 L. Ed. 104, 109 (1938).

The elements necessary to invoke res judicata have been described as follows:

First, the prior judgment must be valid in that it was rendered by a court of competent jurisdiction and in accordance with the requirements of due process. Second, the judgment must be final and on the merits. Third, there must be identity of both parties or their privies. Fourth, the later proceeding must involve the same cause of action as involved in the earlier proceeding.

In re Justice Oaks II, Ltd., 898 F.2d 1544, 1550 (11th Cir. 1990).

There is little dispute that chapter 11 and chapter 13 confirmation orders meet the second, third and fourth elements for res judicata. Confirmation orders have uniformly been found to be final judgments entitled to res judicata effect. Stoll v. Gottlieb, supra; In re Optical Technologies, Inc., 425 F.3d 1294 (11th Cir. 2005). One who participates in a confirmation hearing or has the right to participate is considered to be a named party for res judicata purposes. In re Justice Oaks II, supra (“one who participates in a chapter 11 plan confirmation proceeding becomes a party to that proceeding even if never formally named as such”); Corbett v. McDonald Moving Services, Inc., 124 F.3d 82 (2nd Cir. 1997) (“all persons present and having an opportunity to challenge the bankruptcy court’s jurisdiction to approve or implement each component of the plan must raise subject matter jurisdiction at that time or on direct appeal or not at all”). Whether a proceeding involves the same cause of action depends on the specificity of the plan. Compare Republic Supply Co. v. Shoaf, 815 F.2d 1046 (5th Cir. 1987)(order made it “indisputably clear” that guaranty was released by plan) with Matter of Applewood Chair Company, 203 F.3d 914 (5th Cir. 2000)(release of officers, shareholders and directors was not sufficiently specific to encompass guarantors even when guarantors were also officers, directors and shareholders).

Most of the case law focuses upon the first element: a court of competent jurisdiction and in accordance with the requirements of due process. As will be discussed below, the Supreme Court has effectively foreclosed collateral attacks upon the subject matter jurisdiction of a bankruptcy court to render a confirmation order. However, the requirement of due process in the confirmation context remains the subject of debate.

III. Subject Matter Jurisdiction

Subject matter jurisdiction refers to the court’s authority within a specific area or to grant a specific type of relief. When a litigant claims that a court lacked authority to enjoin actions against non-debtors or to discharge student loan claims pursuant to a plan, it is making an objection to subject matter jurisdiction.

As far back as 1938, the Supreme Court held that while a court has no power to expand its jurisdiction, the very fact of entering a judgment constitutes a finding by the court that it had subject matter jurisdiction. If this finding of jurisdiction is not challenged on direct appeal, it cannot be attacked collaterally.

A court does not have the power, by judicial fiat, to extend its jurisdiction over matters beyond the scope of the authority granted to it by its creators. There must be admitted, however, a power to interpret the language of the jurisdictional instrument and its application to an issue before the court. Where adversary parties appear, a court must have the power to determine whether or not it has jurisdiction of the person of a litigant, or whether its geographical jurisdiction covers the place of the occurrence under consideration. Every court in rendering a judgment, tacitly, if not expressly, determines its jurisdiction over the parties and the subject matter. An erroneous affirmative conclusion as to the jurisdiction does not in any proper sense enlarge the jurisdiction of the court until passed upon by the court of last resort, and even then the jurisdiction becomes enlarged only from the necessity of having a judicial determination of the jurisdiction over the subject matter. When an erroneous judgment, whether from the court of first instance or from the court of final resort, is pleaded in another court or another jurisdiction the question is whether the former judgment is res judicata. After a federal court has decided the question of the jurisdiction over the parties as a contested issue, the court in which the plea of res judicata is made has not the power to inquire again into that jurisdictional fact. We see no reason why a court, in the absence of an allegation of fraud in obtaining the judgment, should examine again the question whether the court making the earlier determination on an actual contest over jurisdiction between the parties, did have jurisdiction of the subject matter of the litigation.
Stoll v. Gottlieb, 305 U.S. at 171-72. This proposition has been confirmed by subsequent Supreme Court cases in the bankruptcy field. Travelers Indemnity Company v. Bailey, supra; Kontrick v. Ryan, 540 U.S. 443 (2004).

The Supreme Court has drawn a distinction between jurisdictional facts which may be challenged collaterally and those which may not. In Stoll v. Gottlieb, the Supreme Court stated:

It is frequently said that there are certain strictly jurisdictional facts, the existence of which is essential to the validity of proceedings and the absence of which renders the act of the court a nullity. . . . For instance, service of process in a common law action within a state, publication of notice in strict form in proceedings in rem against absent defendants, the appointment of an administrator for a living person, a court martial of a civilian. Upon the other hand there are quasi-jurisdictional facts, diversity of citizenship, majority of litigants, and jurisdiction of parties, a mere finding of which, regardless of actual existence, is sufficient. As to the first group it is said an adjudication may be collaterally attacked, as to the second it may not. We do not review these cases as we base our conclusion here on the fact that in an actual controversy the question of the jurisdiction over the subject matter was raised and determined adversely to the respondent. That determination is res adjudicata of that issue in this action, whether or not power to deal with the particular subject matter was strictly or quasi-jurisdictional.
Stoll v. Gottlieb, 305 U.S. at 176-77.

In the recent Travelers Indemnity Co. case, the Supreme Court noted three narrow instances in which subject matter jurisdiction may be collaterally attacked.

(1) The subject matter of the action was so plainly beyond the court's jurisdiction that its entertaining the action was a manifest abuse of authority; or

(2) Allowing the judgment to stand would substantially infringe the authority of another tribunal or agency of government; or

(3) The judgment was rendered by a court lacking capability to make an adequately informed determination of a question concerning its own jurisdiction and as a matter of procedural fairness the party seeking to avoid the judgment. should have opportunity belatedly to attack the court's subject matter jurisdiction.
Travelers Indemnity Co. v. Bailey, 129 S.Ct. at 2206, 174 L.Ed.2d at 111.

The case law is nearly uniform in rejecting collateral attacks upon the power of a bankruptcy court to release a non-debtor or enjoin an action against a non-debtor pursuant to a plan of reorganization. Travelers Indemnity Co. v. Bailey, supra (confirmation order which enjoined all actions against insurance companies, including actions based upon their own misfeasance could not be collaterally attacked); Stoll v. Gottlieb, supra; Monarch Life Insurance Company v. Ropes & Gray, 65 F.3d 973 (1st Cir. 1995)(injunction against actions against the debtors and their attorneys precluded debtor from suing its attorneys and could not be collaterally attacked); Corbett v. McDonald Moving Services, Inc., 124 F.3d 82 (2nd Cir. 1997)(plan which discharged debtor’s parent company could not be collaterally attacked); FOM Puerto Rico SE v. Dr. Barnes Eyecenter, Inc., 255 Fed.Appx. 909 (5th Cir. 2007)(release of guarantor could not be collaterally attacked); Republic Supply Co. v. Shoaf, supra (release of guarantor could not be collaterally attacked); Trulis v. Barton, 107 F.3d 685 (9th Cir. 1995)(plan which discharged country club’s founders, directors and attorneys could not be collaterally attacked).

While releases of non-debtors may be controversial, they must be challenged on direct appeal. “The point is that only a direct attack is available and collateral attack in unavailable.” Trulis v. Barton, 107 F.3d at 691, quoting 5 Collier on Bankruptcy Pra. 1141.01[1](Lawrence P. King, ed., 15th Ed. 1995).

IV. Due Process

On the other hand, courts have not been reluctant to allow collateral attacks based upon lack of due process. In Travelers Indemnity Co. v. Bailey, the Supreme Court noted that it did not reach the issue of due process and remanded the case back to the Court of Appeals for a finding on this subject. In Stoll v. Gottlieb, the Supreme Court distinguished between facts that were strictly jurisdictional and those which were quasi-jurisdictional. Among the strictly jurisdictional facts was service with process, which is one facet of due process.

Since due process may be challenged in a collateral attack, the question is what process is due? Is it enough to bury the proposed treatment of a claim in a plan and hope that the creditor does not catch on? Does Due Process require complete compliance with procedural rules? In what cases does Due Process even require actual notice?

The leading Supreme Court case on due process is Mullane v. Central Hanover Bank & Trust, 339 U.S. 306, 70 S. Ct. 652, 94 L. Ed. 865 (1950), where the Supreme Court stated:

An elementary and fundamental requirement of due process in any proceeding which is to be accorded finality is notice reasonably calculated, under all the circumstances, to apprise interested parties of the pendency of the action and afford them an opportunity to present their objections. (citation omitted). The notice must be of such nature as reasonably to convey the required information (citation omitted), and it must afford a reasonable time for those interested to make their appearance, (citations omitted). But if with due regard for the practicalities and peculiarities of the case these conditions are reasonably met, the constitutional requirements are satisfied. "The criterion is not the possibility of conceivable injury but the just and reasonable character of the requirements, having reference to the subject with which the statute deals." (citations omitted).

But when notice is a person's due, process which is a mere gesture is not due process. The means employed must be such as one desirous of actually informing the absentee might reasonably adopt to accomplish it. The reasonableness and hence the constitutional validity of any chosen method may be defended on the ground that it is in itself reasonably certain to inform those affected (citations omitted) or, where conditions do not reasonably permit such notice, that the form chosen is not substantially less likely to bring home notice than other of the feasible and customary substitutes.

339 U.S. at 314-15, 70 S. Ct. at 657-58, 94 L. Ed. at 873-74.

As a general rule, due process in the bankruptcy context has two main rules: (1) the claimant must receive notice of the pendency of an action affecting his rights; and (2) the notice must allow sufficient time to permit the claimant to present his objections. In re Kendavis Holding Company, 249 F.3d 385 (5th Cir. 2001). However, even these rules have exceptions. While actual notice must be given to a known pre-petition creditor, In re Arch Wireless, Inc., 534 F.3d 76 (1st Cir. 2008), a post-petition creditor must merely have knowledge of the case, In re Sequa Corp., 28 F.3d 512 (5th Cir. 1994). In other instances, “an ordinarily valid form of notice may fail to satisfy due process because of the circumstances of the defendant.” In re Kendavis Holding Company, at 387.

The starting point for analyzing due process claims is the procedural rules. The Bankruptcy Rules provide five types of notice which must be provided to creditors in a chapter 11 case:

The Bankruptcy Rules specify that known creditors must receive: (1) notice of deadlines for filing proofs of claims (bar date), Fed. R. Bankr. 2002(a)(7); (2) a copy of the reorganization plan, Fed. R. Bankr. 3017(d); (3) notice of the confirmation hearing, Fed. R. Bankr. 3017(d); and (5) the confirmation order, Fed. R. Bankr. 2002(f).
In re Arch Wireless, Inc., at 82. Generally, notice provided under these rules will be notice “reasonably calculated to reach interested parties” and will satisfy the requirements of due process. In re Longardner & Associates, Inc., 855 F.2d 455 (7th Cir. 1988); In re Optical Technologies, Inc., supra.

Several cases help to flesh out when notice in connection with a chapter 11 plan will be adequate. Kendavis Holding Company involved a former employee covered by the company’s pension plan. He did not have a pre-petition claim. As a result, due process did not require that he receive actual notice. During the case, Kendavis terminated its pension plan so that it could use the money to fund its reorganization plan. It sent a letter to pension beneficiaries informing them of the termination, but assuring them that their benefits would not be affected. Subsequently, it confirmed a plan which discharged all claims arising prior to the effective date and enjoined pursuit of such claims. Ten years later, when the former employee learned that his pension benefits were gone, he filed suit. The bankruptcy court held him in contempt for violating the company’s discharge. Thus, he not only lost his pension, but was ordered to pay $40,000 to the debtor.

The Fifth Circuit rejected the argument that mere knowledge of the case was adequate to satisfy due process. It held:

Due process requires, at the very least, a debtor to refrain from assuring potential claimants that their rights will not be adversely affected during bankruptcy proceedings. This is especially true when the debtor is a large corporation who owes a fiduciary duty to the individual claimant. Although Kendavis may not have harbored any deceptive intent by assuring Christopher that his rights would not be affected, "fundamental notions of fairness and due process" dictate that we not place the burden on Christopher to come forward with his claim. (citation omitted). Before he was deprived of his claim for pension benefits, Christopher was entitled to notice that would reasonably apprise him "of the pendency of the action and afford [him] the opportunity to present [his] objections." (citation omitted). In these limited circumstances, perfunctory knowledge of the bankruptcy proceeding did not constitute adequate notice to satisfy constitutional due process requirements.
Kendavis Holding Company, at 388. Thus, notice which is misleading is worse than no notice at all.

Three cases dealing with non-debtor releases illustrate the principle that the more specific the notice the more likely it will be enforceable. Republic Supply Co. v. Shoaf, 815 F.2d 1046 (5th Cir. 1987), Matter of Applewood Chair Company, 203 F.3d 914 (5th Cir. 2000) and FOM Puerto Rico SE v. Dr. Barnes Eyecenter, Inc., 255 Fed.Appx. 909 (5th Cir. 2007) are each Fifth Circuit cases dealing with the enforceability of non-debtor releases contained within plans which were not objected to or appealed. Although due process was not expressly addressed in any of the cases, the specificity of the plan language was.

In Shoaf, the widow of one of the company’s founders agreed to contribute money from her husband’s insurance policy to fund the debtor’s plan on condition that he be released from all liability. Another guarantor agreed to release his claims against the company in return for a release of guarantor liability. The plan included a provision that “[The] release shall include the release of any guarantees given to any creditor of the debtor which guarantees arose out of the debtor’s business dealings with any creditor of the debtor. . . .” Later, a creditor (who was also the chairman of the creditor’s committee) filed suit on a guarantee. The Fifth Circuit found that the release provision was “indisputably clear” and that the creditor had waived its right to protest when it did not appeal the confirmation order.

In Applewood Chair Company, the debtor confirmed a plan which stated:

The provisions of the confirmed plan shall bind all creditors and parties in interest, whether or not they accept the plan and shall discharge the Debtor, its officers, shareholders and directors from all claims that arose prior to Confirmation.

When a creditor filed suit on guarantees given by the company’s principals, who were also officers and shareholders, they claimed that they had been discharged by the Plan. The Fifth Circuit disagreed. It stated that, “The lack of a specific discharge distinguishes this situation from that in Shoaf and thus, does not warrant the application of its holding as appellants assert.” Applewood, at 919.

Finally, in Dr. Barnes Eyecenters , the debtor’s plan provided for subordination of claims held by insiders. In return for this subordination, the plan provided:
In return for the subordination of their claims, Debtor's insiders shall not have or incur any liability to any person for any claim, obligation, right, cause of action or liability, whether known or unknown, foreseen or unforeseen, existing or hereafter arising, based in whole or in part on any act or omission, transaction, or occurrence from the beginning of time through the Effective Date in any way relating to DBEI, its Bankruptcy Case, or the Plan; and all claims based upon or arising out of such actions or omissions shall be forever waived and released.
Dr. Barnes Eyecenter, at 3-4. The plan was confirmed without objection. When the inevitable suit against the guarantors followed, the Fifth Circuit found that the language was specific enough to be enforceable.

The language in this case falls somewhere between Shoaf and Applewood Chair with respect to the specificity of the release; however, several factors cause us to conclude that the bankruptcy release does bar FOM Puerto Rico's claims. First, as in Shoaf, the release of claims was an integral part of the bankruptcy order. As stated in Section 5.03 of the Plan, Eyemart agreed to subordinate all of its claims against DBEI to those of other creditors "[i]n return" for the release of all claims against Eyemart. Further, at the hearing before the bankruptcy court regarding the confirmation of the Plan, counsel specifically noted that Eyemart received the release in consideration for its agreement to subordinate its claims. Thus, the release of claims was not simply boilerplate language that was inserted into the Plan, but rather a necessary part of the Plan itself.

Dr. Barnes Eyecenter, Inc., at 8-9. Thus, the Fifth Circuit found that language which was less specific could still be enforced where was “not simply boilerplate” and was “a necessary part of the Plan itself.”

The lesson to be drawn from this trio of cases is that language which is specific and material will be more likely to be enforced than language which is vague and gratuitous. The due process implication for these cases is that plans which are clear are more likely to place creditors on notice. Additionally, provisions which are “not simply boilerplate” are likely to place creditors on notice and thus satisfy due process.

The final chapter 11 case illustrating plan provisions enforceable or not is Matter of Taylor, 132 F.3d 256 (5th Cir. 1998). This case is perhaps closest to the “discharge by declaration” cases and most frustrating in its analysis. In Taylor, the debtor was an individual who was also a principal of a company which was delinquent upon its payroll taxes. In his schedules, he listed a debt for “unassessed potential 941 penalty—corporate taxes” in the amount of $80,000. He listed the claim as contingent, disputed and unliquidated. The IRS filed a proof of claim for personal income taxes, but later withdrew the claim after concluding an audit. Had the debtor done nothing further, the potential liability for trust fund taxes would have been non-dischargeable and would not have been affected by the bankruptcy. Matter of Fein, 22 F.3d 631 (5th Cir. 1994)(IRS could assess personal trust fund penalty post-discharge despite failure to file claim because debt was non-dischargeable). However, in his plan, he created a class for priority tax claims and provided that, “Pursuant to 11 U.S.C. Sec. 505, Debtor is not indebted for any claims in this class. All such claims, whether or not now asserted, are discharged without receiving payment.” The IRS did not object to the plan and the plan was confirmed.

Subsequently, the IRS assessed the debtor with liability in the amount of $96,251.15 for trust fund taxes. The Fifth Circuit refused to apply res judicata, finding that the case fell within a “limited” exception to res judicata developed in chapter 13 cases. In In re Simmons, 765 F.2d 547 (5th Cir. 1985) and In re Howard, 972 F.2d 639 (5th Cir. 1992), the Fifth Circuit ruled that res judicata would not apply to a chapter 13 plan which attempted to treat a secured claim as unsecured or to “compromise” a secured claim. The Fifth Circuit relied upon the notion that a secured creditor is entitled to preserve its lien without participating in the bankruptcy case and that an objection to claim was necessary to challenge a secured claim in a chapter 13 case. The Fifth Circuit stated that a claims objection initiated a contested matter under Rule 9014, while a plan did not.

The Fifth Circuit found that the considerations present in Howard and Simmons applied to determination of a tax claim in chapter 11 as well.

The same policies that weigh against a debtor relying upon a confirmed plan of reorganization to compromise a secured debt weigh in with equal force in the context of a § 6672 tax penalty. First and most important, the IRS has the option to remain outside the bankruptcy proceeding and preserve a debt for a § 6672 penalty without filing a claim in Chapter 11. . . .

Second, the normal procedure to determine the amount of a tax debt is for the debtor (or the IRS) to file a motion requesting that the bankruptcy court make the determination under 11 U.S.C. § 505.(citation omitted). Section 505 authorizes the court to determine "the amount or legality of any tax . . . whether or not previously assessed." (citation omitted) This determination should be made under Rule 9014, which governs contested matters, because it does not fall within adversary proceedings as delineated by Rule 7001. (citation omitted). Under Rule 9014, "relief shall be requested by motion, and reasonable notice and opportunity for hearing shall be afforded the party against whom relief is sought." (citation omitted). The motion should state with particularity the grounds and the relief desired. (citation omitted). Alternatively, the debtor can file a proof of claim on behalf of the IRS and object to it, in order to dispute the § 6672 penalty. (citation omitted).

The Simmons line of cases has held that, in the context of a secured claim, a confirmed plan does not substitute for an objection to a proof of claim. (citation omitted). Filing a § 505 motion institutes a contested matter which puts the parties on notice that litigation is required to resolve a dispute as to the amount of the debt, which, as we held in Simmons, the filing of a plan does not do in relation to a particular debt. (citation omitted). Similarly, the confirmation of a plan does not substitute for a § 505 motion any more than it substitutes for an objection to a proof of claim. (citation omitted).

Taylor failed to invoke the power of the bankruptcy court to determine the amount of the Marshall Mill § 6672 penalty. He did not file a proof of claim on behalf of the IRS or file a motion under § 505, one of which is necessary to compromise a nondischargeable debt. Taylor's listing of the debt in his schedules, disclosure statement, and Plan along with the recitation "Pursuant to § 505" did not invoke in any way the tax determination process. This mere recitation of the authority of § 505 does not make a plan confirmation hearing something that it is not; following the Simmons line of cases, we require an objection to a proof of claim or a § 505 motion to determine the amount of a tax debt. This burden is minor and no greater than the filing of a tax return required of all taxpayers. Therefore, Taylor's Plan is not res judicata as to the amount of his liability on the Marshall Mill § 6672 penalty, and the IRS is not barred from proceeding against him to collect that penalty.
Taylor, at 261-62.

The difficulty with the Simmons/Howard/Taylor line of cases is that they do not make any attempt to fit within traditional res judicata analysis. They simply state that res judicata does not apply because a different procedure should have been followed. The argument that the bankruptcy court lacks the power to modify a secured debt or a tax claim in a plan sounds suspiciously like an argument that the court lacks subject matter jurisdiction, which is clearly not an exception to res judicata.

The argument that a different procedure should have been followed sounds like a claim regarding due process. However, the argument elevates form over substance. The Bankruptcy Rules state that an objection to a plan, an objection to a claim and a motion to determine tax liability are all contested matters. This does not mean that the plan itself fails to initiate a contested matter. A chapter 11 plan is the ultimate contested matter. It can initiate the restructuring of billions of dollars in liabilities and affect hundreds of thousands of persons. While a chapter 13 plan has a more modest scope, it still has the power to restructure the relations between the debtor and his creditors on a fundamental basis. In bankruptcy, every matter is either a contested matter or an adversary proceeding. Plans do not fall within a third category of ministerial orders not giving rise to res judicata. If that were the case, creditors would be free to ignore plans completely.

Instead, the analysis should be whether the creditor was given notice that its rights were subject to being modified and whether it was given a sufficient time to object. As a general matter, the very nature of a chapter 11 or chapter 13 plan gives notice to creditors that their rights are subject to being modified. Additionally, the rules provide for an adequate period in which to object. Therefore, the issue should be whether the notice which was provided was adequate under the circumstances. To the extent that Taylor is not simply wrong, it could be seen as akin to Applewood Chair Company, where the plan was not sufficiently clear to meet the requirements of due process.

The cases dealing with due process in chapter 11 cases can be seen as standing for the following principles:

1) Due process requires notice of the pendency of an action which modify the creditor’s rights and adequate time to object;

2) Due process requires actual notice to a known pre-petition creditor;

3) Due process requires that notice be sufficiently specific to understand how its rights will be affected;

4) Due process is violated by notice which obscures the relief being sought or the threat to the creditor; and

5) Compliance with applicable procedural rules will usually satisfy due process, although failure to comply with procedural rules will not necessarily violate due process.

V. How Closely Should Chapter 13 Follow Chapter 11 Cases?

Chapter 11 and chapter 13 both have at their core the restructuring of the debtor-creditor relationship. Both chapters allow a plan to “include any other appropriate provision not inconsistent with the applicable provisions of this title.” 11 U.S.C. §§1123(b)(6), 1322(b)(11). Confirmation orders under each chapter are entitled to res judicata effect. As a result, it is not unreasonable to expect that res judicata decisions under chapter 11 would be useful in determining the effect of a chapter 13 confirmation order. Specifically, failure to object to or appeal a plan under chapter 11 or chapter 13 should foreclose an argument based upon subject matter jurisdiction, leaving only the challenge for due process.

However, on a functional level, there are significant distinctions between the chapter 11 cases allowing non-debtor releases and the chapter 13 cases allowing “discharge by declaration.” As shown by cases such as Shoaf, a non-debtor release can be critical to the overall success of a plan and benefit creditors in general. On the other hand, a plan provision determining that a student loan should be discharged as a substantial hardship primarily affects the debtor and the student loan creditor, but does not affect the overall ability to propose a plan and thus to benefit the other creditors.

Further, a chapter 11 plan necessarily provides both more due process and less than a chapter 13 plan. In chapter 11, the fact that creditors must receive a disclosure statement, are allowed to vote upon a plan and have the protection of the absolute priority rule all provide more protection to creditors. On the other hand, the sheer density of many chapter 11 plans makes it easier to hide suspect language within the fine print. A special provision contained within a chapter 13 plan is more likely to stand out for a creditor willing to take the time to read the document.

Espinosa Oral Argument Provides Glimpse Into World of Supreme Court

In preparing for a panel discussion of Discharge by Declaration at the ABI Winter Leadership Conference, I had the opportunity to read the transcript of the oral argument in United Student Aid Funds v. Espinosa, which you can find here. These 59 pages provide some insight into what the judges are thinking, as well as the human side of lawyers and judges stammering, talking past each other and slipping back and forth between high minded legal concepts and colloquialisms.

(Warning: I go into a lot of detail here because I find the interaction between the justices and the lawyers to be fascinating. If you just want to get to my prediction about what will happen, you can skip to the end).

The Espinosa Facts

Espinosa involved a chapter 13 plan proposed by a debtor whose only debt was his student loans. His plan proposed to pay $13,250 on the student loan and provided that any amount unpaid would be discharged. The student loan creditor did not object and the plan was confirmed. The debtor made his payments under the plan and received his discharge. The discharge order stated that student loans would not be discharged. Several years later, United Student Aid Funds sought to collect the remaining balance of about $4,000. The debtor went back to the Bankruptcy Court for relief. The Bankruptcy Court amended the discharge order to clarify that the student loans were discharged, finding that entry of the form order was a clerical error which could be corrected after the fact. United Student Aid Funds appealed, arguing that the plan could not discharge the student loans without a finding of undue hardship. The Ninth Circuit ruled that the student loan creditor’s failure to object barred it from challenging the discharge and indeed went so far as to suggest that bankruptcy judges should not “intermeddle” where creditors fail to object.

The Issue: Void Order vs. Legal Error

The issue, as identified by several of the justices, is what to do about an order which should not have been entered. Section 523(a)(8) states that a student loan is not dischargeable absent a finding of undue hardship. Rule 7001 states that a determination of dischargeability must be done through an adversary proceeding. Section 1328(a)(2) states that a chapter 13 discharge does not encompass student loan debts. Thus, a chapter 13 plan which discharged student loan debts without an adversary proceeding and a finding of undue hardship does not follow either the procedural or substantive law. However, in this case, the plan was confirmed without objection and the issue was not teed up until some seven years later.

The issue was framed by Justice Scalia within the first minute of oral argument. Counsel for United Student Aid Funds started with a big concept that the Bankruptcy Code contained three categories of debts, those which are dischargeable, those which are dischargeable unless the creditor objects and those which are not dischargeable, but that the Ninth Circuit had eliminated the third category of debts. Justice Scalia interrupted, stating:

JUSTICE SCALIA: Only -- only -- only if the Bankruptcy Court disregards the law. I mean, it's -it's clear that the Bankruptcy Court should not have done what it did here. The only issue is, it having made that mistake, can it -- can it subsequently be -be undone in the manner that's -- that's sought here?

Justice Sotomayor picked up on the same theme as Justice Scalia.

JUSTICE SOTOMAYOR: It was wrong. Let’s assume –the circuit—the district court judge, the Bankruptcy Court judge, got it wrong. Should not have been discharged, a given. Neither – the confirmation plan should not have been approved, neither should the discharge order have been entered. . . .

How does that give you a right to undo that judgment seven years later – was it 5, 6, 7 years later? That’s the question here. How does something that’s in error become a void judgment?

This changed the focus from one of substantive bankruptcy law to civil procedure. However, when the attorney for United Student Aid Funds continued to argue that the order was void because it contradicted the Bankruptcy Code, Justice Sotomayor countered with:

JUSTICE SOTOMAYOR: But . . . most errors committed by courts, inadvertently or otherwise, are in contravention of some statutory command. This is no different.

Voidness, as I’ve heard it described by many others, appears to mean that the court is acting without jurisdiction over the people, and that’s not at issue here, . . . or without jurisdiction over the res. But the bankruptcy court does have jurisdiction, albeit in some, in all circumstances it had jurisdiction over the student debt. The issue is what it could do with it. But this is not a case involving a lack of jurisdiction by the court over property.

So why is this more than mere error?

MS. WANSLEE: Because Congress’s statutory scheme must be enforced as written. And it’s . . . unequivocal what Congress wants.

Of course, this answer was non-responsive to the question about mere error vs. voidness, prompting Justice Breyer to weigh in.

JUSTICE BREYER: What’s the strongest case you can muster, I mean, that you can muster in support of this proposition, my question being the same as Justice Sotomayor’s? What is the strongest case where you can find any court that said a matter is void . . . not just legal error so you can attack it 90 years later—it’s void—just because just because a lower court that made the error didn’t apply a clear statute?

Give me your strongest case.

MS. WANSLEE: Because Rule 60 says that void orders can be attacked, and the passage of time does not transmute a void order into a valid order.

JUSTICE BREYER: But I would like an answer to my question, because I can – I have read the treatises, which I have in front of me, that it’s void only if you show a – the same thing that Justice Sotomayor just said. And so, since I don’t think there is some kind of constitutional due process error here, and there is clearly jurisdiction over the parties, I guess you are saying there wasn’t subject matter jurisdiction, which is a little vague.

So I want to know what is the strongest case . . . where a court has ever said that a failure of some . . . other court to apply the language of a statute properly, no matter how clear, is a lack of subject matter jurisdiction? What is your strongest case? That’s all I’m asking.

The attorney for United Student Aid Funds responded with a rather weak, “Your Honor, we did cite a number of cases in the materials” and referred to a case about an insurance company in bankruptcy.

This exchange brings two things to mind. When a Supreme Court justice has to say, “I would like an answer to my question,” it is pretty apparent that you are not connecting with your audience. However, even a Supreme Court justice can get lost. Justice Breyer was on a roll as he pointed to his stack of treatises, but then missed his big finish when he said, “it’s void only if you show a –- the same thing that Justice Sotomayor just said.” Of course, maybe he was just shining a little attention on his junior colleague.

How Creative Can You Get?

After a little more sparring on jurisdiction, the justices turned their attention to a series of what-ifs which left the student loan creditor in the uncomfortable position of arguing that nothing other than strict compliance with the procedural rules could ever result in an enforceable order.

JUSTICE GINSBERG: Can a – can a – can a creditor say, oh, skip it, I know this bankrupt is going to be able to prove hardship, why go through the unnecessary expense? Can a – can a creditor waive the hardship determination?

(How cool is it to hear a Supreme Court justice say “oh, skip it”?)

MS. WANSLEE: No, your Honor, a creditor may not waive the undue hardship determination. 523 says that student loans are only discharged upon a finding of undue hardship.

JUSTICE GINSBERG: So he can’t . . . stipulate to say, I want the deal that is being proposed, I think that I am better off getting the principal, skipping the interest. I can’t make that deal? We have to go through this hardship procedure whether the creditor wants it or not?

MS. WANSLEE: Your Honor, within the context of an adversary proceeding has in fact been raised. However, there was never any allegation of undue hardship, ever—

JUSTICE STEVENS: Well, would the case be different if there had been such an allegation in the petition?

MS. WANSLEE: I think not, your Honor, because 523 requires a finding.

JUSTICE STEVENS: It would not have been different then? What if it had been not only an allegation but an affidavit? Would the case be different?

MS. WANSLEE: Once again, your Honor, I go back to the language of 1328, your Honor.

JUSTICE STEVENS: I am kind of curious to know what your answer to my question is. . . . Would the case be different if the Petitioner had filed an affidavit of undue hardship with the papers? Same notice, everything else the same.

MS. WANSLEE: Certainly a harder case, Your Honor. However, I don’t –

JUSTICE STEVENS: Why is it a harder case?

MS. WANSLEE: I don’t think—there would not have been an adjudication of undue hardship, however. Just because the debtor stated it didn’t mean there was then—

JUSTICE STEVENS: And I say it’s supported by an affidavit. . . . (W)ould then the case be different?

MS. WANSLEE: No, your Honor, there has to be—

JUSTICE STEVENS: There has to be an adversary hearing under your view?

MS. WANSLEE: Under our view, the creditor is entitled to the protections of 7001 to say—

From there, the justices went through more hypotheticals. What if there was an offer of proof? What if the creditor was present in the courtroom and participated in the hearing but remained silent on the issue of undue hardship?
In my view, the student loan creditor allowed itself to get backed into a corner by arguing that nothing short of compliance with procedural rules could result in an enforceable order.

At one point, the attorney for the student loan creditor stated that “Due process also requires compliance with whatever—“ prompting Justice Kennedy to exclaim:

JUSTICE KENNEDY: I think – I think that’s an astounding – an astounding conclusion, that you are simply writing out the doctrine of—of waiver altogether.

And Now For Something Completely Different

When debtor’s counsel had his turn, he did not attempt to defend what was done in the specific case.

JUSTICE SCALIA: Do you acknowledge that what the bankruptcy court did here was wrong? Do you acknowledge that?

MR. MEEHAN: I acknowledge that it did violate the statute.

JUSTICE SCALIA: Okay, and it should not have done it, and future bankruptcy courts shouldn’t do it? . . . It makes a big difference in how I am going to look at this case. I mean, if—

MR. MEEHAN: I would agree that it is correct, your Honor.

However, at that point, the debtor’s counsel backtracked slightly and suggested that debtors and creditors could always stipulate to dischargeability under a plan.
In response to a subsequent question, he wisely conceded that the bankruptcy judge could sua sponte question the propriety of a discharge by declaration.

Some Ethics

The debtor’s lawyer also did a deft job of addressing the issue of whether a discharge by declaration was sanctionable.

JUSTICE ALITO: Was the Ninth Circuit correct in saying that an attorney can’t be sanctioned under the bankruptcy rules’ equivalent of Rule 11, for attempting to sneak through a discharge of student debt in a chapter 13 petition?

. . .

MR. MEEHAN: My position is that if it is up front, clear notice, in effect, a proposal that we just don’t have a Federal case out of an undue hardship determination for $4,000, that it does not violate Rule 11 or 9011 to make that proposal.

. . .

JUSTICE BREYER: But why would it not be a sanctionable matter under Rule 11? If the lawyer knows that he is supposed to make this special claim to get this kind of discharge. He knows an ordinary claim won’t do it. He submits a paper that asks for the ordinary discharge, that he has to sign it and that . . . signature is a certification that to the best of his knowledge, the claims and other legal contentions are warranted by existing law.

So if he signs it, knowing that that isn’t the way to do it – indeed, there is not even an argument for doing it that way, for modifying the law—then why isn’t that a sanctionable matter under rule 11?

MR. MEEHAN: I am not here to say absolutely that it is not, Justice Breyer.

. . .

I, as a lawyer who has litigated for 39 years and is very conscious of Rule 11, have never thought that if—again, if it was something that was plain and not obfuscated, that a proposal to simply omit one element of a claim violated Rule 11. I think it's debatable -

JUSTICE BREYER: The reason I ask that is, I think the argument on the other side is that it's so clear in the law that this is not the way to go about it that you have to make a separate piece of paper saying you have special hardship; that that is so clear what Congress wanted that four years later you can come back and attack it, if they didn't do it. I mean, that's basically, in my mind, their argument.

But I think a simpler way would be to say if it's that clear, if it really is that clear, the bar itself will enforce the rule by not knowingly deviating from the way that Congress set it out, to which there is no legal objection. Now, is it really -- what do you think of that?

MR. MEEHAN: I think that -- I think that, again, in the context of what this case -- the issue of this case, I think that's right.

I think -- and this Court said in Taylor v. Freeland & Kronz that we are not going to adopt a rule respecting finality that is going to take all the onus of policing the bar, and noted that rule in criminal bankruptcy fraud and the requirement that a petition be signed and filed on a verification. And I think that's -- I think that's absolutely right. I think that –

JUSTICE SCALIA: If that is the price of your winning this case, it's clearly worth it now. I am agreeing with Justice Breyer on that point.

MR. MEEHAN: You mean that the bar may have further scrutiny?

JUSTICE SCALIA: Yes. I mean, if indeed the Court would not be willing to go along with -- with your assertion that you can't undo it later, once it's been done, unless it is clear that it should not be done and that the bankruptcy judge shouldn't do it, and that the lawyer shouldn't propose it -- if that's the condition, then you should accept it, right? Because you want to win this case.

MR. MEEHAN: I would accept -- I would accept that in any condition.

In this exchange, debtor’s counsel’s reference to Taylor vs. Freeland & Kronz was a wise move. Taylor involved another situation where failure to object allowed an otherwise improper action to be taken without endorsing the strategy.

A Matter of Procedure and Finality

The discussion then moved on to the proper procedure which could have been followed. Under Rule 60(b)(2), the creditor could have moved to set the order aside based on mistake, inadvertence or surprise within one year, but instead chose to rely on Rule 60(b)(4) which allows a void order to be reconsidered at any time.

JUSTICE KENNEDY: I was going to ask whether or not in -- on the facts of this case the client could have voided into the final judgment, not appeal, but then come in under Rule 60?

MR. MEEHAN: I think that they could have. Rule 60, as it -

JUSTICE KENNEDY: So then the client is not required to -- the creditor is not required to appeal?

MR. MEEHAN: Well, they take the risk, Justice Kennedy, that they could fit within 60, (a), (b), or (c): Surprise, inadvertence, mistake, inexcusable neglect, fraud, et cetera. In this instance, I think they might have had a hard time, because at most stage -

JUSTICE KENNEDY: All right. So I don't think they could have -- and of course, you don't think it's void. It could come in under 60(b)if it's void, but you don't think it's void.

MR. MEEHAN: Well, void, under those circumstances, I think would throw us into the due process issue and I don't think so. No, I do not think so.

JUSTICE KENNEDY: All right. So you have to show mistake or surprise and you doubt that there was a mistake or surprise here.


Notice and Unlisted Creditors

Debts owed to unlisted creditors are not dischargeable under section 523(a)(3). Justice Kennedy brought the discussion around to whether the “discharge by declaration” strategy would apply to an unlisted creditor.

JUSTICE KENNEDY: Let me just ask this and maybe I have bankruptcy law wrong. My -- my understanding is that if creditors are not listed they are not discharged, correct? I think that's right in most cases. If you don't list the creditor, the creditor is not discharged.

. . .

JUSTICE KENNEDY: I am just wondering, doesn't it happen all the time that creditors are not listed and then they come in later and say the debt is not discharge? Doesn't that happen all the time?

MR. MEEHAN: I think it does happen frequently.

JUSTICE KENNEDY: And is -- is the rationale that that -- that that discharge would be void as to them, or that they are just not covered?

Suppose the bankruptcy judge makes a mistake and lists a creditor by name as being discharged but that creditor never received notice. Is it void?

MR. MEEHAN: I think it is. I do think it is. I mean, bottom line, about the only thing I submit -

JUSTICE KENNEDY: Well, is this -- is this case all that different, then?

MR. MEEHAN: Well, in this case the creditor got fulsome notice. Submitted to the jurisdiction of the court, filed the proof of claim, accepted -

JUSTICE KENNEDY: He got notice of something that was void.

MR. MEEHAN: No, I may be misunderstanding your question. He was-

JUSTICE KENNEDY: I mean that -- that -that assumes -- he got notice of something that was legally improper.

MR. MEEHAN: But not void. To go -- to proceed without the adversary proceeding, I submit is not void, and what the Petitioners had to try to do is to ask you to interpret the statute, whether it's 1328 or 523(a)(8), to make this some sort of a -- there is no way you can touch it; if you didn't do the adversary it just didn't happen kind of a thing.

The Consequences

JUSTICE GINSBURG: So you think any of these things that are listed as non-dischargeable can become dischargeable unless the creditor -

MR. MEEHAN: If the creditor does not object and if the court does not -

JUSTICE GINSBURG: Then why do we have this third category, then? Nothing is non-dischargeable.

MR. MEEHAN: Well, may I submit, Justice Ginsburg, that the argument proves too much, and that is to say that if one can wait and make a voidance argument under rule 60(b) six years after the discharge and 12 years after the filing of the petition, and if that can happen to anything, then what we have is that we may as well just worry about litigating rule 60 motions whenever they come up.

JUSTICE SCALIA: I guess I don't understand your position, because I thought you had said that this should not have been discharged and now -- now you argued to Justice Ginsburg that so long as the -- as the creditor appears they can all be discharged. Which is it?

MR. MEEHAN: Well, Justice -

JUSTICE SCALIA: Even if the creditor appears it shouldn't be discharged. I thought that that's what you had said before. But now you are saying that so long as the creditor appears all of these are dischargeable.

MR. MEEHAN: What had I tried -- the position I had tried to explain -- again, I think it balances your point with Justice Stevens' point about waiver -- is that should, absolutely, unless there is an affirmative waiver. But let's remember that when we talk about "should," I think we are talking about appellate issues. We are talking about error on appeal, we are talking about what ought to happen. And the reason I say that, the point about the same effect accounting for taxes and breaches of fiduciary duty etcetera et cetera proves too much, is that if we are going to say that none of those is finally put to rest, even though there was notice, even though there was acceptance of benefits, as incurred here, even though there was a submission to the jurisdiction of the Bankruptcy Court, as occurred here -- even though there was, you know, just bypassing the early, if I may say "early" rule 60 remedies -- if we are going to say that none of those -

JUSTICE GINSBURG: But your answer to me was that if the creditor doesn't object, even to a non-dischargeable debt -- if the creditor doesn't object, it's discharged. That's what you answered, I thought.


JUSTICE GINSBURG: And it doesn't matter whether it's child support, taxes, or student loans, right? Anything in the category -- you are saying the creditor must object; otherwise it's covered by the discharge.

MR. MEEHAN: Well, my position, I think, first is -- is that, as I think Justice Breyer said, this is a -- this is a clear waiver and I think the Court could rule on that basis. But number two, I think if this is a judgment -- a final judgment; proper notice, we do not have a notice issue, and the creditor has had plenty of opportunity to -- to raise the error -

JUSTICE KENNEDY: Well, I'm not sure there was proper notice. There was not a notice that there would be a contested hearing. Or that there would be an adversary hearing.

MR. MEEHAN: Justice Kennedy I think -

JUSTICE KENNEDY: I'm not sure there was a proper notice.

MR. MEEHAN: I think you must look at it this way. The notice that was given was for the confirmation of a plan. That is the notice them that is required under the bankruptcy rules and it was noticed in accordance with the bankruptcy rules.
Is it right to do it in a bankruptcy plan confirmation? If objected to, no, it's not. If not objected to, the plan says what the plan says and the notice that must be given is notice of the plan.

JUSTICE KENNEDY: Well, of course that's the problem in the case. Sometimes we decide cases that don't make a lot of difference and that once we decide the rule everybody will know what the rule is. But in this case the Petitioners say that if we adopt the rule that the Ninth Circuit adopted, it's going to be extremely burdensome and costly on -- on municipalities, e a due process concern, we do not on -- on those who give student loans, et cetera. And that -- and that you are just creating a -- a tremendous burden on already overburdened systems.

MR. MEEHAN: Well, the argument that was made by the Petitioner and its amici on that point, i think, as pointed out in one of our amicus briefs, overlooks the electronic notice, the instantaneous notice, the fact that under Federal regulations, which by the way also require the guarantee and lenders to do these things and to exercise due diligence before they can get repaid –

. . .

JUSTICE KENNEDY: On the practicality point, you talk about electronic notice. I suppose that that -- that the creditors for student loans could have the automatic electronic thing where they say, we insist on a hardship hearing. But that doesn't solve the problem, because they then have to go back and see whether or not there was a hardship hearing in the case.

So that -- that means they have -- they have -- they have to -- they have to inquire into every case whether or not the proper hearing has been made.

MR. MEEHAN: Well, Justice Kennedy, they have to inquire, in any event, because the Federal regulations require them to, number one, determine that there was a filing; and number two, even before there is an adversary proceeding to make its own assessment, the lender or the guarantee -- the guarantor to make its own assessment whether it is likely that there would be an undue hardship in the given case and there are other circumstances which are set forth in the -- in an amicus brief -

JUSTICE KENNEDY: Are you -- they can't ask for a hearing unless there is a reasonable doubt to believe that there is no undue hardship?

MR. MEEHAN: No, I don't mean to say that. What I mean to say is that -- is that I submit that the hardship argument is a little bit overblown because they have the obligations, even though they say they don't have -- even an obligation but open the envelope, they have an obligation to look at the petition, to see what the situation is, to see whether there is likely an undue hardship.

They don't have to forebear from making an objection to a plan unless they have a basis to determine that there was undue hardship.

My Take On the Argument

Based on the argument, it looks like the Supreme Court is inclined to affirm Espinosa. This is remarkable because the Ninth Circuit has a high reversal rate before the Supreme Court and because its position on this issue is in the minority. The Fourth, Sixth, Seventh and Tenth Circuits have all taken a contrary position.

However, the discussion before the Supreme Court focused much more on the civil procedure aspect of the case, i.e., what does it take to have an enforceable order. The justices essentially said that to have a valid order, you must have jurisdiction over the parties, jurisdiction over the res and notice satisfying due process. While there was some back and forth on whether notice was adequate, the justices seemed satisfied that the other elements were uncontested.

The argument also raises interesting issues about the tensions between procedure, substance and professional responsibility. The problem in this case was that the debtor proposed to discharge the debt without a finding of undue hardship. However, the hypotheticals posed to counsel for United Student Aid Funds raised the question of whether a hardship determination could be obtained without the necessity for an adversary proceeding. As a general rule, procedural requirements can be waived. There are many reasons why parties would agree to dispense with some procedures, such as allowing testimony by proffer, shortening time frames or using a contested matter as a vehicle to try a claim covered by Rule 7001. As a result, the creditor’s argument that procedural requirements could never be short-circuited seemed forced. However, the flip side to this is the sanctions issue posed to debtor’s counsel. Just because you can get away with something does not mean that it is right to do so. I thought that debtor’s counsel did a good job of framing the “discharge by declaration” plan as a proposal to the student loan creditor, while acknowledging that the bar had a duty to police itself so as not to engage in gamesmanship.

My prediction is that the Supreme Court votes 6-3 to affirm, with justices Breyer, Ginsberg, Kennedy, Scalia, Sotomayor and Stevens voting to affirm.

Saturday, December 05, 2009

BAPCPA Increases Cost of Consumer Bankruptcy Cases

Most practitioners intuitively know that BAPCPA made consumer bankruptcy more expensive. Now, the American Bankruptcy Institute has provided some empirical support for this proposition. The ABI Endowment Fund has sponsored a research project by Prof. Lois Lupica of the University of Maine School of Law. The results of the Pilot Study were presented by Prof. Lupica at the ABI Winter Leadership Conference.

The Pilot Study examined bankruptcy filings in six representative districts both pre and post-BAPCPA. The researchers examined the fees charged in 50 chapter 7 cases and 50 chapter 13 cases during the 2003-04 period and 2007-08 period, so that over 1,000 individual cases were examined.

The biggest change was in fees charged in chapter 13 cases. During the pre-BAPCPA period, the median fee charged across the districts was $2,000.00. That fee has now increased to $3,000.00. However, when increased filing fees, trustee fees and credit counseling fees are factored in, the total administrative cost for a median chapter 13 case has increased from $2,930.00 prior to BAPCPA to $4,077.00 afterward. Meanwhile, the study found that distributions to unsecured creditors went down after BAPCPA.

The results in chapter 7 cases were comparable. The median cost of a chapter 7 proceeding prior to BAPCPA was $650.00. That cost has grown to $1,000.00 after BAPCPA. This is a 53% increase. (I didn’t catch the total administrative cost for chapter 7s, so I don’t have an apples to apples comparison for total cost between chapter 7 and chapter 13). The ratio of the cost of a chapter 13 to a chapter 7 remains constant at 3:1.

What does all this mean?

As a disclaimer, these are my thoughts, rather than those of the study authors. It certainly looks as though BAPCPA has made bankruptcy more expensive all around. This cost has been borne by unsecured creditors, at least in chapter 13 cases. It may also have resulted in a new class of debtors who are too broke to be bankrupt. One trend reported by one of the judges in the audience was below median debtors filing chapter 13, not to pay their unsecured creditors, but to finance the payment of their attorney’s fees. If this is the case, it is a disturbing trend.