Fifth Circuit Finds Inherited IRAs Exempt

In a case of first impression for the Fifth Circuit or any other court of appeals, the Fifth Circuit has ruled that inherited IRA accounts may be claimed as exempt under 11 U.S.C. Sec. 522(d)(12). Matter of Chilton, No. 11-40377 (5th Cir. 3/12/12), which can be found here.

In Chilton, one of the debtors inherited an IRA account in the amount of $170,000. The debtors established an IRA account to receive distributions from the inherited account. The trustee objected that the account was not a "retirement account" and was not the type of tax exempt account identified in section 522(d)(12). The bankruptcy court sustained the objection, but was reversed by the district court.

Section 522(d)(12) allows a debtor who elects federal exemptions (an option available only to debtors in about eleven states since most states have opted out of federal exemptions), to exempt "(r)etirement funds to the extent that such funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a)of the Internal Revenue Code of 1986." Thus, there are two requirements: 1. the funds must be retirement funds and 2. they must be held in an account exempt from taxation under one of the designated sections.

The court rejected the argument that funds set aside for the retirement of another could not be "retirement funds:"

The plain meaning of the statutory language refers to money that was “set apart” for retirement. Thus, the defining characteristic of “retirement funds” is the purpose they are “set apart” for, not what happens after they are “set apart.” Here, there is no question that the funds contained in the debtors’ inherited IRA were “set apart” for retirement at the time Heil deposited them into an IRA. This reasoning finds further support from 11 U.S.C. § 522(b)(4)(C), which provides that “a direct transfer of retirement funds from 1 fund or account that is exempt from taxation under section . . . 408 . . . of the Internal Revenue Code of 1986, . . . shall not cease to qualify for exemption under . . . subsection (d)(12) by reason of such direct transfer.” In other words, the direct transfer of “retirement funds” does not alter their status as “retirement funds.” As we see no reason to interpret the statutory language differently from its plain meaning, we hold that the $170,000 contained in the inherited IRA constitute “retirement funds” as that phrase is used in section 522(d)(12).

Opinion, p. 5.

The Court also ruled that the account was held under the proper section of the Internal Revenue Code. The Trustee argued that the account was tax exempt pursuant to 26 U.S.C. Sec. 402(c)(11)(A), while the Debtor contended that section 408(e) was the relevant section. While this discussion of the Internal Revenue Code would seem arcane and of little interest to bankruptcy lawyers, the Court relied on the expansive language of section 408(e), which stated that "(a)ny individual retirement account is exempt from taxation under this subsection . . . " Because the account was an individual retirement account, it fell within the definition of "any" individual retirement account. Thus, common sense construction carried the day even thought the subject matter was the tax code.

On a final note, the Court of Appeals decided this appeal quite expeditiously. The case was argued on February 22, 2012 and decided on March 12, 2012, just nineteen days later. Judge Carl Stewart should be commended for his prompt work.

Circuits Split Over Impact of Stern on Counterclaims

Following last year’s Stern v. Marshall bombshell, cases are slowly trickling up to the Court of Appeals level. After I wrote about a recent Fifth Circuit opinion which held that the jurisdiction of U.S. Magistrate Judges was not invalidated, a commenter pointed out a recent Seventh Circuit decision. In this post, I will look at that case, In re Ortiz, 665 F.3d 906 (7^th Cir. 2011), in which the Seventh Circuit granted a direct appeal and then concluded that it did not have a final decision to review, as well as an even more recent First Circuit case which appears to reach the opposite conclusion.

The Seventh Circuit Undoes a Direct Appeal

Ortiz involved a health care provider that filed proofs of claim in an estimated 3,200 bankruptcy cases in the Eastern District of Wisconsin over a five year period which disclosed the debtors’ confidential medical information. Two sets of debtors filed class action proceedings under a Wisconsin non-disclosure statute.* Bankruptcy Judge Susan Kelley** granted summary judgment for the health care provider, finding that the debtors had not shown actual damages as required by the Wisconsin statute. Both parties requested a direct appeal to the Seventh Circuit, which was approved. However, in light of Stern v. Marshall, the Seventh Circuit concluded that it was not permitted to allow the direct appeal because there was not a “final” order.

Direct appeals to the Court of Appeals are authorized under 28 U.S.C. §158(d) in three instances:

*Final orders;

*Interlocutory orders increasing or decreasing the debtor’s exclusive period to file a plan; and

*With leave of court over interlocutory orders and decrees.

Even though no party had raised the jurisdictional issue, the Court concluded that it had “an independent duty to determine whether we have jurisdiction.”

The Court noted the schizophrenic nature of the Stern decision which, on the one hand, claims to be a narrow decision, but on the other hand, appears to prohibit the bankruptcy courts from going beyond the power to adjudicate claims. The Court wrote:

The first question (whether the bankruptcy court had authority to enter a final order) requires a close reading of Stern v. Marshall. Although the Court noted that the question presented was "narrow," it was quite significant as Congress "may no more lawfully chip away at the authority of the Judicial Branch than it may eliminate it entirely." (citation omitted). The Court held that Article III prohibited Congress from giving bankruptcy courts authority to adjudicate claims that went beyond the claims allowance process. (citation omitted). The decision rebuffed an intrusion into the Judicial Branch that would "compromise the integrity of the system of separated powers and the role of the Judiciary in that system, even with respect to challenges that may seem innocuous at first blush." (citation omitted).

665 F.3d at 911.

Prior to Stern, the bankruptcy court’s authority would have appeared clear for this was a matter “arising in” a title 11 case. Because proofs of claim only exist in title 11 proceedings, claims arising from proofs of claim could only arise in the bankruptcy context. However, the Court found that the Wisconsin non-disclosure claims were similar to the counterclaim filed by Vicki Lynn Marshall in the Stern case:

Just as Pierce's filing of a proof of claim in Vickie's bankruptcy did not give the bankruptcy judge authority to adjudicate her counterclaim, Aurora's act of filing proofs of claim in the debtors' bankruptcies did not give the bankruptcy judge authority to adjudicate the debtors' state-law claims. The debtors' claims seek "to augment the bankruptcy estate--the very type of claim that . . . must be decided by an Article III court." (citation omitted). Non-Article III judges may hear cases when the claim arises "as part of the process of allowance and disallowance of claims," (citation omitted), or when the claim becomes "integral to the restructuring of the debtor-creditor relationship," (citation omitted). Although there is some factual overlap between the debtors' claims and Aurora's proofs of claim, the bankruptcy judge "was required to and did make several factual and legal determinations that were not 'disposed of in passing on objections' to" Aurora's proofs of claim. (citation omitted). In granting Aurora's summary judgment motion, the bankruptcy judge interpreted a Wisconsin state law to require proof of actual damages as an essential element of the debtors' claims and found that there was no genuine issue of material fact as to the lack of actual damages. Nothing about these decisions involved an adjudication of Aurora's proofs of claim and there is no "reason to believe that the process of adjudicating [Aurora's] proof[s] of claim would necessarily resolve" the debtors' claims. (citation omitted). Stern reaffirmed that "Congress may not bypass Article III simply because a proceeding may have some bearing on a bankruptcy case; the question is whether the action at issue stems from the bankruptcy itself or would necessarily be resolved in the claims allowance process." (citation omitted). The debtors' action owes its existence to Wisconsin state law and will not necessarily resolve in the claims allowance process. That the circumstances giving rise to the claims involved procedures in the debtors' bankruptcies is insufficient to bypass Article III's requirements. Stern v. Marshall makes plain that the bankruptcy judge in our cases "exercised the 'judicial Power of the United States' in purporting to resolve and enter final judgment on" the debtors' Wisconsin state-law claims. (citation omitted). We thus hold that the bankruptcy judge lacked authority under Article III to enter final judgments on the disclosure claims.

665 F.3d at 914.

The Court of Appeals concluded that because the bankruptcy court lacked authority to enter a final order, that it lacked authority to grant a direct appeal. If the court had stopped there, its decision would have been clear. However, it added a cryptic comment suggesting that the bankruptcy court lacked any authority in the matter:

For the bankruptcy judge's orders to function as proposed findings of fact or conclusions of law under 28 U.S.C. § 157(c)(1), we would have to hold that the debtors' complaints were "not a core proceeding" but are "otherwise related to a case under title 11." (citation omitted). As we just concluded, the debtors' claims qualify as core proceedings and therefore do not fit under § 157(c)(1). The direct appeal provision in 28 U.S.C. § 158(d)(2)(A) also does not authorize us to review on direct appeal a bankruptcy judge's proposed findings of fact and conclusions of law.

665 F.3d at 915.

Many commentators have concluded that the Stern decision created a third category of claims to the core/non-core taxonomy: core claims in which the bankruptcy court could not enter a final judgment. The prevailing sentiment, indeed one fostered indirectly by the Stern decision itself, is that the bankruptcy courts may enter proposed findings of fact and conclusions of law in all matters in which they lack authority to enter a final judgment. The Ortiz opinion suggests that this may not be the case, but finds it unnecessary to decide the issue.

The First Circuit Shrugs Off Stern in a Footnote

The Ortiz opinion can be contrasted with a brief discussion contained in a First Circuit opinion. In re Divittorio, 2012 U.S. App. LEXIS 248 (1^st Cir. 1/6/12). In re Divittorio is another chapter in the home mortgage wars being fought in the courts. In that case, the debtor consented to an order conditioning the automatic stay and modifying the underlying loan. After the debtor defaulted, the creditor obtained relief from the automatic stay. The debtor then sought to “rescind” the loan. He filed an adversary proceeding for rescission under the Massachusetts Consumer Credit Cost Disclosure Act and sought to vacate the order lifting the automatic stay. The bankruptcy court declined to vacate the prior order, but stayed the foreclosure for 90 days to determine the rescission claim. The bankruptcy court concluded that the creditor had not violated the MCCCDA and the debtor appealed.

In a footnote, the court noted its belief that its jurisdiction was unimpaired.

We do not believe that the Supreme Court's recent decision in Stern v. Marshall, 131 S. Ct. 2594, 180 L. Ed. 2d 475 (2011), affects the jurisdiction of the bankruptcy court to render a decision in this matter. Stern held:

Article III of the Constitution provides that the judicial power of the United States may be vested only in courts whose judges enjoy the protections set forth in that Article. We conclude today that Congress, in one isolated respect, exceeded that limitation in the Bankruptcy Act of 1984. The Bankruptcy Court below lacked the constitutional authority to enter a final judgment on a state law counterclaim that is not resolved in the process of ruling on a creditor's proof of claim.

(citation omitted). Here, however, it first was necessary to resolve the validity of Mr. DiVittorio's claim under the MCCCDA to determine whether HSBC was entitled to relief from the automatic stay.

2012 U.S. App. LEXIS at *18, n. 4. The Court ultimately decided the appeal in favor of the creditor.

The First Circuit’s discussion is rather unsatisfying because it assumes that determination of the counterclaim was necessary to determine the motion to lift stay. However, how is this distinguishable from the argument that the Wisconsin non-disclosure claims were necessary to determine proofs of claim filed by the health provider? If anything, the automatic stay context is less compelling than determination of a proof of claim, since a motion to lift stay is a summary proceeding. Grella v. Salem Five Cent Savings Bank, 42 F.3d 26 (1^st Cir. 1994).

While the Court’s stated rationale may be unsound, it can probably be vindicated based on consent, since both parties litigated the matter through the bankruptcy court, district court and court of appeals without objection. The Ortiz court rejected consent. However, that case was factually distinguishable because BOTH parties objected to determination by the bankruptcy court. The debtors asked the bankruptcy court to abstain or remand, while the creditor sought to withdraw the reference.

What It Means

The two decisions may or may not signal a split between the circuits. The First Circuit’s decision is so perfunctory that it may be possible for the court to distinguish it away. However, the larger lesson for creditors is that Stern v. Marshall cuts both ways. If a creditor litigates and wins in bankruptcy court, an appellate court may decide that jurisdiction to enter a final judgment was lacking and send the creditor back to relitigate. Thus, the legacy of Stern may be unending litigation.

*--While Federal Rule of Bankruptcy Procedure 9037 imposes privacy restrictions with respect to bankruptcy court filings, including proofs of claim, courts are split over whether it creates a private right of action. Cases allowing a claim for sanctions, include Matthys v. Green Tree Servicing, LLC (In re Matthys), 2010 Bankr. LEXIS S.D. Ind. 2010); French v. American General Financial Services (In re French), 401 B.R. 295 (Bankr. E.D. Tenn. 2009), while cases rejecting such a right include Carter v. Flagler Hospital, Inc., 411 B.R. 730 (Bankr. S.D. Fl. 2009); Lentz v. Bureau of Medical Economics (In re Lentz), 405 B.R. 893 (Bankr. N.D. Ohio 2009); Cordier v. Plains Commerce Bank (In re Cordier), 2009 Bankr. LEXIS 2009).

**--Judge Kelley’s current claim to fame is that she is the judge presiding over the case of the Archdiocese of Milwaukee. As a woman and a practicing Catholic, she is in the unusual position of exercising at least some temporal authority over the male hierarchy of her own church.

Fifth Circuit Rules That Stern v. Marshall Does Not Invalidate Action By Magistrates

In a ruling that could shed some light (but not very much) on the authority of bankruptcy judges, the Fifth Circuit has ruled that a magistrate's ruling in an insurance coverage dispute did not run afoul of the Supreme Court ruling in Stern v. Marshall, ___ U.S. ___, 131 S.Ct. 2594 (2011). Technical Automation Services Corp. v. Liberty Surplus Insurance Corporation, No. 10-20640 (5th Cir. 3/5/12), which you can find here.

The Issue

Technical Automation Services Corp. involved whether an insurance company had a duty to defend an insured in an underlying lawsuit. The parties consented to trial before a U.S. Magistrate. The magistrate granted summary judgment in favor of the insured. On appeal, the Fifth Circuit requested briefing on the application of Stern v. Marshall to a magistrate. See "Fifth Circuit to Consider Impact of Stern v. Marshall on U.S. Magistrates" here.

In response to the question "whether Article III of the Constitution permits a federal magistrate judge, with the consent of the parties, to enter final judgment on a party's state law counterclaim," (opinion, p. 7), the Court answered "yes."

The Decision

By way of prelude, the Court noted that a prior panel of the Fifth Circuit had ruled in favor of the ability of a magistrate to proceed with consent. Puryear v. Ede's Ltd., 731 F.2d 1153, 1154 (5th Cir. 1984). Thus, the court was bound to follow the prior precedent "absent an intervening change in the law, such as by a statutory amendment, or the Supreme Court or by our en banc court." Opinion, p. 9. This framed the question of whether Stern v. Marshall overruled prior decisions about the power of magistrates.

While noting the many similarities between bankruptcy judges and magistrates, the Court chose to base its ruling on the Supreme Court's insistence that Stern was a narrow decision.

Accordingly, the Court reaffirmed that Congress may not withdraw “from judicial cognizance any matter which, from its nature, is the subject of a suit at the common law, or in equity, or admiralty.” (citation omitted). The Supreme Court emphasized that even the slightest “chipping” away of Article III can lead to “illegitimate and unconstitutional practices,” and accordingly held that the jurisdiction of the bankruptcy courts did not extend to most counterclaims based on common law. (citation omitted).

This holding can be translated to the many similarities of the statutory powers of federal magistrate judges. Whereas Article III judges “hold their offices during good behavior, without diminution of salary,” bankruptcy judges and federal magistrate judges are Article I judges who lack tenure and salary protection. (citation omitted). Moreover, the text of 18 U.S.C. § 157(b) (the statute addressed in Stern) and the text of the Magistrates Act, 28 U.S.C. § 636(c), allow Article I judges to enter final judgments, allow for judges’ final judgment to be binding without further action from an Article III judge, entitle the decisions to deference on appeal, and permit the courts to exercise “substantive jurisdiction reaching any area of the corpus juris.” (citation omitted).

Although the similarities between bankruptcy judges and magistrate judges suggest that the Court’s analysis in Stern could be extended to this case, the plain fact is that our precedent in Puryear is there, and the authority upon which it was based has not been overruled. Moreover, we are unwilling to say that Stern does that job sub silentio, especially when the Supreme Court repeatedly emphasized that Stern had very limited application. Id. at 2620. (emphasizing the limited scope of the decision, saying that the issue addressed was a “narrow one” that related only to “certain counterclaims in bankruptcy”) (internal quotation omitted) see also id. (“Article III of the Constitution provides that the judicial power of the United States may be vested only in courts whose judges enjoy the protection set forth in that Article. We conclude today that Congress, in one isolated respect, exceeded that limitation in the Bankruptcy Act of 1984.”) (emphasis added). Article III jurisprudence is complex, requiring the court to do an examination of every delegation of judicial authority. (citation omitted). Notwithstanding that this constitutional question may be seen in a different light post Stern, we will follow our precedent and continue to hold, until such time as the Supreme Court or our court en banc overrules our precedent, that federal magistrate judges have the constitutional authority to enter final judgments on state-law counterclaims. (emphasis added).

Opinion, pp. 11-12.

What It Means

On the most basic level, Technical Automation Services says very little about the authority of bankruptcy judges. It simply holds that Stern does not upset prior Fifth Circuit precedent governing the authority of magistrate judges. However, it provides advocates of bankruptcy court authority with two valuable arguments:

1. The Fifth Circuit is willing to take Chief Justice Roberts at his word when he says that Stern is a narrow decision. While many were concerned that Stern could be another Marathon Pipeline and could signal a return to the old summary/plenary distinction under the Bankruptcy Act, the Fifth Circuit is willing to take it slow. If the other circuits slow play the decision and the Supreme Court strategically declines to grant cert, it could be decades before the issue reaches the Supreme Court again.

2. Since a central feature of magistrate jurisdiction is consent, Technical Automation provides a powerful rebuttal to parties who want to consent to bankruptcy court decision making and then cry "Stern" when they don't like the result.

If nothing else, Technical Automation is significant because it didn't change anything significant.

Post-Script: Although I edited it from the quote above for purposes of brevity, the opinion contains a wonderful quote from Chief Justice Rehnquist's concurrence in Northern Pipeline where he referred to Article III cases as "but landmarks on a judicial 'darkling plain' where ignorant armies have clashed by night." Northern Pipeline Construction Company v. Marathon Pipe Line Company, 458 U.S. 50, 91 (1982)(Rehnquist, J. concurring). I know that I will be looking for ways to include this language in future Stern briefs.

Texas State Court Gets Judicial Estoppel Right

The Dallas Court of Appeals has published a new decision correctly applying the doctrines of judicial estoppel and standing relating to a cause of action omitted from a bankruptcy filing. Norris v. Brookshire Grocery Company, ___. S.W.3d ___ (Tex. App.--Dallas, 2/29/12, no pet.). You can find the opinion here.

In Norris, the plaintiff filed suit against Brookshire Grocery prior to filing bankruptcy. Upon filing bankruptcy, the plaintiff/debtor neglected to mention the suit in either the Schedules or the Statement of Financial Affairs. However, just thirteen days after filing bankruptcy, the debtors filed a motion to dismiss their bankruptcy case on the ground that they "desire to work a payout with creditors." No party objected and the case was dismissed.

After the bankruptcy case was dismissed, Brookshire moved for summary judgment based on judicial estoppel and lack of standing. The trial court granted the motion.

On appeal the Dallas Court of Appeals reversed finding:

1. In order for judicial estoppel to apply, the Bankruptcy Court must have "actually accepted" the debtors' non-disclosure of the asset. Where the debtors dismissed their case without receiving a discharge, there was not an opportunity for the bankruptcy court to "actually accept" their position.

2. Normally, an undisclosed asset remains property of the bankruptcy estate and is not abandoned when the trustee closes the case. This is not the case when the case is dismissed, since the estate ceases to exist. As a result, the debtors had standing to pursue their cause of action.

The opinion by the Dallas Court of Appeals should be commended for correctly applying difficult principles of bankruptcy law. The purpose of judicial estoppel is to prevent debtors from gaming the system and reaping a benefit from taking inconsistent positions. Reading between the lines, it seems likely that when debtors' counsel learned of the cause of action, he gave them a choice: proceed with the bankruptcy and lose the cause of action or dismiss the bankruptcy and keep the cause of action. Because the debtors effectively undid the omission by dismissing their bankruptcy, judicial estoppel did not apply.

Hat tip to St. Clair Newbern.