Saturday, August 30, 2014

Fifth Circuit Provides Valuable Guidance on Jurisdiction and Authority Post-Stern

Many cases deal with debtors who fraudulently convey away their assets before filing bankruptcy.   But what about the situation where the debtor is the victim of a fraudulent conveyance rather than the perpetrator?    In Galaz v. Galaz (In re Galaz), No. 13-50781 (5th Cir. 8/25/14), which can be found here, the Fifth Circuit answers important jurisdictional and Stern questions about the debtor's quest to recover wayward assets.   

What Happened

Lisa and Raul Galaz were once married to each other.   One of their assets was an interest held by Raul in Artist Rights Foundation, LLC ("ARF"), a company which owned the rights to the Ohio Players music catalog.    The other owner of ARF was Julian Jackson.   When Lisa and Raul were divorced in 2002, Raul assigned Lisa 50% of his 50% interest in ARF.   Because the transfer was made without Julian's consent, Lisa received a 25% economic interest in the company but was not a member.    While it is not really relevant to the opinion, another significant occurrence in 2002 was that Raul pled guilty to mail fraud and surrendered his California law license.    

From 1998 to 2005, the Ohio Players catalog was not generating any revenue.   While the opinion describes the Ohio Players as "a former funk band," a little more explanation is justified.   The Ohio Players were formed in 1959 and had gold records with "Funky Worm," "Skin Tight," "Fire" and "Love Roller Coaster."   Their heyday was between 1973 and 1976, when they had seven Top 40 hits.  Their last studio album was released in 1998 and they were inducted into the Official R & B Music Hall of Fame in 2013.  

On June 3, 2005, Raul transferred all of ARF's rights to the Ohio Players to Segundo Suenos, which was nothing more than a name at the time, but was later established as a Texas limited liability company.  According to the Fifth Circuit, when Segundo Suenos is spelled with the tilde (⁓--an accent mark used in Spanish), it means "Second Dreams" in Spanish.   Raul did not get permission from Lisa or Julian before embarking on his second dream of exploiting the Ohio Players music in an entity which excluded them.  Shortly after this transfer, the catalog began to make money, about a million dollars over five years.    The opinion does not say why the catalog started making money.   However, it is worth noting that the song "Love Rollercoaster" appeared in the film Final Destination 3 in 2006.  

In 2007, Lisa filed chapter 13 in the Western District of Texas.   She brought an adversary proceeding against Raul, his father, Alfredo, and Segundo Suenos.   The Defendants brought a third party complaint against Julian, who counterclaimed against them.   After a five day trial, Chief Bankruptcy Judge Ronald B. King found that the transfer to Segundo Suenos was invalid and that Raul had breached his fiduciary duty to Julian but not Lisa.   The Bankruptcy Court awarded $250,000 in actual damages and $250,000 in exemplary damages to Lisa and $500,000 in actual damages and $500,000 in exemplary damages to Julian.   After an appeal to the District Court, the fraudulent transfer judgment was affirmed but the case was remanded for a recalculation of damages.    The Bankruptcy Court reduced the actual damages slightly to reflect taxes incurred by Segundo Suenos, but otherwise left the award intact.   The District Court affirmed the second judgment and the case was appealed to the Fifth Circuit.

 Jurisdiction and Authority

The Fifth Circuit considered two important issues in its opinion:  whether the Bankruptcy Court had jurisdiction over the claims and whether it had authority to enter a final judgment.    These are very different concepts.   Jurisdiction looks at whether the federal courts have authority to consider a matter, while the authority question looks at whether the Bankruptcy Court or the District Court has authority to render a final judgment.

With regard to Lisa, the Fifth Circuit had no trouble finding jurisdiction.   The test for "related to" jurisdiction, which is the most expansive source of bankruptcy jurisdiction, is whether the dispute could "'conceivably' have any effect on the estate being administered in bankruptcy."   See Opinion, p. 5.  Since Lisa's suit could increase the size of the estate, there clearly was jurisdiction.   Julian was another matter.   He was a non-debtor suing another non-debtor.   That is the scenario that was struck down by the Supreme Court in Northern Pipeline.   Even though Julian was unwillingly dragged into the suit, there was ultimately no jurisdiction for his claims and so they went away.   Julian may have recognized this reality before the Fifth Circuit did, since he did not bother to file a brief in the appeal despite being ordered to.  

Although the Bankruptcy Court had jurisdiction to consider Lisa's claims, it did not have authority to enter a final judgment.    This was not a difficult question in 2014 (although it was much less obvious in 2010 when the case was originally tried).    The Fifth Circuit dutifully noted that
when a debtor pleads an action that would augment the bankruptcy estate, but not necessarily be resolved in the claims process, then the bankruptcy court is constitutionally prohibited from entering final judgment.
 Opinion, pp. 7-8.  The Bankruptcy Court had attempted to justify its final judgment on implied consent.   However, the Fifth Circuit's Frazin and BP RE decisions have eliminated consent as a ground for authority in the circuit.   The Supreme Court recently considered and dodged the consent issue in Bellingham and has granted cert to consider the issue again in Wellness International Network.   Nevertheless, the Court noted that "Until the Supreme Court decides, we are bound by controlling circuit precedent."  Opinion, p. 8.

Thus, the Bankruptcy Court had jurisdiction to consider Lisa's claims but not authority to enter a final judgment.    Where does that leave the case?  
The failure of the consent rationale does not vitiate the lower courts’ work altogether, however. As the Supreme Court recently held, claims designated for final adjudication in the bankruptcy court as a statutory matter, but prohibited from proceeding in that way as a constitutional matter, may still “proceed as non-core within the meaning of § 157(c).” (citation omitted). Because Lisa’s claim is “related to a case under title 11,” 28 U.S.C. § 157(c)(1), the bankruptcy court may still hear it and “submit proposed findings of fact and conclusions of law to the district court for de novo review and entry of judgment.” (citation omitted). Accordingly, the district court’s judgment on Lisa’s TUFTA claim must be vacated and remanded for de novo review of the bankruptcy court’s decision as recommended findings and conclusions.
Opinion, pp. 8-9.   Thus, the District Court which has already reviewed the case twice will get to take a third look at it.   This time, the District Court will consider the Bankruptcy Court's opinion as proposed findings of fact and conclusions of law which it may accept or reject on a de novo basis.  What this means is that the District Court is free to disregard the Bankruptcy Court's factual findings rather than being bound by the clearly erroneous rule.    However, given the Bankruptcy Court's greater familiarity with the facts and the District Court's workload, it is highly likely that the District Court's review will be very deferential.    

The Galaz opinion highlights the silliness of all of the attention paid to Stern and its progeny.  Notwithstanding Stern, Bankruptcy Courts can still hear cases within their jurisdiction.   If a case is non-core (or is designated as core but is outside of the Bankruptcy Court's authority), the Bankruptcy Court can still submit proposed findings of fact and conclusions of law to the District Court.  While the District Court could hear more evidence and re-open the record, the District Courts already have a pretty full docket.   As a result, my guess is that they will review proposed findings and conclusions in much the same manner as they have traditionally reviewed bankruptcy appeals.   However, if the District Courts are faced with a high volume of Bankruptcy Court reports and recommendations, they may be tempted to give them even more deferential review.   The District Courts have substantial experience reviewing reports and recommendations from their Magistrate Judges and, although I have not done the research, I suspect that the normal procedure is to approve them.   To quote the Talking Heads, the practical reality may be "same as it ever was."

Even though the Fifth Circuit sent Lisa back for another round of procedural hell, they did give her a parting gift by answering a substantive legal issue.   Lisa had filed suit under the Texas Uniform Fraudulent Transfer Act which allows a creditor to file suit to avoid a transfer.   Raul claimed that Lisa was not a "creditor" because he didn't owe her any money.    However, the Fifth Circuit concluded that a "creditor" under TUFTA means someone who has a "claim" which means a right to "payment or property."   Because Lisa had the right to a share of ARF's assets upon its dissolution, she had a right to property and was thus a creditor with standing to pursue a TUFTA claim.  


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