Friday, June 08, 2018

Supreme Court Decides Three Narrow Bankruptcy Issues

The Supreme Court resolves about eighty cases each year, ranging from major constitutional issues to smallish questions of statutory interpretation. The three bankruptcy cases decided this term fall into the latter category, answering narrow statutory questions.

Supreme Court Sinks Safe Harbor

The first case decided was Merit Management Group, LP v. FTI Consulting. Inc., Case No. 16-784 (2/27/18). This case asked whether a shareholder of a business could be protected from a fraudulent transfer action where the funds passed through a third-party escrow agent which happened to be a bank. Section 546(e) of the Bankruptcy Code exempts from recovery "a transfer made by or to (or for the benefit of) … a financial connection with a securities contract...." In this case, the funds to purchase the stock flowed from the purchaser through two financial institutions to the stock seller. The statutory issue was whether the payment was protected where it flowed through two financial institutions that were merely intermediaries and did not receive the funds for their own benefit.

Writing for a unanimous court, Justice Sotomayor held that the relevant transfer to consider was the one that the Trustee sought to avoid. Since neither the buyer nor the seller was a financial institution, the safe harbor did not apply.   This decision prevents parties from insulating themselves from potential liability for a fraudulent transfer by routing the proceeds through a financial institution which does not have an interest in the transaction.

How Do You Review a Non-Statutory Insider?

Next, the Supreme Court weighed in on the narrow issue of the proper burden of proof when deciding whether a transferee was a non-statutory insider under 11 U.S.C. § 101(31).  U.S. Bank, N.A. v. Village at Lakeridge, LLC, No. 15-1509 (3/5/18).  In order to achieve a cram-down of a chapter 11 plan, a debtor must obtain the consent of a least one impaired class of creditors without counting votes of insiders. The class that accepted the plan consisted of a claim held by the debtor's sole owner, clearly an insider. One of the directors of the insider creditor  (Bartlett) offered to sell the claim to a retired surgeon (Rabkin) with whom she had a romantic relationship (more on this later). Rabkin agreed to purchase the $2.76 million claim for $5,000.00 and agreed to accept the plan. 

The list of defined insiders does not include a person in a romantic relationship with a director of an insider. However, the definition of "insider" states that the term "includes" the defined categories, meaning that the list is not exhaustive. U.S. Bank, which objected to the plan, argued that the romantic doctor was a non-statutory insider. The Bankruptcy Court found that the doctor was not an insider because he purchased the claim as a speculative investment after conducting due diligence. The Ninth Circuit affirmed applying a test that looked at (1) the closeness of the relationship and (2) whether the transaction was negotiated at less than arms-length. The Circuit found that the Bankruptcy Court's determination that the transaction was negotiated at arms-length was not clearly erroneous and affirmed.

The Supreme Court accepted the case, not on the question of the correct legal test to apply, but whether the Court of Appeals had applied the proper standard of review. Factual determinations must be upheld unless they are clearly erroneous while legal conclusions are reviewed on a de novo basis.

Justice Kagan, again writing for a unanimous court, found that it took a three step process to answer the question.    The first step was purely legal, to determine the appropriate legal test to apply.   The second step was purely factual, to determine the “basic” or “historical” facts relevant to the legal test.   The final step was to apply the historical facts to the legal test.   If factual issues predominated, the final step would be reviewed on the clear error standard, while de novo review would apply if legal issues dominated.

The Supreme Court denied cert on whether the Ninth Circuit applied the right legal test, which was the more interesting question.   While applying the historic facts to the legal test is a mixed question of law and fact, it ultimately depends on its component parts—the legal test and the facts.   Since the legal test was not at issue, what remained was the Bankruptcy Court’s fact-finding which is reviewed for clear error.   

The Ninth Circuit’s clear error review may have been assisted by the following testimony from Bartlett, the party offering the claim for sale:

Q:        Okay.  I think the term has been a romantic relationship—you have a romantic relationship?
A:        I guess.
Q.        Why do you say I guess?
A.        Well, no—yes.

Justice Kagan observed that “One hopes Rabkin was not listening.”

It is not clear why the Supreme Court accepted this case and this question since the answer was rather obvious.   Justice Sotomayor, joined by Justices Kennedy, Thomas and Gorsuch, had the same concern.   Justice Sotomayor said that “if that test is not the right one, our holding regarding the standard of review may be for naught.”  Because the Court did not accept the legal standard question, Justice Sotomayor did not provide an answer either.   However, she did suggest that the lower courts might want to spend some time thinking about what the legal test should be.   Justice Kennedy, in his own concurrence, went further.   He said, “The Court’s holding should not be read as indicating that the non-statutory insider test as formulated by the Court of Appeals is the proper or complete standard to use in determining insider status.”   He also suggested that the Bankruptcy Judge may have erred in concluding that the transaction was made on an arms-length basis since the claim was not shopped to other parties.

Thus, what we have is a rather unnecessary explication of how to decide mixed questions of law and fact combined with a statement by four Justices encouraging the lower courts to look for a different standard than the one articulated by the Ninth Circuit.    As a result, this opinion is more interesting for what it didn’t decide than for what it did.

Supreme Court Says Get It in Writing

            Finally, in Lamar, Archer & Cofrin v. Appling, No. 16-1215 (6/4/18), the Court decided whether a false statement about a single asset constituted a statement of financial condition which must be in writing to form the basis for a non-dischargeable debt.  11 U.S.C. §523(a)(2)(B) carves out an exception from the general rule that debts arising from fraud are non-dischargeable.  It provides that a statement “regarding the debtor’s or an insider’s financial condition” must be in writing in order to give rise to a non-dischargeable debt.   

            The case involved a client who got behind on paying his lawyers.   When the lawyers threatened to withdraw, he told them that he was expecting to receive a tax refund of approximately $100,000 and would use those funds to bring the lawyers current and pay future fees.   The trusting lawyers accepted his promise and soldiered on.   However, it turned out that the tax refund was closer to $60,000 and the client spent the money on business expenses.

            When the debtor filed bankruptcy, the unhappy law firm sued to prevent the debt from being discharged, claiming that the client made a false representation to gain their continued services.   The Bankruptcy Court ruled that a statement regarding a single asset, in this case, the tax refund, was not a statement regarding financial condition, and found the debt to be non-dischargeable.   The Eleventh Circuit disagreed.

            Justice Sotomayor, writing once more for a unanimous court, found that a statement regarding a single asset qualified as regarding the debtor’s financial condition.   Relying on grammar, she found that the term “regarding” in the statute broadened the clause such that it referred to both the object, statements of financial condition, and items related to the object.   She also relied on the fact that cases interpreting similar language under the Bankruptcy Act had arrived at the same result.   Since Congress did not change the verbiage, it must have intended to adopt the prior jurisprudence.   

            The lesson here is that a verbal statement about a debtor’s assets is not worth the paper it isn’t written on.   If a creditor wants to rely on a statement about a debtor’s assets, it should get it in writing.   In the case of the law firm, a simple email asking the debtor to confirm that he was expecting to receive a $100,000 tax refund (as opposed to the paltry $60,000 refund), if acknowledged by the client would have sufficed.  

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