Fifth Circuit Opinion Upholds Limits on Actions Between Non-Debtors

 In a case involving multiple parties and proceedings, the Fifth Circuit has affirmed lower court rulings which prohibited one non-debtor from suing a second non-debtor and awarded sanctions against a party that told a state court to disregard the Bankruptcy Court's orders. In the Matter of PFO Global, Incorporated, Case No. 20-10885 (5th Cir. 2/9/22), which can be found here. While the result may sound extreme, it appears to be an unintended consequence of an agreed order entered years earlier.

Exaggerated Allegations Lead to Sanctions in Stay Violation Case

Many consumer debtor attorneys have chosen to enhance their revenue by filing suit on relatively minor violations of the automatic stay or discharge. There is nothing inherently wrong with these suits since they vindicate the rights that debtors receive when they file bankruptcy. However, some practitioners have resorted to filing form complaints which go on for hundreds of paragraphs with boilerplate allegations about the callousness of the particular creditor. Recently, a creditors' lawyer fought back against exaggerated allegations in a complaint against his client and succeeded in recovering sanctions under Fed.R.Bankr.P. 9011. Defeo v. Winyah Surgical Specialists, P.A. (In re Defeo). 2021 Bankr. LEXIS 2685 (Bankr. D. S.C. 9/27/21).  

Supreme Court Rules That Passive Retention Does Not Violate Stay

 The Supreme Court decided that a creditor which passively retains possession of estate property does not "exercise control" over such property in violation of 11 U.S.C. Sec. 362(a)(3). The Court viewed the word "exercise" to require active measures.  Case No. 19-357, Chicago v. Fulton (1/14/21), which can be found here.

In the Fulton case, the City of Chicago impounded the Debtor's vehicle over failure to pay fees. The Debtors (there were multiple consolidated cases) filed chapter 13 and demanded return of their vehicles. The City refused. The Seventh Circuit held that the refusal to relinquish possession was a violation of the automatic stay.

Supreme Court Set to Hear Passive Stay Violation Case

Seeking to resolve a 5-3 split among the Courts of Appeals, the Supreme Court will consider whether a creditor which passively retains property of the estate violates the automatic stay.  Case No. 19-357, City of Chicago v. Fulton. The Second, Seventh, Eighth, Ninth and Eleventh Circuits have ruled that retaining possession or control of property of the debtor violates the stay. The Third, Tenth and D.C. Circuits have held that passive retention of property is not an "act" to exercise control over property of the estate.

Court Rules That Regulatory Actions Can Violate the Stay, Especially When You Say You Are Trying to Collect a Debt

An opinion from San Antonio Bankruptcy Judge Leif Clark examines when a claim against a non-debtor can violate the automatic stay. The short answer is: when the creditor says he is doing it to collect from the debtor. The long answer requires an examination of the interplay between 11 U.S.C. Sec. 362(a)(1) and 362(b)(4). In re Reyes, No. 10-52366-C (Bankr. W.D. Tex. 4/20/11). You can read the opinion here.

What Happened

The Reyes case arises from a real estate transaction gone bad. Josie Jones sued real estate broker Liza Reyes in state court and recovered a judgment. The Court succinctly described what happened next:

After the verdict was rendered, Jones and her lawyer, Robert Wilson, met with the debtor in a conference room at the courthouse. There, the debtor informed Wilson that they intended to file for bankruptcy. In response, Wilson, in the hearing of not only the debtor but also members of the debtorʼs family, told the debtor that he would “run them out of business by filing a complaint with the TREC (Texas Real Estate Commission) and close them down to get the money.” After the debtor filed for bankruptcy, Wilson, true to his word, filed a complaint in September 2010, on behalf of his client, with the TREC. The complaint took a number of months to prepare, and Wilson billed his client for the service. The TRECʼs procedures do not require a pre-investigation as a prerequisite to instituting such a complaint. Instead, the filing of the complaint itself necessitates an investigation by the Commission. If such an investigation results in a determination of wrongdoing on the part of the agent, and if a finding of damages is made, then the the TREC may make a monetary award to the complaining witness, and may subsequently seek reimbursement from the agent in the amount of the award. Wilson is well aware of these rules and procedures, this being one of his areas of practice.

Opinion, pp. 1-2.

The Debtors filed a Motion for Contempt against Jones and her attorney for violating the automatic stay by filing the Complaint with TREC. The Bankruptcy Court agreed with the Debtors and ruled that the stay had been violated.

The Automatic Stay By the Numbers

Among other things, the automatic stay prohibits:

(1) the commencement or continuation . . . of a judicial, administrative, or other action or proceeding against the debtor that was or could have been commenced before the commencement of the case under this title, or to recover a claim against the debtor that arose before the commencement of the case;

* * *

(6) any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case under this title.

It is clear that the respondents commenced an administrative proceeding that could have been commenced before the commencement of the case and that the claim against the Debtor arose before the commencement of the case. More difficult is the question of whether it was a proceeding to recover a claim against the debtor.

The Court answered this question in the affirmative, but only after an extensive discussion of whey the exception to the automatic stay of Sec. 362(b)(4) did not apply. Sec. 362(b)(4) allows

the commencement or continuation of an action or proceeding by a governmental unit . . . to enforce such governmental unit's police and regulatory power . . .

Notably, Sec. 362(b)(4) does not allow a private party to commence an action to enforce a governmental unit's police and regulatory power. Additionally, the Court found it significant that the TREC was required to act on the complaint.

Here, by contrast, the filing of a complaint that stated the requisite grounds for an investigation commences such an investigation, without any independent discretion on the part of the Commission. The TREC had no independent choice in the matter once that complaint was filed. The institution of an action that necessarily required further prosecution was not the mere discharge of a public duty, . . . .

Opinion, p. 8.

Further, the Court found that Ms. Jones, who lives in California, was unlikely to be motivated by a desire to protect Texas residents from unethical real estate brokers, and was more likely to be motivated by collection of money.

The Court ultimately found that the respondents were using the TREC as a vehicle to recover a claim against the debtor. Judge Clark stated:

The filing of this complaint is more correctly viewed as Wilsonʼs following up on his threats -- and his hope to recover his judgment from the debtor indirectly, by way of the TREC. Viewed that way, Jonesʼ initiation of this complaint, carefully crafted by Wilson, is better understood as the commencement or continuation of a proceeding against the debtor to collect on a prepetition debt, in violation of section 362(a)(1).

Opinion, p. 9.

What Does It All Mean?

Does collection of a judgment "from the debtor indirectly" violate the automatic stay? It is black letter law that the automatic stay does not protect non-debtors. Thus, absent the Sec. 1301 co-debtor stay, a creditor is free to proceed against a guarantor or other co-obligor after the debtor has filed bankruptcy. This raises the question of how the TREC is different from any other party who might be jointly or contingently liable on a debt of the debtor.

The Court stated that "(t)he TREC . . . does have the authority to compel payment from the debtors" but did not fully explain that statement. Under Texas law, a person who recovers a judgment against a license or certificate holder for a prohibited practice, may apply for payment from the Texas Real Estate Recovery Trust Account. Tex. Occ. Code Sec. 1101.612. The TREC may revoke a license "if the commission makes a payment from the real estate recovery trust account to satisfy all or part of a judgment against the license or registration holder " and that "a person is not eligible for a license or certificate until the person has repaid in full the amount paid from the account for the person, plus interest at the legal rate." Tex. Occ. Code Sec. 1101.655(a) and (c).

Thus, the Court is correct that the TREC could coerce repayment of amounts paid from the real estate recovery trust account by revoking the debtor's license until the amount was repaid. However, it is unclear that they could do so while the Debtor was in bankruptcy. Sec. 362(b)(4) allows a governmental unit to enforce a judgment "other than a money judgment." Thus, it seems likely that the TREC could not revoke the debtor's license for failure to repay the real estate recovery trust account. Further, Sec. 525(a) states that a governmental unit may not revoke a license based on failure to pay "a debt that is dischargeable in the case under this title."

Sec. 525(a) may provide the glue that holds the court's opinion together. The TREC may revoke a license for failure to pay a nondischargeable debt. The Texas Occupations Code provides that in order to recover from the real estate recovery fund "the person shall verify to the commission that the person has made a good faith effort to protect the judgment from being discharged in bankruptcy."

In this case, the respondents had filed a complaint to determine dischargeability but had not yet proceeded to trial. Had the respondents first obtained a nondischargeable judgment and then filed a complaint with TREC, there would have been no violation. The automatic stay terminates upon entry of the discharge and the discharge does not apply to nondischargeable debts. Here, the respondents jumped the gun. Rather than waiting until they had a nondischargeable judgment, they acted immediately to take actions which would have threatened the debtor's livelihood by threatening her license.

It was a matter of timing rather than a matter of absolute prohibition. It was also really foolish for the lawyer to tell the debtor in the hearing of multiple witnesses that he would "run them out of business by filing a complaint with the TREC and close them down to get the money."

Implications for Hot Check Cases

It is an open secret in Texas that County Attorneys' offices act as a collection agency for merchants who received dishonored checks. It is also quite clear that the automatic stay does not apply to "the commencement or continuation of a criminal action or proceeding against the debtor." 11 U.S.C. Sec. 362(b)(1). Therefore, it is clear that the County Attorney does not violate the automatic stay by filing hot check charges.

However, under the logic of Reyes, it is intriguing to ask whether the merchant who initiates hot check charges as a debt collection device could be held liable for violating the stay. The difference between subsections (b)(1) and (b)(4) may provide the answer. Sec. 362(b)(4) is limited to actions by governmental actions, while 362(b)(1) is not. Thus, if hot check charges are criminal actions, a private party may initiate hot check charges without violating the stay. They only way around that would be to say that hot check charges are not legitimate criminal actions at all, but are really debt collection actions in substance. Unfortunately, telling a state what it can and cannot criminalize probably runs afoul of the Constitution.

Ninth Circuit BAP Finds Wells Fargo Freeze Policy Violates Automatic Stay

Breaking with judges in Texas and New Mexico, the Ninth Circuit Bankruptcy Appellate Panel has found that an administrative freeze policy utilized by Wells Fargo Bank violates the automatic stay. No. 09-1408, Mwangi v. Wells Fargo Bank, N.A. (Ninth Cir. BAP 6/30/10). The opinion can be found here.(PACER access required).

Wells Fargo's Policy

Every night, Wells Fargo compares cases filed in CM/ECF against its account holders. If one of its account holders files chapter 7 bankruptcy, Wells Fargo places an administrative freeze upon the account and sends a letter to the chapter 7 trustee requesting instructions on disposition of the funds. In the Mwangi case, the debtors initially disclosed that they had only $1,300.00 in their Wells Fargo accounts. After Wells Fargo froze the accounts, they amended their schedules to disclose $17,075.06 and claimed 75% of this amount as exempt. The Debtors then demanded that Wells Fargo release the funds based upon their claim of exemption. When Wells Fargo refused, the Debtors filed a motion for sanctions. By the date of the hearing, the exemption had become final. The Bankruptcy Court ruled that Wells Fargo had not violated the stay because the funds were property of the estate and that Wells Fargo had not attempted to collect a debt.

The BAP Doesn't Like the Bank's Policy

The Bankruptcy Appellate Panel disagreed. It held that once the Debtors claimed the funds as exempt, they had an inchoate interest in the funds. This gave them standing to assert a violation of Sec. 362(a)(3), which prohibits acts to "exercise control over property of the estate." The Court found that continuing to hold the funds constituted exercise of control over property of the estate. The Panel wrote:

Wells Fargo asserts that it did not exercise control over property of the estate. We disagree. Wells Fargo could have paid the account funds to the trustee; it did not. Wells Fargo could have released the account funds claimed exempt to the Appellants when demand was made; it did not. Wells Fargo could have sought direction from the bankruptcy court, by way of a motion for relief from stay or otherwise, regarding the account funds; it did not. Instead, it chose to hold the funds until a demand was made for payment that it alone deemed appropriate. If that is not "exercising control over" the funds, we don't know what is. (emphasis added).

. . .

The impact of Wells Fargo's national policy is to turn on its head the balance between rights of parties legislatively created. As a result of the policy, every party, except Wells Fargo, whose rights are impacted by the administrative freeze will need to take action.

Slip Op. at 19, 20.

The BAP remanded for a determination of whether the violation of the stay was willful and whether the debtors were entitled to damages.

The BAP Disagrees With Other Courts

The Ninth Circuit BAP's opinion contrasts with the decisions in Wells Fargo Bank v. Jimenez, 406 B.R. 935 (D. N.M. 2008) and In re Calvin, 329 B.R. 589 (Bankr. S.D. Tex. 2005). In each of those cases, the courts found that until the funds became exempt, they were property of the estate. As a result, the debtors lacked standing to complain that the bank was withholding funds from the trustee. Judge Jeff Bohm was sympathetic to the dilemma faced by the bank, writing:

Under the Bankruptcy Act of 1898, entities owing debts, such as the Bank were shielded from liability even if they paid a debtor post petition as long as the entities were "acting in good faith." (citation omitted). The Bankruptcy Reform Act of 1978 eliminated this provision with the passage of Sec. 542. Entities owing a debt now have exposure to Chapter 7 trustees if payment on the debt is made to the debtor because that debt is owed to the estate until such time as it is abandoned or any exemption becomes final. Under these circumstances, it makes good business sense for the Bank to have instituted a policy that freezes the accounts of depositors who file a Chapter 7 petition. In this manner, the Bank can shield itself from any liability to a trustee while that trustee determines whether the funds are exempt, or nonexempt (or, even if nonexempt, of inconsequential vale to the estate). It is its potential exposure to trustees, not to debtors upon which the Bank must properly focus.

In re Calvin at 604.

A Big Mess

These cases point out an enormous practical problem. Sec. 541 provides that money in the debtor's bank account is property of the estate. Sec. 542 provides that an entity holding property of the estate "shall deliver to the trustee" the property. However, as a practical matter, most funds held by debtors will be exempt or of inconsequential value to the trustee so that the trustee will not administer the asset. Debtors have the expectation that they will continue to be allowed access to the funds since the odds are that they will ultimately receive them. From the Trustee's point of view, it is burdensome to hold funds which will not be administered, but potentially more burdensome to recover those funds from the debtor once they have been spent.

At first blush, the bank appears to be an officious intermeddler. It freezes the funds even when it has no claim to them. Instead of turning them over to the trustee, it holds them. However, Judge Bohm (who was a banker prior to attending law school), has a legitimate point. The Code says turn over the funds. Recognizing that the trustee might not want the funds, the Bank agrees to hold the funds pending direction from the trustee. Of course, trustees rarely provide that direction because it would be burdensome in administering large numbers of cases.

The Ninth Circuit BAP outlined what it believed to be the Bank's options in this situation:

1. It could have turned the funds over to the trustee. This would be appropriate under the Code, but would overwhelm trustees.

2. It could have turned the funds over to the debtor. This would violate the Code and expose the bank to liability.

3. It could have sought direction from the court. While this would be appropriate, it would be very burdensome to the bank when it had to be done in tens of thousands of cases.

Under the Ninth Circuit BAP's opinion, the only viable option for the bank is to transfer the funds to the trustee whether the trustee wants them or not. Of course, there is another option. Trustees could agree to hold banks harmless for allowing debtors access to funds unless directed otherwise. There is no chance that banks will be able to negotiate agreements with hundreds of panel trustees or the the U.S Trustee's office would allow them to agree to it.

Since all of the options under existing law are bad, it might make sense to go back to the "acting in good faith" standard under the Bankruptcy Act of 1898 and leave the bank out of the picture.

Sign Costs Creditor $21,800

Chuck Newton's blog, stayviolation.com, has the details on a case he recently tried in which a creditor posted a sign in a small town stating: "BRAD COLLIER OWES ME $984.23 WILL YOU PLEASE COME AND PAY ME!" The Court awarded $21,820.00 in damages for violation of the automatic stay. No. 08-2004, James Bradley Collier v. Paul Hill (Bankr. E.D. Tex. 4/7/09). Go to Posting Signs About the Debtor Can Constitute A Stay Violation on Chuck's Blog for all the details.

Fifth Circuit Answers Three Questions of First Impression on Violation of Automatic Stay

The Fifth Circuit answered at least three questions of first impression in a recent case regarding violation of the automatic stay. In re Repine, No. 06-20807 (5th Cir. 7/22/08).

The facts of this case sound straight out of a made for TV movie, including love gone bad, prison and a renegade lawyer. Ronald Repine was married to Elizabeth Pollard Repine. Although he had made as much as $147,000 per year at one point, he was unemployed during part of the period from 2001 to 2003. He managed to get behind on his child support to the extent of $22,859. The family court sentenced him to 180 days in jail for criminal contempt and also ordered that he be held in civil contempt indefinitely until he paid the past due support and paid $2,027 to his ex-wife’s attorney Patsy Young.

Shortly after being incarcerated, Ronald did what anyone would do: he filed for chapter 13 bankruptcy. Elizabeth then retained separate counsel to represent her in the bankruptcy. Notwithstanding the automatic stay, Elizabeth made a deal with Ronald to pay the back support and get him out of jail. Ronald agreed to deed his house to Elizabeth who would be allowed to sell it and apply the proceeds to the back child support. There was just one problem: the agreement did not provide for payment of Patsy’s attorney’s fees. Elizabeth’s bankruptcy lawyer came up with a practical solution. He obtained an order from the Bankruptcy Court allowing the transfer of the house to Elizabeth and for the proceeds to be applied to the child support debt, including attorney’s fees. The order also provided that any unpaid attorney’s fees would be paid under Ronald’s Chapter 13 plan.

Elizabeth complied with her part of the deal and asked that Ronald be released from jail. However, Patsy objected because she wanted to be paid her attorney’s fees. As a result, the family court denied the motion. Shortly thereafter, Ronald completed the criminal portion of his contempt sanction and started serving the civil contempt portion. Patsy refused to submit an agreed order for Ronald’s release unless she received certified checks for her attorney’s fees. Elizabeth and Ronald then went to Bankruptcy Court to enforce the agreed order. The Bankruptcy Court ordered Patsy to appear and show cause why she should not be held in contempt for violation of the automatic stay. Despite being served with the order by a U.S. Marshall, Patsy did not appear. As a result, the Bankruptcy Court caused a warrant to be issued and Patsy was taken into custody by the U.S. Marshall’s Service.

The Bankruptcy Court ordered Patsy released but told her to stop trying to collect her attorney’s fees. Undeterred, Patsy refused to submit the order providing for Ronald’s release. Because of Patsy’s actions, Ronald was unable to attend his father’s funeral. Finally, Patsy moved to withdraw from the family law case and Elizabeth’s bankruptcy counsel substituted in. Ronald was finally released after having served about six weeks of his civil contempt sentence.

Once he got out, Ronald filed a complaint for violation of the automatic stay against Patsy. The Bankruptcy Court awarded Ronald total damages of $27,280, including $4,400 for emotional distress and $5,000 in punitive damages plus $33,720. Thus, Patsy’s efforts to collect $2,027 in attorney’s fees caused her to incur liability of $61,000.

The Court of Appeals did not have any difficulty finding that the Bankruptcy Court’s determination that Patsy had violated the automatic stay should be affirmed. While child support may be collected from property which is not property of the estate, Patsy’s demand to be paid or else Ronald could not be released from jail did not distinguish between being paid from property of the estate or non-property of the estate. Patsy just wanted to get paid and she didn’t care where the money came from. Additionally, the Court of Appeals found that Patsy’s determined refusal to submit the order agreed to by her client extended the period of Ronald’s incarceration.

When it came to damages, the Fifth Circuit plowed new ground. Section 362(k) allows punitive damages in “appropriate circumstances,” a rather indefinite mandate. The Fifth Circuit had not previously decided what constituted “appropriate circumstances” to award punitive damages. It accepted the Eighth Circuit’s standard of “egregious intentional misconduct on the violator’s part” and found that Patsy met the standard. Ignoring the Bankruptcy Court's admonition to stop collecting as well as your own client’s wishes is enough to constitute egregious intentional misconduct.

Next, the Fifth Circuit had to consider whether damages for emotional distress could be awarded for a violation of the automatic stay. This was also an issue of first impression. The Court found that a debtor seeking to recover damages for emotional distress must set forth “specific information” rather than “generalized assertions.” The Court found that testimony that he was “very upset” at what his sons would think about him being incarcerated, that it was “very traumatic” to miss his father’s funeral and that he had dreams about missing his father’s funeral and worried about it when interacting with other people all fell within the category of “generalized assertions” which would not give rise to emotional distress. As a result, the Court vacated the award for emotional distress.

Finally, the Fifth Circuit considered whether fees incurred in prosecuting an action for violation of the automatic stay were recoverable as damages. This was also an issue of first impression. The Fifth Circuit agreed that fees incurred in prosecuting an action for violation of the stay were recoverable and rejected a requirement that there be proof that the fees incurred had actually been paid.

At the end of the day, all of the damages except for $4,400 in emotional distress were affirmed.