NCBJ Report 2016: Broken Bench Radio

The first plenary session of NCBJ was Broken Bench Radio, a fast-paced discussion of hot topics in the form of a radio call-in show.   It covered insights from the Caesar's Entertainment case, upcoming Supreme Court decisions, recharacterization, equitable mootness, Chapter 13 updates, the CFPB and the Husky case.  

Insights From Caesar's Entertainment

James Sprayregen was the first caller in to the show.   He talked about the Caesar's Entertainment case.    He repeatedly alluded to the interesting issues that could have been decided, such as the involuntary petition filed against the company and the section 105 injunction in favor of the parent company, if only the case hadn't settled.   His best quote was "Settlement negotiations are never over and the activities in the courtroom are an extension of the settlement negotiations.

Upcoming Supreme Court Decisions

Prof.  Erwin Chemerinsky gave a brief public service announcement about two upcoming Supreme Court cases:  Czyzewski v. Jevic Holding Corp and Midland Funding, LLC v. Johnson.   The Supreme Court has granted cert in both of these cases.   Jevic is about whether a  settlement agreement resulting in a structured dismissal can violate the priority scheme under the Bankruptcy Code.   Midland Funding deals with the question of whether it is a violation of the Fair Debt Collection Practices Act to file a proof of claim that is barred by the statute of limitations.   This is an issue where the Eleventh Circuit, which says yes, is at odds with at least three other circuits.  I have a case on this issue pending before the Fifth Circuit so it is of special interest to me.

Southern District of Texas Takes Itself to Task for Failure to Follow Chapter 13 Rules

In an unusual collaborative proceeding initiated by two judges from the Southern District of Texas and concluded by a third, the Court has taken the Standing Chapter 13 Trustee to task for following the guidance of the former judge and has effectively judged the system guilty.   The opinion exposes an apparent rift between the current and former judges of the district and demonstrates an activist approach to problem solving by the judiciary.     Misc. Case No. 15-701, In re:  Chapter 13 Plan Administration in the Brownsville, Corpus Christi and McAllen Divisions.    The Court's Amended Order can be found here.  

What Happened

The Southern District of Texas adopted a standard plan in 2008 which provided that when a mortgage payment was increased or decreased, the debtor's plan payment would be increased or decreased by the same amount.     This was to be done automatically without the necessity for a plan modification.  

At a hearing on December 16, 2015, Judge Marvin Isgur learned that the Standing Chapter 13 Trustee was not automatically adjusting the plan amounts, but was instead waiting for debtors to file a motion to modify.   As a result, Judge Isgur and Judge Eduardo Rodriguez issued an Order to Show Cause in  Miscellaneous Case No 15-701 on December 22, 2015.    Among other things, the Order to Show Cause stated that:

• It appears that the Chapter 13 Trustee may have made distributions to creditors and debtors with an incorrect application of the Plan.
• If the issue were only an historic issue, the Court would not issue the emergency relief contained in this Order.
• The magnitude of the errors, and the appropriate remedy (if any) for the errors is unclear.
• The Court recognizes the difficult position that this Order imposes on the Chapter 13 Trustee.  Accordingly, the Chapter 13 Trustee should not hesitate to retain counsel, directly or through her errors and omissions carrier.

The judges then issued an order which provided for an Initial Status Conference to take place approximately two weeks later.   They requested that David Jones, the Chief Judge for the District, preside over the hearing.    The judges also required that the Standing Chapter 13 Trustee and the U.S. Trustee appear.   Judge Jones handled all subsequent proceedings.

The Chapter 13  Trustee filed a response in which she stated that she had followed the direction of the former Judge who interpreted the standard plan to require that the Debtor file a motion to modify the plan if the mortgage amount changed. 

For years, at least as early as 2004, I have administered Chapter 13 Plans in accordance with Judge Richard Schmidt’s interpretation of the Plan and his direction and approval. Until his retirement on July 30, 2015, Judge Schmidt required debtors file a motion to modify in the event an increase in mortgage payment caused the plan to not timely pay out. If the debtor failed to file a motion to modify, the Trustee would file a motion to dismiss. If there was no objection filed by the debtor, the Trustee would increase the amount of the mortgage payment to reflect the new increased mortgage payment; however, the debtor’s overall payment to the Plan did not increase unless the court signed an order modifying the plan. This was the standard practice for many courts, including Judge Schmidt’s Court until his retirement.

She also submitted an affidavit from the now retired judge stating that he had in fact provided this direction.  

While the Court and the Trustee had adopted a practice "as early as 2004," the judges of the Southern District adopted a standard plan in May 2006 which took a different approach.  Under the standard plan, upon filing of a Mortgage Payment Change Notification, the Trustee was supposed to automatically increase or decrease the amount of the Debtor's payments so that the distribution to unsecured creditors remained constant.    According to Judge Jones, "(t)he effect of this change was to shift responsibility for any change in the debtor's ongoing mortgage payment from the unsecured creditors to the debtor."    However, the practice apparently followed was to put the burden on the debtor to request a modification or for the unsecured creditors to object.       

Following an initial status conference on January 11, 2016, the Court required the Standing Trustee to provide a report identifying all affected cases.     According to the Trustee's report, there were 367 open cases where Debtors had made aggregate underpayments totaling $820,843.47 and 173 open cases where Debtors had made overpayments totaling $412,881.32.   

The Trustee proposed to remedy the situation by refunding overpayments to the extent of available funds and, if this proved insufficient, to seek to recover the overpayments from creditors.   Where debtors had underpaid, the Trustee proposed (i) changing plan payments to the extent feasible, (ii) extending plans beyond sixty months; and (iii) granting hardship discharges where payments could not be made up.    According to the Court, the Trustee resisted the idea that she give notice to all affected parties and inform them that they might have claims against her.  

The Court's Order

On May 5. 2016, the Court issued its Order (which was modified slightly by an amended order the next day).    The Court began with a quote from Abraham Lincoln:

It is as much the duty of government to render prompt justice against itself, in favor of citizens, as it is to administer the same between private individuals. ABRAHAM LINCOLN, Message to Congress in special session, July 4, 1861.

What followed was a sharp critique of the administration of chapter 13 cases in the Brownsville, Corpus Christi and McAllen divisions of the Southern District of Texas, in effect, the Southern part of the Southern District.     The Court stated that "(r)esponsibility for the administration of the chapter 13 process is vested primarily in three independent parties:  the Court, the United States Trustee and the chapter 13 standing trustee."   Amended Order, page 5.   The Court did not mention the role of the debtors, creditors and their attorneys in administering the system.  However, the Court may have implicitly acknowledged the practical difficulty for someone who makes a living within the system to stand up to those tasked with its implementation.  

Judge Jones went on to state:

Based on the affidavits submitted by Ms. Boudloche and her statements to the Court during this proceeding, the Court finds that chapter 13 debtors in the Brownsville, Corpus Christi and McAllen divisions of the Southern District of Texas were intentionally treated in a manner contrary to the Uniform Plan and to other debtors in the Houston, Galveston, Victoria and Laredo divisions of the Southern District of Texas. This disparate treatment was apparently the result of communications between the Court and Ms. Boudloche and the implementation of an unwritten rule or agreement to disregard the Uniform Plan. The Court finds that Ms. Boudloche violated her duties as a chapter 13 trustee. The Court further finds that the United States Trustee violated its duties of oversight and supervision of Ms. Boudloche. Most embarrassing, the Court violated its duty to uphold the integrity and independence of the judiciary.

Amended Order, pp. 7-8.   

The Court adopted the following remedial measures in open cases with a mortgage change notice:

1.   Where the debtor had overpaid, the Court required that the trustee: (i) immediately adjust the plan; (ii) issue a refund to the debtor to the extent of available funds within fourteen days; (iii) recover any overpayments from creditors within sixty days; and (iv) failing that, the Trustee would be required to "satisfy the unpaid deficiency."

2.  Where the debtor had underpaid, the Court required the trustee to immediately file a "mortgage payment change notice" for cases with more than three months remaining.   The debtor would then be required to object within twenty-one days or be bound by the increase.    The Court also required any debtor wishing to assert affirmative relief against the Chapter 13 Trustee to file a pleading within the Miscellaneous Case within 45 days or the claim would be waived.    Once the debtor completed payments under the plan, the trustee would be required to file a Notice of Plan Completion including language stating:

In this case, the chapter 13 trustee failed to administer the debtor(s)’ plan in accordance with its terms. This failure may have resulted in a distribution to unsecured creditors that is less than what would have been received had the chapter 13 trustee properly administered the plan in accordance with its terms. If you object to the granting of a discharge or wish to assert a claim against the chapter 13 trustee, you must file a written pleading in this bankruptcy case specifically setting forth your objection or claim within 21 days of the date of this notice or any such objection or claim is forever waived.

Thus, the Court gave creditors an opportunity to object to the debtor's discharge or assert a claim against the trustee if they were shortchanged.    If creditors remained silent, the debtor's discharge would go through.

Thus, the Court's remedial procedure consisted of moving to compliance on a prospective basis while allowing parties to object or assert claims within a limited window.   If the parties chose not to upset the status quo (as they had done during the previous ten years when the plan was being ignored), the sins of the past would be laid to rest.

However, the Court did not stop there.    The Court ordered the U.S. Trustee to conduct a review of the standing trustee.   The Court stated:

The Court notes that it has listened to over 20 hours of proceedings involving Ms. Boudloche in her capacity as chapter 13 trustee. The Court encourages the United States Trustee to do the same. The Court will reserve further action pending receipt and review of the United States Trustee’s report.

Amended Order, page 10.

The Court concluded its order with an apology.

On behalf of the Bankruptcy Court, the undersigned offers its sincere apology to those debtors and their families that did not receive the justice they deserve. The Court hopes that practitioners in these divisions will share this Order with their clients and convey just how hard it is for the undersigned to publicly recognize the failure of a system that he took an oath to protect. There will be no more secret rules, unspoken practices or disparate treatment of citizens in different divisions. We are one Bankruptcy Court with a single set of written rules. All citizens within the Southern District of Texas will be treated equally and with respect.

Amended Order, page 10.

The Inquisitorial System of Justice

This case involved a judge-driven investigation.    This is a sharp contrast to the adversary system which is the norm in America.    A few words about the distinction between the adversary system and the inquisitorial system are in order.

The American system of justice is characterized by the adversary system in which the litigation is primarily driven by the parties and their advocates.   The adversary system is followed by most of the countries which inherited their legal system from England.   In contrast, most of the rest of the world follows the inquisitorial system of justice in which the Court takes the lead.    I found a good discussion of this topic in an online legal dictionary.

The inquisitorial system can be defined by comparison with the adversarial, or accusatorial, system used in the United States and Great Britain. In the Adversary System, two or more opposing parties gather evidence and present the evidence, and their arguments, to a judge or jury. The judge or jury knows nothing of the litigation until the parties present their cases to the decision maker. The defendant in a criminal trial is not required to testify.

In the inquisitorial system, the presiding judge is not a passive recipient of information. Rather, the presiding judge is primarily responsible for supervising the gathering of the evidence necessary to resolve the case. He or she actively steers the search for evidence and questions the witnesses, including the respondent or defendant. Attorneys play a more passive role, suggesting routes of inquiry for the presiding judge and following the judge's questioning with questioning of their own. Attorney questioning is often brief because the judge tries to ask all relevant questions.

The goal of both the adversarial system and the inquisitorial system is to find the truth. But the adversarial system seeks the truth by pitting the parties against each other in the hope that competition will reveal it, whereas the inquisitorial system seeks the truth by questioning those most familiar with the events in dispute. The adversarial system places a premium on the individual rights of the accused, whereas the inquisitorial system places the rights of the accused secondary to the search for truth.

The inquisitorial system was first developed by the Catholic Church during the medieval period. The ecclesiastical courts in thirteenth-century England adopted the method of adjudication by requiring witnesses and defendants to take an inquisitorial oath administered by the judge, who then questioned the witnesses. In an inquisitorial oath, the witness swore to truthfully answer all questions asked of him or her. The system flourished in England into the sixteenth century, when it became infamous for its use in the Court of the Star Chamber, a court reserved for complex, contested cases. Under the reign of King Henry VIII, the power of the Star Chamber was expanded, and the court used torture to compel the taking of the inquisitorial oath. The Star Chamber was eventually eliminated as repugnant to basic liberty, and England gradually moved toward an adversarial system.

After the French Revolution, a more refined version of the inquisitorial system developed in France and Germany. From there it spread to the rest of continental Europe and to many African, South American, and Asian countries. The inquisitorial system is now more widely used than the adversarial system. Some countries, such as Italy, use a blend of adversarial and inquisitorial elements in their court system.

http://legal-dictionary.thefreedictionary.com/Inquisitorial+System

While Bankruptcy Courts primarily function under the adversary system, section 105(a) authorizes court-led investigations such as the one in this case.    Specifically, section 105(a) provides:

No provision of this title providing for the raising of an issue by a party in interest shall be construed to preclude the court from, sua sponte, taking any action or making any determination necessary or appropriate to enforce or implement court orders or rules, or to prevent an abuse of process.

In order to satisfy due process requirements, these proceedings often begin with an order to show cause which informs the responding party of the actions being questioned and allows a response.   In re Gleason, 492 Fed. Appx. 86 (11th Cir. 2012)(unreported).    There is also an inherent tension with the Court's ability to initiate and prosecute a proceeding and remain impartial.   In the case of In re Johnson, 921 F.2d 585 (5th Cir. 1991), the Fifth Circuit reversed an order suspending a trustee where the Circuit Court found that the Bankruptcy Court should have recused itself.   This may explain why, in this particular case, Judges Isgur and Rodriguez initiated the proceeding but then referred it to Chief Judge Jones.    This was all the more important for Judge Rodriguez who had been a volume practitioner in this same court until he was appointed to replace Judge Schmidt.

The inquisitorial proceeding in bankruptcy court is a unique creature.  The ability of the Court to compel a party to appear and show cause in a proceeding where the Court initiates the action, defines its boundaries and renders a judgment is a powerful one.   There are many words that could be written about whether this type of proceeding can comply with due process or whether there are separation of powers problems when the judicial branch compels the executive branch to act.  I will leave those for another author.

Disclaimers:

I am presently representing a client in another Miscellaneous Case in the Southern District of Texas.   Nothing written here is intended to be a comment on that proceeding which involves substantially different facts and legal issues.  

In reporting on this opinion, I have relied on the publicly available record and the descriptions of the proceedings contained within the court orders.    I did not participate in these proceedings and have no personal knowledge other than what I read.  

The period for appealing the Court's order has not yet expired.   As a result, the Order is still subject to modification or reversal on appeal.

Supreme Court Rules Debtor Entitled to Funds Remaining Upon Conversion of Chapter 13 Case

Acknowledging that the statutory language "does not say expressly" what should happen, the Supreme Court nevertheless ruled that undistributed funds held by the Chapter 13 trustee should be returned to the debtor following a conversion.   The Court described its result as "the most sensible reading of what Congress did provide."   Justice Ginsberg wrote the opinion for an unanimous Court.   Harris v. Viegelahn, No. 14-400 (5/18/15).

What Happened

Charles Harris, III began his trip to the Supreme Court when he filed a chapter 13 petition in San Antonio, Texas in February 2010.   He was trying to save his home after defaulting upon his mortgage.    However, by November 2010, the Court had lifted the stay to allow the lender to foreclose.   A year later, he converted his case to chapter 7.   At that time, the Chapter 13 Trustee had over $5,500 on hand.  Rather than returning these funds to the debtor or paying them to the Chapter 7 trustee, she paid them to debtor's counsel and the unsecured creditors.   The Debtor filed a motion for return of the funds.   The Bankruptcy Court granted this motion and the trustee appealed.   The Fifth Circuit reversed, finding that the Bankruptcy Court's order would allow the Debtor to receive a "windfall."    In re Harris, 757 F.3d 468 (5th Cir. 2014).   The Supreme Court granted cert to reconcile a conflict with the Third Circuit.

The Ruling

The Court noted that prior to 1994, there was a split of authority over whether the debtor's post-petition earnings vested in the chapter 7 estate upon conversion.    This problem was solved when section 348(f) was added to the Code.   It provides that absent bad faith, property of the chapter 7 estate following conversion from chapter 13 consists of property which was originally part of the chapter 13 estate which remained "in the possession . . . or control" of the debtor on the date of conversion.  Thus, the funds held by the chapter 13 trustee would not become property of the chapter 7 estate.   

However, this did not answer the question of what the chapter 13 trustee could do with the funds upon conversion.   The court noted that under section 348(e), the chapter 13 trustee's "services" are terminated upon conversion.   The Court concluded that paying money to creditors was one of the "services" provided by the trustee and therefore something that could not be done after conversion.   The Court also concluded that paying money to creditors was not part of the trustee's duty to "wind up" the chapter 13 estate and that a chapter 13 plan did not vest funds in creditors until they were paid out.

The Court rejected the policy arguments that were relied upon by the Fifth Circuit.  It was not a "windfall" for the debtor to receive the undistributed funds for the reason that those funds would have belonged to the debtor if he had initially filed under chapter 7.    The Supreme Court agreed that it was a fortuity that some trustees had lots of money on hand when a case converted and others didn't.   However, the Court suggested that creditors "seek() to include in a Chapter 13 plan a schedule for regular disbursement of funds the trustee collects."   Opinion, p. 11.  The fact that creditors could protect themselves showed that the Court did not need to bend the statute to arrive at a reasonable result.

What Does It Mean?

In this case, the Supreme Court followed the text and structure of the statute rather than relying on easily manipulated policy arguments like the Fifth Circuit did.    The Supreme Court showed that it was willing to look at how the Bankruptcy Code functions to resolve a question that was not completely obvious.   While no statute expressly said that the debtor gets to keep funds in the hands of the chapter 13 trustee, the Court noted that other provisions, such as those revesting post-petition property in the debtor and terminating the services of the trustee, pointed to the correct answer.   This is a functional, pragmatic approach toward interpreting the law and will be useful to practicing lawyers.

The case will likely also encourage Chapter 13 trustees to seek authority to make interim distributions.   The ruling only applies to funds held by the Chapter 13 trustee on the date of conversion.   Had the Trustee received permission for interim distributions, there would have been a much smaller amount on hand and the Trustee would have received commissions on the funds which were distributed.   As the Court pointed out, there is nothing wrong with encouraging Trustees to make distributions early and often.    

Because Trustees will likely modify their procedures to address the ruling, the practical effect of the opinion will likely be minimal.   However, any time that the Supreme Court interprets the Bankruptcy Code, it provides valuable guidance as to how they might rule in other cases.    That will be the lasting impact of this case beyond the relatively small sum that Trustee Viegelahn will be required to pay.

Note:  The Bankruptcy Court order was entered by then-Bankruptcy Judge Leif M. Clark.   Over the years, Judge Clark has been a fertile source of material for this blog.   Congratulations to Judge Clark on being affirmed by the Supreme Court.    Congratulations also to local attorney Steven Cenammo who filed the motion which set this in motion.  

Energy Resources Remains Viable for Allocation of Tax Payments

Twenty-five years ago, the Supreme Court held that a Bankruptcy Court had the authority to order the IRS to allocate payments made "voluntarily" by a Debtor when necessary to effectuate a successful reorganization.    United States v. Energy Resources Co., 495 U.S. 545 (1990).   Left to its own devices, the IRS will generally allocate payments to the oldest taxes first, or, in the case of payroll taxes, to non-trust funds taxes first.   If the Debtor can require the IRS to allocate payments differently, it can greatly impact the overall amount the Debtor will be required to pay.   A recent decision out of Fort Worth illustrates how Energy Resources continues to provide a valuable tool for Debtors with tax obligations.    In re Fielding, 522 B.R. 888 (Bankr. N.D. Tex. 2014).  

Fielding was a chapter 13 case where the Debtors owed $539,885.26 to the IRS.    The debt was secured by a lien against all of the Debtors' real and personal property.    The Debtors filed a motion to sell their homestead.   After paying superior obligations, there was approximately $128,000 available to pay on the IRS claim.    The Debtors sought to apply the payment to the base tax amounts but not to interest or penalty.    The IRS, on the other hand, wanted to apply the payments to the oldest taxes first, including penalties and interest.    This could have resulted in paying priority and unsecured claims prior to secured claims.   

The IRS argued that it could not be compelled to allocate the proceeds and that payments from a bankruptcy sale were not "voluntary" payments which could be designated by the taxpayer.    The Court held that Energy Resources could be applied in a chapter 13 case.    In doing so, it noted that other courts and commentators had been hesitant to limit the case to its facts.    (One of the authorities it cited was a law review article that I wrote).    

However, having found that the designation doctrine could be applied to a chapter 13 case, the Court raised the issue of whether it could be done in the absence of a confirmed plan.   The Court noted that:

(J)ust as a debtor in a chapter 11 case must make payments in accordance with its chapter 11 plan upon confirmation, a chapter 13 debtor must make payments in accordance with its proposed plan even prior to confirmation.

Opinion at *15.   Based on this distinction between chapter 11 and chapter 13, the court found that payments could be designated in chapter 13 even prior to confirmation.

Next, the court found that the designation was necessary to effectuate the reorganization.   The Court stated:

In the case at bar, to achieve success through the reorganization, Debtors must be capable of complying with Amended Plan provisions.   To do so, Debtors rely on the sale of assets to reduce the debt owed to the IRS.   If the IRS is permitted to apply the Proceeds to unsecured or priority portions of the debt as requested, then the lien held by the IRS for the secured claim would continue to attach to Debtors' property.   thus, any reduction in the IRS secured claim would not sufficiently correspond with the assets being sold.  Debtors would also continue to incur the interest and penalties on the unpaid, secured portion of the debt, further decreasing the plan's feasibility.

Opinion, at *18.

 Finally, the Court rejected the IRS's argument that payments made in bankruptcy proceedings could never be considered to be voluntary.   It noted that the Supreme Court rejected this position in Energy Resources and there was no basis for limiting the case to its facts.   The Court found that chapter 13 itself was a voluntary process and that the case involved the voluntary sale of exempt property.   As a result, the Court found that the payment was voluntary and could be designated by the Debtors.

The Court's 28-page opinion is very thorough which makes at times for difficult reading.  It has a lot of good discussion of bankruptcy policy in general and chapter 13 in particular.  The main lessons that I picked up are that:   1) it is possible to use chapter 13 creatively and 2) it pays to dust off old precedents you haven't thought about in a while.   

Debtor Wins Big Damages in Fraudulent Conveyance Case

When fraudulent transfer claims arise in bankruptcy, the debtor is usually accused of being the dishonest transferor. However, in a recent case from Chief U.S. Bankruptcy Judge Ronald King, the Debtor successfully pursued a claim against her disbarred ex-husband. Galaz v. Galaz, Adv. No. 08-5043 (Bankr. W.D. Tex. 11/12/10). The opinion can be found here.

A Tangled Procedural Web

The procedural context of the case is incredibly complex (but fortunately is not necessary to understand the 14 page opinion). Denise Vernon sued Lisa Galaz in a dispute over a company called Worldwide Subsidy Group, LLC. Lisa then filed chapter 13. Both Denise and Lisa's ex-husband Raul filed non-dischargeability complaints against Lisa. Lisa removed Denise's action to bankruptcy court. Lisa then sued Raul as a third party defendant relating to the WSG transactions. While this action was pending, Lisa also sued Raul, his father Alfredo and their company Segundo Suenos, LLC for transactions arising out of another company called Artists Rights Foundation, LLC ("ARF"). After mediation, Denise and Lisa settled their claims and those disputes were dismissed. Raul then tried to force Lisa to join Julian James, the other member of ARF. Instead, the Court allowed Raul to file a third party claim against Julian. Julian filed a claim against Raul. Thus, by the time the case went to trial, Lisa and Julian were asserting claims against Raul, Alfredo and Segundo Suenos, who asserted claims back against them.

The Underlying Facts

So what gave rise to all these dead trees? It all had to do with the right to collect royalties from the popular funk and soul group The Ohio Players. Raul and Julian formed ARF to collect royalties relating to The Ohio Players. When Raul and Lisa were divorced, Lisa was awarded 1/2 of Raul's interest in ARF. Raul then sent a notice to Julian seeking to remove him as a member due to failure to pay expenses related to ARF (including legal fees charged by Raul after he was disbarred as a California attorney). Raul sent this notice to the address designated in the LLC agreement even though he knew that Julian would not receive this notice. Raul then unilaterally conveyed the assets of ARF to Segundo Suenos, LLC and dissolved ARF.

The Issues

The issues at trial were:

1. Was the transfer from ARF to Segundo Suenos, LLC void for failure to be authorized by the company?
2. Was Raul collaterally estopped to deny the invalidity of the transaction?
3. Was the transfer a fraudulent conveyance?
4. Did Raul breach his fiduciary duty to Lisa and Julian?

A Short Course in LLC Law

The Court's ruling highlights the intricacies of limited liability company law. Under the LLC agreement, Raul and Julian were the members of the company. The divorce decree awarded Lisa 1/2 of Raul's interest. Under the LLC agreement, assignees were deemed to hold an "economic interest" in the LLC but would not be members unless agreed to by all of the members. By signing off on the Divorce Decree, Raul agreed to allow Lisa to be a member. However, Julian did not. As a result, Lisa held an "economic interest" but was not entitled to vote. Under the LLC agreement, if a member failed to respond to a written request for capital contributions within 10 days, his interest could be converted into an "economic interest." Raul sent a notice to Julian at the address specified in the LLC agreement and Julian did not respond. However, this was not surprising, since Raul knew that Julian would not receive a notice sent to this address.

Raul contended that he had carte blanche to convey the ARF assets because he was the only voting member. He contended that Lisa was never a member and that Julian ceased being a member by virtue of the notice. The Court held that he was half right. As an assignee, Lisa did not have the right to participate in management due to Julian's failure to approve her as a member. However, the notice sent to Julian was not sufficient to take away his vote because it did not identify any specific expenses to pay and was not received by him to boot. Thus, the transfer was not authorized.

The Court also found that Raul was bound by a California Court of Appeals opinion finding that Segundos Sueno had not established its entitlement to the Ohio Players royalties and found that the case contained sufficient badges of fraud to constitute a fraudulent transfer.

Relying on California law, the Court found that members of an LLC owed a fiduciary duty to each other, but not to persons holding an "economic interest" in the company. The California LLC statute expressly adopted the fiduciary standard applicable between general partners which did not reach assignees. As a result, Julian could recover for breach of fiduciary duty but Lisa could not. However, the Court ruled that Lisa and Julian could recover from Raul for fraud.

The Damages

Lisa was awarded actual damages of $250,000 and punitive damages of $250,000, while Julian recovered actual damages of $500,000 and punitive damages of $500,000. The Court ruled that the royalties would vest 50% in Julian, 25% in Raul and 25% in Lisa. It also ruled that Lisa and Julian could collect their damages out of Raul's share.

What Does This Mean for the Chapter 13?

One goal of BAPCPA was to expedite confirmation of chapter 13 plans. This case illustrates that there are some cases that just don't fit that mold. When the case was filed the Debtor scheduled her interest in WSG at $0 and did not list her interest in ARF. If the case had been confirmed at that time based on the facts known at that time, the Debtor would have been required to make a very low distribution to creditors.

However, apparently as the result of the extensive amounts recovered from litigation in the case, the Court ordered the Debtor to pay $200,000 to unsecured creditors plus amounts paid to secured creditors and attorneys. Since the Debtor is already required to effectively pay 100% to unsecured creditors, the recovery from Raul would not appear to increase her obligation to creditors except for one important point. The Debtor was required to make her payment to unsecured creditors in addition to her payments to attorneys. Since the attorney's fees required to litigate the matter were substantial (the court has already approved over $75,000 in fees), the cost to recover the asset is borne directly by the Debtor. It seems a cruel twist of fate that the harder the Debtor and her attorneys had to work to recover funds for the creditors, the more the Debtor is required to pay.

What Does It All Mean?

On one level, this is a case about California LLC law and the difference between a member and the holder of an economic interest. However, on a big picture basis, it is a testament to the perils of dealing with a case involving an ex-spouse and assets that could only be recovered through litigation. When the Debtor's counsel took this case, he most likely did not contemplate that a chapter 13 bankruptcy in San Antonio would generate 418 docket entries in the main case alone. The result of the hard work by Debtor's counsel and Special Counsel is that unsecured creditors will get paid in full.

Fifth Circuit Finds Bad Faith Exception to Absolute Right to Dismiss Chapter 13 Case

In a decision extending the reach of Marrama v. Citizens Bank of Massachusetts, the Fifth Circuit has concluded that a debtor's absolute right to dismiss a chapter 13 petition is subject to an exception for bad faith. Matter of Jacobsen, No. 09-40023 (5th Cir. 6/16/10).

The debtor in the Jacobsen case was a real estate broker who filed for chapter 13 relief after being sued for large amounts of money. His wife, who was born in Afghanistan and spoke little English,was not a party to the bankruptcy. After investigation by the Chapter 13 trustee determined that the non-filing spouse owned substantial properties acquired during marriage which were not listed on the debtor's schedules, he moved to convert the case to chapter 7. The debtor moved to dismiss. The Bankruptcy Court ruled that notwithstanding the absolute right to dismiss under Sec. 1307(b) that the court could deny the motion based on bad faith.

The Fifth Circuit was asked to decide whether the Marrama decision could be extended from its original context, the right to convert a chapter 7 case to chapter 13, to the right to dismiss a chapter 13 case. While Marrama seemed to establish a generally applicable principal, Texas Bankruptcy Courts had split on whether it applied to the right to dismiss a chapter 13 petition.

The Fifth Circuit held that:

Following the Supreme Court’s decision in Marrama, we hold that a bankruptcy court has the discretion to grant a pending motion to convert for cause under § 1307(c) where the debtor has acted in bad faith or abused the bankruptcy process and requested dismissal under § 1307(b) in response to the motion to convert. In doing so, we join the Ninth Circuit 15 in finding that Marrama’s “rejection of the ‘absolute right’ theory as to § 706(a) applies equally to § 1307(b)” because “there is no analytical distinction” between the two statutes. In re Rosson, 545 F.3d at 773. We thereby reject a construction of the statute that would afford an abusive debtor an escape hatch, and we sanction the limited exception that lower courts within our boundaries have accorded the statute for nearly two decades.

Opinion, at 20.

The only surprise here is that the Fifth Circuit followed the Ninth Circuit.

Debtor Gets Mortgage Claim Denied. Now What?

I am in New York for the Commercial Law League conference, so it is appropriate to blog about a case from the Southern District of New York. While the Southern District of New York is known for its multi-billion dollar cases, a recent case highlights a consumer issue faced by courts nationwide. In (Name Withheld by Request), Case No. 09-22261 (Bankr. S.D. N.Y. 9/29/09), the Debtor's lawyer became frustrated with inconsistent information received from a mortgage servicer and filed an objection to claim. The mortgage servicer's submissions raised more questions, leading to denial of the claim. However, the bigger question is what denial of the claim means for the debtor.

A Proof of Claim Walks Into A Bankruptcy

In this chapter 13 case, PHH Mortgage filed a proof of claim on the debtor’s mortgage. PHH stated that it was the secured creditor. The proof of claim attached the following documents:

(a) a one-page itemization;
(b) pages 9 through 16 of a document identified as New York--Single Family . . . Fannie Mae/Freddie Mac UNIFORM INSTRUMENT MERS;
(c) a 4 page Fixed/Adjustable Rate Rider; and
(d) 16 pages out of a 24 page mortgage showing MERS as mortgage holder and Mortgage World Bankers, Inc. as lender.

In response to an inquiry from the Debtor’s attorney, PHH stated that it was the servicer and that US Bank as trustee for a securitization trust was the actual creditor. This was the first problem. The person who filed the claim was not the holder of the claim, but the agent for an undislosed principal.

The Debtor objected to the claim, arguing that the servicer lacked standing to file the claim and that the proof of claim did not demonstrate a complete chain of title from the originator to the securitization trust.

The Creditor Digs Itself In Deeper

In response to the objection, PHH Mortgage filed an affirmation of counsel, an affidavit and a memorandum of law. These documents created more problems for the purported creditor. The affirmation of counsel attached an Assignment of Mortgage from MERS to US Bank. The document was executed by Tracy Johnson as Assistant Vice-President of MERS. (MERS is Mortgage Electronic Recording Service, which exists to serve as a nominee for mortgage holders and allow mortgages to be transferred without the necessity of a formal assignment. In other words, MERS acts as nominee of whoever holds the mortgage.). It also included a power of attorney authorizing PHH to act on behalf of US Bank. The second affidavit was signed by Tracy Johnson, this time as Assistant Vice-President of PHH.

The Memorandum of Law stated that:

The ownership of the Note and Mortgage were subsequently transferred to US Bank. An Assignment of Mortgage was not executed at the time of the transfer. PHH intends to submit documentation to show that US Bank now has the beneficial interest in the Note and Mortgage by virtue of the pre-existing transfer of this loan. In addition, the documentation will demonstrate that PHH is still authorized to file the Proof of Claim as the loan servicing agent for US Bank.

Memorandum, p. 3.

Unfortunately, PHH did not obtain the documentation. The following exchange took place at the hearing on the claims objection:

THE COURT: . . . what is the evidence of the transfer of the mortgage to US Bank?

MR. ______: All I have is PHH’s representations, Judge.

THE COURT: By the woman who also appears to be working for MERS and who isn’t here.

Transcript, pp. 15-16.

The Ruling

In the end, the Court expunged the claim. The Court’s findings are summarized as follows:

1) The documentation attached to the claim was incomplete and did not identify the holder of the note. Recall that the claim included pages 9 through 16 from one document and 16 pages out of 24 pages of another. The Court this selective attachment of partial documents to be suspicious, since the omitted pages would have identified the holder of the debt. As a result, the Court found that the claim was not entitled to prima facie validity.

2) The Court did not accept the affiant as a custodian of records, apparently due to the fact that the same person claimed to be custodian of records for two different entities and because the affidavit was contradictory.

3) The Note contained a stamp indicating that it was transferred from the securitization trust to the servicer, PHH. As the court stated, "To my knowledge of how these securitized mortgage nonte/trusts are structured, it doesn't make sense and it's not explained anywhere in the affdavit as to how it would make sense that it would be transferred to the servicer of the trust, the note would be transferred to the servicer of the trust. That's an odd thing for me to accept." Transcript, p. 24.

4) There was no evidence of assignment of the mortgage to the purported creditor other than the uncorroborated statement of the servicer.

As a result, the Court stated:

You know what, what I will say is this, the owner of the mortgage as far as I can see and the owner of the note has not filed a proof of claim in the case. That’s what I’ve found. Someone filed a proof of claim who’s not been able to establish that they hold the note and the mortgage.

Transcript, pp. 24-25.

What Does This Mean?

Consider what this means. There is someone somewhere who holds a mortgage upon the debtor’s home. That person is not the person who filed the claim. As a result, the true creditor is somewhere outside of the bankruptcy case. A secured creditor can choose to remain outside of the bankruptcy process, in which case the lien will ride through unaffected. The real creditor may appear at some point and ask to lift the stay. If not, at the end of the case, the debtor will receive a discharge from her personal liability but will still be subject to the lien. Of course, if the creditor is never able to prove up its paperwork, then at some point, the lien would be barred by limitations.

Ignoring What We Know To Be True

This leads to the second important point. Complete, consistent documentation matters. The claim was expunged based on incomplete documentation which failed to identify the holder of the note and the mortgage. The affidavits submitted compounded the problem because the same person claimed to be custodian of records for two different entities. The lawyer for PHH forthrightly acknowledged the problem when he stated:

I agree with you, Judge. I think that the reality is that . . . we’re ignoring what we know to be true because we can’t get our hands on the documents.

Transcript,pp. 16-17.

That is a powerful admission. If the creditor’s lawyer cannot get his hands on the documents, where are they? This case started with an originator who advanced actual money which allowed the debtor to purchase a home. For years prior to bankruptcy, the debtor made payments to a servicer. These payments were accepted. The debtor received statements of account. There was never a question raised as to whether the right person was being paid. It was only when the bankruptcy case was filed that questions were raised about proper paperwork.

This raises an interesting question. Was the right person being paid prior to bankruptcy? One possibility is that PHH’s lawyer is correct and that “we’re ignoring what we know to be true because we can’t get our hands on the documents.” The other possibility is that somewhere along the line, there has been a disconnect between the party entitled to payment and the party receiving payment. In this instance, the aggrieved party would be the true holder of the note and mortgage. If the phantom real holder doesn’t complain that its funds are being diverted, what is the debtor’s right to complain? If the debtor’s loan has been lost somewhere in a securitization black hole, does that mean that the debtor gets a free house? This case points out a difficult tension between acknowledging “what we know to be true” and putting the creditor to its proof.