Fifth Circuit Report: April-May 2015

At the same time that the Supreme Court was busy ruling upon its bankruptcy cases for the term, the Fifth Circuit was active as well.  There were so many cases in April, that it took me two months to summarize them.    Over the course of April and May, the Court decided no less than sixteen cases with bankruptcy implications.   These include cases relating to civil contempt, post-judgment remedies being granted pre-judgment, the conclusion of the BPRE case and important opinions on property of the estate, attorney’s fees, discharge and dischargeability.  There are also four cases involving disputes between homeowners and lenders, including two where the homeowner’s claim was revived on appeal.   There is enough substance here, including in the unpublished opinions, to keep a lot of lawyers and judges reading for a long time.

From Bankruptcy Trustee to Orthodox Priest

As a bankruptcy lawyer and trustee, Ronald Ingalls helped troubled debtors absolve their financial sins. As Father Methodios Ronald Ingalls, he will now be able to deal with sins of a broader nature. Today, on January 6, 2011, Ronald Ingalls was ordained to the Holy Priesthood of the Antiochian Orthodox Church. His story is one that shows that the distance between the sacred and the secular is often smaller than we imagine.

For Ron Ingalls, his sacred/legal journey began as he entered law school in 1985. It was at this time that he converted to the Orthodox faith. As a result, there was a strong connection between the law and Orthodoxy in his personal life.

He drew a parallel between his legal and priestly studies. He that, "It's not about you. It's about the client. Now I have the most important client of all."

He graduated from the University of Texas Law School in 1988, served as a law clerk to Judge Glen Ayers, and became a chapter 7 panel trustee in 1994. As a trustee, he administered cases ranging from the missing atheist Madalyn Murray O'Hair to bankrupt developer Gary Bradley.

He also drew parallels between his service as a trustee and a priest. He noted that in both instances, he was commissioned to act on behalf of someone who was not physically present. He also drew the parallel of trying to salvage something for everyone else.

Ron's ordination was a moving three hour service. For those not familiar with the Orthodox Church, it involved a lot of solemn ritual. The service took place on Theophany, which means appearance of God. The service remembers the baptism of Jesus by John and the holy spirit appearing in the shape of a dove. The service included hymns in Greek, Romanian and Arabic. It also included the blessing of the holy water. Shortly after the service, the Bishop and clergy went to bless Barton Springs.

Ron will return for a final semester in seminary and then will spend a year in a mission congregation in Fredericksburg.

Godspeed.

Fifth Circuit Muddles Judicial Estoppel; En Banc Review Needed

In a new opinion, the Fifth Circuit has taken a big step backward in sorting out the doctrine of judicial estoppel. Reed v. City of Arlington, No. 08-11098 (5th Cir. 9/16/10). While adopting the principle that one panel of the Fifth Circuit cannot overrule another one, the opinion appears to be inconsistent with the Fifth Circuit's most recent prior ruling on judicial estoppel, thus indicating the need for en banc review. The opinion can be found here.

Two Wrongs and Two Rights Make a Mess

The first wrong in this case originated with the City of Arlington. It violated the Family Medical Leave Act with regard to Kim Lubke, a former firefighter. Lubke obtained a one million dollar judgment against the City.

A year later, while the judgment was on appeal, Lubke filed chapter 7. He forgot that he had a valuable judgment and apparently omitted a number of other assets as well. The Trustee closed the case as a no-asset filing.

The Fifth Circuit remanded the case for recalculation of damages. Subsequent to the remand, the City offered to enter into a Rule 68 judgment for $580,000. In discussing this offer with his client, the Debtor's non-bankruptcy attorney, Roger Hurlbut first learned about the bankruptcy. He promptly informed the Trustee's counsel. The Debtor and the Trustee successfully reopened the bankruptcy case and the Trustee sought to be substituted as plaintiff. The Debtor also agreed to have his discharge vacated.

Let's recap who behaved well and who behaved badly at this point:

The City of Arlington behaved badly when it violated the FMLA.

The Debtor behaved badly when he lied on his schedules.

The Debtor's nonbankruptcy lawyer performed blamelessly, representing the Debtor competently in the FMLA action and promptly notifying the Bankruptcy Trustee once he learned upon the bankruptcy.

The Bankruptcy Trustee did what she was supposed to do by moving promptly to reopen the bankruptcy case and pursue the litigation.

So at this point, we have two wrongs and two rights. For their part, the creditors did nothing wrong.

The District Court Tries to Follow the Fifth Circuit

The District Court considered the issue of judicial estoppel. After considering the Fifth Circuit's conflicting precedents on judicial estoppel, it found that the Debtor was subject to judicial estoppel. However, it found that the Trustee and the creditors should not be punished for the Debtor's wrongdoing. It allowed the Trustee to proceed with the case, but provided that once creditors were paid, any excess funds would go back to the City of Arlington rather than to the Debtor. Had the District Court been affirmed, the bad would have been punished and the blameless would not.

However, the Fifth Circuit chose not to affirm the District Court.

The Law of Judicial Estoppel

The Supreme Court has fashioned a three pronged test for whether judicial estoppel should apply:

(1) whether a party's later position is clearly inconsistent with its position in a prior case; (2) whether the party succeeded in persuading the first court to accept its position, creating “the perception that either the first or the second court was misled;”and (3) whether the party espousing the inconsistency has gained an unfair advantage or imposed an unfair detriment on an opposing party by that means.

City of Arlington v. Reed, slip op., p. 5, discussing New Hampshire v. Maine, 532 U.S. 742 (2001).

Prior to Reed, the Fifth Circuit had completed a trilogy of cases on judicial estoppel in bankruptcy.

The first of the recent Fifth Circuit cases was In re Coastal Plains, Inc., 179 F.3d 197 (5th Cir. 1999). In that case, the Debtor’s CEO formed a company which acquired the assets of the debtor corporation. The insider purchaser then filed suit on a claim which had not been disclosed in the schedules. The purchaser recovered $3.6 million on the undisclosed claim. The Fifth Circuit reversed on appeal, finding that accepting the argument that the claims were inadvertently left off the schedules “would encourage bankruptcy debtors to conceal claims, write off debts, and then sue on undisclosed claims and possibly recover windfalls.” In re Coastal Plains at 213.

Next came In re Superior Crewboats, 374 F. 330 (5th Cir. 2004). In that case, it was the debtor who was estopped. In that case, one of the debtors was injured prior to bankruptcy. During their chapter 13 case, they filed suit on a claim which was not listed in their schedules. After their case was converted to chapter 7, the debtors told the trustee about their claim, but represented that it was barred by limitations. As a result, the trustee abandoned the claim which the debtors continued to pursue. When the trustee learned about the case, he attempted to substitute in. However, the court granted summary judgment for the defendant.

The third component of the trilogy was Kane v. Nat’l Union Fire Ins. Co., 535 F.3d 380, 384 (5th Cir. 2008). That case looked a bit like Superior Crewboats, but with one major distinction. In Kane, the Debtor failed to disclose a claim. However, the Trustee did not abandon the claim. Instead, once the Trustee learned of the deception, the Trustee sought to pursue the claim on behalf of the creditors. The District Court granted summary judgment, relying on Superior Crewboats. However, the Fifth Circuit said not so fast. In its opinion, it stated:

There, because the trustee had abandoned the claim, he was not the real party in interest and was not entitled to be substituted as such. Rather, following the trustee’s abandonment, the interest in the claim had reverted to the debtors,who stood to collect a windfall from the asset at the expense of the creditors. In the case before us, the Kanes’ personal injury claim became an asset of their bankruptcy estate when they filed their Chapter 7 petition. The Trustee became the real party in interest in the Kanes’ lawsuit at that point and never abandoned his interest therein.

The Fifth Circuit noted that the Kane case did not present any equitable concerns. Indeed, the creditors would be harmed if judicial estoppel was applied to preclude the trustee from pursuing the claims. The court quoted from a great Seventh Circuit opinion which made the obvious point:

[The debtor’s] nondisclosure in bankruptcy harmed his creditors by hiding assets from them. Using this same nondisclosure to wipe out [the debtor’s claim against the defendant] would complete the job by denying creditors even the right to seek some share of the recovery. Yet the creditors have not contradicted themselves in court. They were not aware of what [the debtor] was doing behind their backs. Creditors gypped by [the debtor’s] maneuver are hurt a second time by the district judge’s decision. Judicial estoppel is an equitable doctrine and using it to land another blow on the victims of bankruptcy fraud is not an equitable application.

Kane, quoting Biesek v. Soo Line R.R. Co., 440 F.3d 410, 413 (7th Cir. 2006).

The Fifth Circuit's Ruling in Reed

Given that Reed and Kane involved nearly identical circumstances, the Trustee could have reasonably expected a similar result. However, that was not to be.

The Court acknowledged that its precedents might be a bit hard to follow. However, it insisted that it was necessary to disregard Kane and follow Coastal Plains and Superior Crewboats. Writing for the panel, Chief Judge Edith Jones stated:

What are the bankruptcy courts, which confront these problems regularly in our circuit, to make of these decisions? The grounds on which Kane distinguished In re Coastal Plains are that, in In re Coastal Plains, a corporate officer's misdeeds detrimentally influenced the corporate reorganization process as well as depriving creditors of the concealed cause of action. Id. Kane purports to distinguish In re Superior Crewboats, moreover, based on the differing procedural consequences between a trustee's abandonment of a claim (to the debtor) and the non-disclosure of assets that are not administered although still within the debtor's estate. Id. at 386-87. Whether these distinctions are correct in principle or on the facts are matters for another debate. Absent en banc harmonization, we must endeavor to reconcile the authorities. We are also guided by the principle that one panel of this court cannot overrule another panel decision. (citation omitted). Thus, judicial estoppel remains applicable to litigation claims that are undisclosed in bankruptcy, and the doctrine's essential ingredients remain the same.

Reed at 7 (emphasis added). When one judge within the circuit contends that an opinion by another panel "purports" to distinguish a prior precedent, these are very strong words. Why does Judge Jones believe that the per curiam opinion from Judges King, Wiener and Elrod merely "purports" to distinguish the prior precedent?

Judge Jones makes it seem as though it were a mere procedural distinction, the difference between abandonment and non-abandonment. However, it rests on something much more substantive. In order for judicial estoppel to apply, the case must involve the same parties. The trustee is not the same party as the debtor. Therefore, judicial estoppel should NEVER apply to the trustee based on the Debtor's actions.

However, Judge Jones believes that the distinction between the trustee and the debtor is inconsequential. She writes:

(I)t is not sufficient to distinguish the debtor’s conduct from that of the trustee in applying judicial estoppel. Even though Reed herself takes no inconsistent legal positions, she succeeds to the debtor’s claim with all its attributes, including the potential for judicial estoppel.

Reed, at 7. Judge Jones does not provide any further analysis as to why the Trustee is bound by the Debtor's actions. Since this was the primary focus of the Kane opinion, a little more explanation would have been helpful.

While Judge Jones's statement is true in the abstract, it is disingenuous in the specific case. A trustee succeeds to the debtor's rights as of the petition date. Thus, a trustee would be bound by the fact that the debtor did not preserve his cause of action by filing suit within the period allowed by the statute of limitations. A trustee would also be bound if the debtor had settled the case on an arms length basis and squandered the proceeds before filing bankruptcy.

However, the facts constituting judicial estoppel do not exist on the petition date. Even if the debtor filed the false schedules with the bankruptcy petition, the element of receiving a benefit from the inconsistent position cannot occur until after the petition date.

When a debtor files bankruptcy, all of his legal rights become property of the estate under Section 541. The Trustee is the representative of the Estate. Therefore, if the claim had not been invalidated as of the petition date, the Trustee has the right to pursue it. When the Trustee closes a case, any properly scheduled assets which are not administered revert to the Debtor. However, undisclosed assets remain property of the estate subject to future administration by the Trustee. Since judicial estoppel cannot arise until after the bankruptcy filing and the Debtor is not the representative of the estate and the undisclosed asset never reverts to the Debtor, it should be clear that the Debtor cannot prejudice the rights of the Trustee subsequent to the petition.

This should be pretty obvious. However, the court dismissed it with one sentence and no further elucidation.

Judge Jones offers an alternate explanation of how judicial estoppel works. She writes:

The lowest common denominator appears to lie in a holistic, fact-specific consideration of each claim of judicial estoppel that arises from litigation claims undisclosed to a bankruptcy court.

Reed, at 6.

The Court then went on to find that the equities favored the City of Arlington.

The creditors are not materially advantaged if this case proceeds further. Only about one-sixth of the original creditors (reckoned in amount of claims) timely refiled when the case was re-opened a year after they were informed there were no non-exempt assets to distribute. See supra note 2. The untimely filers have little if any hope of recovery from the bankruptcy estate; the timely filers' recovery will be contingent on the payment of large priority administrative expenses caused by the ongoing litigation. True, Lubke agreed to revoke his discharge, but most creditors will have foregone alternative collection strategies at this point. The rincipal remaining bankruptcy “claimants” are Reed herself and Lubke's trial attorney Roger Hurlbut, who has already received from Lubke some payment for his services. Reed’s claim has been substantially increased because of this judicial estoppel litigation. Here, equity does not favor ignoring Lubke’s misuse of the court system for the primary benefit of attorneys.

Reed, at 8.

Equity is like pornography in that a person should be able to know it when they see it. Here, the court's view of equity is that the City of Arlington should be excused from liability for its wrongdoing because many of the creditors did not file timely claims and because the benefit of the case might go to attorneys.

Let's analyze the relative rights and wrongs here. The creditors who filed timely claims did not do anything wrong. However, under the Court's opinion, they will not stand any chance of recovery. The Debtor's nonbankruptcy attorney did everything right. However, he will lose out on the vast majority of his compensation. The Trustee did everything right. However, she will not receive any compensation. Indeed, the Debtor's nonbankruptcy attorney and the Trustee are placed in a suspect class because they are attorneys (just like the judge who wrote the opinion). The most charitable thing which can be said about the court's equitable analysis is that it is not obvious when you see it.

The Need for En Banc Review

The opinion in Reed was justified by the fact that one panel of the circuit cannot overrule another one absent en banc review. Judge Jones believes that the Kane court overruled Superior Crewboats and that its opinion should not be respected. An equally valid argument can be made that Reed overrules Kane. Of the four Fifth Circuit opinions dealing with judicial estoppel in the bankruptcy context, only two involved claims asserted by trustees. Those two opinions are diametrically opposed. This is a case where the en banc court needs to step in and resolve the inconsistency.

Integrity and Incentives

The en banc court should also consider whether this ruling promotes or hinders the integrity of the bankruptcy system and the larger federal court system. The integrity of the bankruptcy system is policed by multiple parties. At the outset, it depends upon the honesty of the debtor and the professionalism and ethics of the debtor's counsel. It also depends upon the trustee, creditors and the U.S. Trustee to ferret out wrongdoing.

Under Reed, the Debtor is given a perverse incentive to dishonesty. If the Debtor commits fraud and does not get caught, he keeps the benefits of his wrongdoing. If the Debtor commits fraud and does get caught, he has no opportunity to mitigate the damage. While there is no excuse for dishonesty, the Kane opinion gives the ethically wavering debtor the opportunity to make amends, while Reed does not.

The Reed opinion also removes the incentive for Debtor's counsel to bring fraud to light. The real hero in this case is Roger Hurlbut, the Debtor's nonbankruptcy counsel. When he learned about his client's omission, he immediately brought it to the Trustee's attention. His reward for displaying high ethics is that he loses the fee that he had earned. A less ethical lawyer knowing the penalty for disclosure might have been tempted to keep his mouth shut.

The Trustee also is deprived of any incentive to go after undisclosed assets. If the Trustee learns of an undisclosed asset which is being stealthily being pursued by the Debtor, the Trustee will have little motive to go after it. Trustees get paid on a commission. They succeed if the creditors succeed. However, under Reed, the diligent Trustee gets nothing for her effort. Indeed, the fact that she is a lawyer is cited as a reason why it would be inequitable to allow the case to proceed.

Finally, in the context of the larger federal court system, wrongdoers are given an opportunity to escape responsibility. Congress passed the FMLA because it beileved that its policies served an important goal in society. The City of Arlington apparently flouted those policies. The City was ready to settle until it learned that it had an out. What incentive does the City have to change its ways under this decision?

Here is what should happen in the case of an undisclosed asset. First, the parties to the case should have an incentive to discover the fraud and bring it to the trustee's attention. Second, the trustee should be given the first opportunity to pursue the claim. If the trustee does not elect to pursue the claim, then judicial estoppel should apply as to the debtor and the claim should be dismissed. However, if the trustee elects to pursue the claim, the alleged wrongdoer is in no worse position and may even be in a better position. As a fiduciary for the benefit of the creditors, the trustee may be willing to cut a better deal with the defendant so as to minimize the risk and delay to the creditors.

Hat Tip to Steve Roberts and St. Clair Newbern.

UPDATE: The Commercial Law League of America has submitted an amicus brief in support of the Trustee's motion for rehearing en banc. You can read it here.

Trustee Held Liable for Failure to Remit Sales Taxes

Failure to remit trust fund taxes is a common cause of bankruptcy and personal liability for the owners of a business. Far less common is the case of a bankruptcy trustee held responsible for the same violation. However, that is what happened in the case of Texas Comptroller of Public Accounts v. Liuzza, No. 09-50544 (5th Cir. 7/6/10). The opinion can be found here.

The case arose out of the bankruptcy of Texas Pig Stands, described by the court as a "venerable San Antonio restaurant company." Despite its venerable status, it wound up in chapter 11. The court appointed a chapter 11 trustee after the debtor failed to remit post-petition sales taxes to the Comptroller. Then the chapter 11 trustee failed to remit the taxes. The court confirmed a plan which required the trustee to pay all delinquent post-petition taxes on the effective date of the plan and to remain current on the sales taxes. The trustee did neither. Shortly thereafter, the Comptroller froze the company's bank accounts and revoked its sales tax permit, after which the case was converted to chapter 7.

The Comptroller brought an adversary proceeding seeking to hold the trustee liable for the taxes. The Bankruptcy Court ruled that the trust agreement limited the trustee's liability to gross negligence and ruled against the Comptroller. The District Court reversed. The Fifth Circuit agreed with the District Court that the trustee was liable.

The Court found that the trustee was personally liable for the taxes under state law. However, it also found that if the confirmed plan of reorganization protected the trustee from liability, this would override state law. The Court stated:

The Comptroller is bound to any liability limitations imposed by the Plan, which included the Trust Agreement. The Plan and Trust Agreement are contracts that must be read in their entirety to be given full meaning. (citation omitted). Further, under the governing law of Texas, "exculpatory clauses are strictly construed, and the trustee is relieved of liability only to the extent to which it is clearly provided that he shall be excused."

Opinion, p. 8.

The Trust had inconsistent provisions. On the one hand, it stated that "persons dealing with the Trustee in matters relating to the Trustee have recourse only against the Trust Assets to satisfy any liability incurred by the Trustee to such person in carrying out the terms of this Agreement or the Plan, and the Trustee shall have no personal or individual obligation to satisfy such obligation. . . ." However, the Trust Agreement also provided that "Except in the case of fraud, willful misconduct or gross negligence, the Trustee shall not be liable for any loss or damage by reason of any action taken or omitted by him pursuant to the discretion, power and authority conferred on him by this Agreement or the Plan." Reading the two provisions together, the Court found that the Trustee had no personal liability so long as he followed the plan and did not commit fraud or willful misconduct. The Court concluded:

Luizza exceeded his authority, violated the Plan, and committed willful misconduct. Accordingly the Trust Agreement does not limit his liability.

Opinion, p. 9.

There are two lessons here.

The first is that entrepreneurs and fiduciaries occupy much different realms. Entrepreneurs take big risks in the hope of big gains. Occasionally it might make rational sense for an entrepreneur to gamble on not paying trust fund taxes in the hope of preserving the enterprise(although usually not). However, fiduciaries don't get paid extra to take risks. Therefore, it will never make sense for a fiduciary to incur personal liability in the hope of making the case work.

Second, this was not a case where better drafting could have saved the day. While the fatal language was probably boilerplate carried over from another document, it would be hard to draft around this problem. The exculpatory provision of the trust document contained exceptions for fraud, willful misconduct and gross negligence. It also limited the exculpatory provision to actions taken "pursuant to the discretion, power and authority conferred on him by this Agreement or the Plan." Thus, the Court was able to find liability because failure to pay the taxes was not authorized by the plan and constituted willful misconduct. It would have been a closer case if the trust had simply stated that the Trustee would not be liable absent fraud or gross negligence or even limited it to just fraud. However, the more broadly the exculpatory provision is drafted, the more likely it would be to draw objection. Further, in order to avoid the problem, the trust's drafters would have to have contemplated that the trustee would continue to misappropriate trust funds. If that were the case, they should not have supported him for trustee.

This is a harsh result for a trustee who received no personal benefit and thought he was doing the right thing for the estate. However, it is often said that insanity is doing the same thing over and over and expecting a different result. In this case, both the debtor in possession and the chapter 11 trustee failed to remit taxes. When this happened, the Comptroller became upset and demanded relief from the Bankruptcy Court. Thus, a reasonable person would have been on notice that continued failure to pay the taxes could lead to bad results. Bankruptcy is a court of second, third and fourth chances. However, eventually the chances run out, even for a trustee.

Supreme Court Rules for Trustee in Exemption Dispute

The Supreme Court ruled today that when claiming Federal Exemptions, the Debtor is entitled to the dollar amount claimed rather than the actual property. As a result, a trustee could sell property claimed by the debtor as exempt where it proved to be more valuable than the amount claimed by the debtor. Schwab v. Reilly, 560 U.S. ___ (6/17/10).

The majority opinion was written by Justice Thomas and joined by Justices Stevens, Scalia, Kennedy, Alito and Sotomayor. Justice Ginsberg wrote a dissent which was joined by Chief Justice Roberts and Justice Breyer. This was another case of strange judicial bedfellows as conservative and liberal justices signed on to both opinions. The competing opinions each parsed the legislative language to arrive at their conclusions.

What Happened

Nadejda Reilly filed a petition for chapter 7 and claimed equipment from her catering business as exempt. She valued the property at $10,718. She claimed an exemption of $1,850 for tools of the trade under Sec. 522(d)(6) and $8,868 under the wildcard exemption under Sec. 522(d)(5). Thus, the debtor claimed the entire scheduled value as exempt. During the time for filing objections to exemptions, the Trustee obtained an appraisal valuing the equipment at $17,200. However, the Trustee did not object. Instead, the Trustee subsequently filed a motion to auction off the equipment and pay the Debtor the amount claimed as exempt.

The Trustee's request was rebuffed by the Bankruptcy Court, the District Court and the Third Circuit, but not the Supreme Court.

The Statutory Language

Both the majority and the dissent focus on the language of Sec. 522(l) which states that "Unless a party in interest objects, the property claimed on such list is exempt." However, they disagreed about what "the property claimed on such list" referred to.

The dissent contended that "the property claimed on such list" referred to the actual items listed on Schedule C and that when a Debtor claimed the full value as exempt, that the property would be exempt absent a timely objection.

The majority required several more steps to parse the language.

1. Section 522(l) allows the debtor to "file a list of property that the debtor claims as exempt under subsection b of this section."

2. Section 522(b) allows the debtor to claim property exempt under state law or other applicable law or under Section 522(d).

3. If the Debtor claims Federal Exemptions under Section 522(d), the exemptions in Sec. 522(d)(1)-(8) and 11(C) are defined in terms of "the debtor's aggregate interest, not to exceed $____ in value." On the other hand, the exemptions in Sec. 522(d)(9), (10), (11)(A)-(C) and 12 are not defined in terms of value.

4. If the Debtor claims a value limited exemption, the Debtor's exemption is in the value, not the property.

5. So long as the Debtor claims a dollar amount which is within the statutory limits, the Trustee is not required to object, because the Debtor has claimed a value allowed by law and only the value.

The majority rejected the Third Circuit's contention that "an unstated premise" of Taylor v. Freeland & Kronz was that a debtor who claims the full value of an item of property claims the property itself.

What It Means

In her dissent, Justice Ginsberg stated that:

In addition to departing from the prevailing understanding and practice, the Court's decision exposes debtors to protracted uncertainty concerning their right to to retain exempt property, thereby impeding the "fresh start" exemptions are designed to foster.

While the majority claims that its decision did not do violence to its prior holding in Taylor v. Freeland & Kronz, the practical problems are clear.

Under Section 541 of the Bankruptcy Code, all of the debtor's interests in property enter the estate. Under Section 522(b)and(l), property successfully claimed as exempt is no longer property of the estate. However, if the exemption applies to property subject to a dollar value limitation, the property doesn't leave the estate, merely the value. This means that the property (the res, as opposed to the value) remains property of the estate until it is abandoned under Section 552.

Under Section 552(a), the Trustee can voluntarily abandon a piece of property which is burdensome or of inconsequential value. If the property is properly scheduled and the court does not order otherwise, the property is automatically abandoned to the debtor when the case is closed. Furthermore, the debtor may request that the trustee be ordered to abandon the property under Section 552(b). Thus, the practical import is that if a debtor claims a value limited item of property as exempt and wants to dispose of the property, the debtor would need to file a motion to compel abandonment.

The new rule creates possibilities for mischief and malpractice. Assume that the debtor files bankruptcy and claims federal exemptions with regard to their homestead. At the time that they file, they believe that the value of the homestead is within the exemption limit. The trustee neither objects to the exemption nor closes the case. Two years later, the trustee files a motion to sell the debtor's home because values have gone up dramatically. Has the debtor's attorney committed malpractice by not filing a motion to compel abandonment? The trustee's gambit shouldn't work because Section 522(a)(2) defines value in terms of the petition date. However, if the debtor has an appraisal from a year prior to bankruptcy and the trustee has one from a year after the bankruptcy, how certain can the parties be about what the value was on the petition date. Will it be necessary to get an appraisal as of the petition date to protect the debtor?

Here is another facet. Under 11 U.S.C. Section 363(b), the trustee can lease property of the estate. If the homestead remains as property of the estate, could the trustee evict the debtors and lease the property out even if the value of the exemption exceeded the value of the property? If the exemption is in the value rather than the property, does the debtor have to be compensated for use of the property by the trustee?

Taking it further, let's assume that the house burns down without either the debtor or the trustee having insured it. Is the trustee subject to a claim on his bond?

As a practical matter, trustees will likely be motivated to close questionable value estates in order to receive their commission. However, the potential for trouble is tremendous.

Whom do you trust when interpreting a trust?

Update: On June 15, 2011, the Fifth Circuit entered a ruling finding that the Trustee was entitled to 50% of the corpus of the trust. Roberts v. McConnell, No. 10-50462 (5th Cir. 6/15/11). You can read the Fifth Circuit opinion here.

Trusts are interesting things. They are a way to transfer property without completely letting go. One reason to transfer property in trust is to see that the beneficiary receives the benefit of the trust property instead of his creditors. Of course, the bankruptcy trustee has just the opposite incentive. The trustee would like to bust the trust and distribute the proceeds to creditors. When trust provisions are unclear, it can make for an interesting exercise as Judge Craig Gargotta discovered in Roberts v. McConnell, Adv. No. 09-1011 (Bankr. W.D. Tex. 11/3/09).

In this case, Mary McConnell set up a trust for her grandson. The trust allowed the beneficiary to withdraw funds from the trust according to a graduated schedule based on the beneficiary's age, but only if "the Settlor of this Trust (or each Settlor, if more than one) is then deceased." The grandmother passed away in September 1997. At that time, the grandson could have withdrawn 33% of the trust. However, several months later, his mother made a contribution to the trust which she repeated during six additional years.

The debtor filed for bankruptcy in 2004. At that time, he was 37 years old. At that time, he would have been entitled to one-half of the trust if the Settlor (or Settlors if more than one) were deceased. In 2009, the bankruptcy trustee brought suit against the trustee of the trust seeking to recover the entire corpus for the benefit of the bankruptcy estate. The trustee of the trust moved to dismiss.

The issues that the court faced were:

1) Was the term settlor limited to the person who initially created the trust or did it extend to the mother as well?
2) If the mother was deemed to be a settlor, could the trustee at least recover the funds which the debtor was entitled to withdraw for a brief period prior to his mother's initial contribution?

Under the Texas Property Code, the term settlor is defined as the person who creates the trust. However, the Trust defined settlor as anyone who contributed property to the trust. Under the Texas Property Code, the specific language of the trust controlled over the definition of settlor contained within the Property Code. The parenthetical language (or each Settlor if more than one) suggested that there could be additional settlors. Thus, the trustee could not recover the full amount of the trust, since there was still a settlor alive.

However, this gave rise to a second question: could the mother, by becoming a settlor, unvest the debtor's right to make a withdrawal? Recall that when the debtor's grandmother passed away, she was the sole settlor of the trust and he could withdraw one-third of the value of the trust at that time. Had bankruptcy not intervened, one could imagine the unpleasant conversation which might transpire when the son learned that his legacy was now out of reach due to this mother's decision to add to the trust. In this case, the bankruptcy trustee was just making the argument which the son would likely have made, namely, it's not fair.

In trying to determine the intent of the settlor, the court found it significant that the trust imposed two different requirements for withdrawing funds from the trust: reaching a specified age and the prior death of all settlors. The court found an intent for both benchmarks to be present at any time that a withdrawal was requested.

The court's result seems to be a natural reading of the language of the trust. However, it is not hard to imagine how these provisions could be used to reach a twisted result. Imagine that the grandmother had two grandsons, one of whom always wrote his thank you notes timely and never forgot his grandmother's birthday. The other grandson was an ungracious lout who stole spare change from his grandmother's purse and never had a kind word, let alone a thank you. The grandmother decides to create a trust for one of the grandsons but not the other. The grandmother passes on and the ungrateful grandchild learns that he has been passed over. Upon learning of the trust provision, he contributes $10 to his brother's trust so that he can never access the trust funds. In this scenario, could the ungrateful grandson keep his favored brother from ever accessing the trust? Would the likelihood that the sinister grandson would encounter an unfortunate accident go up? These would make for good law school exam questions. Fortunately Judge Gargotta didn't have to reach these questions. (Congratulations to new law clerk Sarah Darnell on her first opinion).

Update #1: Eric Taube advises that this opinion is being appealed.

Update #2: Alert grammarians Pat Autry and Fay Gillham pointed out that my headline should have read "Whom do you trust when interpreting a trust?" instead of the original "Who do you trust when interpreting a trust?" I did some research and found out that they were correct.

According to wikiHow, who is used as the subject of a sentence or phrase while whom is used as the object of a verb. This still left me scratching my head, so I read further on. If the answer to the question is he, then who is correct, while if the answer to the question is him, then it is whom. Thus, the answer to the question would be "I trust him to interpret a trust" indicating that whom was the correct way to begin the sentence.

Tangled Financial Web Allows Assets to Escape Trustee's Reach

A recent opinion by Bankruptcy Judge Craig Gargotta demonstrates the problems arising from the use of cash management systems and also provides an object lesson in why lawyers should have more than a passing knowledge of accounting concepts. In Ingalls v. SMTC Corporation, No. 06-1283 (Bankr. W.D. Tex. 9/11/09), the bankruptcy trustee sought to recover millions of dollars in inter-corporate transfers. After a two week trial, the court issued a 94 page opinion denying all relief.

The case was precipitated when SMTC Manufacturing of Texas filed a chapter 7 petition after divesting its assets. While the debtor paid all of its current trade debt, it also made numerous transfers to insiders leaving it unable to pay a sizeable debt on its lease.

The transfers challenged by the trustee fell into four categories:

1) Payments to the parent company’s affiliates in North Carolina and Mexico;

2) Expense reallocations which increased the Texas company’s share of expenses;

3) Approximately $41 million transferred to the holding company through a cash management system; and

4) Transfer of the debtor’s fixed assets to affiliates.

The Corporate Structure and Cash Management System

To understand the case, it is necessary to understand the relationship between the debtor and its affiliated companies, their cash management system and the companies’ secured debt.

The corporate structure consisted of a parent company, SMTC Corporation, which owned a holding company, HTM Holdings, Inc. HTM owned the operating companies, including SMTC Manufacturing of Texas.

The companies used a cash management system which centralized their funds. Prior to March 2002, the operating companies would deposit funds into their operating accounts which would be swept into a zero balance account maintained by the holding company. The funds in the zero balance account would be applied to the holding company’s debt to Lehman Brothers. As funds were needed by the operating companies, they could either be paid from funds deposited into the operating account that day or funds advanced from the Lehman Brothers loan. Beginning in March 2002, Lehman Brothers required that all funds be deposited into a lockbox account so that the only funds available for operations came from the Lehman Brothers loan.

Lehman Brothers provided a revolving credit line to the holding company which was used to fund the operating companies. The parties kept track of how much money was paid to and paid from each of the operating companies. This number was their portion of the debt. However, each of the operating companies guaranteed the entire debt and pledged their assets. To the extent that any operating company paid more than its individual balance on the loan, it had a right of contribution against the other operating companies.

While the Texas company initially enjoyed a period of rapid growth, it ran into trouble in 2002. In mid-2002, SMTC Texas laid off about half of its employees and moved its manufacturing operations to Mexico. The cost of labor in Mexico was $3.00 per hour compared to $19.00 in Texas. However, even this was not enough to allow the debtor to meet Dell’s pricing demands so that it eventually dropped (or disengaged from) Dell as a customer. After that, it lost Alcatel as a customer and corporate decided that it was time to close the doors. The debtor surrendered its leased facilities in May 2003 and filed chapter 7 in December 2004. Significantly, the other affiliated companies continued to operate and did not file bankruptcy. The chapter 7 trustee looked at all of the transfers out of SMTC and cried foul, leading to a fraudulent transfer complaint.

Was There A Transfer?

The first major issue which the court had to consider was whether there had been any “transfers” at all. Under the Texas Uniform Fraudulent Transfer Act (TUFTA), the definition of a transfer excludes “property to the extent it is encumbered by a valid lien.” The defendants argued that no “transfers” occurred because:

1) Each individual asset transferred was worth less than the amount of the total debt: and

2) Because the debtor was liable for the entire Lehman debt, its collective assets had no equity.

The court ruled against the asset by asset approach. It found that if there was equity in the debtor’s collective assets that transfer of individual assets from that pool would be deemed to be made from the unencumbered portion of the assets rather than the encumbered ones.

This made it necessary to determine whether there was equity in the debtor’s collective assets, raising some difficult accounting issues. The difficulty arose because of the interplay between the following facts:

1) The debtor’s assets were greater than its share of the Lehman Brothers loan at some points in time;

2) The debtor had guaranteed the entire Lehman Brothers loan, which far exceeded its assets; and

3) The SMTC family of companies was making all of their payments n the Lehman Brothers loan, although there were some covenant defaults.

This raised the question of what portion of the Lehman Brothers debt should be accounted for on the debtor’s balance sheet. The trustee argued that the debtor’s obligation on the Lehman Brothers debt was a contingent obligation which did not belong on the balance sheet because of the low probability that the debtor would be called upon to perform. The defendants argued that the entire amount should be included because the debtor was unconditionally liable.

The court agreed that the debt was a contingent liability. However, whether a contingent liability should be stated on the debtor’s balance sheet depended on the likelihood that the contingency would occur and that it would affect the debtor’s balance sheet. A contingent liability could be shown on the balance sheet if the contingency was likely to occur, could be referenced in a footnote or could be omitted entirely if the contingency was unlikely to occur.

The court found that the appropriate way to measure the contingent liability was to apply a percentage to the likelihood that the guaranty would be called upon and multiply that percentage by the amount of the debt. The trustee argued that the appropriate percentage was 0% based on the fact that the SMTC companies had not defaulted upon the debt and that the debt was later paid off. The court rejected this argument because the SMTC companies had defaulted under their loan covenants and that the debt was only paid off through a restructuring in which Lehman Brothers accepted stock in partial satisfaction. Because the possibility that the debtor would be called upon to satisfy the guaranty was greater than 0% and the trustee did not advance an alternate number, the court refused to exclude the debt as a contingent liability.

However, that was not the end of the inquiry. Even though the debtor could be called upon to pay the entire debt, it had a right to contribution from its co-debtors. This was an asset which needed to be added to the balance sheet. The court assumed that the value of the right of contribution was equal to the portion of the debt which exceeded the debtor’s individual account. This may have been a leap of faith, since the court did not analyze the ability of the other companies to pay their portions. However, given that the debt was retired without payment from SMTC Texas, it may have been a reasonable conclusion. The net result was that for determining the debtor’s equity in its assets, the court examined the value of the debtor’s assets minus the amount of the debtor’s portion of the Lehman Brothers loan. The result of this analysis was that the debtor had equity in its assets until March 2003. Once the debtor reached the no equity stage, it could transfer its assets away without risk because they had no net value and were not “transfers” under TUFTA.
The effect of the court’s ruling was to exclude the transfer of the fixed assets and $3.9 million of the cash transferred through the cash management system.

Note that the result would not be the same in an action brought under 11 U.S.C. §548. The definition of “transfer” under the Bankruptcy Code does not exclude encumbered property. 11 U.S.C. §101(54). Thus, it is possible to bring a fraudulent conveyance action to recover a fully encumbered piece of property under the Bankruptcy Code, while the same transfer would not be covered under the Texas statute.

Fraudulent Conveyance Analysis

Under the Texas statute, like the Bankruptcy Code, a transfer can be avoided as a fraudulent conveyance if it is made “with actual intent to hinder, delay or defraud any creditor” or if it was made for less than reasonably equivalent value while insolvent. Actual intent can be shown through direct evidence or through badges of fraud. TUFTA, unlike the Bankruptcy Code, legislatively defines eleven badges of fraud. The badges of fraud are:

1. The transfer was to an insider;

2. The debtor retained possession or control of the property transferred after the transfer;

3. The transfer or obligation was concealed;

4. Before the transfer was made or obligation incurred, the debtor had been sued or threatened with suit;

5. The transfer was of substantially all the debtor’s assets;

6. The debtor absconded;

7. The debtor removed or concealed assets;

8. The value of the consideration received by the debtor was reasonably equivalent to the value of the asset transferred or the amount of the obligation incurred;

9. The debtor was insolvent or became insolvent shortly after a substantial debt was incurred;

10. The transfer occurred shortly before or after a substantial debt was incurred; and

11. The debtor transferred the essential elements of the business to a lienor who transferred the assets to an insider of the debtor.

Tex. Bus. & Com. Code §24.005(b).

The list of badges of fraud raises several interesting issues. First, the issues of solvency and reasonably equivalent value are included in the badges of fraud. Thus, it would make sense to determine these issues first, since a positive finding on these two elements would eliminate the need to determine the other nine badges of fraud. The other implication is that since solvency and reasonably equivalent value are just two of eleven badges of fraud, a transfer can be fraudulent even though the debtor was solvent at the time or received reasonably equivalent value. The second interesting question is how many badges of fraud are enough. The meticulous Judge Gargotta noted that the presence of “many” badges of fraud “will always make out a strong case of fraud” and that four or five have been found to be sufficient in some cases. On the other hand, one badge of fraud is not enough. Once a sufficient number of badges of fraud are established, then the burden shifts to the transferee to establish some “legitimate supervening purpose.”

Analysis of Actual Intent to Hinder, Delay or Defraud

Judge Gargotta chose to do the more difficult analysis of intent to hinder, delay or defraud first. His decision on these issues effectively decided the constructive fraud issue as well.

The Judge rejected the trustee’s arguments regarding direct evidence of fraudulent intent. The Trustee contended that emails discussing the possibility of bankrupting the Texas company and “walking away” from the lease combined with failure to produce board minutes where these options were discussed was proof that the corporate parent intended to defraud the lessor. The trustee also argued that the debtor hindered the lessor when it failed to make several payments on the lease when it had the cash to do so. The court was not moved by this evidence. Discussing the option of bankrupting the company and walking away from the lease did not go one step further and establish intent to transfer the assets away. The court did not give any particular significance to failure to produce the board minutes, refusing to draw an inference that the minutes would have been harmful.

This led to a discussion of badges of fraud. As a preliminary matter, Judge Gargotta had already determined that the debtor was insolvent throughout the relevant period. As a result, one badge of fraud and half of the constructive fraud analysis had already been decided. It was not contested that the transfers were made to insiders, so that a second badge of fraud was present. However, at this point, the trustee hit a wall as the court failed to find any additional badges of fraud.

Badge 1: Transfers were made to insiders. This badge was not disputed.

Badge 2: The debtor retained possession or control of the property transferred. This badge was not present.

Badge 3: The transfer or obligation was concealed. All of the transactions were recorded on the debtor’s books. The transfers were all properly documented. As a result, this badge was not present.

Badge 4: Before the transfer was made, the debtor had been threatened with suit. The debtor was not sued until after it shut down in May 2003.

Badge 5: The transfer was of substantially all the debtor’s assets. Collectively the transfers were of substantially all the debtor’s assets. However, individually none of them were. Furthermore, because the Texas statute excluded fully encumbered assets from the definition of “transfer,” the final series of transfers were not considered. As a result, when the last transfer which could be considered to be a transfer was made, the debtor still had assets left, defeating this badge.

Badge 6: The debtor absconded. This was another badge implicated by the definition of transfer. Because the only “transfers” which could be considered were those occurring prior to March 2003, this badge did not apply because the debtor was still operating its business at this time.

Badge 7: The debtor removed or concealed assets. This badge is similar to badge 3. However, instead of concealing transactions, it relates to concealing assets. However, the result is the same. Since the debtor accounted for all of the transfers in its records, it did not conceal assets.

Badge 8: Reasonably equivalent value. I will return to this badge.

Badge 9: The debtor was insolvent or became insolvent. The court found this issue was present.

Badge 10: The transfer occurred or the obligation was incurred shortly before or shortly after a substantial debt was incurred. The only major debt which the debtor had was its lease. This was incurred on September 1, 2001. All of the disputed transfers occurred during 2002 and 2003. As a result, this badge was not present.

Badge 11: The debtor transferred the essential assets of the business to a lienor who transferred the assets to an insider of the debtor. This was not present.

Based on the definition of transfer and facts which were not seriously contested, the most badges of fraud that could be established was three. Thus, the whole case boiled down to reasonably equivalent value.

Reasonably Equivalent Value

1. The Trustee challenged $104,646.00 in payments to SMTC Charlotte from February 2002 to June 2002 and $37 million to SMTC Mex/SMTC Chihuahua from February 2002 to February 2003.

While these transfers were substantial, the defendants established that the SMTC companies transferred their manufacturing operations from Texas to Mexico to take advantage of lower wages. However, Dell continued to place orders with SMTC Texas, which then filled them with product purchased from SMTC Mex and SMTC Chihuahua. The Debtor added a mark-up to the product purchased from Mexico before it sold it to Dell. The defendants produced invoices, bills of lading and other documents to establish that the transfers to the affiliated companies were for payment of product actually purchased which the debtor sold for a profit. Thus, this group of transfers was factually shown to be for reasonably equivalent value.

2. The Trustee challenged approximately $2 million in expense reallocations between the debtor and the corporate office.

The defendants established that the expense reallocations were based on recommendations from the companies’ accountants and were reasonable. Thus, this set of transactions was supported by reasonably equivalent value.

3. The Trustee challenged $37 million in funds which were upstreamed to the holding company by the cash management system.

This looked to be the trustee’s strongest claim. Between January 2002 and December 2003, the Debtor transferred $41 more to the holding company than it received back. This seemed to be a simple cash in cash out analysis showing a net transfer without reasonably equivalent value. However, this was a case where the complexities of the cash management system worked against the trustee. The court concluded that the trustee’s expert only considered transactions running through the debtor’s bank account and not transactions reconciled at the corporate level. Because many inter-corporate transactions were handled through reconciliations, the court found that an analysis of the bank statements only was insufficient to show whether the debtor received reasonably equivalent value.

The Court stated:

The Trustee has not provided the Court a complete picture that explains specifically why reasonably equivalent value was not received. What the ZBA Master Bank Reconciliation demonstrates is that the $41.1 million figure that was derived solely by analyzing the bank accounts does not accurately reflect the payments made to SMTC Mex or any of the other affiliates on behalf of the Debtor via intercompany transfers. The Trustee failed to account for this reconciliation in his explanation as to what effect these transactions would have on reasonably equivalent value. He therefore has not proved the absence of reasonably equivalent value by a preponderance of the evidence.

Opinion, p. 70.

With this finding, the trustee’s case was doomed.

Why It’s Hard To Be The Trustee

This was a difficult case for the trustee. He was faced with a debtor which had transferred all of its assets to affiliates (although it also paid $3.9 million to trade creditors). However, the case turned into a battle of the accountants. The trustee starts off at a disadvantage in a battle of experts because the trustee usually starts off without any cash to pay experts. In this particular case, the trustee sought to employ an accountant on a contingent fee basis. Unfortunately, this violated the disciplinary rules governing accountants in Texas and the court disqualified the expert. The trustee then had to retain another accountant to testify based on the first accountant’s compilations. The court did allow the first accountant to testify as a fact witness. Thus, the defendant had access to its own expert accountant which it retained as well as the defendants’ management, while the trustee had to start over with a new expert who was looking in from the outside.

Concluding Thoughts

SMTC illustrates the difficulties arising from inter-related companies with a common cash management system. The SMTC companies succeeded in walling off SMTC Texas and allowing it to fail. Despite the fact that many of the assets were transferred to affiliates, it was extremely difficult to unscramble the companies’ finances. The court successfully worked through the issues related to contingent liabilities and rights of contribution. However, it found that the trustee’s expert had failed to account for all of the value provided to the debtor. The result was not based on knowing the answer, but on uncertainty resulting from the inability to fully deconstruct the companies’ intertwined finances. While the defendants may have prevailed in any circumstance, the complexity of the arrangement was certainly an assisting factor for the defense.