Administrative Insolvency, Professional Responsibility and the Art of Judging

Recently I was involved in a heavily litigated chapter 11 case. The professional fees (which included fees from two sets of debtors’ counsel, a chapter 11 trustee, an examiner, various special counsel and parties claiming substantial contribution fees) threatened to consume the estate until the lawyers agreed to limit their take and leave some funds for the pre-petition creditors. In a remarkable display of good sense, the attorneys then compromised on how the professional fees would be allocated rather than continuing the fight. (I can’t claim any credit here since others did the heavy lifting).

At the hearing to approve the fees, the judge commended the lawyers for their professionalism. However, while everyone was basking in good spirits (or at least as good as you can feel after having agreed to a fee reduction), the court asked what could have been done to stop the bleeding before everything got so expensive. Waxing philosophical, the court questioned whether the traditional ethical rules with regard to professional billing work in the bankruptcy context and whether the court should play a more activist role in managing troublesome cases. The court raised a good question.

In the traditional two-party litigation model, professional responsibility is primarily a matter of consumer protection. Fees are governed by a limitation that they may not be unconscionable, Texas Disciplinary Rules of Professional Conduct 1.04, but beyond that, the rates and amounts charged are largely a function of the client’s ability and willingness to pay. Fee shifting distorts the traditional model, since one party can shift its costs onto the other party. However, there are still some limits since there is no guarantee that the party who is on the receiving end of the fee award will have the ability to pay.

In a complex bankruptcy, the dynamic is far different than the two party litigation model. In this context, a “complex” bankruptcy is one where there is a pot of unencumbered assets worth fighting over and multiple parties with an interest in the pot. In an efficient bankruptcy, the pot is maximized for the benefit of the residual claimants, who are typically the unsecured creditors. On the other hand, in an inefficient bankruptcy, the post-petition claimants (such as professionals, committees, secured lenders and parties claiming a “substantial contribution”) consume the estate at the expense of the residual claimants.

An inefficient bankruptcy poses both an ethical challenge for the professionals and a management challenge for the court. Professionals employed by the estate have a duty to maximize value for the estate (and thus to ultimately benefit the creditors) rather than to simply run up their own fees. The Fifth Circuit has held that professionals may not be compensated unless their efforts result in an “an identifiable, tangible and material benefit to the bankruptcy estate.” Matter of Pro-Snax Distributors, Inc., 125 F.3d 414, 426 (5th Cir. 1998). Thus, there should be a practical deterrent to pursuing inefficient litigation on the part of the estate’s professionals.

However, there are several important limitations on the ability of the estate’s professionals to act efficiently and ethically when it comes to incurring fees. First, contested fee applications are fairly unusual. As a result, the deterrent effect is more theoretical than real. Second, efficiency is much easier to judge in hindsight than in the heat of battle. As a result, decisions which result in unproductive fees may have appeared reasonable at the time. Finally and perhaps most importantly, third parties can impose costs on the estate through their litigation tactics quite independently of the good judgment and ethical decision making of the debtor’s professionals. If a creditor decides to pursue a program of expensive discovery and objects to every action proposed by the debtor, the estate’s professionals will often have little choice but to participate to the same extent, resulting in an escalation of professional fees.

So, since the professionals have an imperfect ability to avoid a train wreck, what can the court do?

1. Watch out for ugly cases. While this sounds fairly trite and self-evident, some cases bear closer watching than others. In some cases, the parties and personalities involved have a greater potential for spiraling out of control. Becky McElroy likes to say that you should watch out for any case with an “ex” in it, whether it is an ex-wife, ex-partner, ex-employee and so on. In the business context, this can apply to a rebuffed purchaser, a competitor or a debt buyer whose strategy is to cause trouble until someone buys them off. Of course, litigiousness can be a management style for the debtor as well. If the court is able to see the warning signs, it can step in sooner to manage the case more closely.

2. Monitor Fees. In a particularly ugly case, the parties may be reluctant to submit fee applications for fear of retaliatory objections. However, in a case where no one is submitting their fees for approval, the court may not be aware that the case is approaching administrative insolvency.

3. Send the Parties to Mediation. Not all problems can be solved through litigation. If the parties are using litigation as a negotiating strategy, the court may be able to save costs by requiring the parties to negotiate directly. Of course, mediation can also be another opportunity for delay and expense if the parties aren’t ready to negotiate.

4. Set Deadlines/Force the Issue. All lawyers want more time and some cases require time to find a business solution. However, time also creates more opportunities for mischief. If the debtor’s lawyers are asking to continue the hearing on the disclosure statement for the fifth time and no creditor is stepping up to propose a plan, then perhaps the case is in a stalemate which won’t be resolved unless the court sets deadlines and forces the parties to litigate, reach an agreement or go away.

5. Appoint a Trustee/Change the Parties. Some cases are basically a two party dispute with the remaining creditors held hostage to the main dispute. While appointing a trustee is normally reserved for situations where the debtor has misbehaved, perhaps it is appropriate to appoint a trustee in cases where the parties’ irrational hatred for each other threatens to consume the estate to the detriment of the third party creditors. By appointing a trustee, the court may deprive one of the factions of its motivation to fight. Of course, the opposite could be true as well. If the non-debtor party has an irrational to inflict its will on others, then appointing a trustee may simply create another opponent for the malevolent party while defunding the former debtor-in-possession (who can no longer bill the estate for its fees).

The suggestions offered here are imperfect and incomplete. Please feel free to use the comments function to offer your own suggestions.

Now for Something Completely Different: A Salute to Success

I took my family to the rodeo last night. It was not because I wanted to put on my boots and watch bull riding or mutton bustin’ (although those were my favorite events). No, we went to the rodeo because Aly & AJ were the featured performers last night. If you have a daughter between the ages of 10-14 and own a television, you likely know who I’m talking about, while the rest of you may be scratching your heads. For those of you who are unfamiliar with Aly & AJ, I will take a break from writing about bankruptcy to talk about the Disney/Nickelodeon teen machine.

In case, you may have missed this trend, there are now about a million shows aimed at middle school girls on Disney and Nickelodeon. As a result of aggressive marketing, the teen stars of these shows, rather than being snickered at for being modern Mouseketeers, are plastered all over the pages of Tiger Beat, Pop Star and similar teen girl fan magazines. (In case you may be thinking that it is really weird that I would know this, I need to point out that I spend a lot of time helping my eighth grade daughter with homework and the posters from these magazines cover every available inch of wallspace in her room).

So, what is the secret to this success?

1. The first step is finding the right niche market. Here, it is all girls all the time. .If you flip through the offerings on Disney and Teen Nick, you will find that they are predominately aimed at middle school girls. If boys have a lead role in a show, they must be cute and non-threatening and be part of a cast with strong girl characters (e.g., Dylan and Cole Sprouse from the Suite Life of Zack and Cody or Ricky Ullman in Phil of the Future). Maybe guys of this age are too glued to their Xbox to watch TV. However, middle school girls provide an eager audience. Since they are too young to drive, they spend a lot of time in front of the TV (usually while talking on the phone at the same time). They also buy the magazines, CDs and movie tickets which spin off from these shows and spend hours discussing them with their friends.

2. Second, is that it helps to have some vaguely familiar names. Thus, you will find Julia Roberts’s niece (Emma Roberts of Unfabulous), Billy Ray Cyrus’s daughter (Miley Cyrus of Hannah Montana), Haley Joel Osment’s sister (Emily Osment also of Hannah Montana) and Britney Spears’s sister (Jamie Lynn Spears of Zoey 101). I’m not sure how this helps with the kids, but perhaps it means something to the parents to know that their kids are watching the daughter of the guy who sang “Achy Breaky Heart.” (By the way, Billy Ray also appears in the show).

3. Third, cross-marketing is key. Disney in particular has mastered the three pillars of middle school girl society: music, movies and television (if they could just find a way to bring the telephone into the equation, they would be unstoppable). Aly & AJ are a prime example. The blonde sisters began performing songs on Radio Disney and in Disney movies such as Ice Princess and Herbie: Fully Loaded. The music videos from these songs play constantly on the Disney channel, promoting both the singers and the movies. Alyson Michalka played the female lead in Phil of the Future (which was tragically cut short when Phil’s father unexpectedly fixed the time machine parting the star crossed couple). The Michalka sisters also appeared in their own made for TV movie, Cow Belles, and will be appearing in a movie released for the big screen by MTV this summer. Their debut CD "Into the Rush" quickly went gold (or is it platinum by now?). Last year, I took my daughter to Houston to see Hannah Montana in concert. Hannah Montana is not an actual person, but is a character played by Miley Cyrus. In the show she plays a teen who has a secret life as a pop star. Reality imitated art when the actress had a concert tour playing her character (along with the Cheetah Girls, another made for TV singing group). Brenda Song plays a supporting role in The Suite Life of Zack and Cody, but got to be the star of her own made for TV movie, Wendy Wu: Homecoming Warrior (no, I am not making this up).

For those of you who didn’t know this world was out there, you probably could have lived without this information. However, it is important to acknowledge genius. Only time will tell whether these stars will retain their luster after they turn 18. However, for now they are certainly enjoying their moment in the sun. My next post will be on the somewhat drier topic of administrative insolvency, professional responsibility and the art of judging.

Lunchtime Conversation Prompts Judicial Inquiry, Pt. 2

An alert reader, Jim Hoeffner with Thompson Coe in Austin, pointed out that Sec. 525(b) has been interpreted to permit private employers to refuse to hire persons who have filed bankruptcy. Pastore v. Medford Savings Bank, 186 B.R. 553 (D. Mass. 1995); In re Hendrik, 2004 Bankr. LEXIS 1649 (Bankr. M.D. Fla. 2004)("It is well established now by several cases that Section 525(b) of the Code applies only to actions taken after an employment relationship has been established and does not cover a situation which might be a discriminatory hiring practice by private employers"); In re Stinson, 285 B.R. 239 (Bankr. W.D. Va. 2002).

As a result, my statement that "an entity which which functions as a gatekeeper for the bankruptcy process appeared to be violating the Bankruptcy Code" was more a statement of what the law should be than a statement of what the law currently is. A plain reading of the text "No private employer may ... discriminate with respect to employment against, an individual who is or has been a debtor under this title ...." would seem to prohibit refusal to employ as well as discrimination after an employment relationship has been established. However, that is not what the cases say.

Thus, in reading the tea leaves from Judge Isgur's brief opinion, we are left with the following possibilities:

1. Judge Isgur may be signaling a break with the existing case law on Sec. 525(b) and is willing to entertain a cause of action for failure to hire;

2. Judge Isgur may find that discrimination in employment by credit counseling agencies, while lawful, reflects negatively upon their fitness to provide services to potential debtors; or

3. Judge Isgur may find that cause has been shown and take no further action.

Obviously, the first two possibilities are more interesting. We will have to wait and see what happens.

Lunchtime Conversation Prompts Judicial Inquiry

Over the past year, the Houston bankruptcy court judges have written quite a number of opinions calling attention to unprofessional practices. These opinions have reacted to proceedings coming before their courts, many of which have been quite disturbing. However, now Judge Marvin Isgur has gone one step further. He has initiated a proceeding to investigate a credit counseling agency based upon a lunchtime presentation he attended. In re Credit Counseling in the Southern District of Texas, No. MC-07-301 (Bankr. S.D. Tex. 2/15/07).

Judge Isgur Gets Indigestion and Issues An Order

According to Judge Isgur:

"On January 26, 2007, the undersigned judge attended the monthly meeting of the Houston Association of Debtors Attorneys. At that meeting, the speaker was the chief executive officer of Money Management International. In responding to a question from the audience, the speaker told the assembled group that Money Management International had an employment policy that barred the employment of any credit counselor who had previously been in bankruptcy."

This concerned Judge Isgur because 11 U.S.C. Sec. 525 provides that "no private employer may ... discriminate with respect to employment against an individual who is or has been a debtor under this title ... solely because such debtor or bankrupt" has been a debtor. Thus, an entity which functions as a gatekeeper for the bankruptcy process appeared to be violating the Bankruptcy Code.

Judge Isgur noted that the U.S. Trustee is given responsibility for regulating credit counseling agencies, but surmised that "the United States Trustee would not necessarily have inquired into Money Management International's employment practices as regulated by Sec. 525 of the Bankruptcy Code." In response to this concern, the court issued an order which "requires that the United States trustee determine whether Money Management International should remain on its approved list of counseling agencies." The court scheduled a hearing for March 1, 2007 for the U.S. Trustee to advise the court as to the current status of Money Management International.

By What Authority?

Judge Isgur's concern for the integrity of the bankruptcy system is commendable. It seems apparent that he wants to encourage Money Management International to amend its ways and comply with Title 11. However, the procedure followed is somewhat novel.

Congress gave the power to regulate credit counseling agencies to the United States Trustee, a division of the Department of Justice. Under 11 U.S.C. Sec. 111(b), the United States Trustee is given authority to approve a credit counseling agency for a probationary period of six months and then for successive one year periods. Any person who disagrees with a final decision to approve or deny a subsequent one year appointment may seek review from the appropriate district court of the United States within 30 days.

If this were the entirety of the statutory scheme, then Judge Isgur would appear to be on shaky ground. However, there is another curious provision. Sec. 111(e) states that:

"The district court may, at any time, investigate the qualifications of a nonprofit budget and credit counseling agency referred to in subsection (a) above, and request production of documents to ensure the integrity and effectiveness of such agency. The district court may, at any time, remove from the approved list under subsection (a) a nonprofit budget and credit counseling agency upon finding such agency does not meet the qualifications of subsection (b)."

Thus, the "district court" is given almost blanket authority to review the status of credit counseling agencies "at any time." 28 U.S.C. Sec. 157(a)allows the District Court to refer proceedings arising under Title 11 to the Bankruptcy Court. Thus, unless the term "district court" is intended to refer to the actual U.S. District Court rather than the Bankruptcy Court acting under referral from the District Court, Judge Isgur acted exactly as Congress intended.

Who Is the District Court?

The choice of the words "district court" in Sec. 111 is unusual. In most instances, Title 11 refers to "the court" or "the bankruptcy court." The term "district court" is found in only a few sections. In a few cases, it is used to refer to the U.S. District Court appointed under Article III. For example, under the pre-BAPCPA version of 11 U.S.C. Sec. 110, the bankruptcy court was permitted to certify certain violations by bankruptcy petition preparers to the district court. (Under BAPCPA, this provision was changed to refer to "the court" and eliminate the need to certify the fact to a higher court). In Sec. 524(g)(3)(A), the issuance of certain channeling injunctions are valid if the confirmation order is issued or affirmed by the district court. Both of these sections clearly referred to the Article III court.

Two other provisions are more ambiguous. Sec. 526(c)(4) grants concurrent jurisdiction to the district courts of the state in situations where a state official could bring an action against a debt relief agency. However, other subsections within Sec. 526 refer to "the court" or "a Federal court" such that the context is not clear. In Sec. 1116(4), the debtor must file other documents required by a local rule of the district court. Bankruptcy court local rules are adopted under the authority of the district court. As a result, the reference to district court rules clearly refers to bankruptcy court rules.

While the use of the term "district court" in section 111(e) is ambiguous, it probably refers to the bankruptcy court acting under reference from the district court. The subsection contemplates the court initiating an investigation and making findings with regard to the suitability of a credit counseling agency. It is unlikely that a U.S. District Court, which has no direct dealings with credit counseling agencies, would have the time or inclination to launch such an investigation.

Conclusion

When I began this article, I expected to conclude that Judge Isgur had initiated a well-intentioned but unauthorized Star Chamber proceeding. I believed that the U.S. Trustee had the sole authority to regulate credit counseling agencies and that this case raised a separation of powers issue. Therefore, I was surprised to find that Congress had authorized this type of independent inquiry. This is a remarkable section of the Code and one which has received little attention.

Thus, what is really remarkable about Judge Isgur initating a Miscellaneous Case to investigate comments made at a bankruptcy luncheon is that it seems to be exactly what Congress intended. Sec. 111(e) appears to authorize the bankruptcy judge to launch independent investigations based on whatever facts come to his attention, whether in court, at a luncheon or in cocktail party chatter. This marks a dramatic shift in the role of the court. One of the hallmarks of the Bankruptcy Code of 1979 is that it removed the court from the role of administrator. Now, under BAPCPA, the same Congress which took away much of the Court's discretion with regard to means testing, has given the bankruptcy court an independent administrative role.

Supreme Court Limits "Absolute" Right to Convert to Chapter 13

In the first bankruptcy opinion of the term, the Supreme Court held in a 5-4 decision that a misbehaving Chapter 7 debtor does not have an absolute right to convert his case to Chapter 13. Marrama v. Citizens Bank of Massachusetts, No. 05-996, 549 U.S. ___ (2007). The Supreme Court stated that a debtor whose case could be converted or dismissed for cause under 11 U.S.C. Sec. 1307(c) had forfeited the right to proceed under Chapter 13 and thus was not a person eligible to convert to Chapter 13.

According to Justice Stevens writing for the majority:

"An issue that has arisen with disturbing frequency is whether a debtor who acts in bad faith prior to, or in the course of, filing a Chapter 13 petition by, for example, fraudulently concealing significant assets, thereby forfeits his right to obtain Chapter 13 relief. The issue may arise at the outset of a Chapter 13 case in response to a motion by creditors or by the United States trustee either to dismiss the case or to convert it to Chapter 7, see Sec. 1307(c). It also may arise in a Chapter 7 case when a debtor files a motion under Sec. 706(a) to convert to Chapter 13. In the former context, despite the absence of any statutory provision specifically addressing the issue, the federal courts are virtually unanimous that prepetition bad faith conduct may cause a forfeiture of any right to proceed with a Chapter 13 case. In the latter context, however, some courts have suggested that even a bad-faith debtor has an absolute right to convert at least one Chapter 7 proceeding into a Chapter 13 case even though the case will thereafter be dismissed or immediately returned to Chapter 7."

The Supreme Court took the course of pragmatism, finding that the bankruptcy court could skip to the ultimate result and deny the conversion where the Debtor would not be able to maintain the Chapter 13 case. However, to do this, they had to get around some apparently clear statutory language.

Sec. 706(a) states that "The debtor may convert a case under this chapter to a case under chapter 11, 12 or 13 of this title at any time, if the case has not been converted under section 1112, 1208, or 1307 of this title. Any waiver of the right to convert a case under this subsection is unenforceable." This language seems pretty straightforward. The debtor may convert "at any time." The right to convert cannot be waived. Not so fast said the nimble Justice Stevens. Section 706(d) states that "a case may not be converted to a case under another chapter of this title unless the debtor may be a debtor under such chapter." According to Justice Stevens, a person might not be eligible for Chapter 13 relief on one of two grounds. First, Sec. 109(e) might provide that the person was not eligible. Second, Sec. 1307(c) might allow the case to be dismissed for "cause." Since a case could possibly be dismissed for cause, a person committing an act constituting cause was never eligible to be a debtor under Chapter 13 and his request for conversion could be denied.

In a display of consistent dedication to text, Justice Alito, joined by Chief Justice Roberts and Justices Scalia and Thomas, dissented. They pointed out that the statutory language is "clear" and "unambiguously provides that a debtor who has filed a bankruptcy petition under Chapter 7 has a broad right to convert the case to another chapter." He also pointed out that the word "eligible" under Sec. 706(d) refers to eligibility under Sec. 109(e), which is appropriately titled "Who may be a debtor." Sec. 1307(c) is not an eligibility provision, but rather a device for weeding out eligible but deficient cases. "...Sec. 1307(c) plainly does not set out requirements that an individual must meet in order to 'be a debtor' under Chapter 13. Instead, Sec. 1307(c) sets out the standard ('cause') that a bankruptcy court must apply in deciding whether, in its discretion, an already filed Chapter 13 case should be dismissed or converted to Chapter 7."

The dissent also points out that the majority mistakenly decided that "following the literal terms of the Code would be pointless." Justice Alito pointed out that by denying the right to convert, the majority would deprive a debtor of the ability to propose a plan and convince the court that the plan was filed in good faith. He concluded that, "Today's opinion renders these questions academic, and little is left to guide what a bankruptcy court must consider, or may disregard in blocking a Sec. 706(a) conversion."

This is a case where the conservative justices, with their emphasis on following the text, have the better argument. In trying to simplify procedure in the specific circumstance before them, the majority has muddied the law in several important respects:

1. The court has confused eligibility to file a case with the ability to remain in that case once filed. An ineligible debtor has no right to file. However, a debtor who has committed acts which could rise to the level of cause is at least entitled to file his case and try to convince creditors and the court that he can do better for them in the current chapter. Whether "cause" exists will not be readily apparent until after the court examines the debtor's conduct in the current chapter, i.e., whether he is using chapter 13 for the good faith purpose of paying his creditors or as a continuation of his efforts to evade creditors. Because "cause" often cannot be determined at the outset of a case, it should not form the basis for eligibility to file or convert.

2. From a procedural point of view, the Supreme Court has required the "cause" determination to be made too early. If the court must determine whether "cause" to reconvert the case exists at the time of the original request for conversion, the court is making its decision based on a hypothetical set of facts. While the debtor may be able to talk about what he would do in a potential Chapter 13 case, the court would not have the benefit of seeing the actual plan proposed by the debtor or gaining the input of the Chapter 13 Trustee on that plan.

3. Finally, the Supreme Court blithely stated that federal courts are "virtually unanimous" that pre-petition bad faith conduct may forfeit the right to proceed in Chapter 13. This is not really very accurate. Indeed, some of the "virtually unanimous" cases cited by the Supreme Court dealing with pre-petition bad faith conduct do not actually support the proposition. For example, In re Alt, 305 F.3d 413 (6th Cir. 2002) relied upon a totality of the circumstances test and focused primarily upon the debtor's failure to schedule a known claim. Similarly In re Leavitt, 171 F.3d 1219 (9th Cir. 1999) relied upon a totality of the circumstances test and gave the most emphasis to the debtor's failure to schedule assets, overstated expenses and refusal to amend his plan. Most bad-faith cases rely on a combination of both pre-petition and post-petition conduct. It seems that the Supreme Court has confused general bad faith with pre-petition bad faith. This would be a huge mistake. While bankruptcy is generally designed to benefit the "honest but unfortunate" debtor, Chapter 13 has traditionally been a forum where the previously dishonest debtor may repent and amend his ways to the benefit of both himself and his creditors. Allowing Chapter 13 cases to be dismissed solely based upon pre-petition conduct would be a significant shift in bankruptcy policy.

Houston Judges Find Method to Avoid Unnecessary Filing of Means Testing Form in Cases That Have Mostly Business Debt

While means testing is supposed to be self-effectuating, Congress failed to specify a clear mechanism for separating those debtors required to pass through the analysis and those who were exempt. In a new opinion, Judges Marvin Isgur and Wes Steen have developed a test to help debtors navigate the straits between Scylla and Charibidis (complete with a footnote explaining who Scylla and Charibidis were). No. 06-37157, In re David Michael Beacher, (Bankr. S.D. Tex. 1/26/07) and No. 06-35550, In re Michael Antonio Pena (Bankr. S.D. Tex. 1/26/07).


Means testing is one of the hallmarks of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). It was meant to ensure that debtors who could afford to pay their debts did not take the easy way out by filing chapter 7. Means testing only applies to debtors with "primarily consumer debts." This may have been because Congress figured that business debtors would fail in a big way so that they wouldn't be able to repay their debts or it might have been intended to promote entrepreneurship or it just may have been a consequence of the fact that BAPCPA was championed by the consumer credit lobby. Whatever the reason, means testing applies to individuals with primarily consumer debts but not other individuals.

Means testing is enforced through a regime which requires debtors to file a statement of current income and expenditures, which in the case of an individual debtor with primarily consumer debts must include a calculation to determine whether the presumption of abuse arises. See 11 U.S.C. Sec. 521(a)(1) (requiring filing of statement of income and expense unless the court orders otherwise) and 11 U.S.C. Sec. 707(b)(2)(C) (requiring additional calculation if primarily consumer debts are involved). If a debtor fails to file the information required by Sec. 521 within 45 days, then the case is subject to mandatory dismissal. 11 U.S.C. Sec. 521(i)(1).

Form 22A contains a detailed analysis of income and expenditures under the means test. However, judges have disagreed on whether it must be filed by all chapter 7 debtors or just those with consumer debts. Compare In re Moates, 338 B.R. 716 (Bankr. N.D. 2006)(only consumer debtors need file the form) with In re Copeland, 2006 Bankr. LEXIS 2200 (Bankr. S.D. Tex. 2006)(all debtors must file).

Judges Isgur and Steen disagreed with their Southern District colleague and ruled that requiring all debtors to file the form was neither "reasonable or acceptable." They cited Lord Coke for the maxim that "The law requires no one to do vain or useless things." 5 Coke 21.

With that out of the way, the judges had to decide what to do if a debtor failed to file the form. If the debtor was required to file the form but did not do so, then mandatory dismissal was the penalty. On the other hand, if the debtor was not required to file the form, they could hardly complain about its absence. The two cases consolidated in their opinion illustrate two different ways to approach the problem. In the first case, the debtor filed a motion to be excused from filing Form 22A on the ground that it was not required. In the second case, the court issued a show cause order as to why the case should not be dismissed for failure to file the form. When the debtor did not respond, the case was dismissed, leading to a motion to reconsider. In both cases, someone, whether the debtor or the court, had to take a proactive step to tee up the issue.

Further, the consequences of guessing wrong were serious, since they would result in automatic dismissal. In the Beacher case, the debtors contended that 58% of their debts resulted from their failed business. However, what if it turned out that only 49% fell in the business category? If the decision was made 46 days into the case, they would be dismissed.

To solve this problem and avoid "vain and useless expenditure of resources," the judges have developed a new form for requesting waiver of the requirement to file Form 22A. Based on the certification of the debtor and counsel that debts are not primarily consumer, the court will issue a provisional order excusing the form. If no party objects to the order within 90 days, it will become final and compliance will be excused. According to an email from the Southern District, Judges Bohm, Isgur, Schmidt and Steen plan to use the form.

It is good to see judges who care about making the system work. This is a case where Congress drafted an extensive statutory scheme but failed to address an important detail as to its practical application. There may have been a simpler answer however. Form 1, the Voluntary Petition, requires debtors to indicate whether their debts are primarily business or consumer. The form is signed by the debtor under penalty of perjury and is also signed by counsel. As a result, it contains basically the same information as the new form. When a debtor checks the business box it should presumptively excuse the debtor from filing Form B22A unless a party objects. Of course, there is no rule which says this. As a result, there is no time frame for objecting. Therefore, checking the petition box does not eliminate the 45 day dismissal problem. This distinction may be the factor which commends the new Southern District procedure.

Note: All of this discussion pertains to chapter 7 debtors only. While the means test obviously does not apply to chapter 11 or chapter 13 debtors, they are still required to complete an Official Form of income and expense which can be used to determine amounts payable under a plan. Fed.R.Bankr. Pro. 1007(b)(5)requires chapter 11 debtors to file the appropriate Official Form setting forth their current monthly income. Rule 1007(b)(6) requires chapter 13 debtors to file the Official Form reflecting their monthly income, and if their income exceeds the median, they must also file a calculation of disposable income as set out in Sec. 1325(b)(3).

Judge Rejects Defense of The Computer Made Me Do It

A volume creditors' practice is facing sanctions after the court rejected its explanation that faulty computer coding caused it to file erroneous pleadings. The opinion illustrates the tension between the requirements of Rule 9011 and the need to rely on automation in a volume practice. While the final sanctions to be awarded have not yet been decided, the court in this case was clearly exasperated.

The Plan and the Original Objection

A debtor filed chapter 13 and included a debt with respect to a property he was leasing to his brother. The debtor's schedules plainly stated that the property was NOT the debtor's principal residence. The debtor's counsel also claimed to have informed the lender's counsel of this fact prior to bankruptcy.

The debtor proposed a plan which sought to pay the lender the value of its collateral plus interest through the plan. The payments to be made to the lender under the plan exceeded the amount of the rents being received by the debtor. The creditor filed a proof of claim in which it adopted the debtor's valuation of the property.

The lender's attorney filed an objection to confirmation which the court characterized as "grossly erroneous, and to anyone familiar with bankruptcy law, the objection is clearly legal nonsense." Among other things, the objection claimed that:

* The debtor's attorney, rather than the debtor had executed the note;
* That the plan did not pay the arrearages in full (despite the fact that the plan proposed a cram-down rather than a cure of arrearages);
* That the plan impermissibly modified a loan on a principal residence;
* That the lender's administrative claim was deferred over 36 months (despite the fact that the lender did not have an administrative claim); and
* That the plan impermissibly proposed to pay interest on the lender's non-dischargeable unsecured claim (despite the fact that the lender did not have a non-dischargeable claim).

The Debtor responded and pointed out the errors in the objection.

The First Hearing

At the first hearing on confirmation on October 3, local counsel for the lender argued that the plan impermissibly modified a loan on a principal residence. When the debtor responded that the property was not the debtor's principal residence, "local counsel replied that he had been instructed by (the lender's counsel) to ask for a continuance if Debtor made that contention."

This choice of tactics was not good. As the court later found, the objection relating to the principal residence violated Rule 9011 because the lender had no evidence that the debtor's statements were wrong. However, it got worse.

"As clear as that violation as, it is even more egregious that Countrywide continued to advocate that position in open court on October 3, notwithstanding Debtor's written response on September 28. Countrywide obviously had considered Debtor's response, knew that the argument had no validity, and was prepared to abandon the argument by asking for a continuance to implement 'Plan B,' which apparently had not yet been devised. . . . (T)he court believes that the request for a continuance was not made in good faith but was intended simply for delay."

Of course, the Court had not made these findings yet on October 3. However, the court did warn the lender's counsel that it should scrutinize its position in light of Rule 9011.

The Lender Withdraws Its Objection But "Discovers" A New One

After the hearing, Debtor's counsel sent the lender's counsel a letter demanding that the lender cure the violation of Rule 9011. In response, the lender filed a withdrawal of its objection. Unfortunately, this pleading violated Rule 9011 as well. The withdrawal stated that the lender was withdrawing its objection because the Debtor had filed an amended plan which proposed to cure the arrearage. Of course, this was just plain wrong. The Debtor had not filed an amended plan and was still seeking to cram-down the value on the rental property.

To further complicate matters, just four business days prior to the re-scheduled hearing, the lender filed a new objection which asserted that it just "discovered" that it held an absolute assignment of rents and that because the rents belonged to Countrywide, the Debtor could not use them in the plan. The absolute assignment of rents theory used to be a standard weapon used by lenders in single asset real estate cases during the 1980s and caused a lot of controversy at that time. However, the theory had major practical difficulties (such as how the rents could be conveyed to the lender without reducing the debt) and has not been seriously advocated for many years.

The First Opinion

At the continued hearing on November 14, lender's counsel abandoned all of its original objections and argued the absolute assignment of rents. Debtor's counsel objected that she had been sand-bagged. This was a legitimate complaint because the local rules required any objections to be filed five business days before confirmation. As a result, the court continued the hearing once again. However, at this point, the court's displeasure took written form. On November 28, the Court wrote the first of three written opinions in the case. Case No. 06-60121, In re James Patrick Allen (Bankr. S.D. Tex. 11/28/06)(Order for Memoranda and for Rule 7016 Conference And Order for Hearing on Sanctions Under Rule 9011). In this opinion, the court required the parties to brief the absolute assignment of rents issue and to advise the court as to the witnesses and exhibits they planned to introduce. The court also stated that it appeared that the lender's counsel had violated Rule 9011. The court required both local counsel and lender's primary counsel to attend the hearing.

The Second Opinion

After the pre-trial conference on the absolute assignment of rents issue, the court concluded that there were not any disputed issues of fact. The court wrote its second opinion which concluded that the assignment of rents was intended for purposes of security rather than as an absolute assignment. No. 06-60121, In re James Patrick Allen (Bankr. S.D. Tex. 12/20/06)(Memorandum Opinion Findings of Fact and Conclusions of Law Concerning Order Denying Motion for Turnover & Accounting And Concerning Confirmation of Chapter 13 Plan). As a result, the court confirmed the plan. The court reserved the issue of sanctions for a subsequent opinion.

The Third Opinion

After all of this prologue, the court finally reached the issue of sanctions in a hearing on December 13. No. 06-60121, In re James Patrick Allen (Bankr. S.D. Tex. 1/9/07)(Memorandum Opinion Regarding Sanction of Creditor's Attorneys). Prior to this hearing, the Court was aware of what had happened. The important factual issue was why it happened, and whether this would serve to mitigate or explain away the erroneous pleadings. The testimony received on December 13th provided a window into the internal workings of a volume practice.

The initial attorney who handled the file testified that she recognized that the property was not the debtor's homestead. Based on this determination, none of the pleadings raising homestead-related issues should have been filed. Despite this conclusion, a clerical person apparently coded the file as a homestead case. Under the law firm's computer system, certain codes are entered which are then used to generate pleadings. In this case, a clerical employee apparently entered the wrong codes which then generated the wrong pleadings. Thus, garbage in, garbage out. The Court concluded that no meaningful review was given to the computer generated pleadings.

"There was no testimony that anyone at (lender's counsel) reviews the computer-generated pleadings (with the level of care required by FRBP 9011) before they are filed. It was the Court's sense of the testimony that either there is no review, or else the review is so superficial that it is meaningless."

The firm's response to the Court's initial warning about sanctionable conduct was also dictated by the computer system. When local counsel contacted the initial lawyer about the Court's concerns, she testified that she "could not believe the document that was filed under [her] password." However, because the file was coded as a homestead case, the instruction to withdraw the objection generated a pleading geared to a homestead case. The frightening thing is that the computer generated a pleading which might have been appropriate in a particular type of homestead case. However, the pleading would not be appropriate in all circumstances. Thus, even without the erroneous coding, the pleading could well have been wrong.

The Inconclusive Result

The Court found that the lender's principal law firm should be sanctioned for its conduct in the case. However, the Court did not enter a sanction at this time. The Court noted with frustration that he had previously reprimanded the firm and had ordered it to address quality control issues. Two other judges in the Southern District had published opinions about the firm's conduct, including one case where the firm was required to pay $65,000. The Court noted that sanctions under Rule 9011(c)(2) should be sufficient to deter further repetition of the conduct. The Court went on to state:

"Although the Court has concluded that there is sanctionable conduct, after two warnings and a $65,000 monetary sanction, the Court is at a loss to determine the appropriate sanction in this case. If the prior warnings and sanction have not worked, what will?"

The Court ordered the managing attorney of the firm's Houston office to appear at a hearing to be held and to "report to the Court what sanctions would deter further repetitions of this conduct."

This Order places the firm in an unusual position. It is being asked to recommend its own punishment. If the firm suggests too light of a sanction, it may invite severe penalties for failure to appreciate the gravity of its actions. But what is sufficient?

While the Court may well consider monetary sanctions, and will likely award attorney's fees to debtor's counsel, the Court appears to be looking for more of a structural solution. The problem here appears to be a law firm subservient to its computer system. In an atmosphere where codes entered by clerical employees can generate nonsensical pleadings, it is difficult to comply with the responsibilities of a professional. In this case, even the attempt to withdraw an erroneous pleading generated another factually defective document. Perhaps Judge Steen, like another judge before him, will sanction the computer. However, it seems more likely that he will order the humans to take control of the computer. Failing that, he may require that all future pleadings be written with a quill pen and bear the cursive penmanship of the attorney submitting the pleading.

Post-script: Local counsel, who had the unenviable task of presenting the flawed pleadings to the court, escaped sanctions. Although Local Rule 11.2 required local counsel to be fully informed and prepared, the court noted that this rule had not been strictly enforced in the past. Based on the hope that local counsel had "a much greater appreciation of his responsibilities to the Court," the Court declined to assess sanctions against him.

Exemptions and the Mobile Debtor

Most states do not allow their residents to choose federal exemptions. However, a new opinion from Judge Leif Clark points out that BAPCPA may have expanded the reach of federal exemptions for a limited number of mobile debtors. In re Battle, No. 06-50545 (Bankr. W.D. Tex. 12/12/06).

Exemptions were a major concern for Congress when it passed the Bankruptcy Abuse and Consumer Protection Act of 2005 (BAPCPA). Among other things, Congress was worried about wealthy debtors moving to states with generous exemptions, such as Texas and Florida, for the purpose of filing bankruptcy. One provision enacted to limit this practice imposed a residency requirement of 730 days before an individual could claim under a state's exemption laws. If the person had not resided in one state for the entire 730 day period, then exemptions would be determined under the law of the state where the debtor had resided for the greater portion of the 180 days prior to the 730 days. See 11 U.S.C. Sec. 522(b)(3)(A). If the effect of Sec. 522(b)(3)(A) is that no exemption law applies (for example, if the person resided out of the country during the relevant time period), then the person would be allowed to take federal exemptions under 11 U.S.C. Sec. 522(d). The application of Sec. 522(d) as exemption of last resort is of little solace, since it only applies in the case where no exemptions whatsoever would be allowed.

While the legislation may guard against abuse, it also operates as a trap for the unwary. Each year, about 3% of the population changes states. See Allison Stone Wellner, "The Mobility Myth," Reason Magazine (April 2006). If these individuals wind up in bankruptcy court, they may find their property rights defined by the laws of a state they had long left behind and which are unfamiliar to their counsel. This extraterratorial application of exemption laws may lead to strange results. For example, the Texas homestead exemption applies to "all homesteads in this state whenever created." Tex. Prop. Code Sec. 41.002(d). Thus, if a Texas resident moves to Florida (both states with high homestead exemptions), purchases a Florida homestead and files bankruptcy 729 days later, then the debtor would arguably not be able to claim a homestead exemption under either law. Sec. 522(b)(3)(A) would mandate application of Texas law. However, the Texas law appears to apply only to homesteads within the state of Texas. Thus, even though both states allowed comparable homestead exemptions, a move for a legitimate reason, such as to take a new job, may lead to loss of the exemption.

The federal exemption option under Sec. 522(d) offers limited protection to some debtors. It allows each debtor to exempt $18,450 of equity in a home and includes a wild card provision as well. One problem is that when Congress created the federal exemption scheme, it also allowed states to opt out. See 11 U.S.C. Sec. 522(b)(2). Thirty-six states prohibit their residents from claiming federal exemptions.

In the case of In re Battle, No. 06-50454 (Bankr. W.D. Tex. 12/12/06), Judge Clark considered whether a former Floridian filing bankruptcy in Texas could claim federal exemptions. Because the debtor had lived in Texas for less than 730 days and had lived in Florida during the 180 days prior to the 730 days, the parties agreed that Florida law would apply. Florida is an opt out state. As a result, the Trustee argued that federal exemptions were not available under Florida law. However, Judge Clark noted that the relevant Florida statute provided that "residents of this state shall not be entitled to the federal exemptions." On the date of filing bankruptcy, the Debtor was not a Florida resident. Although the choice of law was determined by where the Debtor resided during the 180 days prior to 730 days, the facts of the exemption were determined as of the petition date. Because the Debtor was not a resident of Florida on the petition date, the opt-out provision did not apply and the Debtor was able to use the federal exemptions.

This is a case of two restrictive statutes canceling each other out. Both Sec. 522(b)(3)(A) and Sec. 522(b)(2)'s opt-out language restrict debtors' exemption choices. However, it appears that an unintended consequence of Sec. 522(b)(3)(A) is to allow most debtors whose exemption choices are governed by the law of another state to choose federal exemptions regardless of whether they could have chosen federal exemptions in either the original state or the new state. Thus, if a debtor moves from one opt-out state to another opt-out state and files bankruptcy less than 730 days later, the result may be to make federal exemptions available where they would not otherwise have been. If State A's exemption laws prohibit its residents from choosing federal exemptions, but the debtor is no longer a resident of State A, State A's prohibition does not apply. If State B's exemption laws prohibit its residents from choosing federal exemptions, but exemptions are determined under State A's law, then State B's prohibition is inapplicable. Thus, the result is to frustrate the policies of both states and make the federal exemption available. This would be little consolation to a debtor with a million dollar homestead who moves between high exemption states. However, it was enough to protect the Debtor in Battle.

Judge Kelly Finds 401k Loans Deductible Under Means Test

Judge Larry Kelly has recently held that 401k loans may be deducted in performing the chapter 7 means test. In re Otero, 06-30691 (Bankr. W.D. Tex. 11/2/06). BAPCPA expressly designates 401k loans as allowable expenses in chapter 13 cases. 11 U.S.C. Sec. 1322(f). However, there is not a similar provision with respect to the chapter 7 means test. Judge Kelly's ruling differs from a recent decision on this issue out of the Northern District. In re Barraza, 346 B.R. 724 (Bankr. N.D. Tex. 2006).

BAPCPA generally gives favorable treatment to retirement plans. Retirement plans loans have an exception from the automatic stay under Sec. 362(b)(19). Retirement plans are exempt up to $1 million under the federal exemptions pursuant to Sec. 522(d)(12). Retirement plan loans are non dischargeable under Sec. 523(a)(18). Finally, amounts withheld from the debtor's wages to be contributed to retirement plans are not property of the estate under Sec. 541(b)(7). However, while chapter 13 expressly allowed the deduction from disposable income, the chapter 7 means test under Sec. 707(b) was silent.

When this issue was argued to Judge Russell Nelms, the parties apparently framed the issue as to whether the payments could be deducted as "other necessary expenses." Judge Nelms found that they could not, but asked "why would Congress presume under section 707(b)(2)(A) that this amount of money could be used to pay unsecured creditors, and then deny unsecured creditors access to that money in chapter 13?"

However, Judge Kelly was asked to decide whether 401k loan payments could be deducted from the means test income as secured debts. While the U.S. Trustee argued that these "loans" were really just advances against the debtor's entitlement to receive retirement plan assets later, Judge Kelly concluded that they met the statutory definitions of secured debts.

Judge Kelly stated:

"The parties do not dispute that funds were advanced to the Debtors, that there exists documentation giving the plan administrator a 'lien claim' against the funds in the Debtors' 401K accounts, and that such accounts represent property of the Debtors. Each loan is therefore certainly a 'claim against property of the debtor' and so also a 'claim against the debtor,' which makes the interest of the plan administrator a 'security interest' against property of these Debtors. This court thus concludes that each loan is a 'secured claim' within the intendment of 11 U.S.C. Sec. 707(b)(2)(A)(iii)."

Judge Kelly's ruling follows an impeccable trail of statutory construction and harmonizes the Code's treatment of retirement plan loans. Not only is Judge Kelly's result right, but it is also the same argument made by this blog at the time that Barraza came out. http://stevesathersbankruptcynews.blogspot.com/2006/08/means-testing-opinions-strictly.html

Update:

The U.S. Trustee appealed Judge Kelly's decision and obtained an opinion from the U.S. District Court reversing it. McVay vs. Otero, 371 B.R. 190 (W.D. Tex. 4/26/07). The District Court looked at the same language as Judge Kelly and concluded that a loan against a 401k plan was NOT a debt, so that it could not be a secured debt deductible under the means test. In making this ruling,the District Court followed the majority position.

The Debtors did not further appeal the District Court ruling. Instead,they converted to Chapter 13 and proposed a plan which allowed them to deduct the 401k payments from disposable income. The Debtor's plan was confirmed on November 19, 2007. Under the confirmed plan, unsecured creditors will receive approximately 3% on their claims.

First Amendment vs. BAPCPA: Connecticut Court Strikes Down Section 526(a)(4)

Another U.S. District Court has found that Sec. 526(a)(4), which prohibits advising an assisted person to incur debt in contemplation of bankruptcy, violates the First Amendment. In Zelotes v. Martini, No. 3:05vc1591, 2006 U.S. Dist. LEXIS 81385 (D. Ct. 11/7/06), Judge Peter Dorsey of the U.S. District Court for the District of Connecticut found that attorney Zenas Zelotes had standing to challenge the law and that the particular section was facially unconstitutional. Judge Dorsey noted that the law would prohibit attorneys from giving advice to refinance a debt with one at a lower interest rate, to purchase and automobile which would allow the debtor to work as well as other legitimate actions. "By prohibiting lawyers from advising clients to take lawful, prudent actions as well as abusive ones, Sec. 526(a)(4) is abusive and restricts attorney speech behond what is 'narrow and necessary' to further the governmental interest."

Zelotes is the third opinion to find Sec. 526(a)(4) to be unconstitutional. Previously, Olsen v. Gonzales, No. 05-6365-HO, 2006 U.S. Dist. LEXIS 56197 (D. Or. 8/11/06) and Hersh v. United States, 347 B.R. 19 (N.D. Tex. 2006) had reached the same result. Another case pending in Connecticut District Court, Connecticut Bar Association v. United States, has challenged multiple sections of BAPCPA. That case is still pending.

Don't Mess With Judge Bohm

This column has devoted several articles to lawyers behaving badly in Houston. The Houston judges have been very proactive in writing about unprofessional conduct lately. Before beginning, two important caveats are important. First, these cases generally deal with the bottom 1% of the bar and are not representative of the bar in general. Second, these cases are presently coming out of Houston, but they could happen anywhere. The latest installment of Lawyers Behaving Badly involves an attorney-debtor who filed cases in bad faith, ignored court orders, failed to appear, evaded the U.S. Marshals and could not count.

A Brief Trip to Bankruptcy Court

In In re David Ortiz, No. 05-39982 (Bankr. S.D. Tex. 10/13/06), the attorney debtor filed an initial chapter 7 petition in January 2005 to avoid being evicted from his law office. The case was assigned to Judge Isgur. The Debtor received only a short delay since the stay was lifted early on. Once the eviction was allowed to go forward, he lost interest in his case. The case was dismissed for failure to attend the 341 meeting on May 31, 2005. Judge Isgur dismissed the case with prejudice to refiling for 180 days. Unfortunately, because the Debtor failed to update his address (most likely the one that he had been evicted from), he claimed that he never received the notice.

Return to Bankruptcy Court

Less than one month later, on June 29, 2005, the Debtor filed his second case, which was assigned to Judge Bohm. This case was filed for the same reason as the first case. In the space of six months, the Debtor had managed to find another landlord, fall behind on the rent and receive eviction papers.

Things Start to Get Bad—The First Sanctions Order

The U.S. Trustee promptly moved for sanctions. The Debtor appeared and pleaded ignorance of the prior order. The patient Judge Bohm agreed to abate the U.S. Trustee’s motion long enough to allow the Debtor to return to Judge Isgur and seek a modification of the prior order. When the parties returned to Court, Judge Bohm found that the Debtor had not sought to modify Judge Isgur’s order. He also determined that the Debtor had failed to file accurate schedules and did not have a good reason for failing to appear at the 341 meeting in the first case. At that point, Judge Bohm ordered the Debtor to pay attorney’s fees of $1,875 to each of his landlords and continued the matter to consider whether other sanctions might be appropriate. The Debtor finally retained an attorney at this point. At the continued hearing, Judge Bohm ordered that the Debtor pay $1,000 in sanctions to the Clerk within 60 days and barred him from filing again for a year without prior permission.

Things Get Worse--The Bench Warrant(s)

By the time of the first sanctions order on November 17, 2005, the Debtor had angered a federal bankruptcy judge. However, his problems could have been solved by paying $4,750. It would have been a really good idea to comply with this order through whatever means possible. The Debtor didn’t get the message. Some four months later, the U.S. Trustee filed a Certificate of Non-Compliance indicating that the Clerk had not been paid. Judge Bohm scheduled yet another hearing, which was continued to May 10, 2006. Neither the Debtor nor his attorney appeared at this hearing. The Debtor also failed to accept service from the U.S. Trustee’s process server after agreeing to do so. Judge Bohm issued a bench warrant that day.

In response to the bench warrant, an attorney who said she was acting merely as an intermediary contacted the U.S. Marshal and promised to inform the Debtor about the bench warrant. She gave the Marshal a non-working number for the Debtor. When the Debtor could not be located at his home or office, Judge Bohm issued a bench warrant for the intermediary attorney. This bench warrant met with more success and the “intermediary” appeared and testified that the Debtor was aware that there was a bench warrant out for him, but wanted to meet with his attorney first. Judge Bohm ordered the intermediary to check in with the U.S. Marshal twice a day until the Debtor was apprehended.

Judge Bohm Tries to Get the Debtor’s Attention—The Second Sanctions Order

On May 16, 2006, Judge Bohm, who had no doubt progressed from furious to livid, issued a second sanctions order which required the Debtor to pay $500 per day for each day that he failed to surrender and to pay $250 per day for each day that he failed to pay the $1,000 sanction to the clerk. The Court ordered the Debtor’s attorney to appear two days later to report whether he had informed the Debtor of the second sanctions order.

Melt-Down—The Third Sanctions Order

On May 18, 2006, the Debtor appeared with a new attorney (a respected bankruptcy attorney) and paid the $1,000 owing to the Clerk. The Debtor claimed that while he was aware of the May 10 hearing, that his attorney was scheduled to be out of the country and assured him that he would get the hearing re-set. The attorney did not do this. However, when the Debtor contacted the attorney’s office to see if any arrangements had been made, he was told that they were not aware of any, but that that the attorney would not have left town without having done something. The Debtor also testified that when he learned of the bench warrant, he checked into a hotel to avoid being found.

Judge Bohm was not amused. However, the order he entered was remarkably restrained. He ordered the Debtor to:

1. Write a letter apologizing to the U.S. Marshals for not turning himself in immediately;
2. Contact the Texas Lawyers Assistance Program to see if he would benefit from counseling;
3. Take 10 hours of bankruptcy continuing legal education (including three hours of ethics) if he ever planned to appear in the Southern District again;
4. Find other counsel for a client he was currently representing in a chapter 7 case; and
5. Either pay $750.00 or write “I will respect the judicial system, and such respect includes obeying all court orders” 750 times.

Judge Bohm gave the Debtor five days to comply.

When the Debtor returned five days later, he only tendered 700 sentences instead of 750, he had failed to pay the prior sanction to his landlords and he had failed to find alternate counsel for his client (whose case was subsequently dismissed by Judge Brown). However, he did complete his CLE.

The Judge gave the Debtor one more opportunity to comply and at the next hearing, he presented cashier’s checks to pay his landlords’ attorney’s fees and tendered the remaining 50 sentences. As a final sanction, the Court wrote a lengthy opinion chronicling the pattern of abuse which had led to his orders.

What Were They Thinking?

Attorneys make mistakes. Sometimes the difference between a good attorney and a disgraced attorney is the ability to engage in damage control. The attorney(s) here did not learn that lesson.

Mr. Ortiz’s motivations in filing bankruptcy to avoid eviction were not pure. Filing a second bankruptcy in violation of a court order that he arguably did not know about was bad but not fatal. At this stage, the Debtor/Attorney had a problem, but the court offered a way out (returning to Judge Isgur to modify the prior order of dismissal). This was a serious mistake.

When the Debtor missed his first opportunity to extricate himself, he could have begged or borrowed the money to pay the initial sanctions and limped away, humbled but not crushed. However, at the point that he failed to appear in court and then evaded the U.S. Marshal, he risked serious jail time. The fact that the ultimate consequences were so light may have been because the Debtor finally retained a competent bankruptcy attorney or perhaps because the court was happy just to have gotten his attention. However, it is clear that things could have been worse—much worse.

The Debtor’s first attorney and the “intermediary” attorney do not come off very well either. The opinion does not explain why the first attorney went off to Jordan without obtaining a continuance of the May 10 hearing. However, the attorney had to know that he was dealing with an extremely volatile situation. His absence caused a bench warrant to be issued for his client. The attorney who appeared only as an intermediary does not fare very well either. She was in contact with the Debtor on a regular basis, but somehow managed to provide the U.S. Marshal with a non-working number to contact him. The court found her testimony to be less than forthcoming.

When all was said and done, three attorneys found themselves named in an opinion which did not reflect well upon them. This opinion should be made required reading in legal ethics courses.

Don't Mess With Judge Jernigan

Stacey Jernigan is both the newest and the youngest bankruptcy judge in the State of Texas. However, in a recent opinion she made it clear that she is not one to be fooled by clever lawyers.

In Baker v. Sharpe, Adv. No. 06-3208 (Bankr. N.D. Tex. 9/28/06), a male debtor dressed to impress as he persuaded a recent divorcee to loan him large amounts of money. Having run through her money, he then filed chapter 7. She then sued to establish a non-dischargeable debt under Sec. 523(a)(2)(A) and 523(a)(6). The only problem was that most of her case revolved around verbal and implied statements concerning his solvency (including his statement that he could pay her out of the money he was hiding from his current wife).

Section 523(a)(2) draws a careful dichotomy between fraudulent statements of financial condition and other fraudulent representations. Section 523(a)(2)(A) expressly excludes statements of financial condition from its scope, while Section 523(a)(2)(B) only applies to written statements of financial condition. Thus, verbal statements of financial condition can never form the basis for a dischargeability action (at least not under Sec. 523(a)(2)).

The clever plaintiff's attorney tried to conceal this distinction from Judge Jernigan by omitting a few words when quoting the statute.

Judge Jernigan was not fooled. In a footnote, she stated:

"Indeed, Ms. Baker--or at least her attorney--knew there was this very large flaw in her argument, for in the Plaintiff's Brief in Support of Non-Dischargeability of Indebtedness Under Sec. 523(a)(2)(A) and (a)(6) filed with this court in advance of trial, the plaintiff quoted Section 523(a)(2)(A), but left out, with the convenient use of an ellipsis, the critical phrase 'other than a statement regarding the debtor's or an insider's financial condition.' Thankfully, the court has several copies of the Bankruptcy Code handy so it could consult the entire statutory provision in addressing this this question."

Memorandum Opinion, p. 26, n. 13 (emphasis added).

It is good to know that in these days of budgetary shortfalls that bankruptcy judges have not just one but several copies of the Bankruptcy Code available for use.

With the vigilant eye of the judge to protect him, the pro se defendant prevailed.

Individual Involuntary Petitions Remain Viable Under BAPCPA

The Bankruptcy Abuse Prevention and Consumer Protection Act requires that an individual filing for relief under Title 11 obtain credit counseling within 180 days prior to filing bankruptcy. 11 U.S.C. Sec. 109(h). Some commentators have questioned whether this requirement would spell the end of involuntary bankruptcy cases against individuals (since they would not have completed credit counseling). Judge Monroe has recently held that involuntary cases are not subject to the credit counseling mandate. In re Sadler, No. 06-10091 (Bankr. W.D. Tex. 10/18/06).

In Sadler, the Cadle Company filed an involuntary petition against the debtor without the joinder of any other creditors. The alleged debtor moved to dismiss the case claiming that he was not eligible for chapter 7 relief because he had not completed credit counseling, that he was generally paying his debts as they came due and that he had more than 11 creditors requiring three petitioning creditors.

Judge Monroe parsed the statutory language of Sec. 109(h) and found that it referred to completing credit counseling within 180 days "preceding the filing of the petition by such individual." Since an involuntary case is not filed by the debtor, then the eligibility provision does not apply. This result seems to be consistent with both the statutory language and congressional intent. BAPCPA is all about shifting control from debtors to creditors. While some have questioned the benefits of credit counseling (See Opinions Regarding Failure to Seek Credit Counseling Underscore Dissatisfaction With Law, 7/18/06), its only efficacy would be in the case of a voluntary filing. If a creditor takes the unusual step of initiating a petition, it is unlikely that credit counseling by the debtor would change the creditor's mind about the need to seek relief.

The rest of the opinion is devoted to creditor counting for purposes of Sec. 303(b). Cadle took the gutsy step of filing the involuntary petition without the joinder of any other creditors. If the debtor could show that he had at least 12 creditors, then the petition would be required to be dismissed unless additional joining creditors could be found. The debtor, who clearly did not want to be in bankruptcy, came up with a list of 24 creditors. However, this was not sufficient to keep him out of bankruptcy.

After an initial pass, Judge Monroe eliminated 11 potential creditors from the calculus, allowed 10 and saved three for further scrutiny. The debts excluded on the first pass included several that were owed by other parties, one which was time barred and eight which were for current, recurring expenses. Judge Monroe excluded the recurring expenses, which included such items as the electric bill and insurance based on an old Fifth Circuit case, Denham v. Shellman Grain Elevator, Inc., 444 F.2d 1375 (5th Cir. 1971).

The court's initial ruling created high drama. If the debtor could include two out of the three remaining debts, then the case could be dismissed and the creditor would face potential sanctions. If the creditor could exclude at least two of the three debts, then the case would proceed. The Court excluded all three remaining debts for three different reasons.

First. the debtor claimed that he owed a judgment to First Financial Resolution for $156,000. Unfotunately, the debtor could not provide a copy of the judgment or even an address for the creditor. Bankruptcy Rule 1003(b) requires that a debtor claiming to owe more than 12 debts file a list of the names and addresses of his creditors. Because the debtor could not provide an address for the creditor or otherwise prove that the debt existed, it did not count.

Second, the debtor relied on a debt owed to company controlled by his wife and brother-in-law. This company loaned him $65,000 to settle a $3 million debt. Judge Monroe classified this creditor as an insider so that they did not count toward the number of creditors.

Finally, the debtor claimed that he owed money to the IRS. Since the debtor had not filed tax returns for several years, it was very likely that he did owe taxes. However, because he could not prove any specific liability, Judge Monroe did not count the debt.

Thus, the creditor count stalled out at 10 and the involuntary was allowed to stand with a single petitioning creditor.

One Year Since BAPCPA Took Effect

One year ago today the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) took effect. This followed what can only be described as a period of insanity as potential debtors raced to file under the old law. One year later, consumer bankruptcy filings are a mere shadow of their former self. Congress has certainly succeeded in limiting the number of debtors seeking a quick discharge under chapter 7, but has dramatically decreased chapter 13 filings as well.

A Tale of Three Times

To make sense of the numbers, it is important to look at three periods of time. The year from April 17, 2004 to April 16, 2005 is the last record we have of what "normal" bankruptcy filings used to look like. (Technically this period should run through April 19, 2005, the day before BAPCPA was signed. However, for ease of comparison, I have used used months running from the 17th through the 16th to reflect the fact that BAPCPA took effect on October 17, 2005). The period from April 17, 2005 through October 16, 2005 reflects the "rush" period as debtors flocked to the bankruptcy courts in record numbers. Finally, the period since October 17, 2005 is the BAPCPA period.

During the "normal" period, there were 92,872 consumer bankruptcy cases filed in the State of Texas. Of these, 52,985 were chapter 7 liquidations, while 39,887 were chapter 13 liquidations. This reflects the trend prior to the new law for more people to choose liquidation over reorganization.

During the "rush" period, an astonishing 65,797 chapter 7 cases were filed. Thus, the cases filed in just six months represented 124% of the total for the entire previous year. Chapter 13 filings during the "rush" period numbered 22,118 representing only a slightly elevated level of filings.

Filings Anemic Under BAPCPA

Since BAPCPA, filings have been relatively anemic. For the past 12 months, there have been just 29,163 consumer bankruptcy cases filed statewide. This compares to 42,420 cases filed in just one month from September 17, 2005 to October 16, 2005. Under the new world of BAPCPA, chapter 13 cases predominate with 17,419 filings under chapter 13 and just 11,744 under chapter 7. Thus, chapter 13 is now the dominant form of consumer bankruptcy relief as opposed to practice under the old law. However, the newly dominant chapter 13 filings are themselves a mere shadow of filings under the old law.

The new chapter 13 filings of 17,419 represent a mere 44% of the filings during the "normal" period, while the 11,744 chapter 7 cases are just 22% of the "normal" period filings.

The trend shows a gradually increasing number of Texas consumer cases. In the first month after the effective date, there were a puny 743 cases filed statewide. After that, there were a series of ever increasing plateaus.

Month 1: 743
Months 2-3: 1,575 (avg.)
Months 4-5: 2,289 (avg.)
Months 6-9: 2,680 (avg.)
Months 10-12: 3,323 (avg.)

By comparison, the average filings during the "normal" year were 7,739 per month. The past seven months show an average increase of 92 cases per month. Rounding up, if filings increase by an average of 100 cases per month on a steady basis, it would take about 44 months for filings to return to their old levels.

Thus, the recap after one year is that chapter 13s are down, chapter 7s are way down, but the overall volume is slowly increasing.

Fourth Catholic Diocese Files Chapter 11

This week the Diocese of Davenport filed for chapter 11 protection in the Southern District of Iowa (Case No. 06-02229). At least three other Catholic Dioceses have filed for chapter 11 protection in response to sexual abuse lawsuits. Each of the three other cases was filed during 2004. Of the prior cases, the Roman Catholic Church of the Diocese of Tucson has successfully confirmed a plan (although that order is under appeal), while the cases for the Roman Catholic Archbishop of Portland and the Catholic Bishop of Spokane are pending with competing plans. Together, the four dioceses serve nearly 900,000 parishioners.

The Difficult Dynamic

The Catholic Diocese cases present an unusual dynamic for a chapter 11 case.

(1) The cases were prompted by waves of sexual abuse tort claims dating back decades. In each instance, the case was precipitated by sexual abuse tort claims. The underlying acts of abuse occurred anywhere from the 1930s to the 1980s. However, the lawsuit claims did not emerge until the late 1990s and early 2000s. Although several of the dioceses were able to settle an initial wave of cases, they found more cases coming out of the woodwork as publicity spread and claims averaged in the millions. As a result, the dioceses could not determine how many claims would ultimately be filed and could not rely upon insurance and current assets to resolve claims as they came in.

(2) The cases created a conflict between the betrayed and the faithful. The bad acts were performed by a limited number of bad actors (approximately 15 in the Spokane case) and were allegedly covered up by a finite number of persons in positions of authority. However, it was not possible to get justice from the bad actors and their facilitators, some of whom were already dead themselves. Instead, the major liability would be borne by the dioceses and their insurance companies. The insurance companies, many of whom were defending under a reservation of rights, were able to limit their exposure through their contracts. That left the dioceses themselves holding the final liability. However, a diocese is nothing more than the current and accumulated contributions of the faithful. As a result, the current faithful were in a position of having to pay for the sins of their church. This conflict between the faithful and the betrayed was especially apparent in Spokane and Portland where the courts ruled that property used by the parishes was owned by the dioceses rather than the individual congregations.

The challenge for the Catholic Dioceses and the lawyers for the tort claimants was to find a solution which would provide compensation and vindication to those who had been sexually abused without so alienating the parishioners that they lost faith and allowed the diocese to collapse.

A Learning Process

The Catholic Dioceses appear to be learning from experience. The Portland case, which was the first filed, was marked by acrimony from day one. While first day motions are normally routine, one pro se creditor objected to a motion to maintain cash management systems on the ground that the church should not be allowed to use a bank with Catholic officers due to the potential for conflict of interest. In the subsequent cases, the first day motions were used as a vehicle to tell the Diocese's story with descriptions of the historic background of the diocese, the ministries provided, the persons served and the church's response to the sexual abuse crisis. The first day motions in the recent Davenport case show a remarkable similarity to those in the Tucson and Spokane cases.

In the Portland case, the Debtor did not file a plan for sixteen months (by which time it was docket entry #2389) and drew a competing plan shortly thereafter. However, in the Tucson case, the Debtor filed a plan on the first day of the case, which was ultimately confirmed.


In the Portland and Spokane cases, the Debtor was faced with adversary proceedings determining that parish properties were property of the estate. In the Tucson and Davenport cases, the Debtor entered the case with a position as to why the parish properties were not included in the estate.

Based on a review of the lengthy docket in the Portland case, it appears that every issue that could be committed to paper and litigated was. In at least the Tucson case, the process appeared to be more focused and battles were chosen more selectively.

A Note About Fees

One feature common to all of the Catholic Diocese cases has been the relatively low billing rates charged by Debtor's counsel. The rates charged by principal counsel include $200 per hour in Spokane, $230 per hour in Davenport, $300 per hour in Tucson and $325 per hour in Portland. This contrasts with the eye-popping rates of $500-$600 per hour starting to appear in some large cases. Perhaps the church lawyers realized that there was already plenty that would appear obscene in their cases without obscene billings.

Judge Clark Attracts Attention With War on Terror Comments

Judge Leif Clark is a frequent source of colorful commentary. Whether he is skewering BAPCPA or illustrating the difficulty with multi-prong tests, his opinions make for interesting reading. He has even garnered the attention of NPR by quoting Adam Sandler in a footnote. He has been featured on NPR again, but this time, the subject is the war on terror. Judge Clark recently sent an email critical of comments by a Bush administration spokesman discussing enemy combatant rules. http://www.npr.org/templates/story/story.php?storyId=6195853. Now, according to an article carried in the Austin American Statesman, some are questioning whether Clark's comments went too far. See "Judge likens U.S. policy to that of Soviet Union," Austin American Statesman, October 10, 2006, p. B3.

The following email appears on NPR's web site:

'Can This Be America?'

Listening to John Yoo talk about this new legislation was chilling. I'm a federal judge, and have taught constitutional law for 16 years. The very idea of holding anyone without trial, without the right to see the evidence that was used to justify naming them an "enemy combatant," and depriving them of the ability to challenge why they are even there is so repugnant to a constitutional democracy that I am shocked that this man actually claims to be defending American values. These are the tactics of the old Soviet Union, not of a country that stands for freedom and the rule of law.

I also quibble with his contention that U.S. citizens still have the right to habeas review. I've read the law. The president can form his own tribunal, which can determine who is an "enemy combatant" (not just an alien enemy combatant), and the decision of that tribunal would not be subject to habeas review. Moreover, persons targeted by this tribunal would not even have access to the military tribunal trial created under this law.

How easy it would be for a president to use such a law to make his political enemies simply disappear. Can this be America? -- Leif Clark, San Antonio, Texas

According to the article carried in the American Statesman, some unnamed lawyers think that Judge Clark's "outburst" could subject him to discipline. Chief Judge Edith Jones of the Fifth Circuit acknowleged that "This is a very novel situation." Judge Jones said that she didn't know how the situation would be handled or if it would be handled at all.

A quick review of the Code of Conduct for United States Judges appears to support the judge's ability to speak out on legal issues. Canon 4(A) states that "A judge may speak, write, lecture, teach, and participate in other activities concerning the law, the legal system, and the administration of justice." To continue the theme, Canon 5(A) states that, "A judge may write, lecture, teach, and speak on non-legal subjects, and engage in the arts, sports, and other social and recreational activities, if such avocational activities do not detract from the dignity of the judge's office or interfere with the performance of the judge's judicial duties." Thus, the canons seems to protect the ability of a judge to write, lecture, teach or speak on legal or non-legal topics.

The canons which might limit judicial speech are more oblique when applied to this situation. Canon 1 requires a judge to uphold the "integrity and independence" of the judiciary, while Canon 2 requires a judge to obey the law and to "act at all times in a manner that promotes public confidence in the integrity and impartiality of the judiciary." Canon 7 states that a judge should refrain from political activity. However, the specifically prohibited conduct does not address speaking out on politically charged topics.

Thus, with all due respect to the anonymous lawyers quoted in the newspaper, and regardless of whether you agree with the substance of Judge Clark's statements, the judicial canons allow him to speak on both legal and non-legal topics so long as his comments do not detract from the dignity of his office. Unless it is considered just plain unseemly for a member of the judicial branch to criticize the executive branch, then it is hard to see how Judge Clark's comments detract from the dignity of his office.

The interesting thing here is because he is a bankruptcy judge, Judge Clark is unlikely to have these issues arise in his court. His email identified himself as a federal judge and constitutional law professor. However, because he is a very specialized federal judge, he has no jurisdiction over and thus no special expertise with respect to writs of habeas corpus. As a result, his status as a federal bankruptcy judge may be more of a red herring. Instead, his real standing to speak on the issue arises from his status as a private citizen and constitutional law professor. These are both capacities in which he should be free to speak his mind.

Gadzooks! Northern District Judge Limits Impact of Pro-Snax

Judge Harlin Hale was just written an important opinion on attorney's fees in chapter 11. In re Gadzooks, Inc., No. 04-31486 (Bankr. N.D. Tex. 10/5/06). Judge Hale questions the applicability of the Fifth Circuit's Pro-Snax dicta in light of subsequent Supreme court precedent. Alternatively, he would limit the opinion to debtor's counsel in doomed cases.

A Little Background

Since the Bankruptcy Reform Act of 1978, bankruptcy has become big business. Large firms which once shunned bankruptcy as being beneath them now have large departments. As a result, issues relating to employing and compensating professionals are of keen interest to those who make their living in the bankruptcy world.

In 1998, the Fifth Circuit decided the narrow issue of whether the statutory language of 11 U.S.C. Section 330(a) allowed debtor's counsel to be compensated subsequent to appointment of a trustee. The Fifth Circuit followed the statutory language and said no. Matter of Pro-Snax Distributors, Inc., 157 F.3d 414 (5th Cir. 1998). That result was subsequently upheld by the Supreme Court in another case. Lamie v. U.S. Trustee, 540 U.S. 526, 124 S.Ct. 1023 (2004). Not surprisingly, the Supreme Court said that courts should follow statute as written.

However, Pro-Snax had a second component to it. Because the firm was going to be able to receive some compensation, the Fifth Circuit gave instructions on how that compensation should be determined. The Court stated that in order to be compensable, services must result in an "identifiable, tangible and material benefit to the estate." The Court rejected the argument that services "need only be reasonable to be compensable." This holding arguably re-wrote the statute. Section 330(a)(4)(A) states that services may not be compensable if they "were not … reasonably likely to benefit the debtor’s estate or …necessary to the administration of the estate.” Since services "not ...reasonably likely" to benefit the estate could not be compensated, by negative implication, services which were reasonably likely to benefit the estate should be compensated even if they did not ultimately turn out to yield a benefit. It could be argued that while Pro-Snax was uniformly harsh toward debtors' counsel, it was schizophrenic when it came to statutory language; the primary holding was based on a strict reading of the statute, while the dicta edited out part of the text.

At least one court has held that, regardless of whether Pro-Snax properly read the statute, that it was still the law in the Fifth Circuit and should be followed. In re Weaver, 336 B.R. 115 (Bankr. W.D. Tex. 2005).

The Gadzooks Case

The recent opinion by Judge Hale addresses the situation where an Equity Security Holders Committee performed services which were objectively reasonable at the time they were performed, but did not yield a benefit to the equity holders for reasons beyond the committee's control. Gadzooks was a publicly traded company which catered to women between the ages of 14-22. At the time that it filed, equity was still in the money and the U.S. Trustee appointed an equity committee. The equity committee proposed a plan which could have paid unsecured creditors as much as 75% on their claims and would have allowed equity to buy back in. Unfortunately, the Debtor's sales tanked over the 2004 holiday season. As a result, the Debtor defaulted on its DIP financing, the proposed investment transaction was canceled and the equity committee was dissolved.

Hughes & Luce, the counsel to the equity committee, filed a fee application for approximately one million dollars. Both the creditors' committee and the liquidating trustee under the subsequently confirmed plan objected based on Pro-Snax. The case set up a perfect opportunity to examine the apparent conflict between Pro-Snax and Section 330(a). First, all parties stipulated that the services were reasonably calculated to provide a benefit up through the point that the Debtor's performance crashed. Second, the failure to achieve results was a result of factors the committee could not control. Third, the party making the request was not the debtor.

The Ruling

After a lengthy analysis, Judge Hale allowed compensation up until the point of futility for two independent reasons. First, Judge Hale applied the traditional lodestar analysis used by the Fifth Circuit prior to Pro-Snax to determine how much compensation was allowable. This conclusion was based on the preceeding analysis which rejected hindsight as a basis for denying fees. Judge Hale quoted the following language from the Supreme Court's Lamie opinion: "It is well established that 'when the statute's language is plain, the sole function of the courts--at least where the disposition required by the text is not absurd--is to enforce it according to its terms." Judge Hale added his own conclusion that, "This Court finds that, based on the wording in Section 330(a)(3) and (4), professional fees are not to be judged in hindsight."

Judge Hale relied on the intervening Supreme Court decision overturn the inconsistency in Pro-Snax.The Supreme Court said to follow the text of Section 330(a). The Pro-Snax dicta strayed from the text. Thus, while the Supreme Court upheld the holding in Pro-Snax, it implicitly rejected the dicta.

Judge Hale acknowledged that his ruling might be a little bold. He stated, "This Court realizes that its understanding of Pro-Snax may be misplaced. Certainly, other courts in Texas have constured the decision as requiring a hindsight analysis for professionals." Consequently, he offered a second rationale, finding that "Nevertheless, the Pro-Snax opinion is directed at a debtor's professionals, for obvious reasons--usually they have far more control over the reorganization efforts and strategy in a bankruptcy case. At least in Pro-Snax, they controlled the conversion to chapter 11 and the failed plan process." In his concluding paragraph, Judge Hale characterized Pro-Snax as "directed to professionals for the debtor who knew that their efforts were futile."

Judge Hale's order (which preceded the opinion) has already been appealed. Therefore it is likely that the Fifth Circuit will have the opportunity to revisit Pro-Snax in light of a decision squarely on point. If Gadzooks holds up, it will mean that professionals in bankruptcy will be less likely to have their fees denied based on factors beyond their control, such as poor holiday shopping sales. Of course, Gadzooks can't fix the largest problem in professional compensation--estates with no cash to pay professionals. However, it does remove an artificial roadblock.

Update:

On appeal, U.S. District Judge Jane Boyle reversed the Bankruptcy Court's opinion in Gadzooks. William Kaye vs. Hughes & Luce, LLP, No. 3:06-CV-01863-B (N.D. Tex. 7/13/07). Judge Boyle found that although the Fifth Circuit's Pro-Snax discussion of the correct standard to apply in awarding attorney's fees under Sec. 330 was dicta, that it was judicial dicta rather than obiter dicta. Judical dicta is defined as an opinion on an issue which was directly briefed and argued by the parties, but which was not essential to the decision. Judge Boyle found that judicial dicta should not be lightly disregarded. The Court also questioned whether the Circuit's instructions on the test to be applied on remand was really dicta at all.

The District Court engaged in a curious discussion of whether Pro-Snax was inconsistent with the language of Sec. 330. On the one hand, the District Court noted that it was bound to apply Pro-Snax regardless of whether it was correct and that many courts had disagreed with its logic. On the other hand, the District Court found that Sec. 330 could possibly be construed consistently with Pro-Snax.

Finally, the District Court rejected the Bankruptcy Court's attempt to limit Pro-Snax to its original context of awarding fees to debtor's counsel. The District Court found that the language of Sec. 330 did not distinguish between different types of professionals.

The District Court ruling has been appealed to the Fifth Circuit.

On Abstention, Multi-Prong Tests and Being Mistaken for David Bowie

Who would have thought that abstention could be so interesting? Judge Leif Clark has written a new opinion on abstention which jabs at some of the boilerplate language found in motions to abstain and contains a footnote destined to become a Clark-classic. The Official Committee of Unsecured Creditors of Schlotzsky's, Inc. v. Grant Thornton, LLP, Adv. No. 05-5109, 2006 Bankr. LEXIS 2435 (Bankr. W.D. Tex. 8/30/06).

In the Grant Thornton case, the creditors' committee received permission to sue the debtor's auditors. They brought seven causes of action, five of which arose under state law. Grant Thornton responded with a motion to abstain from hearing the state law claims and a motion to dismiss. In denying the motion to abstain, Judge Clark resisted the temptation to check off factors on a multi-prong test. In fact, he questioned the usefulness of such tests in general. He stated:

"Many courts, in an effort to give expression to the parameters of that (equitable) discretion, have developed multi-factor tests. While helpful, they are by their very nature, not dispositive. Mechanical applications of such tests to rule on equitable issues that are heavily fact-specific are often doomed to produce incorrect outcomes. The various tests offered by these opinions must be viewed in the larger context of the task presented--to arrive at the equitable application of the permissive abstention doctrine, as appropriately applied in the bankruptcy context. Or, more simply, we must avoid losing the forest for the trees."

Slip Op. at 5.

Judge Clark illustrated his point in a footnote which only he could have written.

"A person is sent into a crowded room with directions to find Judge Clark by applying the following multi-factor test: (1) tall, (2) blond hair, (3) angular features, (4) dressed stylishly and (5) having a resonant voice. The person returns with David Bowie in tow. If the person had simply been given a recent picture of Judge Clark (which would have been worth far more than all the factors one could write down on a piece of paper), chances are he would have quickly returned with the judge, not the singer."

Instead, Judge Clark tried to identify the larger policies served the abstention doctrine, stating:

"The larger context of permissive abstention is informed by the base principles that led to its inclusion in the bankruptcy jurisdiction statute in 1978. Those principles included the importance of centralized administration in one forum, the breadth of bankruptcy jurisdiction intended to have been conferred, the need to deal with unexpected exigencies or to step back when the matter to be litigated is especially important to be resolved in a state forum, and the need to do justice (as well as to avoid doing an injustice)."

Slip Op. at 5.

In the discussion which followed, Judge Clark addressed some of the boilerplate allegations which turn up in most motions to abstain:

* Forum Shopping
* State Law Issues
* Non-Core Status

With regard to forum shopping, Judge Clark pointed out that all parties with a choice of venue engage in forum shopping. The pertinent question is whether the particular exercize of forum shopping is abusive or consistent with the jurisdictional provisions of the Bankruptcy Code. In this case, the presumption in favor of centralizing proceedings related to the bankruptcy case in the Bankruptcy Court won out.

With regard to the prevalence of state law issues, Judge Clark pointed out many of the issues which the bankruptcy court deals with a daily basis, such as property of the estate, allowance of claims, determination of exemptions, validity and priority of liens, avoidance actions brought under section 544(b) and questions concerning the enforceability of executory contracts, all arise under state law. Judge Clark had previously ruled upon a case involving professional liability. Therefore, the mere presence of questions of state law was not dispositive.

With regard to non-core status, Judge Clark pointed out that this should really be a non-factor, since bankruptcy courts are expressly given the authority to hear non-core proceedings in the jurisdictional scheme of title 28. "Unless we are to read Congress' own enactment of section 157(c)(1) of title 28 as a perverse sort of statutory self-fulfilling prophesy, that section's operation should not factor into the abstention calculus." Slip Op. at 9. Properly understood, non-core status is a prerequisite to asking the abstention question. However, beyond that, it is not independently important.

At the end of the day, Judge Clark found that abstention was not appropriate.

It is refreshing to see Judge Clark take on some of the dogma surrounding abstention doctrine. So many of the opinions about abstention (and the briefs citing those same opinions) are long and self-important. However, abstention is really just about whether a particular choice of forum would be unfair. Although he did not use this specific formulation, his concept of not losing the forest amongst the trees could be summed up in two questions (which are arguably a multi-factor test themselves, but are certainly more direct and to the point):

(1) Is the Plaintiff trying to obtain an unfair advantage by its choice of forum?
(2) Is the Defendant being unfairly prejudiced by the choice of forum?

The answers to those questions should generally result in an answer as reliable as the multi-pronged tests.

(Note: In fairness to the promulgators of multi-factor tests, this approach is at least implied by the statute, which lists the interest of justice, comity with state courts and respect for state law as factors to be considered).

More Lawyer Problems in Houston

Judge Letitia Clark has added an entry to the growing list of opinions dealing with attorney problems in the Southern District of Texas. In In re John M. Diaz, No. 05-95123, 2006 Bankr. LEXIS 2008 (Bankr. S.D. Tex. 8/28/06), the Debtors' attorney in a chapter 13 case filed a fee application requesting $4,132.00 in fees and $301.50 in expenses. Apparently the Court had been tipped off as to problems with the case because both Debtors and several employees from the attorney's law firm testified at the fee application hearing. The picture painted by that testimony was not pretty.

According to the Debtors, they met with their attorney once for 30-40 minutes before filing the initial schedules and plan. They were not asked any questions about their budget. However, the documents filed under penalty of perjury included a detailed budget which contained just enough disposable income to pay secured claims and 7% to unsecured creditors. The Debtors then amended their plan and schedules five times with the result that under the final confirmed plan unsecured creditors were to receive a dividend of 100%. One of the amended schedules included an expense item of $800 per month despite the fact that the debtors had not made charitable contributions in several years. The Debtors testified that they did not understand the various changes to their schedules and plans and that all of their communications with the law firm were through secretaries and paralegals.

When Debtors' counsel realized that he was in trouble, he offered to reduce his fee to $500. However, the Court did not accept this offer. Instead, the court denied all fees. The court stated:

"In the instant case, (attorney) presented false schedules to the court, without adequately counseling his clients as to what the schedules represented, and without conducting any investigation into their veracity. It appears that the schedules contained figures invented by (attorney) or his subordinates, and filed for the improper purpose of evasion of Debtor's obligations to pay creditors. These services violated counsel's duty to instruct and supervise the Debtors, and violated (attorney's) ethical duty of candor to the tribunal. The services rendered by (attorney) and his subordinates were of zero value, no matter how much time was spent on such services, and irrespective of the ultimate confirmation of the plan in the instant case. In addition, (attorney) has imposed considerable burdens of time and detailed attention on his clients, the Trustee, and the court system, through his inadequate client counseling, filing of false documents, and lax supervision of staff."

Slip Op. at 13-14.

The facts of this case, if accurately found by the Court, are shocking. The Court found that the law firm made up numbers to minimize the Debtors' disposable income, did not bother to obtain actual expense figures and did not tell the Debtors what they were signing. It strains credibility a little bit to assume that Debtors making $11,000 a month were not sophisticated enough to know that something was not right with their filings, especially after the trustee requested amendments at the creditors meeting and filed several motions to dismiss based upon the inaccurate schedules. It also seems foolish at best that the attorney would risk being caught and exposed (as he ultimately was) just to earn a fee in a chapter 13 case.

On a certain level, this opinion is good because it points out that there are consequences for bad behavior. However, in a world of trial by anecdote, it gives fuel to the bankruptcy reformers who believe that all debtor's lawyers are unethical and out of control. This case is noteworthy precisely because it is an aberration. This was a case where the system worked. Therefore, it should not be viewed an an indictment of the system or the vast majority of the participants within that system.