Texas State Court Strikes Down Ch. 11 Litigation Trust Agreement As Void Against Public Policy

A Texas Court of Appeals has ruled that a litigation trust created under a chapter 11 plan of reorganization was void as against public policy as a “Mary Carter Agreement.” Turoff v. McCaslin, 2007 Tex. App. LEXIS 2343 (Tex. App.—Waco, 3/21/07). As a result, the court sustained a take-nothing summary judgment rendered against the plan trustee and in favor of the corporate officers and directors (D & O Defendants) and the corporate auditor who had been sued.

The Litigation Trust Agreement

ProMedCo Management Company (PMC) and its affiliates filed bankruptcy in 2000 amidst allegations that they had operated as a Ponzi scheme. On April 30, 2002, the Bankruptcy Court confirmed a plan of reorganization which provided for a Litigation Trust Agreement . The Litigation Trust Agreement was intended to provide a vehicle for pursuing claims against the D & O Defendants and the corporate auditor Arthur Andersen, as well as to allocate any proceeds recovered between the beneficiaries of the trust.

The beneficiaries of the trust were the Bank Group, the Preferred Shareholders and the unsecured creditors. The Bank Group agreed to advance $400,000 to fund the trust and would receive the first $800,000 in proceeds. The Bank Group and the Preferred Shareholders were to divide 95% of any proceeds over $800,000, while the unsecured creditors would receive 5%. Each of the parties which contributed claims to the trust released each of the other parties contributing claims.

Thus, the essence of the trust was an agreement by the Debtors, the Bank Group and the Preferred Shareholders to pool their claims for the benefit of the Bank Group and Preferred Shareholders (and to a de minimus extent the unsecured creditors) and not to sue each other. The covenant not to sue apparently protected the Bank Group from being sued by the Preferred Shareholders based on allegations that it had withheld critical information from the Preferred Shareholders at the time of their investment. Thus, rather than suing each other, the Bank Group and Preferred Shareholders agreed to combine forces and jointly pursue the D & O Defendants and Arthur Anderson under the framework of the Litigation Trust Agreement.

The D & O Defendants cried foul and filed a Motion for Summary Judgment seeking to characterize the Litigation Trust Agreement as a “Mary Carter Agreement.” Because a Mary Carter Agreement is void under Texas law, invalidating the trust would deprive the trustee of standing to pursue the claims.

Who Was Mary Carter Anyway?

The seminal Texas case on Mary Carter Agreements is Elbaor v. Smith, 845 S.W.2d 240 (Tex. 1992). In that case, the plaintiff sued three doctors and a hospital. The plaintiff then settled with two of the doctors and the hospital. Instead of dismissing out the settling defendants, these parties continued to participate in the trial where they could point the blame at the non-settling defendant. In return for this collaboration, they could be reimbursed for the amount of their settlement out of amounts recovered from the non-settling defendant. Needless to say, this was a problem, because the jury was given the impression that the case involved one plaintiff against four defendants, when in fact the real alignment was that one plaintiff and three defendants were all out to get the remaining defendant.

The Court of Appeals explained the problem with Mary Carter Agreements as follows:

“The classic Mary Carter Agreement exists when the settling defendant retains a financial stake in the plaintiff’s recovery and remains a party at the trial of the case. (citation omitted). It presents to the jury a sham of adversity between the plaintiff and a settling defendant, while these parties are actually allied for the purpose of securing a substantial judgment for the plaintiff and, in some cases, exoneration for the settling defendant. (citation omitted). These types of agreement tend to promote litigation rather than settle it and distort the trial against the nonsettling defendants. (citation omitted). And Texas does not favor settlement arrangements that tend to skew the trial process, mislead the jury, promote unethical collusion among nominal adversaries, and create the likelihood that a less culpable defendant will be hit with the full judgment. (citation omitted).”

Slip Op. at p. 4.

The Litigation Trustee pointed out that the Litigation Trust Agreement did not meet the literal definition of a Mary Carter Agreement. Critically, there was not a settling defendant who concealed the fact of settlement in return for a share of the proceeds. Instead, the potential adversaries settled out their claims well before any litigation was ever brought so that there were no sham defendants in the suit.

The Court of Appeals did not allow such a literal reading of the Texas case law to restrict it. It stated:

“(T)he law on Mary Carter Agreements in Texas has evolved to include agreements that violate the principles laid out in Elbaor even if the precise structure of the agreement does not fit the precise pattern of an agreement previously determined to be in violation of public policy. (citation omitted). A strict application of Elbaor is not necessary to find a Mary Carter Agreement.”

Id.

The Court of Appeals found that the Litigation Trust Agreement was a Mary Carter Agreement based upon the following factors:

1. The beneficiaries in the trust had a financial interest in the outcome of the litigation;
2. The beneficiaries were required to cooperate and assist with the suit;
3. The beneficiaries mutually released each other as well as four individuals employed by Goldman Sachs (one of the preferred shareholders);
4. The beneficiaries “skewed” the trial process by settling their claims between themselves and contributing their other claims to the trust; and
5. It appeared likely that less culpable defendants would be hit with the full judgment.

Thus, it seems that the Court of Appeals was offended by the fact that the Litigation Trust Agreement was essentially a joint venture between the Bank Group and the Preferred Shareholders to settle the claims between them and present a united front against the other potential defendants.

Bankruptcy Order Not So Supreme

The Court of Appeals also rejected an argument that the Supremacy Clause precluded the court from invalidating the Litigation Trust Agreement. The Court of Appeals was careful to note that the Litigation Trustee had not argued for the application of collateral estoppel or res judicata so that the court did not consider these doctrines.

The Court of Appeals stated that there were three types of pre-emption arguments: (1) where Congress has expressly pre-empted all state laws in a field; (2) where Congress has inferentially pre-empted all state laws in a field; and (3) where state law actually conflicts with federal law. The Court of Appeals analyzed the Supremacy Clause argument under the third type of pre-emption and found that it did not. According to the Court of Appeals, the issue as framed by the Litigation Trustee was whether the trial court’s summary judgment order stood as an obstacle to the execution of the Confirmation Order.

The Court of Appeals noted that the Litigation Trustee “provides no case law to support the concept that a Confirmation Order, itself, preempts a state trial court’s decision in litigation that does not relate to the bankruptcy proceeding.” The Court rejected an argument that the Bankruptcy Court’s finding that the plan was proposed in good faith and not by any means forbidden by law would prevent another court from determining that implementation of the Litigation Trust Agreement was forbidden by state law. Finally, the court noted that the purpose of the Litigation Trust Agreement, as stated in the Confirmation Order, was to “liquidate the Contributed Causes of Action.” The Court noted that one definition of “liquidate” was to determine the amount of a claim or damages. Because the Confirmation Order could not guaranty the success of the claims in state court, the state court’s order granting summary judgment liquidated the claims within the meaning of the Confirmation Order and thus implemented rather than conflicted with the Confirmation Order.

What Does It All Mean?

From the perspective of the Litigation Trust, this decision was a disaster. A structure commonly used in chapter 11 plans and specifically approved by order of the Bankruptcy Court was struck down as invalid by a state court with the result that parties who had allegedly contributed to the downfall of the debtors were able to escape liability. The result is particularly galling because the Court of Appeals really had to reach to apply the Mary Carter doctrine. Unlike a “traditional” Mary Carter Agreement, there was no sham defendant participating in the litigation and the terms of the agreement were disclosed to the world before the litigation was ever filed.

However, it may be that the problem lay with this particular litigation trust agreement and not with litigation trusts in general. Specifically, the Court of Appeals may have done rough justice by stretching state law (and this ruling does appear to be a stretch) to strike down an agreement that served only a dubious bankruptcy policy. The Litigation Trust Agreement served three constituencies:

(a) the Bank Group;
(b) the Preferred Shareholders; and
(c) the Unsecured Creditors.

Taking these in reverse order, the unsecured creditors had very little interest in the litigation. They would receive 5% of proceeds in excess of $800,000. It appears likely that the unsecured creditors were thrown into the trust as window dressing to make it appear that the trust served a valid bankruptcy purpose.

On the other hand, the Preferred Shareholders received a significant share of the trust despite the fact that they likely did not have a cognizable bankruptcy interest. Under the absolute priority rule, the interest of the preferred shareholders should have been canceled out unless the unsecured creditors received payment in full. Thus, their participation in the Litigation Trust Agreement was clearly based on their contribution of causes of action to the trust and their release of claims against the Bank Group. It can be argued that this was “new value” which would allow them to participate under the plan. However, the fact remains that they were using the bankruptcy case as a vehicle to make a deal with the Bank Group which could have been done outside of bankruptcy.

The Bank Group has the strongest claim to a share of the pie. As secured creditors of the debtors, they had the right to be paid out of causes of action asserted by the estate. However, they also had an independent interest in not getting sued. The Litigation Trust Agreement can be viewed as an agreement by the Bank Group to pay $400,000 to settle claims which could have been asserted by the Preferred Shareholders. Rather than having the money go directly to the Preferred Shareholders, the parties agreed that the money would be used to fund a joint venture between them. The complicating factor here is that it is impossible to unscramble whether the Bank Group received more value from being able to recover a share of the proceeds from the estate’s causes of action (a proper bankruptcy interest) or from not being sued by the Preferred Shareholders (a private interest). No doubt, it was the mixed nature of these interests which made the Litigation Trust Agreement appear to be beneficial, since it resolved both interests in one package.

In a perverse way, it can be argued that no substantial bankruptcy purpose was maligned by the Court’s ruling. The Bank Group paid $400,000 and received a release of claims. While they did not receive anything more, this was a risk that they took. The Preferred Shareholders were entitled to nothing under the absolute priority rule and that is exactly what they received. The unsecured creditors stood to gain very little, so that they lost very little as well.

Having said all this, it is still a bit unseemly that the D & O Defendants apparently sat back and did not challenge the plan in bankruptcy court and then attacked the validity of the structure created by the plan in state court. It could be that they didn’t know enough to raise the objection at the time or it could be that they waited to press the argument in a local state court which would be less receptive to the subtleties of federal bankruptcy law.

It is also confusing why the Litigation Trustee relied upon the Supremacy Clause, which is basically a pre-emption doctrine, when there were other arguments which could have been made. Section 1141(a) provides that the plan is binding upon the debtor, creditors, equity security holders, persons acquiring property from the debtor and persons issuing securities under the plan. It seems highly likely that the D & O defendants were either creditors or equity security holders. The Court of Appeals does not mention this section at all. As a result, it is unclear whether it glossed over the issue to get to the result it wanted or whether this argument was not made. It is also perplexing why the Litigation Trustee did not argue that the Confirmation Order had res judicata or collateral estoppel effect upon the D & O Defendants or why judicial estoppel was not urged.

Regardless of what could have or should have been argued or how the Court of Appeals should have applied the law, this case should be required reading for chapter 11 lawyers drafting litigation trust agreements in the future.

BAPCPA Allows Bad Faith Debtor To Escape Trustee Based on Failure To Make Necessary Filings

In a recent case described as “the poster child for a bad faith debtor,” the debtor was allowed to escape bankruptcy over the objection of his chapter 7 trustee because he failed to file meaningful schedules within 45 days from the petition date. In re Walter Lee Hall, Jr., No. 06-11248 (Bankr. W.D. Tex. 4/23/07). This result, according to the court, was mandated by BAPCPA.

The pro se Debtor filed his first case on May 17, 2006. He filed schedules and a statement of financial affairs, but omitted schedules E, F and G and the Form B22C Means test. However, his major offense was failure to provide his tax returns to the chapter 13 trustee. As a result, the Court concluded that the chapter 13 case had been automatically dismissed on the 46th day after the petition date based on 11 U.S.C. §521(i)(1).

The Debtor then filed a second chapter 13 case on August 15, 2006. He filed schedules which substantially consisted of the notations “TAB” and “To Be Amended.” The Debtor’s chapter 13 plan was similarly deficient. After a hearing, the Court declined to continue the stay in the second case. Among other things, the Court found that the Debtor was pursuing Chapter 13 for the purpose of frustrating his secured creditors without any legitimate hope to reorganize. While the Chapter 13 Trustee’s motion to dismiss was pending, the Debtor converted his case to Chapter 7. This time, he filed a Schedule B which listed two automobiles, but no other personal property. The 341 meeting was never completed due to the fact that the Debtor either failed to appear or invoked his 5th Amendment privilege against self-incrimination. In the course of other hearings, it became apparent that the Debtor had transferred three parcels of real property to a corporate entity he controlled.

The Court entered a Show Cause Order as to why the case should not be dismissed. The United States Trustee and the Chapter 7 Trustee appeared and requested that the case be retained, while the Debtor failed to appear. The Debtor then filed a motion requesting that the Court determine that his case had been automatically dismissed for failure to comply with the provisions of §521(a). The Debtor filed a Notice of Withdrawal of Document with respect to this motion on the day of the hearing.

At this point, the court was faced with a dilemma. There were assets which could be liquidated to pay creditors and no party was requesting dismissal of the case. However, the Court found that under Section 521(i)(1), “the case shall be automatically dismissed on the 45th day after the filing of the petition” if the Debtor fails to file the information required by Section 521(a). Under Section 521(i)(2), the court is required to enter an order reflecting that the case had been dismissed on request by a party in interest. Following the unambiguous statutory language, the court found that the Debtor was a party in interest and that the Court was required to dismiss the case based upon the Debtor’s failure to file the required documents even though the Debtor was no longer requesting dismissal. Thus, the Debtor, by the simple expedient of not meeting his obligations under Title 11, was able to receive an automatic dismissal of his case. To temper the result, the Court ordered that the case be dismissed with prejudice to refile for a period of two years. Thus, the Court would be protected from seeing this Debtor again for a period of two years. However, the Chapter 7 Trustee who was prepared to pursue the Debtor’s non-exempt and fraudulently transferred assets was left empty-handed.

This case stands in marked contrast to In re Cochener, 2007 Bankr. LEXIS 460 (Bankr. S.D. Tex. 2007)(discussed on this blog on 5/7/07). In that case, a Debtor who sought to evade her obligations under Title 11 was not allowed to dismiss her case and, in the end, both debtor and counsel were sanctioned for their efforts to evade the Chapter 7 trustee. In a perverse display of irony, the Court in that case cited it as an example of abuse justifying the enactment of BAPCPA. However, in the Hall case decided under BAPCPA, the Debtor was allowed a free pass out of bankruptcy court due to his own derelictions, while the diligent Chapter 7 Trustee received nothing. It is truly bizarre that BAPCPA allows the fortunate but dishonest debtor to escape from bankruptcy based on his own failings, when prior law would have brought him to account. Whether it was intentional or not, Congress has not done any favors for Chapter 7 Trustees.

Brief Representation Comes Back to Haunt Attorney Six Years Later

“The law has not been dead, though it has slept.” Shakespeare, Measure for Measure, Act. II, Scene ii, l. 90.

A Houston lawyer recently discovered that the passage of time was not sufficient to protect him from the consequences of actions taken in a brief representation nearly six years earlier. In re Cochener, 2007 Bankr. LEXIS 460 (Bankr. S.D. Tex. 2/6/07). The Court began its tome of an opinion with the comment that:

“In 2005, Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) to rectify perceived fraud and abuse in the bankruptcy system. . . . In the case at bar, which was initiated upon the voluntary filing of a Chapter 7 petition in 2001, the conduct of (the Debtor) and one of her attorneys demonstrates why Congress perceived that there was sufficient abuse to warrant passage of this legislation.”

That a federal bankruptcy judge would acknowledge that BAPCPA might have been a legitimate response to a problem is extraordinary enough that this case bears some scrutiny.

What Happened

The Debtor filed her chapter 7 petition on May 1, 2001, some six months after being divorced. She showed $403.00 in assets and approximately $111,000.00 in debts. The Debtor’s ex-husband informed the Trustee that the Schedules and Statement of Financial Affairs were far from accurate. As a result, the Trustee asked some searching questions and requested additional documents at the first meeting of creditors. The Debtor’s initial lawyer agreed that the documents would be produced and that the Debtor would appear for a continued creditors’ meeting.

Based on the conduct of the first meeting, the Debtor’s attorney had enough sense to realize that he was in over his head. He referred the Debtor to an attorney who was Board Certified in Consumer Bankruptcy Law and had been practicing for fifteen years. He also told the new attorney that there were allegations of concealed assets.

The new attorney apparently decided that the Debtor had made a horrible mistake in filing for bankruptcy. Even before he was formally substituted into the case, he prepared and filed a Motion to Dismiss the chapter 7 case. The motion represented that the interests of creditors would be better served by permitting dismissal and that no creditor would be prejudiced by dismissal. However, the motion did not make any factual allegations. At the same time, counsel blithely informed the trustee that based on the motion to dismiss, the Debtor would not be attending the continued meeting. The Trustee objected to the dismissal and informed the Debtor’s new counsel that attendance at the creditor’s meeting was not optional.

Nevertheless, the Debtor and her new counsel failed to attend the creditors’ meeting, which the Trustee continued yet again. The Debtor’s substitute counsel informed the Trustee that they would not be attending once again, based on the pending Motion to Dismiss. The Debtor also failed to produce any of the documents requested.

At the hearing upon the Debtor’s Motion to Dismiss, the Court apparently continued the hearing and instructed the Trustee to conduct discovery. When the Trustee requested dates for a Rule 2004 exam, Debtor’s counsel did not respond. When the Trustee noticed the exam anyway, Debtor’s counsel objected to the production requests on the basis that they went back more than one year. This was material because one of the allegations was that the Debtor had transferred property to her son more than one year before the petition, but less than the four years in which an action could be commenced under the Texas Uniform Fraudulent Transfer Act.

The Debtor failed to appear for the scheduled Rule 2004 exam and counsel contended that he had not heard from her in several weeks. Shortly thereafter, the Debtor’s second lawyer filed a motion to withdraw. At this point, he had been representing the Debtor for just over five months. The Court allowed Debtor’s second attorney to withdraw, but noted that “This order is without prejudice to any claims, ethical or otherwise, held by the Ch. 7 trustee.”

The Trustee’s counsel informed Debtor’s second attorney that he should reimburse the Trustee for the cost of responding to the Motion to Dismiss. Counsel never accepted the Trustee’s offer to make amends. This would prove to be a poor choice.

The Motion to Dismiss was eventually denied, some eleven months after it was filed. The Trustee eventually found out that the Debtor had transferred away over $90,000 in assets. The Trustee obtained a default judgment in the adversary proceeding he brought to recover these assets. Finally, several years later and after filing a forcible detainer action, the Trustee recovered two pieces of real property. The properties had been thoroughly trashed and the words “Thou Shalt Not Steal or Covet” and other similar phrases had been written on the walls. The Debtor and her son blamed this vandalism upon day laborers who did not otherwise speak English but were apparently able to quote the Bible in a foreign language.

On May 9, 2006, the Trustee’s counsel sent Debtor’s substitute counsel the first of several letters stating that the Trustee intended to seek sanctions. The third letter provided Debtor’s counsel with a proposed motion for sanctions and informed him that the motion would be filed the next day if a settlement offer was not forthcoming. Debtor’s counsel did not make a settlement offer and so the Motion for Sanctions was filed some five years after the substitute counsel had first been retained. The Court subsequently issued its own show cause order requiring the Debtor, her son and the initial attorney to show cause why they should not be sanctioned as well.

At the hearing on sanctions, it was brought out that Debtor’s second attorney was the same attorney who had been sanctioned by Judge Steen in the case of In re Thomas, 337 B.R. 879 (Bankr. S.D. Tex. 2006), which had involved false scheduling of IRS claims.

The Court’s Ruling

One of the more interesting aspects of this case was the passage of time. Although not explicitly stated by the court, claims for sanctions are apparently not subject to traditional limitations periods. In the introduction to its opinion, the Court summarily disposed of the delay issue, stating:

"The attorney . . . raises certain defenses, not the least of which is that his actions occurred in 2001, and to sanction him now after the passage of this much time is absurd and unfair. It is neither. Indeed, (counsel) has known since 2001 that the Chapter 7 trustee was very unhappy with his conduct, and ever since the Trustee's initial expression to (counsel) of misgivings about his conduct, the Trustee has repeatedly told him that he needed to reimburse the Trustee for the unnecessary legal fees and expenses which the Trustee incurred due to (counsel's) conduct. . . . Given that, in 2006, the Trustee was finally able to liquidate certain assets, the existence of which (counsel) did everything in 2001 to prevent the Trustee from uncovering , the Trustee's Motion for Sanctions is hardly absurd or untimely. Just the converse: it is reasonable and timely."

Opinion, at 2-3.

Thus, with apologies to Neil Young, sanctions, like rust, never sleep.

Having disposed of the timeliness issue, the Court concluded that Rule 9011 did not apply. Because the Trustee did not send a sanctions demand letter until May 9, 2006, some four years after the court ruled upon the motion to dismiss, counsel was never given the opportunity to withdraw the offending pleading. As a result, sanctions under this rule were not available. However, that was not the end of the inquiry.

Instead, the Court found that it could use its inherent powers under §105 to impose sanctions. On the surface, this appears to be an end run around the text of the rule. However, it is one endorsed by the Supreme Court. In Chambers v. Masco, 501 U.S. 32, 111 S.Ct. 2123, 115 L.Ed.2d 27 (1991), the Supreme Court stated that a court’s inherent power includes situations where “neither the statute nor the Rules are up to the task.” Thus, the text of Rule 9011 appears to be largely superfluous, since the court can find that the rule is not up to the task and grant relief beyond what is expressly authorized.

The Court also found that where the relief requested does not include disbarment or suspension, that proof by a preponderance of the evidence will suffice.

The Court found that counsel had engaged in five instances of sanctionable conduct: (1) he “concocted” a reason for her not to attend the first meeting of creditors and then instructed her not to do so; (2) he personally did not attend the meeting of creditors; (3) he filed a Motion to Dismiss “which included blatantly false factual and legal contentions;” (4) he wrote a letter to the Trustee’s counsel objecting to production of documents which disingenuously argued the wrong look-back period as a ground for not producing documents; and (5) he instructed the Debtor not to produce documents after prior counsel had agreed that the Debtor would do so. The Court found that sanctions were particularly appropriate because the attorney was board certified.


The Court also found that sanctions could be imposed under 28 U.S.C. §1927, which allows the court to order any attorney “who so multiplies the proceedings in any case unreasonably or vexatiously” to pay “the excess costs, expenses and attorneys’ fees reasonably incurred because of such conduct.”

The Court imposed aggregate sanctions in the amount of $25,121.89 against the Debtor’s substitute counsel, consisting of: (1) disgorgement of the $2,500 retainer paid to counsel; (2) reimbursement of the Trustee’s attorney’s fees of $6,901.25 and costs of $704.47 incurred in responding to the Motion to Dismiss; and (3) reimbursement of the Trustee’s attorney’s fees of $13,951.25 and costs of $1,064.92 incurred in prosecuting the Motion for Sanctions. The Court also imposed sanctions against the Debtor and her son in the amount of $50,000 for damage to the real properties.

In its Conclusion, the Court made the following comments which summed up its feelings about the matter:

“Lawyers occupy a special position in this country’s judicial system. Not only are they representatives of an advocates for their clients, but they are also officers of the court who bear responsibility for ensuring the integrity and fairness of our judicial system. (citation omitted). Particularly in the consumer bankruptcy system, where the clients are typically very unsophisticated about their legal duties and in desperate straits personally, attorneys must take emphatic care to encourage their clients to comply with the requirements of the Bankruptcy Code and the Bankruptcy Rules.

“In the case at bar, (Debtor’s substitute counsel) not only failed to take such care; he went out of his way to encourage the Debtor to disregard the duties imposed upon her. . . .

“At the Sanctions hearing, (Debtor’s substitute counsel) testified that ‘I believe my representation of (the Debtor) was in accordance with acceptable practice. (citation omitted). This Court strongly disagrees. (Counsel’s) gaming of the judicial process by filing a frivolous Motion to Dismiss, his instructions to the Debtor not to attend the continued Meeting of Creditors and not to produce documents which (Debtor’s original counsel) had already agreed she would produce, and his misinforming the Trustee’s counsel about the one-year look back period—all of which was done to impede the Trustee’s investigation of the Debtor’s financial affairs—was completely inimical to acceptable practice, in Houston or anywhere else.

In sum, (Counsel’s) conduct I this Court has done much to justify the passage of BAPCPA. Congress might well be pleased to know that its perception of abuse is not unfounded. Congress would probably not be pleased to learn about (Counsel’s) conduct. For his actions, he will need to immediately write a cashier’s check to the Trustee in the amount of $25,121.89.”

Opinion, at 143-145.

What Does It Mean?

The Court’s grounds for awarding sanctions raise questions about where zealous advocacy of a client ends and when obstruction of the bankruptcy process begins. The initial strategy employed by counsel sought to protect his client from the consequences of her actions. This strategy was one possible response to a difficult predicament. As noted by the Court:

“At the Sanctions hearing, (counsel) testified that his job as counsel for the Debtor, was to look out for her interests, not the interests of creditors. (citation omitted). This court agrees with (counsel) that he had a duty to look out for the Debtor’s interests. This Court disagrees with the approach that he took to do so.”

Because there is not an automatic right to dismiss a chapter 7 case, as there is in chapter 13, counsel faced the prospect that a tenacious trustee would refuse to let go of the case once allegations of fraud had been raised. That is in fact what happened. The case went south for counsel when he failed to change tactics once he became aware that the Trustee and the ex-husband were not going to allow the case to quietly go away. At this point, both his duty to the Court and his instinct for self-preservation should have created a conflict between him and his client. This conflict could only be resolved by insisting that the client cooperate with the Trustee or by making a prompt withdrawal. The fact that counsel continued to pursue a doomed strategy was not only a poor choice, but was guaranteed to earn the Trustee’s enmity and the Court’s disdain.

The Debtor in this case did not need much encouragement to behave badly. Unfortunately counsel provided, and continued to provide, that encouragement over a period of several months (at least according to the Court’s findings). A prompter attempt to make the Debtor cooperate with the Trustee probably would not have changed the Debtor’s behavior. However, it might have salvaged counsel’s reputation.

A second lesson to be learned is that Debtor’s counsel lost a valuable opportunity to quietly settle the matter. Over a period of several years, the Trustee’s counsel patiently counsel to reimburse the Trustee for his expenses in opposing the Motion to Dismiss. These quiet efforts were followed by several increasingly more insistent letters. Had counsel heeded these warnings and settled up with the Trustee, he could have limited his liability to $7,000 and avoided a 100+ page written opinion. This illustrates the rule that nearly any bad situation can be made worse by failing to address it early on.

Update:

This case was appealed to the U.S. District Court. On December 28, 2007, U.S. District Judge Sim Lake issued a Memorandum Opinion in which he affirmed the portion of the order requiring Debtor's counsel to return his retainer in the amount of $2,500, but reversed the remaining award in the amount of $22,621.89. Barry v. Sommers, No. H-07-0629 (S.D. Tex. 12/28/07). The case has now been appealed to the Fifth Circuit Court of Appeals.

On October 23, 2008, the Fifth Circuit reversed the District Court opinion and entered an order affirming the Bankruptcy Court opinion. Matter of Cochener, No. 08-20048, 2008 WL 4681579 (5th Cir. 2008).

Mother-Daughter Debacle Plays Out in Waco; Family Debts Determined to Be Dischargeable

“Traditionally, trials of family conflicts often involve emotion and controversy, yet are short on reason, logic and admissible evidence. These adversary proceedings share these traits.” Thus, began Judge Larry Kelly’s Memorandum Opinion in which he sought to sort out the tangled mother-daughter disputes in Rose Douso Petro v. Irene E. Holland, et al, Adv. No. 06-6001, 06-6002 and 06-6004 (Bankr. W.D. Tex. 1/12/07). This opinion is significant both because it was one of Judge Kelly’s final opinions prior to retirement (after 20+ years on the bench) and because it offers an object lesson in the difficulty in translating informal family dealings into legal proceedings.

Some Background

In better times, Irene Holland was married to Scottie Holland and Irene’s parents advanced money to her. These borrowings were later documented in a promissory note in the amount of $305,000 in 1988. The debt was evidenced by a note which was payable on November 1, 1993 or when the Hollands sold a piece of property they owned in San Antonio. Seven years later, the Hollands sold the San Antonio property but neglected to pay off the note. According to Irene’s mother Rose Petro, they also failed to inform her of the sale. Rose contended that she did not learn of the sale until spring 2002, some 14 years after the date of the loan and seven years after the sale.

In the spring of 2003, the Hollands sold a residence they owned in Hawaii for $1.6 million. Around the same time, they divorced. In connection with the divorce, the Hollands agreed that Rose would receive $286,568.53 out of the sales proceeds to be paid on her note. Judge Kelly noted that there is no explanation for why they chose this amount rather than the full face amount of the note (although apparently this is what Irene believed was owing). The Title Company issued the check payable to Rose, but wrote it in care of Irene. It is not explained why the check went to Irene. However, a lot of subsequent litigation could have been avoided if the check had gone straight to Rose. In apparent violation of the divorce agreement, Irene returned the check to the title company and requested that it be voided. In its place, she requested that four new checks be issued. One of the four checks was issued to Rose in the amount of $110,000 and was received by Rose. In a development which would become important later, Irene contended that Rose gave her permission to do this.

Rose was not happy when she found out what had happened. In June 2004, she sued Irene, Scottie and the title company in District Court in Bell County. The state court found that it lacked jurisdiction over the title company and dismissed all claims against it. Irene engaged Waco attorney John Montez and filed bankruptcy during the October 2005 bankruptcy rush. At this point, adversary proceedings began to get filed left and right. Rose removed the state court litigation to bankruptcy court where it was assigned Adv. No. 06-6001. She then filed a complaint against Irene seeking to except her debt from discharge under Sec. 523(a)(2), (4) and (6) and objecting to Irene’s general discharge under Sec. 727(a)(2)-(5). This became Adv. No. 06-6002. Scottie filed his own adversary proceeding based on breach of the Agreement Incident to Divorce, which was docketed as Adv. No. 06-6004. Prior to trial, Scottie settled his claims against Irene as well as Rose’s claims against him. Thus, the sole issues which remained for trial were Rose’s claims against Irene.

The Trial

Prior to trial, it appeared as though Irene had not gone out of her way to repay the note to her parents. However, it was unclear whether this would translate into a non-dischargeable debt.

Before determining whether the debt was non-dischargeable, the court had to decide whether there was even an enforceable debt. The promissory note was due within four years after the property sold. Since the property was sold on March 29, 2000, the deadline to file suit would have expired on March 29, 2004, approximately three months before suit was actually filed. The court found that Irene had not fraudulently concealed the sale of the property from her mother and that her mother knew about the sale by 2002. As a result, the court concluded that the original debt was barred by limitations. However, under Texas law, a debt barred by limitations can be revived by a written agreement signed by the obligor. Even though Rose was apparently unaware of the terms of the Agreement Incident to Divorce, the Court found that Rose was a third party beneficiary of this agreement and that it was sufficient to revive the debt. Thus, but for Irene and Scottie’s agreement to provide for Rose in their divorce, the debt would have been unenforceable and the court’s opinion would have been much shorter.

Having overcome the limitations defense, Rose still needed to prove one of the grounds for non-dischargeability which she alleged.

Fraud

The court had no trouble dispatching the fraud ground under Sec. 523(a)(2). There was simply no evidence that Irene had made a false representation at the time that the note was executed or that Rose had relied upon any false representation. Since Rose did not know about the Agreement Incident to Divorce, it was not possible for her to rely upon this agreement as a false representation. While Irene very likely made a false representation to Scottie, she wisely resolved her dispute with him.

This illustrates an important distinction between “fraud” in the popular sense and the legal sense. If I make a promise to pay you with the best of intentions and then later make a capricious and whimsical decision not to pay, even though I had the ability to do so, you would feel defrauded. However, legally this constitutes nothing more than a breach of contract. The essence of fraud is a false representation made with bad intent which is relied upon by the other party to their detriment. If the representation is originally made with good intent, all the subsequent bad faith in the world will not transform the original representation into fraud. Thus, where the original promise is made honestly and there is subsequent bad conduct, the plaintiff must be able to show a subsequent false representation which they relied upon.

In a series of informal dealings over a lengthy period of time, such as in this case, proving anyone’s intent at the outset is nearly impossible.

Fraud or Defalcation in a Fiduciary Capacity

Fraud or defalcation in a fiduciary capacity under Sec. 523(a)(4) did not present much difficulty either. A fiduciary under federal law requires a much higher standard than under state law. A federal fiduciary must be akin to a trustee. The mother-daughter bond simply does not rise to this level. Judge Kelly found that there were no other factors, such as control over Rose’s finances, which would give rise to a fiduciary relationship. An argument could have been made that the Agreement Incident to Divorce imposed trustee-like duties upon Irene with respect to the cashiers check which was later voided. However, this claim would have likely failed based on Irene’s unrebutted testimony that Rose gave her permission to use the funds.

Embezzlement

The claim for embezzlement failed for the reason that the funds from the real estate closing were never property of Rose. In order for embezzlement to take place, there must be an appropriation of another person’s property for the debtor’s benefit with fraudulent intent. Here, Irene exercised control over a cashiers check made payable to Rose. However, once again, the popular wisdom parts company with the legal test. Under Texas law, a cashier’s check remains the property of the person who purchased it until it is delivered. Judge Kelly found that because the check for $286,568.53 was never delivered to Rose, it was never her property. Thus, while it looks bad that Irene canceled out the check and didn’t give the funds to Rose, it didn’t constitute embezzlement.


Willful and Malicious Injury

Finally, Judge Kelly found that the claim for willful and malicious injury under Sec. 523(a)(6) failed. Of all the claims, this one appeared to have the greatest chance of success. If the court had believed that Irene had voided the cashiers check from the real estate closing for the purpose of harming Rose, then the court might have been able to find willful and malicious injury. However, Irene testified at trial that she had oral permission from Rose to void the check. This testimony came out on direct examination from Rose’s attorney and was not rebutted. As a result, the testimony stood without contradiction and was accepted by the court. The result might have been different on a claim by Scottie, since he was certainly harmed by the failure to pay Rose. However, he had already settled with Rose and Irene prior to trial.

Conclusion

This case shows why the bankruptcy discharge is an imperfect screen for unethical or immoral behavior. Some observers would probably conclude that Irene behaved badly, or at least selfishly. Despite the fact that she had received a huge sum of money from her parents and signed a written promise to pay, she always found other things to spend her money on when she had the opportunity. Her conduct in agreeing to repay her mom out of the Hawaii sales proceeds and then voiding the check appears to constitute double dealing. Thus, it could be argued that good lawyering and weak laws helped Irene escape her just desserts.

However, a counter argument can be made that this was much ado about nothing. Irene’s parents did not treat the “loan” like a business transaction. They apparently advanced funds first and documented the transaction later. According to Irene, the note was never intended to be collected, but would be used to adjust the sisters’ share of the inheritance later. As found by Judge Kelly, the note would have been barred by limitations and become unenforceable were it not for Irene and Scottie’s decision to include it in the Agreement Incident to Divorce. While the decision to void the cashier’s check looks bad, the unrebutted testimony about verbal consent supports an inference that the mother may have initially approved the transaction and then changed her mind.

This case is a good example of why informal dealings based on trust make for bad legal cases. Rose could have protected herself if she had tried to enforce the note when it matured or when she found out about the sale of the San Antonio property. She did not do so, perhaps hoping that her daughter would eventually do the right thing. Or perhaps she never intended to enforce the note at the time it came due and only changed her mind after the fact. The Court had an unenviable job in trying to sort all the sort out the mother-daughter brawl. However, the resulting opinion provides a good primer on the law of dischargeability.

Houston Judges Continue Inquiry Into Practices of Prominent Creditors' Firm

Proceedings involving a prominent Houston creditors’ firm (hereafter referred to as the Firm)* heated up recently as two bankruptcy judges considered sanctions issues arising out of the Firm’s extensive bankruptcy practice. The Firm feuded publicly with the U.S. Trustee’s office while seeking to demonstrate the sincerity of its repentance. While a significant amount of information was added to the public record, no resolution is likely until mid-summer.

Background

The firm in question operates a high volume foreclosure and bankruptcy practice. Its recent spate of difficulties began on February 3, 2006, when U.S. Bankruptcy Judge Marvin Isgur assessed sanctions of $65,000 against the Firm in connection with its requests for attorney’s fees in connection with motions for relief from stay. In re Porcheddu, 338 B.R. 729 (Bankr. S.D. Tex. 2006). In the opinion, the court estimated that the firm filed 5,000 motions for relief from stay per year in the Southern District of Texas alone and estimated the Firm’s revenues from motions for relief from stay at $125,000 every two weeks.

U.S. Bankruptcy Judge Wesley Steen issued a series of orders arising out of objections to a chapter 13 plan filed by the Firm on behalf of its client, Countrywide Home Lending, Inc., which culminated in an opinion finding that sanctions should be assessed against the Firm. In re Allen, 2007 Bankr. LEXIS 231 (Bankr. S.D. Tex. 1/9/07). See “Court Rejects Defense of The Computer Made Me Do It” (1/10/07). The Court bemoaned the fact that prior warnings and the Porcheddu sanction had not caused the firm to change its behavior. The Court scheduled a hearing at which the Firm was ordered to appear and report what sanctions would deter future repetition of the conduct.

Meanwhile, Judge Jeff Bohm issued his own show cause order after the Firm filed a motion for relief from stay and then withdrew it following allegations that it was based on a flawed payment history. In re Parsley, No. 05-90374 (Bankr. S.D. Tex. 2/12/07). This case involved Countrywide as well. (Note: The specific allegations regarding the accuracy of the pay history are disputed. Apparently the debtor would have been in default even if the two disputed payments were disregarded). Judge Bohm scheduled a hearing for March 5, 2007.

Thus, by the end of February 2007, one Houston judge had assessed sanctions against the Firm, a second Houston judge was preparing to assess sanctions and a third Houston judge was considering whether sanctions should be imposed. The stage was set for March madness.

The Parsley Hearing

Judge Bohm’s case was the first to be scheduled for a hearing. On March 2, 2007, the U.S. Trustee appeared and submitted a nine page Statement. The U.S. Trustee suggested that the Court should investigate whether Countrywide and its counsel had engaged in similar conduct in the past and should consider that information when deciding whether to assess sanctions. The U.S. Trustee concluded that “additional inquiry is needed to determine with certainty whether conduct at issue involves bad faith.” On the day of the hearing, the Firm's counsel filed an Emergency Motion to Strike, or in the alternative to Limit Issues and/or to Continue Hearing. The Firm objected that the U.S. Trustee had “at the eleventh hour” requested that the Court’s inquiry “be exponentially expanded.” The Firm also questioned the trustee’s ability to participate and criticized its failure to confer prior to filing its Statement.

The Bankruptcy Court declined to strike the U.S. Trustee’s Statement. The Court heard some testimony and then continued the remainder of the hearing until June 26, 2007. Some of the testimony received at the hearing related to the relationship between the Firm and its client. Specifically, testimony was received which indicated that Countrywide Home Lending, Inc. did not allow the Firm to communicate directly with it, but instead required that all communications be routed through another law firm.

In a post-hearing brief, the Firm argued that it had acted simply as local counsel for the referring law firm and had acted reasonably in relying upon the information provided to it.

The Allen Hearing

Shortly after the Parsley hearing, Judge Steen invited the U.S. Trustee to submit a statement in his case as well. When the U.S. Trustee submitted its statement one week later, it had grown to 35 pages and included selections from the transcript of the Parsley hearing. The U.S. Trustee suggested that the court expand its inquiry to examine the relationship between the Firm, Countrywide Home Lending and the national firm identified as the go-between. The U.S. Trustee pointed to specific statements by the Firm which referenced direct communications with Countrywide and suggested that these statements could not be correct if the Firm were not allowed to speak directly with its client.

The Firm's attorneys were not amused by the U.S. Trustee’s comments. They stated, “It is at once poignant and disturbing to witness the U.S. Trustee – in connection with a Rule 9011 sanction hearing – file a pleading containing reckless and untrue allegations concerning (the Firm) and third parties.” The Firm's counsel sent a Rule 9011 safe harbor letter to the U.S. Trustee demanding that it withdraw its allegations and attached a copy to its response. Apparently, there were only certain types of loans where Countrywide required that all of its law firms communicate through a single law firm. The Parsley case involved a no direct contact case, where the Allen case apparently involved a case where direct contact was allowed. The bemused U.S. Trustee pointed out that it had simply quoted from the transcript in the Parsley case.

In preparation for the Allen hearing, the Firm's attorneys filed several pleadings designed to show the sincerity of the Firm's repentance. In response to an order from Judge Steen requiring it to disclose “all similar occurrences and proceedings involving the firm” in the prior five years, the Firm submitted a list of nine proceedings which it contended were directly relevant (including Porcheddu, Allen and Parsley), as well as five other incidents which it contended were not directly relevant but were submitted in the interest of full disclosure.

The Firm also submitted a Response in which it accepted responsibility for its actions. It suggested that the Court consider the damage to the Firm’s reputation in assessing a sanction** and detailed a list of actions taken subsequent to the Porcheddu opinion. Among other things, the Firm stated through its counsel that:

• It had hired an experienced Managing Bankruptcy Attorney in April 2006;
• It had retained former bankruptcy judge Bill Brister as an independent “legal” auditor;
• It had conducted in-house trainings, including training in ethics and attorney due diligence as well as the specific issues raised by the Allen case;
• It had required additional CLE for its staff;
• It made 211 changes to its software during 2006;
• It had developed new payment tracking software;
• It had required that its motions include payment histories certified by its clients;
• It had required greater involvement and review by senior attorneys; and
• It had terminated two attorneys.

The Firm estimated the compliance costs which it had incurred at over $2 million.

On March 22, 2007, Judge Steen conducted a hearing on the sanction to be imposed. However, he did not make a ruling at that time. Instead, he entered an Order for Continuance, Supplemental Report, and Discovery. The Court made the following rulings:

• It required the U.S. Trustee and the Firm to confer about whether discovery was required with regard to the Certificate of Conference attached to the Firm’s first objection to plan confirmation;
• It allowed the U.S. Trustee to file a revised Statement based upon the testimony received and the discussion regarding the Certificate of Conference;
• It allowed the Firm to respond to the U.S. Trustee’s revised Statement and to respond to issues addressed in open court with regard to Case No. 04-50312; and
• It stated that it might enter an order stating that it would rule without any further hearings or it might hold a hearing to consider an update from Judge Brister and to determine the issues surrounding the Certificate of Conference.

The Court’s order indicates concern in two specific areas. The objection to confirmation contained a Certificate of Conference which recited that “I, (Attorney), an attorney employed by the offices of (the Firm) made a good faith effort to negotiate a settlement of the dispute with Debtor’s counsel. Resolution of this dispute was not successful and the filing of this Objection to Confirmation is therefore necessary.” If the parties had conferred and the Debtor’s counsel failed to raise the issue subsequently raised in its response, then the mistakes in the subsequent pleadings would be more innocent. On the other hand, if no conference occurred, then the subsequent errors would appear more serious. A false certificate combined with an erroneous pleading would be more serious than an erroneous pleading standing alone.

The Court also focused attention on prior proceedings in In re Cordova. Cordova was a case in which an objection to confirmation had been filed and then withdrawn. On January 12, 2005, Judge Steen issued an Order Continuing Hearing and Requiring Attendance at Hearing to Show Case Why Sanctions Under Rule 9011 Are Not Appropriate. According to the docket, Judge Steen admonished the Firm, but declined to issue sanctions at that time. Curiously, the Cordova case was not mentioned by the Firm in its self-disclosure of “similar occurrences and proceedings” despite the fact that Judge Steen's Allen opinion had specifically referred to a prior instance in which he had admonished the Firm.

What Does It All Mean?

In the short-term, there has been a lot of attention focused on the Firm without any resolution of the issues. However, the cases raise several important questions.

How does a firm handle a high volume of cases and still satisfy its professional obligations? That seems to be the question raised by the Houston judges. It is also seems to be the issue which the Firm has addressed in its responses.

There is also a question as to the extent that the Firm must assume responsibility for the information provided by its clients. In the Parsley case, the Firm apparently submitted inaccurate information which it received from its client (although the extent to which the information was inaccurate is a matter of dispute). To what extent should the Firm be responsible for policing the accuracy of the information received from its clients? Under the new procedure proposed by the Firm, the Firm’s clients must certify as to the accuracy of its pay histories. At what point does any attorney have an affirmative obligation to question the information being provided by his client?

What is the Firm’s obligation to disclose that it is merely acting as local counsel and does not have direct contact with its client? In at least the Parsley case, it appears to be undisputed that the Firm accepted referrals from another law firm on the condition that all communications go through that law firm. However, the Firm filed pleadings in which the identity of the other firm was not disclosed. If a Firm files pleadings on behalf of a client, is it representing that it has had direct contact with that client?

___________________________

*The identity of the firm involved is widely known. However, it is this blog’s policy not to specifically name attorneys involved in sanctions issues.
**In a separate pleading, the Firm stated that “The spoken and written comments by the Court are widely read, blogged, and commented on by practitioners and other courts as well as clients and potential clients.”

Mental Incapacity Excuses Debtor From Credit Counseling; Prior History Proves Insufficient Grounds for Dismissal

Judge Robert Jones from the Northern District of Texas was recently faced with a situation which looked like an easy candidate for dismissal. The debtor filed pro se, did not obtain credit counseling, had previously filed ten unsuccessful bankruptcy cases and had filed over 100 suits against various parties. Despite the debtor's unsympathetic profile, the court carefully read the statute and considered the circumstances in determining not to dismiss the case. In re Jarrell, No. 06-10409 (Bankr. N.D. Tex. 3/9/07).

The Incapacity Exception to Credit Counseling

While the requirement to obtain credit counseling is well known, the exceptions are somewhat more obscure. Under Sec. 109(h)(4), a debtor may be excused from credit counseling if he has an incapacity or a disability. Incapacity is defined as meaning that the debtor "is impaired by reason of mental illness or mental deficiency so that he is incapable of realizing and making rational decisions with respect to his financial responsibilities." Disability means that "the debtor is so physically impaired as to be unable, after reasonable effort, to participate in an in person, telephone, or Internet briefing."

At the hearing on the motion to dismiss, the debtor's psychologist testified he had diagnosed the debtor with bipolar disorder, schizophrenia and clinical depression. The psychologist testified that the debtor "is severely impaired to the point where he is unable to make rational decisions regarding his financial responsibilities and ... doesn't have the mental ability to realize his decisions are irresponsible." On the other hand, the debtor had sufficient capacity to recognize his income and specific assets and debts. The court was satisfied that the debtor had a mental illness and commented that his filing of over 100 lawsuits "may in and of itself be evidence of mental illness." Based on the undisputed testimony of the psychologist, the court found that the debtor's mental incapacity was sufficient to justify a waiver of the pre-filing credit counseling briefing.

Judge Jones's ruling should be unremarkable for the reason that he read the statute and applied it as written. However, the exception which the court applied highlights a weakness in the statute itself. The credit counseling requirement has been described as "absurd," "a meaningless formality" and "a trap for the unwary" by Texas judges. In re Sosa, 336 B.R. 115 (Bankr. W.D. Tex. 2005); In re Navarro, No. 06-51007 (Bankr. W.D. Tex. 6/27/06). While the mentally ill may escape credit counseling due to the fact that they would not receive a benefit from it, other debtors must still fulfill the requirement regardless of whether it serves a useful purpose.

Dismissal for Bad Faith/Totality of the Circumstances

The court also considered whether the case should be dismissed under Sec. 707(b)(3) based on bad faith or totality of the circumstances. The court noted that there was certainly plenty of evidence to raise the specter of bad faith. Double-digit bankruptcy filings, triple-digit lawsuits and dilatory conduct in dealing with his major creditor all pointed to a debtor who was out of control and gaming the system. However, Judge Jones made an admirable effort to go below the surface and analyze the significance of the facts.

First, the court examined the circumstances of the present case. The debtor filed after Huntington State Bank obtained a judgment against him. The debtor testified that he was concerned that the judgment could cause him to lose his home and social security payments. The court found that this was a legitimate reason for filing.

It was true that the debtor filed many unsuccessful bankruptcies and frivolous lawsuits. However, this conduct occurred before the debtor moved to Texas and incurred the debt which ultimately caused him to file bankruptcy. As a result, the court found that there no connection between the prior pattern of bad conduct and the present case. Additionally, the present case was distinguishable from the typical serial filing abuser. As Judge Jones noted, the modus operendi of a serial filer involves the filing and dismissal of multiple cases. Failure to follow through with the bankruptcy case is part and parcel of what makes it abusive. Here, the debtor, after filing pro se, retained qualified counsel, filed schedules and the statement of financial affairs and appeared at his first meeting of creditors. Thus, the debtor was faced with possible dismissal for bad faith at the point where he was finally taking his obligations to the bankruptcy court seriously.

The court considered the effect of allowing the bankruptcy case to proceed on each of the constituent parties. The court found that creditors would not be harmed since it was unlikely that the debtor would ever accumulate significant wealth. (Left unasked was the question of what the bank was thinking when it extended credit to a person who had previously filed ten bankruptcies, whose only income consisted of social security and who had serious mental health issues.).

The court found that the debtor would benefit:

"Jarrell has more problems than should be visited upon any human being. His wife and four children suffer from various illnesses; Jarrell is very sick. While no one deserves a free pass by simply offering up the excuse that he does not know wht he is doing, Jarrell's situation is unique. This bankruptcy will not begin to address the majority of the many problems that Jarrell has, but it may provide token relief from some of his debts."

Finally, the court considered the interests of the court and judicial process. The court found that Mr. Jarrell's conduct had burdened both the state and federal courts and the public at large. Nevertheless, the court decided to give him one last chance. "The Court concludes that it will take Jarrell with his many problems and issues, at least one more time, and allow him the opportunity to pursue some modicum of relief." Thus, the court decided to retain the case even though it was undesirable.

Recognition to Debtor's Counsel

Debtor's counsel, Dick Harris, should be commended for taking on a difficult and unsympathetic client. While he may not be paid much (or at all) for his efforts, the court's opinion recognizes him as a "competent counsel (who) has for many years practiced before this Court representing both creditors and debtors in a professional manner."

Supreme Court Allows Recovery of Post-Petition Attorney's Fees Based On Pre-Petition Contract

In a unanimous opinion, the Supreme Court ruled that nothing in the Bankruptcy Code prohibits a creditor from asserting an unsecured claim for attorney's fees incurred post-petition where such fees would have been recoverable outside of bankruptcy. Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co., No. 05-1429 (U.S. 3/20/07).

Travelers had issued a surety bond to Pacific Gas & Electric. In connection with the bond, the parties executed a series of indemnity agreements which allowed recovery of attorney's fees incurred in protecting Travelers rights. Travelers filed a claim to protect itself in the event that the debtor defaulted in the future. The debtor's plan preserved Travelers right to subrogation and indemnity in the event of a default, but Travelers disputed whether the language was sufficient. As part of a settlement, PG & E agreed that Travelers could assert an unsecured claim for its attorney's fees. However, when Travelers amended its claim to add the attorney's fees, the debtor objected. The Bankruptcy Court sustained the objection based upon a Ninth Circuit decision which held that attorney's fees were not recoverable for litigating issues unique to bankruptcy. In re Fobian, 951 F.2d 1149 (9th Cir. 1991). Not surprisingly, the District Court and the Ninth Circuit affirmed.

The Supreme Court reversed, finding that Sec. 502(b)(1) generally allows claims to the same extent that they would be allowable outside of bankruptcy. The only subsection of Sec. 502(b) which addresses recovery of attorney's fees is Sec. 502(b)(4), which limits claims by an attorney for the debtor to the reasonable value of such services. Thus, where the Code contained a specific limitation on attorney's fees, the Court would not imply a broader one.

The Supreme Court found that Fobian did not have any support in the language of the Bankruptcy Code. Travelers did not attempt to defend the Fobian rule. Instead, it argued that because Sec. 506(b) only allows attorney's fees to oversecured creditors, that unsecured creditors should not be entitled to recover them at all. The Supreme Court declined to address this argument on the basis that it had not been raised in the lower courts.

This ruling is important for what is decides and for what it does not decide. The first important point is that this case was determined with regard to unsecured claims under Sec. 502(b). Even though the litigation in this case took place post-petition, the creditor did not attempt to assert a post-petition administrative claim. The Supreme Court's broad reading of claims allowable under Sec. 502 would not apply to administrative claims under Sec. 503, which have a much narrower scope. Although it was not discussed in the Supreme Court's opinion, it appears that the parties recognized that litigation under a pre-petition contract created a pre-petition claim even though the litigation occurred during the bankruptcy. The Travelers opinion will create more opportunities for parties who could have recovered attorney's fees pre-petition to amend their unsecured claims to include post-petition attorney's fees. For example, if the debtor unsuccessfully objects to a proof of claim which had a contractual attorney's fees provision, the creditor could add the fees for defending the claim to its unsecured claim. In most cases, adding additional amounts to the unsecured pot will not have a major effect on the case. However, the potential for amending claims after the bar date could create administrative headaches in cases.

The opinion also creates potential tension between Sec. 502(b) and Sec. 506(b). Sec. 502(b)(2) disallows claims for unmatured interest, while Sec. 506(b) allows interest to oversecured claimants. Thus, these two sections are consistent. On the other hand, Sec. 502(b) is silent as to allowance of attorney's fees while Sec. 506(b) allows such fees only to oversecured creditors. Thus, there is a potential for claims for post-petition attorney's fees to be allowed under Sec. 502(b) and disallowed under Sec. 506(b). Because the Sec. 506(b) issue on attorney's fees was not addressed by the Supreme Court, lower courts will have to guess at how it would resolve this issue. However, it may be a safe bet to assume that with all nine justices silent, it might be reasonable to assume that the Supreme Court would find a way to reconcile the two statutes as opposed to overruling a recent precedent.

Judge Clark Protects the Brooklyn Bridge

The prolific Judge Leif Clark, who has written many memorable footnotes, including one quoted here yesterday, has written another one which is both quotable and addresses an important point. In In re Rendon, No. 06-52501 (Bankr. W.D. Tex. 3/15/07), a party who claimed to be purchasing a home from the debtors filed a Motion to Create Equitable Lien/Motion for Expedited or Emergency Hearing. The court found that the motion requested three forms of relief: an order quieting title, an injunction and an objection to the debtors’ claim of exemption. The court found that the first two forms of relief must be brought in an adversary proceeding and dismissed the motion without prejudice. The court found that the objection to exemptions was untimely and must be denied. Even though the purchasers were not listed as creditors in the bankruptcy, they admitted that they had actual knowledge of the bankruptcy case prior to the 341 meeting.

The court noted that the mere fact that the debtors had successfully claimed the property as exempt did not establish their ownership of the property. In a footnote, the court added the following comment:

"Just in case there is any confusion, let’s suppose I claim an exemption on the Brooklyn Bridge, and you fail to timely object to my exemption claim. Is the sainted bridge thus exempt? Technically, section 522(l) says it is. But of course, what difference does my exemption claim make if Hizzoner, Mayor Bloomberg, comes to court and successfully establishes that, in fact, the Brooklyn Bridge is not my bridge to claim, but is safely still the property of the City of New York, safely untarnished by my exercise in hubris? None at all you correctly reply, none whatsoever.”

It is important to note that an exemption merely determines whether property is excluded from the estate. However, it does not operate to grant title to the property. Mayor Bloomberg will no doubt sleep more soundly.

Forum Shopping Is Bad--Or Is It???

Judge Leif Clark recently wrote a very brief opinion with regard to jury demands and forum shopping. He ruled that the defendant's good or bad faith was not relevant to whether a jury could be demanded. Osherow v. Clonch Industries, Adv. No. 06-5200 (Bankr. W.D. Tex. 2/5/07). He stated:

"Congress has authorized bankruptcy courts to adjudicate matters involving trial by jury, but only with the consent of all the parties. A party can thus easily obtain a change of fourm by the fiat of first demanding a jury then refusing to consent to the bankruptcy court's conduct of the trial. (citation omitted). A pleading filed for the purpose of forum shopping is potentially sanctionable. Then again, it might not be (citation omitted)."

In support of the proposition that forum shopping might not be bad, Judge Clark cited this wonderful comment from Judge Rubin of the Fifth Circuit:

"Forum-shopping is sanctioned by our judicial system. It is as American as the Constitition, peremptory challenges to jurors, and our dual system of state and federal courts."

McCuin v. Texas Power & Light Co., 714 F.2d 1255, 1261 (5th Cir. 1983).

So, the next time someone hurls the charge of forum-shopping, be sure to point out that you are defending the Constitition and the American way (although you might still want to have an argument as to why you are engaging in good forum-shopping as opposed to the other kind).

Lunchtime Conversation Prompts Judicial Inquiry, Pt. 3

Previous posts discussed the independent investigation initiated by Judge Marvin Isgur with regard to a credit counseling firm in the Southern District of Texas. Judge Isgur was concerned with regard to statements made at a lunchtime presentation which suggested that Money Management International refused to hire individuals who had filed bankruptcy as credit counselors.

At the hearing on March 1, 2007, MMI appeared and informed the court that "it does hire individuals notwithstanding any prior bankruptcy filing." The court was not completely satisfied and wanted to know whether they had hired former debtors in the past and whether they would in the future. As a result, the court continued the status conference to March 30, 2007.

Subsequent to the hearing, MMI submitted a new affidavit which represented that at least 24 of its current employees, including a manager and two supervisors, had filed for bankruptcy in the past. The affidavit also represented that "MMI intends to continue the practice of hiring qualified persons as credit counselors, including qualified persons who have been in bankruptcy." Thus, it would appear that the court's inquiry corrected a misunderstanding and most likely provided some job security for former bankrupts employed as credit counselors.

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.