This blog previously reported on In re Cochener, 360 B.R. 542 (Bankr. S.D. Tex. 2007), a case in which an attorney was sanctioned under 11 U.S.C. Sec. 105 and 28 U.S.C. Sec. 1927 based on events which had occurred years earlier. See "Brief Representation Comes Back to Haunt Attorney." (May 7, 2007). Now, a U.S. District Court has reversed most of the sanctions award and the case is on its way to the Fifth Circuit. Barry v. Sommers, No. H-07-0629 (S.D. Tex. 12/28/07).
What Happened in the Bankruptcy Court
The underlying case involved a debtor who had made questionable transfers prior to bankruptcy. When the trustee began asking difficult questions at the 341 meeting, the first attorney realized that he was in over his head and referred the case to a board certified attorney. The second attorney realized that the debtor was not helping herself by being in bankruptcy and tried to get the case dismissed. While the motion to dismiss was pending, the attorney advised the debtor not to attend a re-scheduled 341 meeting or to produce documents which the prior counsel had agreed to hand over. When the trustee sought to conduct a Rule 2004 examination, the second attorney argued against producing documents going back four years on the basis that 11 U.S.C. Sec. 548 only allowed the trustee to recover transfers made within one year prior to bankruptcy. The debtor failed to appear for the examination, after which the second attorney sought permission to withdraw. The second attorney was given permission to withdraw, but the court reserved the power to issue sanctions.
Over four years later, the trustee brought a motion for sanctions under Rule 9011 and 11 U.S.C. Sec. 105. Because the trustee had never given the safe harbor notice under Rule 9011, the court concluded that this relief was not viable. However, after hearing four days of testimony, the court granted relief under both Sec. 105 and 28 U.S.C. Sec. 1927 based upon the following actions:
(1) The attorney concocted a reason for the debtor not to attend the continued 341 meeting and then advised the debtor not to appear;
(2) The attorney did not attend the continued meeting of creditors;
(3) The attorney filed a motion to dismiss which included "blatantly false factual and legal allegations;"
(4) The attorney wrote a letter to the trustee which misstated the law regarding the appropriate lookback period for a fraudulent transfer case;
(5) The attorney instructed the debtor not to produce the documents requested at the initial meeting of creditors.
Based on these actions, the court awarded sanctions of $25,121.89 based upon disgorgement of the retainer paid to the attorney and payment of the trustee's attorney's fees incurred in resisting the motion to dismiss and prosecuting the motion for sanctions.
Reversal on Appeal
On appeal, the District Court reversed all of the sanctions, except for the disgorgement order. However, to get there, it had to work through several preliminary issues first.
The District Court refused to apply laches based on the delayed prosecution of the sanctions motion. While the four year delay in bringing the sanctions motion represented a long period of time, it was not prejudicial because the attorney had been placed on notice of the claim at the time of his withdrawal and because no evidence had become stale in the meantime.
The District Court also rejected the argument that the Bankruptcy Court lacked authority to issue sanctions under 11 U.S.C. Sec. 105. The Court noted the recent Supreme Court opinion in Marrama v. Citizens Bank of Massachusetts, 127 S.Ct. 1105 (2007)in which the court stated that section 105(a) provides Bankruptcy Courts broad authority to "take any action that is necessary or appropriate to prevent an abuse of process." The Court concluded that Sec. 105(a) gave bankruptcy courts the inherent power to sanction bad faith conduct that was applicable to Article III Courts under Chambers v. NASCO, Inc., 501 U.S. 32 (1991).
However, before sanctions could be awarded under the Court's inherent powers under Sec. 105(a), the court had to find bad-faith conduct. Bad faith conduct was equated with either an attempt to abuse the judicial process or an affirmative misrepresentation. After an exhaustive analysis, the District Court upheld the Bankruptcy Court's finding that the attorney had engaged in bad faith conduct when he told the debtor not to appear or produce documents at the continued 341 meeting. However, the District Court reversed the other findings as being clearly erroneous.
Having concluded that only one act was sanctionable, the District Court turned to the proper sanction to be applied. The Court noted that "Inherent powers may be exercised only if essential to preserve the authority of the court, and the sanction imposed must employ the least possible power adequate to the purpose to be achieved." Memorandum Opinion and Order, p. 81. The Court found that disgorgement of the retainer was appropriate under this standard. "Attorneys who instruct their clients to violate duties imposed by the Bankruptcy Code have not provided effective assistance of counsel and have not earned a fee." Memorandum, p. 83.
The District Court reversed the award of attorney's fees to the trustee. Because the Court found that filing the motion to dismiss was not sanctionable, it found that the Trustee could not recover his fees incurred in opposing the motion to dismiss. The District Court denied the attorney's fees incurred in prosecuting the motion for sanctions on the basis that the debtor's attorney (who had already withdrawn at this point) did not commit any sanctionable conduct during the time that the trustee was pursuing the motion for sanctions. As a result, an award of attorney's fees in connection with the motion for sanctions was not necessary to deter sanctionable conduct.
The District Court also found that the Bankruptcy Court abused its discretion in imposing sanctions under 28 U.S.C. Sec. 1927. The Court found that there were three elements to an award of sanctions of Sec. 1927: (1) the attorney must engaged in "unreasonable and vexatious" conduct; (2) the "unreasonable and vexatious" conduct must be conduct that "multiplies the proceedings;" and (3) the dollar amount of the sanction must bear a financial nexus to the excess proceedings, i.e., the sanction may not exceed the "costs, expenses and attorneys' fees reasonably incurred because of such conduct." The Court found that the motion to dismiss did not merit sanctions under Sec. 1927 because it could not be plausibly argued that it was filed in bad faith. Although the District Court found that the attorney could be sanctioned under Sec. 105 for advising the debtor not to attend the creditors' meeting, this conduct did not merit sanctions under Sec. 1927 for the reason that it did not multiply the proceedings.
The Final Analysis
In the final analysis, it appears that while Rule 9011, Sec. 105(a) and Sec. 1927 serve similar purposes, they each have slightly different focuses. Rule 9011 applies to pleadings and papers only. It applies where motions are filed for an improper purpose or are legally or factually frivolous. However, the mere filing of a frivolous or odorous pleading is not enough. It is the refusal to withdraw a sanctionable pleading after fair warning which triggers the penalty. This means that a victorious party cannot go back after the fact and decide that his opponent's position was friviolous. Sec. 105(a) and Sec. 1927, on the other hand, apply to any conduct and allow for an after the fact examination. As a result, these sections require a higher standard before sanctions can be awarded. In order to violate the Court inherent power under Sec. 105(a), counsel must make an affirmative misrepresentation or try to abuse the judicial process, either of which will add up to the requisite finding of bad faith. Sec. 1927 invokes the three-party test discussed above, which must include a finding that court proceedings were multiplied.
In this case, advising a client not to obey her duties under the Code was sanctionable, while filing a questionable motion to dismiss and taking a questionable position on a discovery matter (which was later abandoned) were not.
The Trustee has appealed this case to the Fifth Circuit, so that we may hear from this case again.
Kudos to the District Court
As a final note, U.S. District Judge Sim Lake deserves high praise for the diligence and speed with which he handled this bankruptcy appeal. He produced his thoughtful, 93-page opinion just ten months after the notice of appeal was filed and seven months after the last brief was filed. The Court did the parties and the bar a service with the prompt manner in which this case was handled.
Update:
On October 23, 2008, the Fifth Circuit reversed the opinion of the District Court and affirmed the opinion of the Bankruptcy Court. Matter of Cochener, No. 08-20048, 2008 WL 4681579 (5th Cir. 2008).
Friday, March 21, 2008
Monday, March 03, 2008
A Modest Proposal
There has been a lot of talk about the sub-prime mortgage crisis lately. The presidential candidates are very concerned about it, but don't seem to be offering a lot of specifics. One of the candidates wants to impose a 90 day moratorium on foreclosures. This will help the problem--for about 90 days.
Perhaps we as bankruptcy lawyers can suggest a remedy from our area of the law: credit counseling. After all, when do you really need credit counseling? If it is good to use when deciding to file bankruptcy, wouldn't it be even better when deciding whether to incur the debt in the first place?
Here is what I would envision. Prior to taking out a mortgage loan, a prospective borrower would have to receive a credit counseling briefing from someone who had actually read their loan documents and looked at their financials. If the credit counselor recommends against the loan and the borrowers still want to do it, the borrowers would have to pass a test on the contents of their loan documents (a passing grade being 70, the same as it is in public school). If the prospective borrower receives a passing grade on the exam and still wants to take out the bad loan, the credit counselor would give them a stern talking to and would stamp "Don't Do It!!!" on the loan application. If at this point, the borrower insists, they would be allowed to do the loan. After all, this is a free country. However, if they choose to take out a bad loan after being told not to do it, reading the loan documents and being told not to do it a second time, they would forfeit all protections under federal law. If they default, they could be subjected to abusive debt collectors, barred from filing bankruptcy and be thrown in debtor's prison.
On the other hand, if the borrower passed credit counseling, they would be allowed to take out the loan and would also receive a golden ticket. If they ever got into financial difficulty and were posted for foreclosure, they could take their golden ticket to the bankruptcy court and exchange it for one that said "honest but unfortunate debtor". With the "honest but unfortunate debtor" ticket, they would be allowed to restructure their loan at whatever level they could afford to pay. Why would we do this? If they have the golden ticket, we know that they made a responsible decision to incur credit. Since they made a responsible decision to incur credit, any subsequent default would have to be the result of unforeseeable hardship or calamity. Thus, we would know that they were the very picture of the honest but unfortunate debtor that the bankruptcy laws are supposed to protect.
This would be a win-win solution for almost everyone. Once a few debtors were cast into outer darkness for taking out debts that they had no business incurring, other borrowers would learn to shy away from the "Don't Do It!!!!" stamp. On the other hand, if lenders knew that they would have to live with debtors holding the golden ticket, they might be more careful about who they lend to. Of course, the other possibility is that people won't learn and will keep making the same mistakes over and over again and that the only people who benefit will be the newly minted armies of credit counselors. However, at least we know that someone would benefit.
Disclaimer: No firm that I work for or any of their clients approves this proposal.
Perhaps we as bankruptcy lawyers can suggest a remedy from our area of the law: credit counseling. After all, when do you really need credit counseling? If it is good to use when deciding to file bankruptcy, wouldn't it be even better when deciding whether to incur the debt in the first place?
Here is what I would envision. Prior to taking out a mortgage loan, a prospective borrower would have to receive a credit counseling briefing from someone who had actually read their loan documents and looked at their financials. If the credit counselor recommends against the loan and the borrowers still want to do it, the borrowers would have to pass a test on the contents of their loan documents (a passing grade being 70, the same as it is in public school). If the prospective borrower receives a passing grade on the exam and still wants to take out the bad loan, the credit counselor would give them a stern talking to and would stamp "Don't Do It!!!" on the loan application. If at this point, the borrower insists, they would be allowed to do the loan. After all, this is a free country. However, if they choose to take out a bad loan after being told not to do it, reading the loan documents and being told not to do it a second time, they would forfeit all protections under federal law. If they default, they could be subjected to abusive debt collectors, barred from filing bankruptcy and be thrown in debtor's prison.
On the other hand, if the borrower passed credit counseling, they would be allowed to take out the loan and would also receive a golden ticket. If they ever got into financial difficulty and were posted for foreclosure, they could take their golden ticket to the bankruptcy court and exchange it for one that said "honest but unfortunate debtor". With the "honest but unfortunate debtor" ticket, they would be allowed to restructure their loan at whatever level they could afford to pay. Why would we do this? If they have the golden ticket, we know that they made a responsible decision to incur credit. Since they made a responsible decision to incur credit, any subsequent default would have to be the result of unforeseeable hardship or calamity. Thus, we would know that they were the very picture of the honest but unfortunate debtor that the bankruptcy laws are supposed to protect.
This would be a win-win solution for almost everyone. Once a few debtors were cast into outer darkness for taking out debts that they had no business incurring, other borrowers would learn to shy away from the "Don't Do It!!!!" stamp. On the other hand, if lenders knew that they would have to live with debtors holding the golden ticket, they might be more careful about who they lend to. Of course, the other possibility is that people won't learn and will keep making the same mistakes over and over again and that the only people who benefit will be the newly minted armies of credit counselors. However, at least we know that someone would benefit.
Disclaimer: No firm that I work for or any of their clients approves this proposal.
Thursday, February 21, 2008
How to Count Backwards
Deadlines are important. As a result, it is important to know when a deadline falls. Fed.R.Bankr.P. 9006(a) explains that the last day of a period is not counted if it falls on a Saturday, Sunday or legal holiday. In that instance, the time period “runs until the end of the next day which is not one of the aforementioned days.” This is straightforward when the period runs forward. Thus, if an action is required to be taken 25 days after a given date and the last day falls on Sunday, the deadline would expire at the end of Monday unless Monday was a legal holiday. In this case, the 25 day period becomes an 26 day period. However, what happens when time is counted backwards? Assume that an action must be taken 25 days before a set date and the last day falls on a Saturday. Does the deadline expire on Friday (in which case the deadline is expanded to 26 days) or on Monday (in which case the deadline is truncated to 23 days).
San Antonio Bankruptcy Judge Leif Clark recently ruled that “next day” means Monday, not Friday. While acknowledging that “both conclusions are reasonable under the circumstances” he noted that “alas, there can be only one deadline.” He stated that, “Because the calculation of this deadline requires counting backward, the court finds that the determination of this ‘next day’ should continue counting backward. Therefore, when, as was the case here, the 25th day falls on a Saturday, Sunday or holiday, the deadline must be the next countable day before the 25th day.” In re Russell Keith Dick, No. 05-56196 (Bankr. W.D. Tex. 1/11/08).
Counting backward is a trap for the unwary. When counting forward, the rule protects the person taking the action who gets another day. However, when counting backward, the rule protects the person who is waiting for the action to be taken. Thus, the next day is actually the prior day when viewed on the calendar.
San Antonio Bankruptcy Judge Leif Clark recently ruled that “next day” means Monday, not Friday. While acknowledging that “both conclusions are reasonable under the circumstances” he noted that “alas, there can be only one deadline.” He stated that, “Because the calculation of this deadline requires counting backward, the court finds that the determination of this ‘next day’ should continue counting backward. Therefore, when, as was the case here, the 25th day falls on a Saturday, Sunday or holiday, the deadline must be the next countable day before the 25th day.” In re Russell Keith Dick, No. 05-56196 (Bankr. W.D. Tex. 1/11/08).
Counting backward is a trap for the unwary. When counting forward, the rule protects the person taking the action who gets another day. However, when counting backward, the rule protects the person who is waiting for the action to be taken. Thus, the next day is actually the prior day when viewed on the calendar.
Ten Day Rule Protects Trustee
Most bankruptcy lawyers find the arcane details of the Federal Rules of Civil Procedure to be deadly dull. However, for Austin Bankruptcy Trustee Dan Roberts, the difference between Fed.R.Civ.P. 59 and 60 proved to be very important. In re Geneva Peterson Berg, No. 06-11933 (Bankr. W.D. Tex. 2/7/08)(Judge Frank R. Monroe).
In the Berg case, the estate included a mineral interest which appeared to have little value. The Debtor valued it as $6,987 in her schedules, but was only willing to offer $3,000 to purchase it. When the Trustee contacted the operator, he found out that there was a well upon the mineral interest and that it was expected to produce $5,260 per year. Based on this information, the Trustee negotiated a sale to the operator for $25,000. After the Debtor offered more and an auction ensued, the court approved a sale for $34,000 and the sale closed. At this point, the Trustee should have felt very good, having increased the original offer by ten-fold.
Three days after the sale closed, the Trustee received a check for $10,190.80 representing one month’s production. It turns out that the operator had failed to mention that two new wells had been drilled on the lease as a result of a farm-out the previous year. The operator apparently gave the trustee accurate information about the existing well, but apparently took an attitude of “don’t ask, don’t tell” about any other wells which might be drilled. Based upon the new production, the value of the mineral interest was estimated at $180,000 to $300,000.
The Trustee was not amused and filed a prompt motion to reconsider the order approving the sale. The motion was filed less than ten days after entry of the initial order, which proved to be important.
The Bankruptcy Court noted that a motion filed within ten days was governed by Fed.R.Civ.P. 59, as incorporated by Fed.R.Bankr.P. 9023. Rule 59 allows relief from a judgment “for any reason for which a new trial has heretofore been granted in a suit in equity.” On the other hand, Fed.R.Civ.P. 60(b) allows relief up to one year from entry of an order, but is limited to the specific grounds listed within the rule (such as mistake inadvertence, surprise, excusable neglect, fraud and newly discovered evidence). Judge Monroe pointed out that while a motion was Rule 59 was subject to “much more stringent time limitations than a comparable motion under Rule 60(b),” it was not subject to “the same exacting substantive requirements.”
In practice, the standards under Rules 59 and 60 may be very similar. In fact, in the Berg case, Judge Monroe analyzed the motion to reconsider based on newly discovered evidence, which is a specified ground under Rule 60(b)(2). However, in this case, the tipping point may have been the interest in protecting the finality of bankruptcy sales. Where the motion to reconsider was filed within ten days of entry of the order, it was unlikely that the purchaser would have significantly relied upon the order. On the other hand, had the motion been filed six months or a year later, the prejudice to the buyer could have been significant. Thus, while motions under Rules 59 and 60(b) may consider the same or similar grounds, the court is much more likely to grant an equitable do-over under Rule 59 than Rule 60.
In the Berg case, the estate included a mineral interest which appeared to have little value. The Debtor valued it as $6,987 in her schedules, but was only willing to offer $3,000 to purchase it. When the Trustee contacted the operator, he found out that there was a well upon the mineral interest and that it was expected to produce $5,260 per year. Based on this information, the Trustee negotiated a sale to the operator for $25,000. After the Debtor offered more and an auction ensued, the court approved a sale for $34,000 and the sale closed. At this point, the Trustee should have felt very good, having increased the original offer by ten-fold.
Three days after the sale closed, the Trustee received a check for $10,190.80 representing one month’s production. It turns out that the operator had failed to mention that two new wells had been drilled on the lease as a result of a farm-out the previous year. The operator apparently gave the trustee accurate information about the existing well, but apparently took an attitude of “don’t ask, don’t tell” about any other wells which might be drilled. Based upon the new production, the value of the mineral interest was estimated at $180,000 to $300,000.
The Trustee was not amused and filed a prompt motion to reconsider the order approving the sale. The motion was filed less than ten days after entry of the initial order, which proved to be important.
The Bankruptcy Court noted that a motion filed within ten days was governed by Fed.R.Civ.P. 59, as incorporated by Fed.R.Bankr.P. 9023. Rule 59 allows relief from a judgment “for any reason for which a new trial has heretofore been granted in a suit in equity.” On the other hand, Fed.R.Civ.P. 60(b) allows relief up to one year from entry of an order, but is limited to the specific grounds listed within the rule (such as mistake inadvertence, surprise, excusable neglect, fraud and newly discovered evidence). Judge Monroe pointed out that while a motion was Rule 59 was subject to “much more stringent time limitations than a comparable motion under Rule 60(b),” it was not subject to “the same exacting substantive requirements.”
In practice, the standards under Rules 59 and 60 may be very similar. In fact, in the Berg case, Judge Monroe analyzed the motion to reconsider based on newly discovered evidence, which is a specified ground under Rule 60(b)(2). However, in this case, the tipping point may have been the interest in protecting the finality of bankruptcy sales. Where the motion to reconsider was filed within ten days of entry of the order, it was unlikely that the purchaser would have significantly relied upon the order. On the other hand, had the motion been filed six months or a year later, the prejudice to the buyer could have been significant. Thus, while motions under Rules 59 and 60(b) may consider the same or similar grounds, the court is much more likely to grant an equitable do-over under Rule 59 than Rule 60.
Saturday, February 02, 2008
Impressions of Jury Duty
As a lawyer, I never expected to be selected for jury duty. Although I have gone through voir dire several times in the past, I had always been struck or not reached. As a result, when I was called for service in County Court at Law #7, I expected to be back in the office by the end of the afternoon.
When I was seated in the jury pool, the odds were still against being selected. I was seated in position #12. A misdemeanor jury consists of six jurors. That meant that in order to be picked, five people ahead of me would have to be struck and I would have to avoid being struck myself.
Voir dire was both a warm-up for the trial itself and an interesting examination of the human condition. This case involved a misdemeanor DWI charge. Out of the randomly selected jury panel, there were several people with DWI arrests and one person who had lost a family member to a drunk driver. There several panel members who expressed distrust of police in general. Balancing them out was a jury member who volunteered that he had not had a drink since the 1970s. There was also a medical doctor who was familiar with a specific test which would prove to be important later on.
There were several interesting moments during jury selection. The prosecutor asked the panel for a show of hands to see how many people had driven under the influence of alcohol. At least half the hands on the jury panel went up. At this particular moment, the defendant chose to stretch and thus raised his hand as well in subconscious answer to the prosecutor's question. When we were seated, there was a box of girl scout cookies poised on the edge of the railing between the jurors and the lawyers. Finally, when it was time for the defense lawyer to ask his questions, he picked up the box of cookies and used it to prop up one of his charts, prompting a collective "aha" moment from the jury panel. Those cookies had no doubt been on everyone's minds throughout the prosecutor's questions.
The lawyers did a good job of using voir dire to preview their case to the point where the opening statements the next day were almost superfluous. Based on the questions that were asked by both sides, it was possible to deduce that this was a case where the defendant was not falling down drunk, that his performance on a field sobriety test would be important to the case, that he had refused to take a blood alcohol test and that the burden of proof to show guilt beyond a reasonable doubt (as opposed to just being probably guilty) would be important.
I was questioned several times by both the prosecutor and the defense attorney. This made me feel like my time in sitting through jury selection was not being completely wasted, since at least my presence was being acknowledged. I managed to flub my answer to the question of what preponderance of the evidence meant, saying that it meant more reasonable than not, instead of more probable than not. I also got to be the defense lawyer's straight man when he asked what you call someone who doesn't speak up in jury selection. (The correct answer was "a juror.").
Although I was not trying to get selected (I had about a million other things to do), I was not completely disappointed when Judge Elisabeth Earle announced that I would be "one of the lucky six." After we were sworn in, the court reminded us that a lot of people had died for our right to be sitting in the jury box. While the civics lesson was a little trite, it helped reinforce that what we were doing was important business rather than just a personal inconvenience.
The trial itself last just one day and consisted of a single witness, a police officer from the DWI Enforcement Unit. It was clear that the police officer and the defense lawyer were well acquainted with each other. While a bankruptcy lawyer can build up experience appearing before a specific judge, it struck me that a criminal defense lawyer could build up experience sparring with a specific officer. In many respects, the case was a battle between the officer and the defense lawyer rather than between the two attorneys (which is not to minimize the prosecutor who put on a very professional and organized case).
This was a case where the visual evidence played an important role. The entire sequence from when the police officer decided to pull over the driver to the moment where he was walked up the ramp into the jail was recorded. As a result, the jury could see the exact tests which the officer conducted to determine intoxication. It was one thing to hear the officer testify that on a certain test that six out of eight clues for intoxication were present. It was far more powerful to see the actual test being performed. We watched the tape of the arrest backwards and forwards, at regular speed and at fast forward. One factor which became important in the trial was whether the defendant had swayed. When the tape was played at fast forward, the defendant could be seen standing straight as a ramrod while the officer swayed like a hula dancer. It may have been an unfair comparison, but it was effective.
This was also a case where common sense prevailed over expert testimony. Because the defendant had refused to take the breathalyzer test (thus subjecting himself to suspension of his driver's license), the legal standard (as given in the court's charge) was whether he had lost the "normal" use of his mental and physical faculties. Since "normal" is subjective (as opposed to .08 blood alcohol content, which is objective), the jury was given leeway to consider how normal the defendant appeared.
The evidence showed that the only things that the defendant did wrong prior to being pulled over was to drive 11 mph over the speed limit on a stretch of road where the limit was not posted (and where many people drive over the speed limit) and making a wide turn. When the officer lighted him up, the defendant made a safe and controlled turn into a nearby parking lot.
After the driver admitted that he had had "a couple of beers," the officer walked him through a field sobriety test. According to the officer, the defendant flunked each test that he was given. However, to the layman's eye, the defendant performed reasonably well on each part of the test. While the defendant stumbled a few times and could not walk heel to toe keeping his feet within half an inch of each other, the very nature of the tests being performed was abnormal. For example, there was one test where the defendant had to make a turn while keeping one foot planted on the ground. The defendant was not able to do this (which would be a very unusual way to turn), but made a smooth pivot at the other end of the test.
After the defendant was arrested, his main concerns were ensuring that his girlfriend got home safely and wondering when he could get bonded out (both showing the normal use of his mental faculties). At the very end of the tape, the defendant was able to walk smoothly up a ramp with his hands handcuffed behind his back (showing the normal use of his physcial faculties).
As a result, the expert testimony established that the defendant was clearly intoxicated, since he had failed every test that he was given. However, the layman's eye saw that the defendant was in possession of reasonably normal mental and physical faculties except when he was being asked to peform abnormal tests. The fact that some study somewhere established that this was a reliable method to establish intoxication was not sufficient to overcome the fact that the defendant did not look or act intoxicated (even when keeping in mind that intoxicated was a lesser standard than drunk).
Another factor which was important was the burden of proof. In voir dire and again in closing, the defense lawyer used a very effective graphic illustrating the various levels of proof from no evidence through probable cause, preponderance of the evidence, clear and convincing and beyond a reasonable doubt. Had our case involved a lesser standard of proof, it would have been much more difficult. However, the defendant's actions both before and after the field sobriety test were normal enough to raise a reasonable doubt. Had we been asked to decide more likely than not, we could easily have ruled for the prosecutor. However, the jury did not have a problem understanding and applying the higher standard of beyond a reasonable doubt.
When we retired to the jury room, there were initially four votes to acquit and two undecided votes. However, after an hour of deliberation we were able to bring back a verdict of not guilty. The defendant may well have been intoxicated that night. However, because the evidence was close, he was let off with a good scare and a hefty legal bill.
On a final note, both lawyers in the case gave a good impression. Both sides represented their clients zealously. However, they remained professional in that they avoided unnecessary sniping between themselves and didn't pull any stupid lawyer tricks (such as referring to things which not in evidence or trying to contradict the court's charge). They also tried their case efficiently and did not waste our time. While it is unlikely that I will be selected as a juror again, I would not hesitate to rule in favor of the earnest, young prosecutor in a case with stronger facts. I also would not hesitate to refer a client to the defense attorney (whose card I forgot to get).
When I was seated in the jury pool, the odds were still against being selected. I was seated in position #12. A misdemeanor jury consists of six jurors. That meant that in order to be picked, five people ahead of me would have to be struck and I would have to avoid being struck myself.
Voir dire was both a warm-up for the trial itself and an interesting examination of the human condition. This case involved a misdemeanor DWI charge. Out of the randomly selected jury panel, there were several people with DWI arrests and one person who had lost a family member to a drunk driver. There several panel members who expressed distrust of police in general. Balancing them out was a jury member who volunteered that he had not had a drink since the 1970s. There was also a medical doctor who was familiar with a specific test which would prove to be important later on.
There were several interesting moments during jury selection. The prosecutor asked the panel for a show of hands to see how many people had driven under the influence of alcohol. At least half the hands on the jury panel went up. At this particular moment, the defendant chose to stretch and thus raised his hand as well in subconscious answer to the prosecutor's question. When we were seated, there was a box of girl scout cookies poised on the edge of the railing between the jurors and the lawyers. Finally, when it was time for the defense lawyer to ask his questions, he picked up the box of cookies and used it to prop up one of his charts, prompting a collective "aha" moment from the jury panel. Those cookies had no doubt been on everyone's minds throughout the prosecutor's questions.
The lawyers did a good job of using voir dire to preview their case to the point where the opening statements the next day were almost superfluous. Based on the questions that were asked by both sides, it was possible to deduce that this was a case where the defendant was not falling down drunk, that his performance on a field sobriety test would be important to the case, that he had refused to take a blood alcohol test and that the burden of proof to show guilt beyond a reasonable doubt (as opposed to just being probably guilty) would be important.
I was questioned several times by both the prosecutor and the defense attorney. This made me feel like my time in sitting through jury selection was not being completely wasted, since at least my presence was being acknowledged. I managed to flub my answer to the question of what preponderance of the evidence meant, saying that it meant more reasonable than not, instead of more probable than not. I also got to be the defense lawyer's straight man when he asked what you call someone who doesn't speak up in jury selection. (The correct answer was "a juror.").
Although I was not trying to get selected (I had about a million other things to do), I was not completely disappointed when Judge Elisabeth Earle announced that I would be "one of the lucky six." After we were sworn in, the court reminded us that a lot of people had died for our right to be sitting in the jury box. While the civics lesson was a little trite, it helped reinforce that what we were doing was important business rather than just a personal inconvenience.
The trial itself last just one day and consisted of a single witness, a police officer from the DWI Enforcement Unit. It was clear that the police officer and the defense lawyer were well acquainted with each other. While a bankruptcy lawyer can build up experience appearing before a specific judge, it struck me that a criminal defense lawyer could build up experience sparring with a specific officer. In many respects, the case was a battle between the officer and the defense lawyer rather than between the two attorneys (which is not to minimize the prosecutor who put on a very professional and organized case).
This was a case where the visual evidence played an important role. The entire sequence from when the police officer decided to pull over the driver to the moment where he was walked up the ramp into the jail was recorded. As a result, the jury could see the exact tests which the officer conducted to determine intoxication. It was one thing to hear the officer testify that on a certain test that six out of eight clues for intoxication were present. It was far more powerful to see the actual test being performed. We watched the tape of the arrest backwards and forwards, at regular speed and at fast forward. One factor which became important in the trial was whether the defendant had swayed. When the tape was played at fast forward, the defendant could be seen standing straight as a ramrod while the officer swayed like a hula dancer. It may have been an unfair comparison, but it was effective.
This was also a case where common sense prevailed over expert testimony. Because the defendant had refused to take the breathalyzer test (thus subjecting himself to suspension of his driver's license), the legal standard (as given in the court's charge) was whether he had lost the "normal" use of his mental and physical faculties. Since "normal" is subjective (as opposed to .08 blood alcohol content, which is objective), the jury was given leeway to consider how normal the defendant appeared.
The evidence showed that the only things that the defendant did wrong prior to being pulled over was to drive 11 mph over the speed limit on a stretch of road where the limit was not posted (and where many people drive over the speed limit) and making a wide turn. When the officer lighted him up, the defendant made a safe and controlled turn into a nearby parking lot.
After the driver admitted that he had had "a couple of beers," the officer walked him through a field sobriety test. According to the officer, the defendant flunked each test that he was given. However, to the layman's eye, the defendant performed reasonably well on each part of the test. While the defendant stumbled a few times and could not walk heel to toe keeping his feet within half an inch of each other, the very nature of the tests being performed was abnormal. For example, there was one test where the defendant had to make a turn while keeping one foot planted on the ground. The defendant was not able to do this (which would be a very unusual way to turn), but made a smooth pivot at the other end of the test.
After the defendant was arrested, his main concerns were ensuring that his girlfriend got home safely and wondering when he could get bonded out (both showing the normal use of his mental faculties). At the very end of the tape, the defendant was able to walk smoothly up a ramp with his hands handcuffed behind his back (showing the normal use of his physcial faculties).
As a result, the expert testimony established that the defendant was clearly intoxicated, since he had failed every test that he was given. However, the layman's eye saw that the defendant was in possession of reasonably normal mental and physical faculties except when he was being asked to peform abnormal tests. The fact that some study somewhere established that this was a reliable method to establish intoxication was not sufficient to overcome the fact that the defendant did not look or act intoxicated (even when keeping in mind that intoxicated was a lesser standard than drunk).
Another factor which was important was the burden of proof. In voir dire and again in closing, the defense lawyer used a very effective graphic illustrating the various levels of proof from no evidence through probable cause, preponderance of the evidence, clear and convincing and beyond a reasonable doubt. Had our case involved a lesser standard of proof, it would have been much more difficult. However, the defendant's actions both before and after the field sobriety test were normal enough to raise a reasonable doubt. Had we been asked to decide more likely than not, we could easily have ruled for the prosecutor. However, the jury did not have a problem understanding and applying the higher standard of beyond a reasonable doubt.
When we retired to the jury room, there were initially four votes to acquit and two undecided votes. However, after an hour of deliberation we were able to bring back a verdict of not guilty. The defendant may well have been intoxicated that night. However, because the evidence was close, he was let off with a good scare and a hefty legal bill.
On a final note, both lawyers in the case gave a good impression. Both sides represented their clients zealously. However, they remained professional in that they avoided unnecessary sniping between themselves and didn't pull any stupid lawyer tricks (such as referring to things which not in evidence or trying to contradict the court's charge). They also tried their case efficiently and did not waste our time. While it is unlikely that I will be selected as a juror again, I would not hesitate to rule in favor of the earnest, young prosecutor in a case with stronger facts. I also would not hesitate to refer a client to the defense attorney (whose card I forgot to get).
Wednesday, January 30, 2008
Fifth Circuit Rules on Homestead Cap
The Fifth Circuit started off the new year with an opinion construing the homestead cap under 11 U.S.C. Sec. 522(p)(1). Matter of Rogers, 2008 U.S. App. LEXIS 129 (5th Cir. 1/4/08). While the case addresses a fairly narrow issue, it is significant because it appears to be the first appellate court opinion construing the new statute.
The issue in Rogers was whether a debtor triggered Sec. 522(p)(1)'s homestead cap when a property acquired more than 1,215 days prior to bankruptcy became the debtor's homestead within the statutory period. Sec. 522(p)(1) states that a debtor may not exempt "any amount of interest" in a homestead that was acquired by the debtor within 1,215 days before bankruptcy which exceeds $125,000 in value. The debtor inherited the property in 1994, but did not make it her homestead until January 2004 after she separated from her husband. The property was awarded to her in the parties' subsequent divorce in April 2004.
The debtor filed for bankruptcy in September 2005 and a creditor objected to the homestead exemption. The bankruptcy court denied the objection to exemption and the district court affirmed this ruling. However, the courts gave different reasons for their rulings. The bankruptcy court ruled that because the debtor obtained title to the property outside of the 1,215 day period that the cap did not apply. The district court ruled that it was impossible to have "a quantity of classification as homestead." As a result, it ruled that the word "interest" referred to the equity acquired by the debtor during the 1,215 day period. Because a homestead designation did not enhance the debtor's equity in the property, the district court held that the cap did not apply.
The split between the bankruptcy court and the district court mirrors a split within the cases nationally. In general, the proponents of the title and equity theories are each trying to avoid what they perceive to be a bad result. The cases which hold that the words "any amount of interest" refers to when the debtor acquired title were ruling on cases where the debtor acquired legal title more than 1,215 days prior to bankruptcy but enhanced their equity within the statutory period. The judges in these cases hold that where title is acquired outside of the statutory period that any enhancement of equity during the 1,215 days is not relevant because title is something which can be acquired, while equity is not. The equity cases generally deal with the situation where the debtor acquired a property whose equity was initially below the cap, but where passive appreciation increased the value beyond the amount of the cap. These cases reject the challenge to the homestead on the basis that the debtor did not acquire any more equity in the property during the statutory period but simply had the value increased by market forces.
The Fifth Circuit found it unnecessary to resolve the conflict. It found that at a minimum, the debtor must acquire "vested economic interests" within the 1,215 day period in order for the cap to apply. The court concluded that "A debtor acquires an interest in property, not in an exemption." As a result, it found that a property's change in status from non-homestead to homestead was not sufficient to trigger the limitation on what could be exempted.
The Fifth Circuit also dismissed as a red herring the argument that the debtor acquired her interest in the property through the divorce decree. Because the property had been inherited, it was the debtor's separate property. The divorce decree merely confirmed the property's status as her separate property rather than conveying any new interest.
Disclaimer: I have a case pending which may turn on the title vs. equity distinction. While I have tried to accurately summarize the distinctions between the two lines of cases, anyone interested in these issues should read the cases for themselves.
The issue in Rogers was whether a debtor triggered Sec. 522(p)(1)'s homestead cap when a property acquired more than 1,215 days prior to bankruptcy became the debtor's homestead within the statutory period. Sec. 522(p)(1) states that a debtor may not exempt "any amount of interest" in a homestead that was acquired by the debtor within 1,215 days before bankruptcy which exceeds $125,000 in value. The debtor inherited the property in 1994, but did not make it her homestead until January 2004 after she separated from her husband. The property was awarded to her in the parties' subsequent divorce in April 2004.
The debtor filed for bankruptcy in September 2005 and a creditor objected to the homestead exemption. The bankruptcy court denied the objection to exemption and the district court affirmed this ruling. However, the courts gave different reasons for their rulings. The bankruptcy court ruled that because the debtor obtained title to the property outside of the 1,215 day period that the cap did not apply. The district court ruled that it was impossible to have "a quantity of classification as homestead." As a result, it ruled that the word "interest" referred to the equity acquired by the debtor during the 1,215 day period. Because a homestead designation did not enhance the debtor's equity in the property, the district court held that the cap did not apply.
The split between the bankruptcy court and the district court mirrors a split within the cases nationally. In general, the proponents of the title and equity theories are each trying to avoid what they perceive to be a bad result. The cases which hold that the words "any amount of interest" refers to when the debtor acquired title were ruling on cases where the debtor acquired legal title more than 1,215 days prior to bankruptcy but enhanced their equity within the statutory period. The judges in these cases hold that where title is acquired outside of the statutory period that any enhancement of equity during the 1,215 days is not relevant because title is something which can be acquired, while equity is not. The equity cases generally deal with the situation where the debtor acquired a property whose equity was initially below the cap, but where passive appreciation increased the value beyond the amount of the cap. These cases reject the challenge to the homestead on the basis that the debtor did not acquire any more equity in the property during the statutory period but simply had the value increased by market forces.
The Fifth Circuit found it unnecessary to resolve the conflict. It found that at a minimum, the debtor must acquire "vested economic interests" within the 1,215 day period in order for the cap to apply. The court concluded that "A debtor acquires an interest in property, not in an exemption." As a result, it found that a property's change in status from non-homestead to homestead was not sufficient to trigger the limitation on what could be exempted.
The Fifth Circuit also dismissed as a red herring the argument that the debtor acquired her interest in the property through the divorce decree. Because the property had been inherited, it was the debtor's separate property. The divorce decree merely confirmed the property's status as her separate property rather than conveying any new interest.
Disclaimer: I have a case pending which may turn on the title vs. equity distinction. While I have tried to accurately summarize the distinctions between the two lines of cases, anyone interested in these issues should read the cases for themselves.
Wednesday, January 16, 2008
Judge Follows Legal Priority While Acknowledging "Moral Priority" Of Losing Parties
San Antonio Bankruptcy Judge Leif Clark is known as the master of the footnote. Thus, when faced with a relatively straightforward case requiring him to construe a confirmed chapter 11 plan, he held his nose and applied the law. In re Texas Pig Stands, Inc., No. 05-52336 (Bankr. W.D. Texas 1/10/08). However, he used his written opinion to let the disappointed parties know that they had "moral priority" and told them where to complain.
Texas Pig Stands is a case, like many, that didn't work out quite as well as it should have. The Debtor confirmed a liquidating plan. The Liquidation Trustee sold the Debtor's property. After the first lienholder and the property taxes were paid at closing, there was a balance of $62,655.35 left over. The parties acknowledged that some of these funds would have to go to pay the lienholder's attorney and a mechanic's lien creditor. The question was what to do with the remaining balance.
The Liquidation Trustee requested permission to pay the employees and vendors who had incurred post-confirmation claims. The State of Texas asserted that the balance should go to pay its tax claim, which had accrued pre-petition, pre-confirmation and post-confirmation. Interestingly enough, the State's claim had not been a secured claim prior to bankruptcy. However, the default language in the plan allowed the State to exercise "all right and remedies under applicable non-bankruptcy law." Of course, one of these remedies is to file a tax lien. When the Liquidation Trustee failed to pay the State under the terms of the confirmed plan, the State gave notice of default and then filed a post-confirmation tax lien. When it came time to distribute the sales proceeds, the State contended that its lien covered all taxes, whether incurred pre-petition, pre-confirmation or post-confirmation.
Judge Clark methodically worked through the issues, concluding that he had post-confirmation jurisdiction to hear the dispute, that the default language of the plan allowed the filing of the tax lien and that the tax lien secured all of the taxes. As a result, the Judge concluded that:
"(T)he Comptroller is entitled to distribution from the sales proceeds to the extent that the proceeds are available to satisfy the Comptroller's tax lien, subject to the payment of prior liens and claims. Unfortunately, the sale proceeds will not satisfy the Comptroller's tax lien in full. The employees, trade vendors aand all other general unsecured creditors therefore will remain unpaid."
Order Granting Authority for Liquidation Trustee to Distribute Sales Proceeds, p. 7.
However, the Court did not stop there. In a footnote, the Judge told the parties where to complain.
"This is, no doubt, an unfortunate result, but one which is mandated by the Texas Tax Code itself. The court can only refer these unpaid employees and trade vendors to Governor Rick Perry's office and to the office of the Texas Comptroller for a fuller explanation for why the state elected to deprive them of their honest, hard-earned compensation. The unpaid employees have a clear moral priority over the claims of the Comptroller for unpaid sales taxes. But for the employees' willingness to work at the restaurant and the trade vendor's willingness to extend credit to the Liquidation Trustee, there would not have been any money to pay the Comptroller. The state clearly is receiving an economic windfall, and further expects these employees to work for free to confer that windfall. Despite the employees' and vendors' moral priority, the Comptroller nonetheless holds legal priority under the Texas Tax Code and the confirmed plan. This court is bound by the latter."
Order, n. 5 (emphasis added).
With all respect to His Honor's good intentions, what else could the State have done? Under Texas law, monies collected for sales taxes are trust funds required to be held for the benefit of the State. The State apparently acquiesced in allowing the Debtor and later the Liquidation Trustee to continue to operate the business despite the fact that tax monies were being collected and not remitted to the State. When the Liquidation Trustee defaulted under the plan, over a year before the sale took place, the State could have closed the restaurant down, in which case the employees would have been unemployed and uncompensated much sooner. Instead, the State, like all the other parties in the case, waited to see whether a brighter future lay ahead. When that prospect did not fully materialize, the State insisted on its legal rights. Had the State passed on its right to get paid ahead of those with lower priorities, the elected officials who are the public face of the State would have opened themselves up to a firestorm of criticism from the public for giving away the State's money.
The Liquidation Trustee was faced with a terrible choice here. He was tasked with paying creditors under a plan and maximizing the value of the Debtor's assets. When the Debtor's business could not pay for current operations, the Trustee had a choice. He could either close the business and likely lose it to foreclosure, or he keep cross his fingers and hope that things got better. While closing the business and not incurring further post-confirmation debt was the correct legal answer (first, do no harm), all of the parties--the Liquidation Trustee, the employees, the vendors, the first lienholder, the State--apparently thought it was better to keep going. In a perfect world, the parties drafting the plan could have created a carve-out for payment of post-confirmation expenses. However, who goes into a plan anticipating that the Debtor won't be able to pay operating expenses? Also, who anticipates that the boilerplate default language contained within a plan will allow a seventh priority unsecured creditor to become a secured creditor?
While the result in this case is unfortunate for the employees who did not get paid, it is not all that unusual. To draw an analogy from George Orwell's Animal Farm, some creditors are more equal than others. Employees, vendors and customers will always rank below lienholders. When businesses fail, there are always winners and losers and those without liens are always the losers. If the Judge wanted to drop a bomb onto someone's lap, he could have directed the unpaid employees to contact their state legislators and demand to know why there is not a floating lien for unpaid wages, much like the floating lien for perishable agricultural commodities. While such a proposal would be politically infeasible, it would at least raise the issue of whether legal priorities should be more closely aligned with moral priorities.
Texas Pig Stands is a case, like many, that didn't work out quite as well as it should have. The Debtor confirmed a liquidating plan. The Liquidation Trustee sold the Debtor's property. After the first lienholder and the property taxes were paid at closing, there was a balance of $62,655.35 left over. The parties acknowledged that some of these funds would have to go to pay the lienholder's attorney and a mechanic's lien creditor. The question was what to do with the remaining balance.
The Liquidation Trustee requested permission to pay the employees and vendors who had incurred post-confirmation claims. The State of Texas asserted that the balance should go to pay its tax claim, which had accrued pre-petition, pre-confirmation and post-confirmation. Interestingly enough, the State's claim had not been a secured claim prior to bankruptcy. However, the default language in the plan allowed the State to exercise "all right and remedies under applicable non-bankruptcy law." Of course, one of these remedies is to file a tax lien. When the Liquidation Trustee failed to pay the State under the terms of the confirmed plan, the State gave notice of default and then filed a post-confirmation tax lien. When it came time to distribute the sales proceeds, the State contended that its lien covered all taxes, whether incurred pre-petition, pre-confirmation or post-confirmation.
Judge Clark methodically worked through the issues, concluding that he had post-confirmation jurisdiction to hear the dispute, that the default language of the plan allowed the filing of the tax lien and that the tax lien secured all of the taxes. As a result, the Judge concluded that:
"(T)he Comptroller is entitled to distribution from the sales proceeds to the extent that the proceeds are available to satisfy the Comptroller's tax lien, subject to the payment of prior liens and claims. Unfortunately, the sale proceeds will not satisfy the Comptroller's tax lien in full. The employees, trade vendors aand all other general unsecured creditors therefore will remain unpaid."
Order Granting Authority for Liquidation Trustee to Distribute Sales Proceeds, p. 7.
However, the Court did not stop there. In a footnote, the Judge told the parties where to complain.
"This is, no doubt, an unfortunate result, but one which is mandated by the Texas Tax Code itself. The court can only refer these unpaid employees and trade vendors to Governor Rick Perry's office and to the office of the Texas Comptroller for a fuller explanation for why the state elected to deprive them of their honest, hard-earned compensation. The unpaid employees have a clear moral priority over the claims of the Comptroller for unpaid sales taxes. But for the employees' willingness to work at the restaurant and the trade vendor's willingness to extend credit to the Liquidation Trustee, there would not have been any money to pay the Comptroller. The state clearly is receiving an economic windfall, and further expects these employees to work for free to confer that windfall. Despite the employees' and vendors' moral priority, the Comptroller nonetheless holds legal priority under the Texas Tax Code and the confirmed plan. This court is bound by the latter."
Order, n. 5 (emphasis added).
With all respect to His Honor's good intentions, what else could the State have done? Under Texas law, monies collected for sales taxes are trust funds required to be held for the benefit of the State. The State apparently acquiesced in allowing the Debtor and later the Liquidation Trustee to continue to operate the business despite the fact that tax monies were being collected and not remitted to the State. When the Liquidation Trustee defaulted under the plan, over a year before the sale took place, the State could have closed the restaurant down, in which case the employees would have been unemployed and uncompensated much sooner. Instead, the State, like all the other parties in the case, waited to see whether a brighter future lay ahead. When that prospect did not fully materialize, the State insisted on its legal rights. Had the State passed on its right to get paid ahead of those with lower priorities, the elected officials who are the public face of the State would have opened themselves up to a firestorm of criticism from the public for giving away the State's money.
The Liquidation Trustee was faced with a terrible choice here. He was tasked with paying creditors under a plan and maximizing the value of the Debtor's assets. When the Debtor's business could not pay for current operations, the Trustee had a choice. He could either close the business and likely lose it to foreclosure, or he keep cross his fingers and hope that things got better. While closing the business and not incurring further post-confirmation debt was the correct legal answer (first, do no harm), all of the parties--the Liquidation Trustee, the employees, the vendors, the first lienholder, the State--apparently thought it was better to keep going. In a perfect world, the parties drafting the plan could have created a carve-out for payment of post-confirmation expenses. However, who goes into a plan anticipating that the Debtor won't be able to pay operating expenses? Also, who anticipates that the boilerplate default language contained within a plan will allow a seventh priority unsecured creditor to become a secured creditor?
While the result in this case is unfortunate for the employees who did not get paid, it is not all that unusual. To draw an analogy from George Orwell's Animal Farm, some creditors are more equal than others. Employees, vendors and customers will always rank below lienholders. When businesses fail, there are always winners and losers and those without liens are always the losers. If the Judge wanted to drop a bomb onto someone's lap, he could have directed the unpaid employees to contact their state legislators and demand to know why there is not a floating lien for unpaid wages, much like the floating lien for perishable agricultural commodities. While such a proposal would be politically infeasible, it would at least raise the issue of whether legal priorities should be more closely aligned with moral priorities.
Friday, January 11, 2008
Fifth Circuit Recommends Impeachment of Federal Judge Based on Bankruptcy Misconduct
On December 20, 2007, the Judicial Council of the Fifth Circuit entered a Memorandum Order and Certification in which it certified to the Judicial Conference of the United States its determination that U.S. District Judge G. Thomas Porteous had engaged in conduct which might constitute grounds for impeachment. In re: Complaint of Judicial Misconduct against United States District Judge G. Thomas Porteous, Jr., under the Judicial Conduct and Disability Act of 1980, Docket No. 07-05-351-0085. One of the grounds stated for possible impeachment was the Judge's misconduct while he was a Chapter 13 debtor.
Judge Porteous was appointed to the U.S. District Court bench in New Orleans in 1994. On March 28, 2001, he filed a chapter 13 bankruptcy petition in the Bankruptcy Court for the Eastern District of Louisiana. The Bankruptcy Judges for the Eastern District recused themselves on the basis that they were a unit of the District Court of which Judge Porteous was a judge. The Judicial Council of the Fifth Circuit appointed Bankruptcy Judge William Greendyke to hear the case. Judge Porteous confirmed a plan and ultimately received a discharge on July 22, 2004.
The Judicial Council made the following findings about the Judge's bankruptcy case:
"Judge Porteous filed numerous false statements under oath during his and his wife's Chapter 13 bankruptcy, including filing the petiiton under a false name; concealing assets of the bankruptcy estate; failing to identify gambling losses; and failing to list all creditors. Judge Porteous additionally violated bankruptcy court orders forbidding him from incurring debt during the course of the Chapter 13 cse without approval of the trustee or bankruptcy judge, in that he continued regularly to incur short-term extensions of credit from various casinos. Judge Porteous additionally made unauthorized and undisclosed payments to preferred creditors after the commencement of the bankruptcy case."
Memorandum Order, p. 3.
In addition to the bankruptcy grounds stated, the Judicial Council found that the Judge had engaged in deceptive conduct concerning a debt he owed to Regions Bank prior to bankruptcy, that he received gifts and things of value from attorneys who had cases pending before him and that he failed to report the gifts on his financial disclosures.
According to an article in The New Orleans Times-Picayune, there were 7,462 complaints filed against federal judges in the decade ending September 30, 2006. Out of those complaints, eight required action by a judicial council and none was referred to the Judicial Conference for possible impeachment. Meghan Gordon, "Move to impeach federal judge a rarity," The Times-Picayune, December 23, 2007. Since the current law was passed in 1981, three federal judges have been removed from office through impeachment, all of them during the 1980s.
From this point, the Judicial Conference of the United States will review the case and will make a recommendation to the House of Representatives. If the House of Representatives votes for impeachment, there will be a trial before the Senate.
Judge Porteous was appointed to the U.S. District Court bench in New Orleans in 1994. On March 28, 2001, he filed a chapter 13 bankruptcy petition in the Bankruptcy Court for the Eastern District of Louisiana. The Bankruptcy Judges for the Eastern District recused themselves on the basis that they were a unit of the District Court of which Judge Porteous was a judge. The Judicial Council of the Fifth Circuit appointed Bankruptcy Judge William Greendyke to hear the case. Judge Porteous confirmed a plan and ultimately received a discharge on July 22, 2004.
The Judicial Council made the following findings about the Judge's bankruptcy case:
"Judge Porteous filed numerous false statements under oath during his and his wife's Chapter 13 bankruptcy, including filing the petiiton under a false name; concealing assets of the bankruptcy estate; failing to identify gambling losses; and failing to list all creditors. Judge Porteous additionally violated bankruptcy court orders forbidding him from incurring debt during the course of the Chapter 13 cse without approval of the trustee or bankruptcy judge, in that he continued regularly to incur short-term extensions of credit from various casinos. Judge Porteous additionally made unauthorized and undisclosed payments to preferred creditors after the commencement of the bankruptcy case."
Memorandum Order, p. 3.
In addition to the bankruptcy grounds stated, the Judicial Council found that the Judge had engaged in deceptive conduct concerning a debt he owed to Regions Bank prior to bankruptcy, that he received gifts and things of value from attorneys who had cases pending before him and that he failed to report the gifts on his financial disclosures.
According to an article in The New Orleans Times-Picayune, there were 7,462 complaints filed against federal judges in the decade ending September 30, 2006. Out of those complaints, eight required action by a judicial council and none was referred to the Judicial Conference for possible impeachment. Meghan Gordon, "Move to impeach federal judge a rarity," The Times-Picayune, December 23, 2007. Since the current law was passed in 1981, three federal judges have been removed from office through impeachment, all of them during the 1980s.
From this point, the Judicial Conference of the United States will review the case and will make a recommendation to the House of Representatives. If the House of Representatives votes for impeachment, there will be a trial before the Senate.
Thursday, January 10, 2008
Texas Supreme Court Limits Penalties for Invalid Home Equity Loan
Texas has a long tradition of protecting its homesteads. Texas was the last state in the nation to allow home equity lending. When it did, the loans came with a host of technical requirements and draconian penalties for failing to meet those requirements. In certain circumstances, failure to comply with the home equity laws results in forfeiture of principal and interest. However, under a new opinion from the Texas Supreme Court, the forfeiture to be suffered does not extend to any constitutionally valid liens which were refinanced with the invalid home equity loan.
In LaSalle Bank National Association vs. Geistweidt, No. 06-1016 (Tex. 12/21/07), the borrowers owned a 53.722 acre homestead property which had a prior purchase money lien for $185,010.51 and also a valid lien for ad valorem taxes in the amount of $9,410.96. The lender advanced $260,000.00 to the borrowers which paid off the prior liens and paid the borrowers $57,518.50 in additional money. The borrowers defaulted after making only five payments on the loan. When the lender tried to foreclose, the borrowers claimed that the lien was secured by property designated for agricultural use and thus invalid. The trial court and the court of appeals both agreed and ruled that the lender had to forfeit all principal and interest with the result that the borrowers would get to keep their homestead free and clear. This would be a substantial benefit for the borrowers, since it would mean that they could keep the $57,000 in new money which they had received and would be excused from paying nearly $200,000 in liens which had been validly established against the homestead prior to the refinance.
On petition for review to the Texas Supreme Court, LaSalle Bank did not dispute that they had made an invalid home equity loan. Instead, they took the more modest position that the constitutional provisions relating to home equity loans did not displace the prior case law allowing for equitable subrogation. It has long been the law in Texas that a party that pays off a valid lien against a homestead is subrogated to the position of the prior lender.
The Texas Supreme Court agreed with the lender. They looked at Tex. Const. Art. XVI, sectin 50(e), which states that a refinance that includes the advance of additional funds "may not be secured by a valid lien against the homestead" unless the refinance was an advance of credit authorized by the home equity provisions or was to pay reasonable costs necessary to the refinance.
One way to read the statute is to look at the words "a refinance of debt secured by a homestead ... may not be secured by a valid lien" unless the conditions are met. Reading this language literally, it would appear that the refinanced debt could not be secured by a valid lien in any event. However, the state Supreme Court found that the statute "contains no language that would indicate displacement of common law remedies was intended, and we decline to engraft such a prohibition onto the constitutional language." Slip Op. at 4. Thus "not be secured by a valid lien" was read as "not be secured by a valid lien except under equitable principles."
While this reading may appear to strain the text, another way to look at the constitional language is to say that the home equity loan itself would not be secured by a valid lien, but that the lender would still have the rights that any other person paying off a valid lien against a homestead would have. This seems to be the direction that the court was going.
From an equitable point of view, this result makes sense. The homestead is not burdened by any more debt than it had before the invalid home equity loan was placed upon it and the lender's penalty for not following the law is the loss of over $57,000.
In LaSalle Bank National Association vs. Geistweidt, No. 06-1016 (Tex. 12/21/07), the borrowers owned a 53.722 acre homestead property which had a prior purchase money lien for $185,010.51 and also a valid lien for ad valorem taxes in the amount of $9,410.96. The lender advanced $260,000.00 to the borrowers which paid off the prior liens and paid the borrowers $57,518.50 in additional money. The borrowers defaulted after making only five payments on the loan. When the lender tried to foreclose, the borrowers claimed that the lien was secured by property designated for agricultural use and thus invalid. The trial court and the court of appeals both agreed and ruled that the lender had to forfeit all principal and interest with the result that the borrowers would get to keep their homestead free and clear. This would be a substantial benefit for the borrowers, since it would mean that they could keep the $57,000 in new money which they had received and would be excused from paying nearly $200,000 in liens which had been validly established against the homestead prior to the refinance.
On petition for review to the Texas Supreme Court, LaSalle Bank did not dispute that they had made an invalid home equity loan. Instead, they took the more modest position that the constitutional provisions relating to home equity loans did not displace the prior case law allowing for equitable subrogation. It has long been the law in Texas that a party that pays off a valid lien against a homestead is subrogated to the position of the prior lender.
The Texas Supreme Court agreed with the lender. They looked at Tex. Const. Art. XVI, sectin 50(e), which states that a refinance that includes the advance of additional funds "may not be secured by a valid lien against the homestead" unless the refinance was an advance of credit authorized by the home equity provisions or was to pay reasonable costs necessary to the refinance.
One way to read the statute is to look at the words "a refinance of debt secured by a homestead ... may not be secured by a valid lien" unless the conditions are met. Reading this language literally, it would appear that the refinanced debt could not be secured by a valid lien in any event. However, the state Supreme Court found that the statute "contains no language that would indicate displacement of common law remedies was intended, and we decline to engraft such a prohibition onto the constitutional language." Slip Op. at 4. Thus "not be secured by a valid lien" was read as "not be secured by a valid lien except under equitable principles."
While this reading may appear to strain the text, another way to look at the constitional language is to say that the home equity loan itself would not be secured by a valid lien, but that the lender would still have the rights that any other person paying off a valid lien against a homestead would have. This seems to be the direction that the court was going.
From an equitable point of view, this result makes sense. The homestead is not burdened by any more debt than it had before the invalid home equity loan was placed upon it and the lender's penalty for not following the law is the loss of over $57,000.
Friday, December 21, 2007
Interesting Cases That I Didn't Get Around To This Year
As we reach the end of another year, I have a few cases that I meant to blog about, but never quite found the time. Many of these cases are every bit as important as the ones that I did write about. Here are the best of the rest in capsule form. Maybe I will find time to write some more about them next year.
The National Benevolent Association of the Christian Church vs. Weil, Gotshal & Manges, LLP, No. 05-5134 (Bankr. W.D. Tex. 2/6/07). Debtor sued its former attorneys for actions taken during the bankruptcy case. Judge King ruled that where the Court approved the Debtors' motion to sell property free and clear of liens and approved the Debtors' plan of reorganization, res judicata prevented the Debtors from suing their lawyers based on their successful representation of the Debtors. Additionally, failure to disclose the claims in the disclosure statement barred the claims under the doctrine of judicial estoppel. (Note: Although Weil, Gotshal prepared the disclosure statement which did not disclose the claims against it, the Debtors did have a second law firm which could have insisted that the claims be included).
Mahoney v. Washington Mutual, Inc., No. 06-5187 (Bankr. W.D. Tex. 4/23/07). Judge Clark ruled that reporting debt to credit bureau standing alone did not violate the debtor's discharge. Discharge did not make debt go away. Therefore, creditor could continue to report debt as delinquent despite discharge so long as creditor did not steps to try to collect. Excellent discussion on the relationship between sacrificing goats to Mercury and the discharge.
In re Spillman Development Group, Ltd., No. 05-14415 (Bankr. W.D. Tex. 9/20/07). Two determined parties battle intensely. "The parties were in full combat mode sparing no expense." The secured creditor ultimately purchased the property by exercising a credit bid. Did Debtor's counsel achieve a tangible, identifiable benefit which would allow it to be compensated under Pro-Snax? Judge Monroe said yes, although he reduced the fees in some respects. This opinion has an interesting discussion of how the debtor can achieve a positive benefit while acting in opposition to the wishes of the major creditor. The opinion is also full of Judge Monroe's no-holds barred commentary on the no-holds barred tactics of the litigants.
In re Sanders, No. 07-50783 (Bankr. W.D. Tex. 10/18/07). Debtors purchased a new vehicle but could not afford to pay off the old one. Depending on how you analyze the transaction, the negative equity was either financed as part of the new purchase or paid off with a rebate on the new vehicle. Debtor proposed to cram-down the vehicle even though it was purchased 846 days before bankruptcy (which was less than 910 days) and creditor objected. Judge Clark ruled that where the deficiency from the prior vehicle was included in the amount financed, that the loan did not qualify as a PMSI loan which was protected from cram-down under Sec. 1325(a)(*). Judge Clark ruled that PMSI status was an all or nothing proposition so that the entire debt was subject to cram-down even though the majority of the debt was purchase money in character.
The National Benevolent Association of the Christian Church vs. Weil, Gotshal & Manges, LLP, No. 05-5134 (Bankr. W.D. Tex. 2/6/07). Debtor sued its former attorneys for actions taken during the bankruptcy case. Judge King ruled that where the Court approved the Debtors' motion to sell property free and clear of liens and approved the Debtors' plan of reorganization, res judicata prevented the Debtors from suing their lawyers based on their successful representation of the Debtors. Additionally, failure to disclose the claims in the disclosure statement barred the claims under the doctrine of judicial estoppel. (Note: Although Weil, Gotshal prepared the disclosure statement which did not disclose the claims against it, the Debtors did have a second law firm which could have insisted that the claims be included).
Mahoney v. Washington Mutual, Inc., No. 06-5187 (Bankr. W.D. Tex. 4/23/07). Judge Clark ruled that reporting debt to credit bureau standing alone did not violate the debtor's discharge. Discharge did not make debt go away. Therefore, creditor could continue to report debt as delinquent despite discharge so long as creditor did not steps to try to collect. Excellent discussion on the relationship between sacrificing goats to Mercury and the discharge.
In re Spillman Development Group, Ltd., No. 05-14415 (Bankr. W.D. Tex. 9/20/07). Two determined parties battle intensely. "The parties were in full combat mode sparing no expense." The secured creditor ultimately purchased the property by exercising a credit bid. Did Debtor's counsel achieve a tangible, identifiable benefit which would allow it to be compensated under Pro-Snax? Judge Monroe said yes, although he reduced the fees in some respects. This opinion has an interesting discussion of how the debtor can achieve a positive benefit while acting in opposition to the wishes of the major creditor. The opinion is also full of Judge Monroe's no-holds barred commentary on the no-holds barred tactics of the litigants.
In re Sanders, No. 07-50783 (Bankr. W.D. Tex. 10/18/07). Debtors purchased a new vehicle but could not afford to pay off the old one. Depending on how you analyze the transaction, the negative equity was either financed as part of the new purchase or paid off with a rebate on the new vehicle. Debtor proposed to cram-down the vehicle even though it was purchased 846 days before bankruptcy (which was less than 910 days) and creditor objected. Judge Clark ruled that where the deficiency from the prior vehicle was included in the amount financed, that the loan did not qualify as a PMSI loan which was protected from cram-down under Sec. 1325(a)(*). Judge Clark ruled that PMSI status was an all or nothing proposition so that the entire debt was subject to cram-down even though the majority of the debt was purchase money in character.
Update on Deductibility of 401k Loan Payments Under Means Test
This blog previously reported on Judge Larry Kelly's decision in In re Otero which allowed payments on 401k loans to be deducted under the chapter 7 means test. http://stevesathersbankruptcynews.blogspot.com/2006_11_01_archive.html. That decision was subsequently reversed on appeal by the U.S. District Court. McVay vs. Otero, 371 B.R. 190 (W.D. Tex. 4/26/07). The District Court looked at the same language as Judge Kelly and concluded that a loan against a 401k plan was NOT a debt, so that it could not be a secured debt deductible under the means test. In making this ruling,the District Court followed the majority position.
The Debtors did not further appeal the District Court ruling. Instead,they converted to Chapter 13 and proposed a plan which allowed them to deduct the 401k payments from disposable income. The Debtor's plan was confirmed on November 19, 2007. Under the confirmed plan, the Debtors will pay $99 a month for 36 months and unsecured creditors will receive approximately 3% on their claims. Thus, while the U.S. Trustee was successful in its legal argument, the practical effect to creditors in the specific case appears to be negligible.
This is a subject which merits further discussion. The majority position followed by the District Court seems to be inconsistent with the treatment of 401k loans elsewhere under BAPCPA. Under Sec. 523(a)(18), a debt owed to a 401k plan is not dischargeable. Similarly, Sec. 362(b)(19) has an exception to the automatic stay relating to a "loan" from a tax qualified retirement plan. If Congress considered a loan owed to a 401k plan to be a "debt" for purposes of Sec. 523(a)(18) and created an exception for payments on a "loan" under Sec. 362(b)(19), why would payments owed to a tax qualified retirement plan not be considered to be debts under the means test? This seems to be a case where the majority has the weaker side of the argument.
The Debtors did not further appeal the District Court ruling. Instead,they converted to Chapter 13 and proposed a plan which allowed them to deduct the 401k payments from disposable income. The Debtor's plan was confirmed on November 19, 2007. Under the confirmed plan, the Debtors will pay $99 a month for 36 months and unsecured creditors will receive approximately 3% on their claims. Thus, while the U.S. Trustee was successful in its legal argument, the practical effect to creditors in the specific case appears to be negligible.
This is a subject which merits further discussion. The majority position followed by the District Court seems to be inconsistent with the treatment of 401k loans elsewhere under BAPCPA. Under Sec. 523(a)(18), a debt owed to a 401k plan is not dischargeable. Similarly, Sec. 362(b)(19) has an exception to the automatic stay relating to a "loan" from a tax qualified retirement plan. If Congress considered a loan owed to a 401k plan to be a "debt" for purposes of Sec. 523(a)(18) and created an exception for payments on a "loan" under Sec. 362(b)(19), why would payments owed to a tax qualified retirement plan not be considered to be debts under the means test? This seems to be a case where the majority has the weaker side of the argument.
Gadzooks Update
This blog previously reported on an opinion by Judge Harlin Hale of the Northern District of Texas which limited the effect of the Fifth Circuit's opinion in Matter of Pro-Snax Distributors, Inc., 157 F.3d 414 (5th Cir. 1998). http://stevesathersbankruptcynews.blogspot.com/2006_10_01_archive.html. U.S. District Judge Jane Boyle has now reversed the Bankruptcy Court opinion. William Kaye vs. Hughes & Luce, LLP, No. 3:06-CV-01863-B (N.D. Tex. 7/13/07).
Judge Boyle found that although the Fifth Circuit's Pro-Snax discussion of the correct standard to apply in awarding attorney's fees under Sec. 330 was dicta, that it was judicial dicta rather than obiter dicta. Judical dicta is defined as an opinion on an issue which was directly briefed and argued by the parties, but which was not essential to the decision. Judge Boyle found that judicial dicta should not be lightly disregarded. The Court also questioned whether the Circuit's instructions on the test to be applied on remand was really dicta at all.
The District Court engaged in a curious discussion of whether Pro-Snax was inconsistent with the language of Sec. 330. On the one hand, the District Court noted that it was bound to apply Pro-Snax regardless of whether it was correct. It also noted that many courts had disagreed with its logic. It then engaged in a rather tortured analysis of how Pro-Snax could be reconciled with the language of Sec. 330. Thus, the District Court fulfilled its obligation to follow binding precedent and did so with a straight face.
Finally, the District Court rejected the Bankruptcy Court's attempt to limit Pro-Snax to its original context of awarding fees to debtor's counsel. The District Court found that the language of Sec. 330 did not distinguish between different types of professionals.
The District Court ruling has been appealed to the Fifth Circuit. This may set the stage for the en banc Fifth Circuit to reconsider Pro-Snax.
Judge Boyle found that although the Fifth Circuit's Pro-Snax discussion of the correct standard to apply in awarding attorney's fees under Sec. 330 was dicta, that it was judicial dicta rather than obiter dicta. Judical dicta is defined as an opinion on an issue which was directly briefed and argued by the parties, but which was not essential to the decision. Judge Boyle found that judicial dicta should not be lightly disregarded. The Court also questioned whether the Circuit's instructions on the test to be applied on remand was really dicta at all.
The District Court engaged in a curious discussion of whether Pro-Snax was inconsistent with the language of Sec. 330. On the one hand, the District Court noted that it was bound to apply Pro-Snax regardless of whether it was correct. It also noted that many courts had disagreed with its logic. It then engaged in a rather tortured analysis of how Pro-Snax could be reconciled with the language of Sec. 330. Thus, the District Court fulfilled its obligation to follow binding precedent and did so with a straight face.
Finally, the District Court rejected the Bankruptcy Court's attempt to limit Pro-Snax to its original context of awarding fees to debtor's counsel. The District Court found that the language of Sec. 330 did not distinguish between different types of professionals.
The District Court ruling has been appealed to the Fifth Circuit. This may set the stage for the en banc Fifth Circuit to reconsider Pro-Snax.
Thursday, December 20, 2007
Dallas Judge Investigates Mortgage Rescue Scam; Urges Debtor's Bar to Warn Clients
Dallas Judge Stacey Jernigan recently issued an opinion concerning a mortgage protection scheme which the court found to prey upon both desperate debtors and mortgage lenders seeking to protect their legal rights. In re Michael White, No. 06-32324 (Bankr. N.D. Tex. 12/7/07). The Court ultimately concluded that the debtors were naive victims of a shady operation designed to fraudulently delay enforcement of mortgage liens. In addition to ordering the perpetrators to appear and show cause, the Court made a referral for a possible bankruptcy crime violation and urged the consumer debtor's bar to warn their clients about similar schemes.
Desperate Debtors
The debtors in this case filed chapter 13 to save their homestead. Unfortunately, they were not able to make the post-petition payments required. This led to an order conditioning the stay, which the debtors defaulted upon as well. With the stay lifted, the stage was set for the debtors to receive a barrage of solicitations (eight to twelve per day) from "foreclosure specialists" offering to legally save the house. The debtors responded to one of these offers from an operation calling itself "North American Foreclosure." According to North American Foreclosure, the debtors could delay foreclosure for years if they were to deed a 1% interest in their home to a company which would file bankruptcy and invoke a new automatic stay. In return for this service, the debtors would pay $650 per month to buy back the interest they had deeded over for as long as they needed the service. North American Foreclosure assured the debtors that everything was legitimate because: (a) the document transferring the 1% interest would be notarized; and (b) the transaction would be disclosed to the new bankruptcy court.
Although North American Foreclosure was apparently located in California, they arranged for a local agent named David Curtis, whose business card identified him as working for Jireh Capital Services, LLC to visit the debtor's home. This local agent had the debtors sign several contracts which required that payment be made in cash only. The Debtors were then given a backdated deed to sign. The deed was executed in the name of "C**** C****" who the debtors were assured was an agent of the company. On the eve of foreclosure, the mortage company's servicer received an anonymous fax containing a copy of the deed to C**** C**** and a copy of C**** C****'s bankruptcy petition which had been filed in the Central District of California the previous month.
The Lender Shows Good Sense
The mortgage servicer acted with remarkable restraint. As noted by the Court: "In any event, despite the questionable validity and effect of the Warranty Deed document, and despite the mysterious manner of its delivery (from anonymous senders), HomEq did what one might hope any prudent creditor would do: it took no further action with regard to its collection efforts as to the Homestead (i.e., it did not record the substitute trustee's deed reflecting the foreclosure sale that had already occurred earlier in the day) out of concern over the implications of the C**** C**** bankruptcy case and the automatic stay as to her alleged 1% interest." Memorandum Opinion and Order, p. 5.
HomEq's restraint was commendable in that this was not the first time they had received a notice involving conveyance of a fractional interest to a bankruptcy filer. According to HomEq, this was something which happened several times a month. As a result, they filed a Motion Requesting Show Cause Order. The Court ordered that both sets of debtors appear and show cause. The debtors in both the Northern District of Texas and the Central District of California showed remarkably good judgment by cooperating with Judge Jernigan's Show Cause Order. The Texas debtors testified and produced copies of their documents with North American Foreclosure. It turned out that the California debtor had filed a pro se petition and had nothing to do with the scheme. Instead, North American Foreclosure obtained the name of a random pro se debtor who had recently filed bankruptcy in the Central District of California and arranged for the deed to be executed in the name of an innocent third party.
Judge Jernigan accepted the Debtors' testimony. She concluded that, "This court is satisfied that the Whites have been naively duped in this matter and have not themselves knowingly or fraudulently participated in acts that might be described as a bankruptcy crime. (citation omitted). At worst, they appear to be 'bit characters' in a scheme to defraud borrowers and lenders alike who are in the midst of foreclosure proceedings." Memorandum Opinion and Order, p. 13.
A Cottage Industry of Bottom Feeders
Judge Jernigan had much greater concern for the perpetrators of the scheme. In a section of her opinion entitled "A New Cottage Industry of Bottom Feeders: For Every Action (i.e., Foreclosure Crisis) there is an Opposite Reaction (i.e., Folks Trying to Make a Buck)," she detailed other instances in which similar shenanigans had surfaced.
Judge Jernigan ordered North American Foreclosure, LLP (the instigator of the scheme), David Curtis (the local agent who signed the debtors up and took their money) and Jireh Capital Services, LLC (Curtis's company) to appear and show cause why they should not be found to have violated the automatic stay and be held liable for damages. The Court ominously noted that David Curtis might come to regret the fact that he had accepted a check from the debtors (despite the contract's cash only requirement), which created a paper trail.
The Court annulled the automatic stay to allow HomEq to record its substitute trustee's deed. This was more in the nature of a comfort order, since it appears unlikely that there was ever a new automatic stay arising from the C**** C**** bankruptcy.
The Court gave notice to the U.S. Attorney that a possible bankruptcy crime had taken place.
Plea to the Debtor's Bar
Finally, the Court issued a "Plea to the Consumer Debtor Bankruptcy Bar," stating:
"The court urges attorneys representing consumer debtors to warn their clients of the apparent schemes being solicited to debtors such as the Whites. while this court is of teh view in this matter that the Whites were naive 'bit characters' who did not fully understand the consequences of their actions and did not set out to defraud HomEq, this may not always be the case. The Whites have lost $1,300 and have not saved their home. This court suspects other debtors have lost even more. The court hopes that it will become a standard part of consumer debtor representation in this district to warn debtors of the hazards of dealing with some of the non-attorney Bankruptcy Services that are offering the illusion of relief from foreclosure for a steep fee."
Memorandum Opinion and Order, pp. 21-22. So, there you have it. Warn your clients. If something seems to be too easy, it is probably a scam. Also, please tell your clients that if you, as a trained bankruptcy professional cannot help them, that they should not expect that a non-lawyer who sends them a slick brochure and expects to be paid in cash can do any better.
Desperate Debtors
The debtors in this case filed chapter 13 to save their homestead. Unfortunately, they were not able to make the post-petition payments required. This led to an order conditioning the stay, which the debtors defaulted upon as well. With the stay lifted, the stage was set for the debtors to receive a barrage of solicitations (eight to twelve per day) from "foreclosure specialists" offering to legally save the house. The debtors responded to one of these offers from an operation calling itself "North American Foreclosure." According to North American Foreclosure, the debtors could delay foreclosure for years if they were to deed a 1% interest in their home to a company which would file bankruptcy and invoke a new automatic stay. In return for this service, the debtors would pay $650 per month to buy back the interest they had deeded over for as long as they needed the service. North American Foreclosure assured the debtors that everything was legitimate because: (a) the document transferring the 1% interest would be notarized; and (b) the transaction would be disclosed to the new bankruptcy court.
Although North American Foreclosure was apparently located in California, they arranged for a local agent named David Curtis, whose business card identified him as working for Jireh Capital Services, LLC to visit the debtor's home. This local agent had the debtors sign several contracts which required that payment be made in cash only. The Debtors were then given a backdated deed to sign. The deed was executed in the name of "C**** C****" who the debtors were assured was an agent of the company. On the eve of foreclosure, the mortage company's servicer received an anonymous fax containing a copy of the deed to C**** C**** and a copy of C**** C****'s bankruptcy petition which had been filed in the Central District of California the previous month.
The Lender Shows Good Sense
The mortgage servicer acted with remarkable restraint. As noted by the Court: "In any event, despite the questionable validity and effect of the Warranty Deed document, and despite the mysterious manner of its delivery (from anonymous senders), HomEq did what one might hope any prudent creditor would do: it took no further action with regard to its collection efforts as to the Homestead (i.e., it did not record the substitute trustee's deed reflecting the foreclosure sale that had already occurred earlier in the day) out of concern over the implications of the C**** C**** bankruptcy case and the automatic stay as to her alleged 1% interest." Memorandum Opinion and Order, p. 5.
HomEq's restraint was commendable in that this was not the first time they had received a notice involving conveyance of a fractional interest to a bankruptcy filer. According to HomEq, this was something which happened several times a month. As a result, they filed a Motion Requesting Show Cause Order. The Court ordered that both sets of debtors appear and show cause. The debtors in both the Northern District of Texas and the Central District of California showed remarkably good judgment by cooperating with Judge Jernigan's Show Cause Order. The Texas debtors testified and produced copies of their documents with North American Foreclosure. It turned out that the California debtor had filed a pro se petition and had nothing to do with the scheme. Instead, North American Foreclosure obtained the name of a random pro se debtor who had recently filed bankruptcy in the Central District of California and arranged for the deed to be executed in the name of an innocent third party.
Judge Jernigan accepted the Debtors' testimony. She concluded that, "This court is satisfied that the Whites have been naively duped in this matter and have not themselves knowingly or fraudulently participated in acts that might be described as a bankruptcy crime. (citation omitted). At worst, they appear to be 'bit characters' in a scheme to defraud borrowers and lenders alike who are in the midst of foreclosure proceedings." Memorandum Opinion and Order, p. 13.
A Cottage Industry of Bottom Feeders
Judge Jernigan had much greater concern for the perpetrators of the scheme. In a section of her opinion entitled "A New Cottage Industry of Bottom Feeders: For Every Action (i.e., Foreclosure Crisis) there is an Opposite Reaction (i.e., Folks Trying to Make a Buck)," she detailed other instances in which similar shenanigans had surfaced.
Judge Jernigan ordered North American Foreclosure, LLP (the instigator of the scheme), David Curtis (the local agent who signed the debtors up and took their money) and Jireh Capital Services, LLC (Curtis's company) to appear and show cause why they should not be found to have violated the automatic stay and be held liable for damages. The Court ominously noted that David Curtis might come to regret the fact that he had accepted a check from the debtors (despite the contract's cash only requirement), which created a paper trail.
The Court annulled the automatic stay to allow HomEq to record its substitute trustee's deed. This was more in the nature of a comfort order, since it appears unlikely that there was ever a new automatic stay arising from the C**** C**** bankruptcy.
The Court gave notice to the U.S. Attorney that a possible bankruptcy crime had taken place.
Plea to the Debtor's Bar
Finally, the Court issued a "Plea to the Consumer Debtor Bankruptcy Bar," stating:
"The court urges attorneys representing consumer debtors to warn their clients of the apparent schemes being solicited to debtors such as the Whites. while this court is of teh view in this matter that the Whites were naive 'bit characters' who did not fully understand the consequences of their actions and did not set out to defraud HomEq, this may not always be the case. The Whites have lost $1,300 and have not saved their home. This court suspects other debtors have lost even more. The court hopes that it will become a standard part of consumer debtor representation in this district to warn debtors of the hazards of dealing with some of the non-attorney Bankruptcy Services that are offering the illusion of relief from foreclosure for a steep fee."
Memorandum Opinion and Order, pp. 21-22. So, there you have it. Warn your clients. If something seems to be too easy, it is probably a scam. Also, please tell your clients that if you, as a trained bankruptcy professional cannot help them, that they should not expect that a non-lawyer who sends them a slick brochure and expects to be paid in cash can do any better.
Tuesday, November 06, 2007
Pakistani Lawyers Risk Lives for Rule of Law
In Pakistan, thousands of lawyers dressed in black suits and ties took to the street to protest the dissolution of the supreme court and the suspension of the constitution. It is estimated that 500-700 were arrested. "Bush criticizes Musharraf," Austin American Statesman, November 6, 2007, p. A1. Meanwhile, in the United States, 37,000 dissidents gathered (in cyberspace) around a slogan implicitly advocating overthrow of the government ... and set a one-day fundraising record for Republicans. "YouTube video, Guy Fawkes motto help Paul collect $4.2 million in 1 day," Austin American Statesman, November 6, 2007, p. A6.
What do these two stories have in common? The connection is arguably tenuous, but the common link seems to be fear or the lack thereof.
In Pakistan, the president feared the power of an independent judicial branch and the rule of law which it represented. When the Supreme Court questioned his right to seek another term, Gen. Musharraf chose to impose emergency rule. Curiously, the General dissolved the supreme court but left parliament in place. This seems to suggest that a cowed legislative branch is less of a threat to absolute power than an independent judiciary. In a system where the rule of law is subordinate to the rule of power, lawyers are reduced from independent actors to government functionaries. Thus, the lawyers correctly perceived that they were under attack and took to the streets.
The story about Ron Paul's fundraising is not grim. Indeed, it is humorous in its cheekiness. Ron Paul is the Texas Congressman running a longshot campaign for the Republican nomination for president. The Paul campaign organized a one-day internet fundraiser around the slogan "Remember, remember the 5th of November." This is the first line from a poem recalling the attempt by Guy Fawkes to blow up parliament and assasinate King James I. It also featured prominently in the recent movie "V for Vendetta" in which a masked vigilante leads a mob of citizens to overthrow an oppressive British government. Ron Paul and his band of followers fancy themselves as modern day revolutionaries. They oppose most everything government does from social security to the war in Iraq. However, when they openly use the language of revolution to advance their cause, it evokes at best a chuckle or a yawn, but not fear.
While the story about Ron Paul is somewhat silly (and in no way compares to the bravery of the Pakistani lawyers), perhaps it makes a point about what we take for granted. Here, we can talk about overthrowing the government because we allow for the potential of overthrowing the government every four years. We know that on January 20, 2009, President Bush will voluntarily leave the White House. There is a good possibility that he will hand over power to the opposing party. On the other hand, the Pakistani lawyers and judges have no assurance that their constitution will prevail and that Gen. Musharraf will cede power to anyone other than a hand-picked successor.
What do these two stories have in common? The connection is arguably tenuous, but the common link seems to be fear or the lack thereof.
In Pakistan, the president feared the power of an independent judicial branch and the rule of law which it represented. When the Supreme Court questioned his right to seek another term, Gen. Musharraf chose to impose emergency rule. Curiously, the General dissolved the supreme court but left parliament in place. This seems to suggest that a cowed legislative branch is less of a threat to absolute power than an independent judiciary. In a system where the rule of law is subordinate to the rule of power, lawyers are reduced from independent actors to government functionaries. Thus, the lawyers correctly perceived that they were under attack and took to the streets.
The story about Ron Paul's fundraising is not grim. Indeed, it is humorous in its cheekiness. Ron Paul is the Texas Congressman running a longshot campaign for the Republican nomination for president. The Paul campaign organized a one-day internet fundraiser around the slogan "Remember, remember the 5th of November." This is the first line from a poem recalling the attempt by Guy Fawkes to blow up parliament and assasinate King James I. It also featured prominently in the recent movie "V for Vendetta" in which a masked vigilante leads a mob of citizens to overthrow an oppressive British government. Ron Paul and his band of followers fancy themselves as modern day revolutionaries. They oppose most everything government does from social security to the war in Iraq. However, when they openly use the language of revolution to advance their cause, it evokes at best a chuckle or a yawn, but not fear.
While the story about Ron Paul is somewhat silly (and in no way compares to the bravery of the Pakistani lawyers), perhaps it makes a point about what we take for granted. Here, we can talk about overthrowing the government because we allow for the potential of overthrowing the government every four years. We know that on January 20, 2009, President Bush will voluntarily leave the White House. There is a good possibility that he will hand over power to the opposing party. On the other hand, the Pakistani lawyers and judges have no assurance that their constitution will prevail and that Gen. Musharraf will cede power to anyone other than a hand-picked successor.
Wednesday, October 24, 2007
Timely Amended Claim Avoids Usury Penalty
After just sixteen days on the bench, Austin Bankruptcy Judge Craig Gargotta has penned his first opinion. In Ingalls vs. Cunningham, Adv. No. 06-1236 (Bankr. W.D. Tex. 10/16/07), Judge Gargotta considered whether a creditor which filed an arguably usurious claim could take advantage of Texas's usury cure provision when it amended the claim to delete the offending charges. Judge Gargotta concluded that it could.
In this case, the creditor filed an initial claim for $89,280 on November 19, 2005. On April 24, 2007, the Trustee sought to amend an existing adversary proceeding to include a claim for usury. Ten days later, the creditor objected to the motion and filed an amended claim for $32,041.66 which eliminated the offending charges. The parties entered an agreed order which allowed the amendment but preserved the defendant's right to challenge the usury claim.
On defendant's motion to dismiss, the court considered whether the creditor's amended claim was sufficiently timely to constitute an allowable cure under the Texas Finance Code. Texas has two separate usury cure provisions. If the creditor discovers the usury violation, Texas Finance Code Sec. 305.103 allows the creditor to correct the violation within 60 days from "the date the creditor actually discovered the violation" by giving notice to the obligor. A second section, Texas Finance Code Sec. 305.006, applies when the obligor discovers the violation. It requires the obligor to give the creditor 60 days notice prior to filing suit or filing a counterclaim. During the 60 day period, the creditor may correct the violation in the same manner as under Sec. 305.103 (that is, by giving notice to the debtor).
In this case, the court found that Sec. 305.006 applied because this case involved a suit by the debtor's chapter 7 trustee. The court found that the trustee's motion for leave to amend constituted notice to the obligor of the usury violation triggering the 60 day period to cure. The court found that amending the proof of claim to exclude the allegedly usurious charges consituted an adequate cure. Because the creditor filed its amended claim well within the 60 day cure period, it was not subject to being sued for usury. As a result, the court granted the motion to dismiss.
This case raises several practice points. The first is that a proof of claim in a bankruptcy case can constitute a demand for usurious interest. As a result, alert debtors and trustees should scrutinize the claims filed to see if there are claims which could be asserted. Second, the two usury cure provisions appear to work independently. If a creditor discovers the usury, it has 60 days to cure the violation. However, if the creditor fails to do so, it has a second 60 day period once it receives notice from the obligor. Thus, although Texas has "draconian" usury penalties, a prudent creditor has an easy means to avoid liability if it acts promptly.
In this case, the creditor filed an initial claim for $89,280 on November 19, 2005. On April 24, 2007, the Trustee sought to amend an existing adversary proceeding to include a claim for usury. Ten days later, the creditor objected to the motion and filed an amended claim for $32,041.66 which eliminated the offending charges. The parties entered an agreed order which allowed the amendment but preserved the defendant's right to challenge the usury claim.
On defendant's motion to dismiss, the court considered whether the creditor's amended claim was sufficiently timely to constitute an allowable cure under the Texas Finance Code. Texas has two separate usury cure provisions. If the creditor discovers the usury violation, Texas Finance Code Sec. 305.103 allows the creditor to correct the violation within 60 days from "the date the creditor actually discovered the violation" by giving notice to the obligor. A second section, Texas Finance Code Sec. 305.006, applies when the obligor discovers the violation. It requires the obligor to give the creditor 60 days notice prior to filing suit or filing a counterclaim. During the 60 day period, the creditor may correct the violation in the same manner as under Sec. 305.103 (that is, by giving notice to the debtor).
In this case, the court found that Sec. 305.006 applied because this case involved a suit by the debtor's chapter 7 trustee. The court found that the trustee's motion for leave to amend constituted notice to the obligor of the usury violation triggering the 60 day period to cure. The court found that amending the proof of claim to exclude the allegedly usurious charges consituted an adequate cure. Because the creditor filed its amended claim well within the 60 day cure period, it was not subject to being sued for usury. As a result, the court granted the motion to dismiss.
This case raises several practice points. The first is that a proof of claim in a bankruptcy case can constitute a demand for usurious interest. As a result, alert debtors and trustees should scrutinize the claims filed to see if there are claims which could be asserted. Second, the two usury cure provisions appear to work independently. If a creditor discovers the usury, it has 60 days to cure the violation. However, if the creditor fails to do so, it has a second 60 day period once it receives notice from the obligor. Thus, although Texas has "draconian" usury penalties, a prudent creditor has an easy means to avoid liability if it acts promptly.
Monday, October 22, 2007
Court Protects Homestead Proceeds But Leaves Open Question on Tardy Objections
Texas has one of the most generous homestead exemptions in the country. However, a quirk in the law allows an exemption in homestead proceeds to be lost due to the passage of time. San Antonio Bankruptcy Judge Leif Clark recently found a creative solution to the problem created by an obstreperous creditor seeking to outlast the debtor and preclude reinvestment of the proceeds from sale of a homestead. In re Bading, No. 06-52750 (Bankr. W.D. Tex. 9/22/07). However, the opinion raises the question of why Judge Clark had to work so hard when Supreme Court precedent provided a simpler alternative.
The Vanishing Exemption and Absolute Protection of Exempted Property
Most exemption statutes are limited by the type and value of the property to be claimed as exempt, but are not limited as to time. Thus, exempt property will keep its status so long as it retains its exempt character. However, a sale or other transformation of the exempt property will usually cause it to lose its exempt character. The Texas homestead exemption extends not only to a homestead owned and occupied by the debtor, but to the proceeds from sale of a homestead as well. Tex. Prop. Code §41.001(c). The proceeds exemption is one which is limited by time. It lasts for the lesser of six months or until the debtor acquires another homestead. The purpose of the proceeds exemption is to give the debtor a limited period of time in which to acquire a new homestead. As a result, the statute creates a vanishing exemption. Homestead proceeds which were fully protected five months and 29 days after sale of the home become cash subject to claims of creditors after six months and one day.
This vanishing exemption creates a potential conflict between state and federal law in the bankruptcy context. According to 11 U.S.C. §522(c), “property exempted under this section is not liable during or after the case for any debt of the debtor that arose, or that is determined under section 502 of this title as if such debt had arisen, before the commencement of the case” (with certain exceptions). Thus, the Bankruptcy Code gives exempted property absolute protection from pre-petition claims.
This absolute protection is implemented in two ways. First, the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure provide a limited time in which to object to exempt property. 11 U.S.C. §522(l); Fed.R.Bankr.P. 4003(b). If the property is claimed as exempt and the exemption is not timely challenged, the property remains exempt regardless of whether it would have been subject to a valid objection. Taylor v. Freeland & Kronz, 503 U.S. 638 (1992). Second, the property’s exempt status is determined as of the petition date using the “snapshot” approach. Matter of Zibman, 268 F.3d 298 (5th Cir. 2001).
A Fading Snapshot
While the Zibman decision recognized the “snapshot” approach, it also noted that like a bad Polaroid, the picture could fade. According to the Fifth Circuit:
“(T)he law and facts existing on the date of filing the bankruptcy petition determine the existence of available exemptions but . . . it is the entire state law applicable on the filing date that is determinative. Courts cannot apply a juridical airbrush to excise offending images necessarily picture in the petition-date snapshot.”
Zibman at 304.
Thus, Zibman teaches that where conditions exist on the petition date which would limit the exemption, the snapshot approach does not eliminate those limitations. However, it seems important to the Fifth Circuit’s analysis that the condition must exist as of the petition date. In the Zibman case, the debtors had sold their homestead approximately two months prior to bankruptcy. Thus, the snapshot on the petition date revealed an exemption which had just four months remaining in the absence of reinvestment. Since the debtors had moved to another state, reinvestment was not a possibility.
In the Zibman case, the Trustee obtained an order extending the time to object to exemptions until after the six month reinvestment period expired. When the debtor failed to purchase a new homestead, the trustee objected and was sustained by the Fifth Circuit. Thus, although the exemption was still valid on the petition date, it was a limited exemption and was defeated by the timely filed objection.
Although the Trustee benefitted from an extension of time in Zibman, the court noted that the debtor could benefit from one as well. In a footnote, the Court noted that although the debtors could have requested tolling of the six month period, they failed to do so.
Bading Determines Calculation of Six Month Period
In Judge Clark’s Bading decision, the court examined how to calculate the six month period in the face of creditor obstruction. The debtor owned two contiguous lots which made up her homestead. Prior to bankruptcy, Gulfside Supply, Inc. recorded an abstract of judgment against the debtor. Under Texas law, an abstract of judgment creates a lien against all real estate owned by the debtor in the county, but does not attach to a homestead. Since the debtor only owned a homestead, the abstract of judgment should have been a nullity. However, as noted by the Bankruptcy Court, “title companies are notorious cowards.” When the creditor refused to release the lien, the debtor was put to a Hobson’s choice to either pay off the invalid lien or risk losing the ability to sell the property.
In this case, the debtor found a middle ground. It reached an agreement with the creditor to release its lien from one of the two tracts. The sale of the first lot closed on December 4, 2006 and the debtor received proceeds of approximately $142,000. The debtor did not reinvest these proceeds out of fear that acquiring a new homestead would void the exemption on the second tract.
Instead, the debtor then filed bankruptcy on December 29, 2006 and filed a motion to avoid lien on the second tract. The motion to avoid lien was granted. However, at this point, the debtor was faced with a timing dilemma. The creditor, which had not objected to the debtor’s exemptions, contended that it was not required to file an objection until after the property lost its exempt character and that the six month clock had begun to run on the sale of the first tract. Under the creditor’s position, there was only one month in which to complete the sale of the second tract and invest the proceeds from both tracts in a new homestead. To avoid this problem, the debtor, relying on the Zibman dicta, filed a motion to toll the reinvestment period.
After a hearing, the Bankruptcy Court came to three important conclusions:
1) The fact that Gulfside failed to file a timely objection to exemption was irrelevant. The court stated:
“Gulfside responds that a creditor should not be required to file a ‘conditional objection’ based on what might happen after the close of the time allowed for objection to exemptions, on pain of those exemptions being allowed as a matter of law under section 522(l). The court agrees with Gulfside on this issue. Were the rule otherwise, then trustees and creditors alike would have a duty to object in every proceeds case, just to make sure they preserved their rights. That strikes the court as an unnecessary formality, and one that is difficult to square with the rationale employed by the Fifth Circuit in Zibman to reach its result.”
Bading, slip op., p. 6, n. 5.
2) The six month clock did not begin to run until the second tract was sold.
The six month clock is triggered by sale of “a” homestead, not part of the homestead. Here, the debtor had a single purchaser for both parts of the homestead. The closing of the sale of the complete homestead was delayed by the creditor’s unjustified refusal to release its lien. As a result, there was not a sale of “a” homestead until the second closing, so that the six month clock did not begin to run until that date.
3) If the single sale theory did not work, the court found that equitable tolling would apply.
The court noted that both Texas law and the Zibman opinion held open the possibility that the six month period to reinvest could be tolled. Tolling is an equitable principle. Where, as here, the creditor delayed the debtor’s ability to sell through its refusal to release an invalid lien, there were sufficient grounds to toll the six month reinvestment period.
Thus, the net result was that the debtor was able to sell her homestead free of the offending judgment lien and the creditor’s stall tactics failed to achieve their desired result.
Invoking Avril Lavigne
Judge Clark’s reasoning is elegant and avoided an obvious injustice. However, it raises an obvious question: “Why do you have to make things so complicated?”* Judge Clark would never have had to reach the issues of unitary homestead sales or equitable tolling if he had simply followed Taylor v. Freeland & Kronz and ruled that failure to timely object to the claimed exemption ended the inquiry.
Judge Clark justified his failure to deem the objection waived on two grounds:
1) Practicality; and
2) Fealty to the Fifth Circuit’s reasoning in Zibman.
The practical argument questions the reasonableness of requiring conditional objections in cases involving homestead proceeds. The most reasonable response to this argument is: So what? Cases involving exemptions of homestead proceeds are relatively rare. In order to have a case involving proceeds, the sale must have taken place pre-petition. The deadline to object to exemptions occurs 30 days after the conclusion of the first meeting of creditors. Fed.R.Bankr.P. 4003(b). While the creditors’ meeting must be commenced 20-40 days after the filing of the petition, Fed.R.Bankr.P. 2003(a), there is no rule as to when the meeting must be concluded. As a result, the trustee may simply continue the meeting to a date after the conclusion of the six month reinvestment period. If that isn’t satisfactory, a creditor could move to extend the time to object or could file a conditional objection. All of these solutions are easy to accomplish. Since proceeds cases are unusual, it is reasonable to require trustees and creditors to take these nominal steps to preserve their rights rather than to argue that Supreme Court precedent should be disregarded.
The rationale of the Zibman opinion offers offers little support to the tardy creditor. In that case, the trustee obtained an order extending the time to object to exemptions. The trustee filed his objection within that time period. As a result, Zibman should not be construed as authorizing out of time objections. Indeed, the Zibman rationale simply recognizes that the debtor’s right to exempt proceeds may depend on events happening after the petition date. This is not an invitation to ignore the rules requiring timely objections to exemptions.
Finally, allowing untimely objections to exemptions based on events occurring after the petition date would lead to absurd results. Under Taylor v. Freeland & Kronz, which is an intellectual cousin to Republic Supply Co. v. Shoaf, 815 F.2d 1046 (5th Cir. 1987), failure to file a timely objection to exemption allows the debtor to retain the claimed property regardless of whether the debtor had a colorable claim of exemptions in the first place. If Zibman is read as allowing untimely objections, it means that a conditional claim to exemption of homestead proceeds would receive less protection than a debtor’s attempt to exempt a stack of gold bullion or a herd of Ethiopian hog-nosed goats** as his homestead. The legal system would be seriously out of joint if it accorded greater rights to the frivolous than the conditionally correct. The entire concept of statutes of limitation assumes that creditors must be diligent to protect their rights. If a creditor is unable to focus its attention on a claim which will be resolved in less than six months, the court should not create a judicial do-over for it.
*--This is the refrain from a recent song by semi-punk songstress Avril Lavigne.
**--A rare form of livestock found only in Bastrop County. Apologies to Joe Martinec and Eric Borsheim. For the full story of the Ethiopian hog-nosed goats, write to me at ssather@bnpclaw.com.
The Vanishing Exemption and Absolute Protection of Exempted Property
Most exemption statutes are limited by the type and value of the property to be claimed as exempt, but are not limited as to time. Thus, exempt property will keep its status so long as it retains its exempt character. However, a sale or other transformation of the exempt property will usually cause it to lose its exempt character. The Texas homestead exemption extends not only to a homestead owned and occupied by the debtor, but to the proceeds from sale of a homestead as well. Tex. Prop. Code §41.001(c). The proceeds exemption is one which is limited by time. It lasts for the lesser of six months or until the debtor acquires another homestead. The purpose of the proceeds exemption is to give the debtor a limited period of time in which to acquire a new homestead. As a result, the statute creates a vanishing exemption. Homestead proceeds which were fully protected five months and 29 days after sale of the home become cash subject to claims of creditors after six months and one day.
This vanishing exemption creates a potential conflict between state and federal law in the bankruptcy context. According to 11 U.S.C. §522(c), “property exempted under this section is not liable during or after the case for any debt of the debtor that arose, or that is determined under section 502 of this title as if such debt had arisen, before the commencement of the case” (with certain exceptions). Thus, the Bankruptcy Code gives exempted property absolute protection from pre-petition claims.
This absolute protection is implemented in two ways. First, the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure provide a limited time in which to object to exempt property. 11 U.S.C. §522(l); Fed.R.Bankr.P. 4003(b). If the property is claimed as exempt and the exemption is not timely challenged, the property remains exempt regardless of whether it would have been subject to a valid objection. Taylor v. Freeland & Kronz, 503 U.S. 638 (1992). Second, the property’s exempt status is determined as of the petition date using the “snapshot” approach. Matter of Zibman, 268 F.3d 298 (5th Cir. 2001).
A Fading Snapshot
While the Zibman decision recognized the “snapshot” approach, it also noted that like a bad Polaroid, the picture could fade. According to the Fifth Circuit:
“(T)he law and facts existing on the date of filing the bankruptcy petition determine the existence of available exemptions but . . . it is the entire state law applicable on the filing date that is determinative. Courts cannot apply a juridical airbrush to excise offending images necessarily picture in the petition-date snapshot.”
Zibman at 304.
Thus, Zibman teaches that where conditions exist on the petition date which would limit the exemption, the snapshot approach does not eliminate those limitations. However, it seems important to the Fifth Circuit’s analysis that the condition must exist as of the petition date. In the Zibman case, the debtors had sold their homestead approximately two months prior to bankruptcy. Thus, the snapshot on the petition date revealed an exemption which had just four months remaining in the absence of reinvestment. Since the debtors had moved to another state, reinvestment was not a possibility.
In the Zibman case, the Trustee obtained an order extending the time to object to exemptions until after the six month reinvestment period expired. When the debtor failed to purchase a new homestead, the trustee objected and was sustained by the Fifth Circuit. Thus, although the exemption was still valid on the petition date, it was a limited exemption and was defeated by the timely filed objection.
Although the Trustee benefitted from an extension of time in Zibman, the court noted that the debtor could benefit from one as well. In a footnote, the Court noted that although the debtors could have requested tolling of the six month period, they failed to do so.
Bading Determines Calculation of Six Month Period
In Judge Clark’s Bading decision, the court examined how to calculate the six month period in the face of creditor obstruction. The debtor owned two contiguous lots which made up her homestead. Prior to bankruptcy, Gulfside Supply, Inc. recorded an abstract of judgment against the debtor. Under Texas law, an abstract of judgment creates a lien against all real estate owned by the debtor in the county, but does not attach to a homestead. Since the debtor only owned a homestead, the abstract of judgment should have been a nullity. However, as noted by the Bankruptcy Court, “title companies are notorious cowards.” When the creditor refused to release the lien, the debtor was put to a Hobson’s choice to either pay off the invalid lien or risk losing the ability to sell the property.
In this case, the debtor found a middle ground. It reached an agreement with the creditor to release its lien from one of the two tracts. The sale of the first lot closed on December 4, 2006 and the debtor received proceeds of approximately $142,000. The debtor did not reinvest these proceeds out of fear that acquiring a new homestead would void the exemption on the second tract.
Instead, the debtor then filed bankruptcy on December 29, 2006 and filed a motion to avoid lien on the second tract. The motion to avoid lien was granted. However, at this point, the debtor was faced with a timing dilemma. The creditor, which had not objected to the debtor’s exemptions, contended that it was not required to file an objection until after the property lost its exempt character and that the six month clock had begun to run on the sale of the first tract. Under the creditor’s position, there was only one month in which to complete the sale of the second tract and invest the proceeds from both tracts in a new homestead. To avoid this problem, the debtor, relying on the Zibman dicta, filed a motion to toll the reinvestment period.
After a hearing, the Bankruptcy Court came to three important conclusions:
1) The fact that Gulfside failed to file a timely objection to exemption was irrelevant. The court stated:
“Gulfside responds that a creditor should not be required to file a ‘conditional objection’ based on what might happen after the close of the time allowed for objection to exemptions, on pain of those exemptions being allowed as a matter of law under section 522(l). The court agrees with Gulfside on this issue. Were the rule otherwise, then trustees and creditors alike would have a duty to object in every proceeds case, just to make sure they preserved their rights. That strikes the court as an unnecessary formality, and one that is difficult to square with the rationale employed by the Fifth Circuit in Zibman to reach its result.”
Bading, slip op., p. 6, n. 5.
2) The six month clock did not begin to run until the second tract was sold.
The six month clock is triggered by sale of “a” homestead, not part of the homestead. Here, the debtor had a single purchaser for both parts of the homestead. The closing of the sale of the complete homestead was delayed by the creditor’s unjustified refusal to release its lien. As a result, there was not a sale of “a” homestead until the second closing, so that the six month clock did not begin to run until that date.
3) If the single sale theory did not work, the court found that equitable tolling would apply.
The court noted that both Texas law and the Zibman opinion held open the possibility that the six month period to reinvest could be tolled. Tolling is an equitable principle. Where, as here, the creditor delayed the debtor’s ability to sell through its refusal to release an invalid lien, there were sufficient grounds to toll the six month reinvestment period.
Thus, the net result was that the debtor was able to sell her homestead free of the offending judgment lien and the creditor’s stall tactics failed to achieve their desired result.
Invoking Avril Lavigne
Judge Clark’s reasoning is elegant and avoided an obvious injustice. However, it raises an obvious question: “Why do you have to make things so complicated?”* Judge Clark would never have had to reach the issues of unitary homestead sales or equitable tolling if he had simply followed Taylor v. Freeland & Kronz and ruled that failure to timely object to the claimed exemption ended the inquiry.
Judge Clark justified his failure to deem the objection waived on two grounds:
1) Practicality; and
2) Fealty to the Fifth Circuit’s reasoning in Zibman.
The practical argument questions the reasonableness of requiring conditional objections in cases involving homestead proceeds. The most reasonable response to this argument is: So what? Cases involving exemptions of homestead proceeds are relatively rare. In order to have a case involving proceeds, the sale must have taken place pre-petition. The deadline to object to exemptions occurs 30 days after the conclusion of the first meeting of creditors. Fed.R.Bankr.P. 4003(b). While the creditors’ meeting must be commenced 20-40 days after the filing of the petition, Fed.R.Bankr.P. 2003(a), there is no rule as to when the meeting must be concluded. As a result, the trustee may simply continue the meeting to a date after the conclusion of the six month reinvestment period. If that isn’t satisfactory, a creditor could move to extend the time to object or could file a conditional objection. All of these solutions are easy to accomplish. Since proceeds cases are unusual, it is reasonable to require trustees and creditors to take these nominal steps to preserve their rights rather than to argue that Supreme Court precedent should be disregarded.
The rationale of the Zibman opinion offers offers little support to the tardy creditor. In that case, the trustee obtained an order extending the time to object to exemptions. The trustee filed his objection within that time period. As a result, Zibman should not be construed as authorizing out of time objections. Indeed, the Zibman rationale simply recognizes that the debtor’s right to exempt proceeds may depend on events happening after the petition date. This is not an invitation to ignore the rules requiring timely objections to exemptions.
Finally, allowing untimely objections to exemptions based on events occurring after the petition date would lead to absurd results. Under Taylor v. Freeland & Kronz, which is an intellectual cousin to Republic Supply Co. v. Shoaf, 815 F.2d 1046 (5th Cir. 1987), failure to file a timely objection to exemption allows the debtor to retain the claimed property regardless of whether the debtor had a colorable claim of exemptions in the first place. If Zibman is read as allowing untimely objections, it means that a conditional claim to exemption of homestead proceeds would receive less protection than a debtor’s attempt to exempt a stack of gold bullion or a herd of Ethiopian hog-nosed goats** as his homestead. The legal system would be seriously out of joint if it accorded greater rights to the frivolous than the conditionally correct. The entire concept of statutes of limitation assumes that creditors must be diligent to protect their rights. If a creditor is unable to focus its attention on a claim which will be resolved in less than six months, the court should not create a judicial do-over for it.
*--This is the refrain from a recent song by semi-punk songstress Avril Lavigne.
**--A rare form of livestock found only in Bastrop County. Apologies to Joe Martinec and Eric Borsheim. For the full story of the Ethiopian hog-nosed goats, write to me at ssather@bnpclaw.com.
Wednesday, October 17, 2007
Creditor Trust Fails to Revive Claims Brought by Debtor; Creditors Found to Have Derivative Standing Only
While plan trusts have many uses, overcoming res judicata is not one of them. In Medlin, Trustee v. Wells Fargo Bank, N.A., Adv. No. 04-5041 (Bankr. W.D. Tex. 7/31/07), the Bankruptcy Court considered whether claims contributed to a plan trust by investors could overcome a prior take nothing judgment entered in a suit by the debtor’s trustee. In this case, the motto try, try again proved unavailing.
In the initial action, Len Blackwell, Chapter 11 trustee for the Inverworld debtors brought claims against Wells Fargo Bank, N.A. and Wells Fargo Bank of Texas, N.A. Pursuant to a Cash Management Services Agreement, the claims were referred to arbitration. The arbitration resulted in a take nothing judgment.
Subsequently, the cases proceeded to confirmation. The plan allowed for creditors to contribute their claims to an investor claim trust. The investor claim trust then brought its own claims. Although the reference was withdrawn, the Bankruptcy Court retained preliminary matters. The Bankruptcy Court was asked to consider whether the creditor claims were barred by res judicata.
Drawing an analogy to Orson Welles who proclaimed that Gallo Wineries would sell no wine before its time, the Bankruptcy Court noted that this issue was now ripe for decision since a new opinion by the Delaware Supreme Court resolved the issue. In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, __ A.2d __, 2007 WL 1453705 (Del. Sup. 5/18/07), the Delaware Supreme Court held that creditors of an insolvent firm could assert breach of fiduciary claims; however, such claims were derivative claims just like those which could be asserted by shareholders. Because the creditor claims were derivative of the company’s claims, they were barred by res judicata based on the prior adverse ruling against the company. Thus, even though both the company and the creditors were allowed to assert clams, they were not considered to be separate parties for purposes of res judicata.
The derivative nature of these breach of fiduciary duty claims raises an interesting race to the courthouse problem. Because multiple parties have standing to pursue the same claim, it is possible that the first party to file might be the least qualified to pursue the claim or might have an actual incentive to sandbag the claims. For example, if debtor's management chooses to pursue claims against other members of management, it is possible that they might pursue the claims for the purpose of eliminating them. Thus, if management puts on a weak case and loses, the creditors would be barred. The same logic would seem to apply if management pursued the claims and then settled them on behalf of the company. There is some protection where the party sabotaging the claims is part of the debtor's management. In that case, the disingenuous pursuit of breach of fiduciary claims could give rise to new breach of fiduciary claims against the parties who caused the prior claims to be lost. However, if the claims are pursued by a small third party creditor who simply lacks the resources to put on a good case, there is no similar protection. Indeed, it is possible that a friendly creditor could bring claims for the express purpose of allowing them to go down to defeat. In that case, the creditor would not have a pre-existing fiduciary duty to the company (although it might acquire one by virtue of pursuing the claims)and its failure would bind both the debtor and its creditors.
In the initial action, Len Blackwell, Chapter 11 trustee for the Inverworld debtors brought claims against Wells Fargo Bank, N.A. and Wells Fargo Bank of Texas, N.A. Pursuant to a Cash Management Services Agreement, the claims were referred to arbitration. The arbitration resulted in a take nothing judgment.
Subsequently, the cases proceeded to confirmation. The plan allowed for creditors to contribute their claims to an investor claim trust. The investor claim trust then brought its own claims. Although the reference was withdrawn, the Bankruptcy Court retained preliminary matters. The Bankruptcy Court was asked to consider whether the creditor claims were barred by res judicata.
Drawing an analogy to Orson Welles who proclaimed that Gallo Wineries would sell no wine before its time, the Bankruptcy Court noted that this issue was now ripe for decision since a new opinion by the Delaware Supreme Court resolved the issue. In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, __ A.2d __, 2007 WL 1453705 (Del. Sup. 5/18/07), the Delaware Supreme Court held that creditors of an insolvent firm could assert breach of fiduciary claims; however, such claims were derivative claims just like those which could be asserted by shareholders. Because the creditor claims were derivative of the company’s claims, they were barred by res judicata based on the prior adverse ruling against the company. Thus, even though both the company and the creditors were allowed to assert clams, they were not considered to be separate parties for purposes of res judicata.
The derivative nature of these breach of fiduciary duty claims raises an interesting race to the courthouse problem. Because multiple parties have standing to pursue the same claim, it is possible that the first party to file might be the least qualified to pursue the claim or might have an actual incentive to sandbag the claims. For example, if debtor's management chooses to pursue claims against other members of management, it is possible that they might pursue the claims for the purpose of eliminating them. Thus, if management puts on a weak case and loses, the creditors would be barred. The same logic would seem to apply if management pursued the claims and then settled them on behalf of the company. There is some protection where the party sabotaging the claims is part of the debtor's management. In that case, the disingenuous pursuit of breach of fiduciary claims could give rise to new breach of fiduciary claims against the parties who caused the prior claims to be lost. However, if the claims are pursued by a small third party creditor who simply lacks the resources to put on a good case, there is no similar protection. Indeed, it is possible that a friendly creditor could bring claims for the express purpose of allowing them to go down to defeat. In that case, the creditor would not have a pre-existing fiduciary duty to the company (although it might acquire one by virtue of pursuing the claims)and its failure would bind both the debtor and its creditors.
Monday, September 24, 2007
Fifth Circuit Rules on Bradley Appeal; Lazarus Trust Is Not Resurrected From Bankruptcy Court Judgment
“This is the way the world ends/Not with a bang but a whimper.”
--T.S. Elliott
The long-running bankruptcy case of flamboyant Austin developer Gary Bradley came one step closer to its end with a dissertation by the Fifth Circuit Court of Appeals on . . . burden of proof. Matter of Bradley, No. 05-51626 (5th Cir. 9/20/07). The Court’s ruling upheld the decisions by the lower courts with the result that bankruptcy trustee Ronald Ingalls was able to recover certain traceable assets from the Lazarus Exempt Trust but not others, while Mr. Bradley lost his discharge.
Once Upon A Time . . .
The roots of this case go back decades. Gary Bradley and James Gressett were involved in a number of investments, including the Circle C real estate development in Southwest Austin. While Circle C was ultimately very successful, it got caught up in the real estate bust of the 1980s and proved to be financially devastating for its owners. Circle C Development Joint Venture was able to reorganize in a chapter 11 proceeding, but Mr. Bradley and Mr. Gressett were left with tens of millions of dollars of liability to the FDIC. Gressett filed for chapter 7 protection and received a discharge in the early 1990s, while Gary Bradley resolutely tried to recover without the benefit of bankruptcy.
One strategy that Mr. Bradley allegedly employed to resurrect his finances while keeping his creditors at bay involved an entity known as the Lazarus Exempt Trust. While this trust was formed by his sister, who contributed $1,000 to it, the trust came to own many assets which had been connected with Bradley and his associates in the past. Within two years, the trust had grown from its initial seed capital of $1,000 to own over $40 million in assets. The Trust and its entities paid Bradley a salary of $15,000 per month.
Finally, facing pressure from the FDIC (which was reportedly receiving pressure from Austin’s zealous environmental community) and a family court judge who found that he could afford to pay large amounts of child support, Bradley filed for chapter 7 bankruptcy protection in 2002. Trustee Ronald Ingalls focused on the Lazarus Exempt Trust and sought to recover its assets for the benefit of creditors.
The Bankruptcy Court Ruling
After a trial in April 2004, Bankruptcy Judge Frank Monroe issued a 145 page opinion in which he found that Bradley and his associates had engaged in an elaborate plan to transfer assets controlled by Bradley into the trust. Memorandum Opinion, Ingalls vs. Bradley, Adv. No. 02-1183 (Bankr. W.D. Tex. 10/28/04). Despite the fact that none of the “self-settled” assets were directly transferred into the trust by Bradley, the court found that Bradley maintained ownership of these assets through a set of informal and largely unwritten agreements. This ownership was established through memorandums, prior deposition testimony and the way that certain transactions were structured.
Of particular importance to Judge Monroe was an understanding between Bradley and Gressett that Bradley would own an 80% interest in their joint real estate investments, while Gressett would own 80% of the non-real estate investments. While Messrs. Bradley and Gressett contended that this split was more of a guideline than an agreement, Judge Monroe determined that it made sense out of a number of transactions which would have been nonsensical otherwise. Judge Monroe found that it was this 80% interest in real estate investments which was contributed to the Lazarus Exempt Trust.
Judge Monroe was not circumspect in offering his assessment about what had occurred, making comments such as “Can anyone play the shell game better than Bradley and Gresset?” and “Backdating was a way for life for them . . . .” Memorandum Opinion, pp. 58 and 71. However, despite his obvious disdain for Bradley and company, he did not give the trustee all that he requested. The Court found that certain specific assets, which could be traced into the trust and which remained within the trust, could be determined to self-settled assets and awarded them to the bankruptcy estate. However, he declined to invalidate the trust in toto. He also declined to award a remedy for self-settled assets which could be traced into the trust, but which had been subsequently dissipated. As a result, the trust lost many but not all of its assets. Judge Monroe also denied Mr. Bradley’s discharge on the grounds that he had transferred or concealed property within one year prior to bankruptcy.
Appeal to the Fifth Circuit
Both parties appealed to the Fifth Circuit, which rendered its decision on September 20, 2007. The Court spent most of its opinion explaining why Trustee Ingalls was not entitled to more relief than he received below. The Court of Appeals acknowledged that the burden of proof for tracing assets into a self-settled trust was res nova in Texas. However, based upon general principles of trust law, the Court ruled that the party seeking to recover trust assets had the burden of proof to both trace assets into the trust and to prove that those assets or their proceeds remained within the trust. The Court of Appeals declined to assign any burden of proof to the trust. The Trustee’s two-fold burden had two consequences for his ultimate recovery. The first was that where assets could be traced into the trust, but their provenance remained uncertain, that the trust could retain these assets. Second, where self-settled assets could be traced into the trust, but had been sold or dissipated such that their current form could not be determined, that the trust would not be held liable for these assets which had passed through it. In making its ruling, the Court of Appeals was careful to note that the bankruptcy trustee had been given full access to the trust’s records. Presumably, the result could have been different in a case where the transferee was less cooperative.
The Court of Appeals also affirmed the Bankruptcy Court’s decision to reject two global challenges to the trust. The Court of Appeals agreed with Judge Monroe that Texas courts have not recognized the concept of sham or illusory trust except in cases involving marital property rights. Thus, although Judge Monroe indicated that he would have found the trust to be a sham or illusory trust, there was no legal remedy available for this finding. The Fifth Circuit also found that the Bankruptcy Court properly denied an 11th hour attempt to amend the adversary proceeding to assert a constructive trust claim over the trust assets. Thus, the trust remained intact but wounded.
The Court of Appeals was fairly dismissive of the arguments raised by the Trust and the Debtor, devoting just 3 ½ pages to these issues. The Fifth Circuit rejected the argument that it would be necessary to pierce the corporate veil in order to consider transfers to entities controlled by the trust to be self-settled assets. The Court found that a trust is not a legal entity separate from its trustee. Apparently this led to the conclusion that an asset transferred to a corporation owned by the trust was the same as a transfer to the trust itself. Next, it found that the trust had waived its argument that Mr. Bradley was not a “settlor” of the trust (as opposed to his sister who made the original contribution) for the reason that this argument was not made to the District Court. Finally, the Circuit Court noted that “when the bankruptcy court’s weighing of the evidence is plausible in light of the record taken as a whole, a find of clear error is precluded, even if we would have weighed the evidence differently.” Fifth Circuit opinion, p. 17. This generic finding of plausibility avoided the need to examine the evidence in depth as Judge Monroe did.
What Does It All Mean?
While the opinion from the Court of Appeals turned out to be somewhat dry and technical and largely anticlimactic, there are several lessons which can be learned from the larger saga.
1. It is better to file sooner rather than later.
In some respects, this is a tale of two partners. James Gressett took his medicine and filed bankruptcy in the early 1990s. He received a discharge and was able to start over again. Gary Bradley, on the other hand, tried to tough it out. When he filed bankruptcy some ten years later, he succeeded in attracting much more attention than if he had filed more promptly. It has long been rumored that environmental activists who did not like Bradley’s development activities exerted political pressure on the FDIC to attempt to collect from Bradley rather than settle with him. This led to Bradley’s ill-advised decision to attend a post-judgment deposition without the benefit of counsel. By the time that Bradley filed for bankruptcy, newspaper articles and the FDIC deposition provided the Trustee with a road map for his investigation.
2. The concept of a self-settled trust just got larger.
In some respects, the Fifth Circuit’s opinion on the Bradley matter is like Arthur Conan Doyle’s dog which didn’t bark (that is, the remarkable thing is what was never discussed). The Fifth Circuit never really explained how assets which had never been held in the name of the debtor could be treated as self-settled assets in the hands of the trust. Normally, a self-settled trust is easy to determine. The Debtor owns an asset and then contributes that asset to a trust under which he is the beneficiary. At this point, the trust is determined to be self-settled and any spendthrift trust restriction is unenforceable.
In the Bradley case, Judge Monroe took a very expansive view of what constituted a self-settled asset. Although his opinion is quite detailed, he still had to buy into the trustee’s theory of the debtor as puppet-master pulling the strings of his associates and their entities. Based upon the opinions, it appears that there was never a legally enforceable agreement for third parties to hold property for Mr. Bradley, but that they acted as if there was such an agreement. Whether the other parties to the alleged scheme acted out of fear, loyalty or foolishness, it doesn’t seem as though they had an obligation to act at Bradley’s direction. This raises the question of whether the fact that the parties acted as though they were dealing with Gary Bradley’s property is sufficient to establish that they were in fact dealing with Gary Bradley’s property. The Fifth Circuit responded to this tantalizing question with a shrug, dismissing the issues as mere fact finding to be upheld so long as they were plausible. The Fifth Circuit also punted on the issue of whether someone who was not the named settler of a trust could make a self-settled contribution to the trust, finding that although this issue was presented to the bankruptcy court, it had not been presented to the district court. While the court of appeals did not expressly rule on this issue, the clear implication is that they would have agreed with the bankruptcy court that anyone who contributes an asset to a trust is a settler; otherwise, the entire case would turn on a technicality of appellate procedure (namely, whether an issue raised in the bankruptcy court but not the district court is waived).
The potentially expansive reach of this case is shown by the following hypothetical. Assume that parents own a business and their children work in the business. When the children reach adulthood, the parents sell the business to the children at a favorable price with an “understanding” that the children will take care of the parents in their old age. More than four years later, the children decide to form a trust for their parents’ support. They sell the business to the trust at the same favorable price that they paid and name the parents as primary beneficiaries. Prior to the Bradley case, this transaction would have been untouchable. The original transfer occurred outside of the four year period for recovering a fraudulent transfer and the property was transferred to the trust by the children, not the parents. However, following the logic of the Bradley opinion, it could be argued that the parents retained ownership of the business through their “understanding” with the children such that the asset was self-settled when it was contributed to the trust. The main difference between this hypothetical and the Bradley case is that the parents and children would be considered sympathetic parties, while Gary Bradley failed to attract much sympathy for himself. Of course, this should not be determinative when resolving legal issues.
3. Documents are important.
In discussing one of the many transactions in his Memorandum Opinion, Judge Monroe states, “None of the trial testimony makes sense. The documents do.” Memorandum Opinion, p. 55. Although the Trustee did not win on every issue, it is clear that his success was due to his ability to process large quantities of documents and sort out the ones which helped his case. The proof of the conspiracy emerged from prior deposition testimony (which can be considered low-hanging fruit), notes from meetings and analysis of the details of a myriad of transactions. Without these documents, the Trustee would not have had a case, since the witnesses on the Bradley side all testified to a different version of the facts. Conversely, the fact that the Lazarus Trust cooperated and provided the Bankruptcy Trustee with massive amounts of documents allowed the Court to apportion the burden of proof to the Trustee with the result that the Trustee did not prevail on all of his arguments.
--T.S. Elliott
The long-running bankruptcy case of flamboyant Austin developer Gary Bradley came one step closer to its end with a dissertation by the Fifth Circuit Court of Appeals on . . . burden of proof. Matter of Bradley, No. 05-51626 (5th Cir. 9/20/07). The Court’s ruling upheld the decisions by the lower courts with the result that bankruptcy trustee Ronald Ingalls was able to recover certain traceable assets from the Lazarus Exempt Trust but not others, while Mr. Bradley lost his discharge.
Once Upon A Time . . .
The roots of this case go back decades. Gary Bradley and James Gressett were involved in a number of investments, including the Circle C real estate development in Southwest Austin. While Circle C was ultimately very successful, it got caught up in the real estate bust of the 1980s and proved to be financially devastating for its owners. Circle C Development Joint Venture was able to reorganize in a chapter 11 proceeding, but Mr. Bradley and Mr. Gressett were left with tens of millions of dollars of liability to the FDIC. Gressett filed for chapter 7 protection and received a discharge in the early 1990s, while Gary Bradley resolutely tried to recover without the benefit of bankruptcy.
One strategy that Mr. Bradley allegedly employed to resurrect his finances while keeping his creditors at bay involved an entity known as the Lazarus Exempt Trust. While this trust was formed by his sister, who contributed $1,000 to it, the trust came to own many assets which had been connected with Bradley and his associates in the past. Within two years, the trust had grown from its initial seed capital of $1,000 to own over $40 million in assets. The Trust and its entities paid Bradley a salary of $15,000 per month.
Finally, facing pressure from the FDIC (which was reportedly receiving pressure from Austin’s zealous environmental community) and a family court judge who found that he could afford to pay large amounts of child support, Bradley filed for chapter 7 bankruptcy protection in 2002. Trustee Ronald Ingalls focused on the Lazarus Exempt Trust and sought to recover its assets for the benefit of creditors.
The Bankruptcy Court Ruling
After a trial in April 2004, Bankruptcy Judge Frank Monroe issued a 145 page opinion in which he found that Bradley and his associates had engaged in an elaborate plan to transfer assets controlled by Bradley into the trust. Memorandum Opinion, Ingalls vs. Bradley, Adv. No. 02-1183 (Bankr. W.D. Tex. 10/28/04). Despite the fact that none of the “self-settled” assets were directly transferred into the trust by Bradley, the court found that Bradley maintained ownership of these assets through a set of informal and largely unwritten agreements. This ownership was established through memorandums, prior deposition testimony and the way that certain transactions were structured.
Of particular importance to Judge Monroe was an understanding between Bradley and Gressett that Bradley would own an 80% interest in their joint real estate investments, while Gressett would own 80% of the non-real estate investments. While Messrs. Bradley and Gressett contended that this split was more of a guideline than an agreement, Judge Monroe determined that it made sense out of a number of transactions which would have been nonsensical otherwise. Judge Monroe found that it was this 80% interest in real estate investments which was contributed to the Lazarus Exempt Trust.
Judge Monroe was not circumspect in offering his assessment about what had occurred, making comments such as “Can anyone play the shell game better than Bradley and Gresset?” and “Backdating was a way for life for them . . . .” Memorandum Opinion, pp. 58 and 71. However, despite his obvious disdain for Bradley and company, he did not give the trustee all that he requested. The Court found that certain specific assets, which could be traced into the trust and which remained within the trust, could be determined to self-settled assets and awarded them to the bankruptcy estate. However, he declined to invalidate the trust in toto. He also declined to award a remedy for self-settled assets which could be traced into the trust, but which had been subsequently dissipated. As a result, the trust lost many but not all of its assets. Judge Monroe also denied Mr. Bradley’s discharge on the grounds that he had transferred or concealed property within one year prior to bankruptcy.
Appeal to the Fifth Circuit
Both parties appealed to the Fifth Circuit, which rendered its decision on September 20, 2007. The Court spent most of its opinion explaining why Trustee Ingalls was not entitled to more relief than he received below. The Court of Appeals acknowledged that the burden of proof for tracing assets into a self-settled trust was res nova in Texas. However, based upon general principles of trust law, the Court ruled that the party seeking to recover trust assets had the burden of proof to both trace assets into the trust and to prove that those assets or their proceeds remained within the trust. The Court of Appeals declined to assign any burden of proof to the trust. The Trustee’s two-fold burden had two consequences for his ultimate recovery. The first was that where assets could be traced into the trust, but their provenance remained uncertain, that the trust could retain these assets. Second, where self-settled assets could be traced into the trust, but had been sold or dissipated such that their current form could not be determined, that the trust would not be held liable for these assets which had passed through it. In making its ruling, the Court of Appeals was careful to note that the bankruptcy trustee had been given full access to the trust’s records. Presumably, the result could have been different in a case where the transferee was less cooperative.
The Court of Appeals also affirmed the Bankruptcy Court’s decision to reject two global challenges to the trust. The Court of Appeals agreed with Judge Monroe that Texas courts have not recognized the concept of sham or illusory trust except in cases involving marital property rights. Thus, although Judge Monroe indicated that he would have found the trust to be a sham or illusory trust, there was no legal remedy available for this finding. The Fifth Circuit also found that the Bankruptcy Court properly denied an 11th hour attempt to amend the adversary proceeding to assert a constructive trust claim over the trust assets. Thus, the trust remained intact but wounded.
The Court of Appeals was fairly dismissive of the arguments raised by the Trust and the Debtor, devoting just 3 ½ pages to these issues. The Fifth Circuit rejected the argument that it would be necessary to pierce the corporate veil in order to consider transfers to entities controlled by the trust to be self-settled assets. The Court found that a trust is not a legal entity separate from its trustee. Apparently this led to the conclusion that an asset transferred to a corporation owned by the trust was the same as a transfer to the trust itself. Next, it found that the trust had waived its argument that Mr. Bradley was not a “settlor” of the trust (as opposed to his sister who made the original contribution) for the reason that this argument was not made to the District Court. Finally, the Circuit Court noted that “when the bankruptcy court’s weighing of the evidence is plausible in light of the record taken as a whole, a find of clear error is precluded, even if we would have weighed the evidence differently.” Fifth Circuit opinion, p. 17. This generic finding of plausibility avoided the need to examine the evidence in depth as Judge Monroe did.
What Does It All Mean?
While the opinion from the Court of Appeals turned out to be somewhat dry and technical and largely anticlimactic, there are several lessons which can be learned from the larger saga.
1. It is better to file sooner rather than later.
In some respects, this is a tale of two partners. James Gressett took his medicine and filed bankruptcy in the early 1990s. He received a discharge and was able to start over again. Gary Bradley, on the other hand, tried to tough it out. When he filed bankruptcy some ten years later, he succeeded in attracting much more attention than if he had filed more promptly. It has long been rumored that environmental activists who did not like Bradley’s development activities exerted political pressure on the FDIC to attempt to collect from Bradley rather than settle with him. This led to Bradley’s ill-advised decision to attend a post-judgment deposition without the benefit of counsel. By the time that Bradley filed for bankruptcy, newspaper articles and the FDIC deposition provided the Trustee with a road map for his investigation.
2. The concept of a self-settled trust just got larger.
In some respects, the Fifth Circuit’s opinion on the Bradley matter is like Arthur Conan Doyle’s dog which didn’t bark (that is, the remarkable thing is what was never discussed). The Fifth Circuit never really explained how assets which had never been held in the name of the debtor could be treated as self-settled assets in the hands of the trust. Normally, a self-settled trust is easy to determine. The Debtor owns an asset and then contributes that asset to a trust under which he is the beneficiary. At this point, the trust is determined to be self-settled and any spendthrift trust restriction is unenforceable.
In the Bradley case, Judge Monroe took a very expansive view of what constituted a self-settled asset. Although his opinion is quite detailed, he still had to buy into the trustee’s theory of the debtor as puppet-master pulling the strings of his associates and their entities. Based upon the opinions, it appears that there was never a legally enforceable agreement for third parties to hold property for Mr. Bradley, but that they acted as if there was such an agreement. Whether the other parties to the alleged scheme acted out of fear, loyalty or foolishness, it doesn’t seem as though they had an obligation to act at Bradley’s direction. This raises the question of whether the fact that the parties acted as though they were dealing with Gary Bradley’s property is sufficient to establish that they were in fact dealing with Gary Bradley’s property. The Fifth Circuit responded to this tantalizing question with a shrug, dismissing the issues as mere fact finding to be upheld so long as they were plausible. The Fifth Circuit also punted on the issue of whether someone who was not the named settler of a trust could make a self-settled contribution to the trust, finding that although this issue was presented to the bankruptcy court, it had not been presented to the district court. While the court of appeals did not expressly rule on this issue, the clear implication is that they would have agreed with the bankruptcy court that anyone who contributes an asset to a trust is a settler; otherwise, the entire case would turn on a technicality of appellate procedure (namely, whether an issue raised in the bankruptcy court but not the district court is waived).
The potentially expansive reach of this case is shown by the following hypothetical. Assume that parents own a business and their children work in the business. When the children reach adulthood, the parents sell the business to the children at a favorable price with an “understanding” that the children will take care of the parents in their old age. More than four years later, the children decide to form a trust for their parents’ support. They sell the business to the trust at the same favorable price that they paid and name the parents as primary beneficiaries. Prior to the Bradley case, this transaction would have been untouchable. The original transfer occurred outside of the four year period for recovering a fraudulent transfer and the property was transferred to the trust by the children, not the parents. However, following the logic of the Bradley opinion, it could be argued that the parents retained ownership of the business through their “understanding” with the children such that the asset was self-settled when it was contributed to the trust. The main difference between this hypothetical and the Bradley case is that the parents and children would be considered sympathetic parties, while Gary Bradley failed to attract much sympathy for himself. Of course, this should not be determinative when resolving legal issues.
3. Documents are important.
In discussing one of the many transactions in his Memorandum Opinion, Judge Monroe states, “None of the trial testimony makes sense. The documents do.” Memorandum Opinion, p. 55. Although the Trustee did not win on every issue, it is clear that his success was due to his ability to process large quantities of documents and sort out the ones which helped his case. The proof of the conspiracy emerged from prior deposition testimony (which can be considered low-hanging fruit), notes from meetings and analysis of the details of a myriad of transactions. Without these documents, the Trustee would not have had a case, since the witnesses on the Bradley side all testified to a different version of the facts. Conversely, the fact that the Lazarus Trust cooperated and provided the Bankruptcy Trustee with massive amounts of documents allowed the Court to apportion the burden of proof to the Trustee with the result that the Trustee did not prevail on all of his arguments.
Wednesday, August 08, 2007
Cash Value of Surrendered Policy Not Exempt In Texas
The Fifth Circuit has held that proceeds from a surrendered whole-life policy are not exempt under Texas law. Trautman vs. Milligan, No. 06-50363 (5th Cir. 8/8/07). The Trautman decision relied on both interpretation of the Texas Insurance Code and policy considerations.
In Trautman, the Debtor owned an insurance policy in which he was the insured and his wife was the beneficiary. Prior to bankruptcy, he surrendered the policy and received a check for the cash value. He claimed the un-cashed check as exempt property. The Bankruptcy Court allowed the exemption, but both the District Court and the Fifth Circuit held that the property was not exempt.
The exemption turned upon statutory language which provided that “the cash value and proceeds of an insurance policy, to be provided to an insured or beneficiary” under an insurance policy issued by a life, health or accident insurance company were exempt. Texas Insurance Code Sec. 1108.051.
The Court of Appeals noted the difference between three parties to an insurance contract: the owner, the insured and the beneficiary. In this case, the husband was both the owner of the policy and the insured, while the wife was the beneficiary. The Insurance Code protects “cash value” and “proceeds” payable to an “insured” or a “beneficiary.” At first blush, there appears to be a reasonable argument for the exemption. After all, the undisputed facts were that the policy was surrendered and that the cash value was paid to the husband, who was both owner and insured. However, the Court found that the funds were paid to the husband, not as insured, but as owner. Since amounts paid to owners are not listed as exempt, the argument failed.
The Court of Appeals also noted that cash values had not always been protected from creditors. The Court surmised that the legislature allowed exemption of cash values in order to prevent creditors from seizing the value of the policy and thwarting the interest of the beneficiary. However, the Court did not feel that allowing the debtor to use a whole-life policy as a savings account free from the claims of creditors was a worthy goal. Indeed, the court noted that under the debtor’s proposed interpretation, a person could transfer funds into an insurance policy and then immediately surrender the policy and shelter the proceeds from creditors. The Court succinctly remarked that “That can’t be the law.”
This case points out an important bankruptcy planning consideration. Cash value contained within an existing insurance policy is protected by statute, while cash value in a surrendered policy is not. As a result, a financially distressed debtor will be better off waiting until after bankruptcy (and after the period for objecting to exemptions has passed) before accessing the cash value of a policy. Additionally, a debtor who needs temporary access to policy cash values will be better served by borrowing against the policy rather than surrendering it.
While the Court of Appeals was concerned about debtors fraudulently transferring their cash into an insurance policy, this possibility is addressed by the statute itself. Under Texas Insurance Code Sec. 1108.053(1), the exemption does not apply to “a premium payment made in fraud of a creditor, subject to the applicable statute of limitations for recovering the payment.”
In Trautman, the Debtor owned an insurance policy in which he was the insured and his wife was the beneficiary. Prior to bankruptcy, he surrendered the policy and received a check for the cash value. He claimed the un-cashed check as exempt property. The Bankruptcy Court allowed the exemption, but both the District Court and the Fifth Circuit held that the property was not exempt.
The exemption turned upon statutory language which provided that “the cash value and proceeds of an insurance policy, to be provided to an insured or beneficiary” under an insurance policy issued by a life, health or accident insurance company were exempt. Texas Insurance Code Sec. 1108.051.
The Court of Appeals noted the difference between three parties to an insurance contract: the owner, the insured and the beneficiary. In this case, the husband was both the owner of the policy and the insured, while the wife was the beneficiary. The Insurance Code protects “cash value” and “proceeds” payable to an “insured” or a “beneficiary.” At first blush, there appears to be a reasonable argument for the exemption. After all, the undisputed facts were that the policy was surrendered and that the cash value was paid to the husband, who was both owner and insured. However, the Court found that the funds were paid to the husband, not as insured, but as owner. Since amounts paid to owners are not listed as exempt, the argument failed.
The Court of Appeals also noted that cash values had not always been protected from creditors. The Court surmised that the legislature allowed exemption of cash values in order to prevent creditors from seizing the value of the policy and thwarting the interest of the beneficiary. However, the Court did not feel that allowing the debtor to use a whole-life policy as a savings account free from the claims of creditors was a worthy goal. Indeed, the court noted that under the debtor’s proposed interpretation, a person could transfer funds into an insurance policy and then immediately surrender the policy and shelter the proceeds from creditors. The Court succinctly remarked that “That can’t be the law.”
This case points out an important bankruptcy planning consideration. Cash value contained within an existing insurance policy is protected by statute, while cash value in a surrendered policy is not. As a result, a financially distressed debtor will be better off waiting until after bankruptcy (and after the period for objecting to exemptions has passed) before accessing the cash value of a policy. Additionally, a debtor who needs temporary access to policy cash values will be better served by borrowing against the policy rather than surrendering it.
While the Court of Appeals was concerned about debtors fraudulently transferring their cash into an insurance policy, this possibility is addressed by the statute itself. Under Texas Insurance Code Sec. 1108.053(1), the exemption does not apply to “a premium payment made in fraud of a creditor, subject to the applicable statute of limitations for recovering the payment.”
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