NCBJ 2012: From Stern's Fallout to Arguing Before the Supreme Court

The National Conference of Bankruptcy Judges consistently delivers some of the best continuing legal education in the country for bankruptcy lawyers.   Here are some highlights from this year’s conference.

I started my day Thursday with the Bernstein-Burkley firm’s Wake Up and Run.   For the past three year’s the firm has sponsored a daybreak 5k run at the conference.   This year’s run drew about 80 participants who ran, jogged or meandered around the waterfront in San Diego.    At 33:58, I was near the back of the pack, so I can’t tell who the fastest judge was or how the Fifth Circuit fared against the Ninth Circuit.   The fact that so many people would get together at 6:30 a.m. to go for a communal run shows that you don’t have to be crazy to practice bankruptcy law, but it helps.

The Reaction to Stern v. Marshall

So much has been written about Stern v. Marshall that it is hard to say anything new.   The panel did a good job on focusing on the judicial reaction to the decision rather than rehashing the story of the former Playboy playmate who didn’t get her multi-million judgment because Congress created an unconstitutional allocation of work between the bankruptcy courts and the district courts.    The panel gamely tried to wade through the reams of decisions mentioning Stern v. Marshall.  As of October 25, there were 712 of them.    The trend appears to be that while there are still about 50 decisions a month mentioning the Supreme Court ruling, the sky is not falling.   Out of a sample of cases, the panel found that a majority of Stern-based motions to withdraw reference, motions to dismiss and motion to abstain had been denied.    Two early decisions which suggested that bankruptcy courts lacked the power to even consider matters which were core proceedings but could not be constitutionally decided by the bankruptcy court were walked back by subsequent decisions.   

The most important response to Stern v. Marshall is that a few courts have developed local rules to deal with the decision and the national rules committee has proposed a set of rules changes as well.   The Southern District of New York’s rules have provided the template for several other courts that have addressed the issue.  Their rules can be found here.   

The Southern District rules attempt to require parties to state whether they will consent to entry of a final judgment by the Bankruptcy Court or whether they object.   The new rules require a statement of consent in the first pleading filed in an adversary proceeding, in the first pleading filed by a defendant, and upon removal o f a case.    These rules reflect a belief, which is probably warranted, that the parties can consent to decision by a non-article III judge.   New Rule 9033-1 provide that if a matter is core but the court cannot constitutionally enter a final judgment, the Court shall enter proposed findings and conclusions “as if it is a non-core proceeding.”

The proposed national rules amendments can be found here.  The proposed rules eliminate the core/non-core terminology from rules 7008, 7012, 9027 and 9033.  Instead, parties will simply state whether they consent to entry of a final order by the bankruptcy court.   New Rule 7016(b) states that the court shall, either sua sponte or on timely motion of one of the parties decide  whether to enter a final judgment, enter proposed findings and conclusions or “take some other action.”   Parties may submit comments on the proposed rules amendments until February 15, 2013.

What the Puck:  Sports Teams in Bankruptcy

This presentation discussed the bankruptcies of the Phoenix Coyotes, the Texas Rangers and the Los Angeles Dodgers.   According to the panelists, a sports league is nothing more than a cooperative of the teams.    When an owner acquires a team, he agrees to give the league veto power over who will own the team and where it will be located.    This gives the league enormous power over the teams and theoretically gives it the power to veto most decisions that would be made in a bankruptcy proceeding.  In bankruptcy terms, the debtor is a party to an executory contract which either is not subject to being assumed or at or cannot be assumed in a manner compatible with the proposed reorganization.  Nevertheless, bankruptcy has been successful to varying degrees because of the incentive of the fellow owners to allow the bankrupt team to, in the words of Tom Salerno, “bend the league rules.”

The three cases each had their own unique stories.  The Phoenix Coyotes were losing money because Arizona was not a particularly good market for a hockey club.   Their owner wanted to sell out to a Canadian technology entrepreneur who would move the team.   However, the league had vetoed the proposed sale.   The Texas Rangers, on the other hand, were a profitable team, whose parent company was mired in debt.   The team owners and the league were both happy to allow the team to be sold to a group led by Nolan Ryan.   However, to get the benefit of bankruptcy, they had to allow a competitive sales process.   The Los Angeles Dodgers were losing money and had been drained of $240 million by owner Frank McCord.  McCord wanted to sell the media rights for a small fortune and hang onto the team.   The league did not want to allow this to happen.

All three cases resulted in auctions.   In the case of the Phoenix Coyotes, the league bought the team, even though it did not have the highest bid.  Three years later the team is still losing money and the league has not found a new owner.   In the case of the Texas Rangers, a sales process designed to favor the Nolan Ryan group was upset when Judge Michael Lynn convinced the parties to allow genuine competitive bidding.   Dallas Mavericks bad boy Mark Cuban almost got the team until he was outbid by the Ryan group.    In the Dodgers case, the team sold for $2 billion, which will likely allow Frank McCord to walk away with anywhere from hundreds of millions to a billion dollars.   In each case, the bankruptcy case transitioned the team to a new owner acceptable to the league (although in the Coyotes case, that owner was the league itself).

A Grimm Fairy Tale:   Perspectives in the Next Chapter of the U.S. Mortgage Market Story

My notes from this panel would fill a ten page article.   However, a few highlights will have to suffice.
  

New York Times journalist and author Gretchen Morgenson is the author of Reckless Endangerment:  How Outsized Ambition, Greed and Corruption Led to Economic Armageddon.   She argued that the government’s role in subsidizing home ownership through Fannie Mae and Freddie Mac corrupted the mortgage market.   When the executives, shareholders and lobbyists for Fannie and Freddie were able to get part of the subsidies for themselves, they promoted more demand for subsidized mortgages.  The private mortgage market which is based on securitization was rampant with conflicts of interest and lack of disclosure.    Due to the collapse of the private mortgage market, Fannie and Freddie now comprise 95% of the mortgage market.

She said that if the government is going to subsidize housing finance, it should do so directly on the government’s own balance sheet.   She also said that the private sector must be “deeply engaged in building a market that is trustworthy, clean and not corrupt.      

Another speaker pointed out the extent of the mortgage foreclosure crisis.   3.5 million foreclosures have been completed, 2 million more are in the pipeline and 7 million more are at risk.   Foreclosure has been shown to reduce the value of foreclosed homes by 27% and to reduce the value of homes in the neighborhood by 1%.   

Franklin Codel, head of Mortgage Production for Wells Fargo Home Mortgage stated that Wells Fargo works very hard with borrowers experiencing financial distress but servicers and investors were not ready for the elevated level of foreclosure activity.   Nevertheless, he said that Wells Fargo completes two mortgage modifications for every foreclosure.

Clifford White, Executive Director of the Executive Office for U.S. Trustees highlighted the role of the bankruptcy system in dealing with the mortgage crisis.   He said that “our experienced in the bankruptcy system has been that large banks were not performing well” and that the bankruptcy system has been at the forefront of identifying problems in the mortgage industry.   He added that 300,000 distressed homeowners go into chapter 13 each year.

Mr. White argued that the bankruptcy courts saw the mortgage crisis sooner than other segments of the economy, but that the U.S. Trustee’s program “faced an onslaught of resistance” to efforts to try to address the problem.   

Mr. White also stated that the bankruptcy system should think of itself as a regulatory mechanism. He highlighted the disclosures required by the amended bankruptcy rules.   He said that these rules “affect bank processors in a way that no other federal rules do.”

Both Mr.Codell and Steven Swartout, who is the Executive Vice-President for a community bank, stated that their institutions have a high level of modifying mortgages that they own but that they have difficulty getting responses from the investors on mortgages they service.  

Ms. Morgenson was critical of the HAMP program, describing it as “ill-conceived” and with very few sticks attached.   The program was voluntary and did not address second liens which were often retained by the originating bank.   She questioned whether the government was trying to strike a balance between protecting the financial sector and protecting bad actors.  

Mr. Swartout explained that there were different markets for long-term and short-term mortgages.  He said that there were only a limited number of entities that could take on the risk of a 30 year fixed rate mortgage.    As a community bank, their market is in making two, three or five year callable mortgages.   He said that the expectation is that these mortgages would be repriced at maturity.  However, he said that they would not meet the requirements of a “Qualified Mortgage” under proposed federal regulations.     

In closing Gretchen Morgenson complimented the work of the bankruptcy courts, stating, “without you questioning what came into your courtrooms we wouldn’t be even this close to a turnaround in the housing market.”

Justice Stevens and Advocacy Before the Supreme Court

The Commercial Law League luncheon featured the presentation of the Lawrence King Award to retired Supreme Court justice John Paul Stevens and a keynote address by Supreme Court advocate Eric Brunstad.    (Unfortunately, Justice Stevens was not able to accept the award in person).  The two blended nicely into a program on bankruptcy and the Supreme Court.  

A few stories about Justice Stevens:

Shortly after he was appointed to the Seventh Circuit, the court considered the case of protesters who had occupied the state capital grounds.   The legislature voted the protesters in contempt of the legislature and had them arrested.   This was during the height of the Nixon law and order days. While the other members of the panel had no problem with the arrest, it troubled Justice Stevens and he dissented.   He also assumed that he had lost his chance to be considered for the Supreme Court.  However, when President Nixon resigned and President Ford was looking for a nominee who was not closely tied to Nixon, Stevens got the nod.

Justice Stevens said that brilliance was not how much you knew but whether you used it in a wise and humane manner.

Justice Stevens, unlike many appellate judges, was most comfortable around practicing lawyers.

Bankruptcy Judge James Gregg accepted the award on behalf of Justice Stevens.    He described him as intelligent, inquisitive and cordial, the opposite of pompous and egotistical.    He said that Justice Stevens said that his most interesting bankruptcy case was Central Virginia Community College v. Katz, 126 S.Ct. 990 (2006) in which he found that sovereign immunity did not protect a state from recovery of a preference, a decision which dialed back the Supreme Court’s sovereign immunity jurisprudence which Justice Stevens felt had been exalted beyond anything the framers intended.

Eric Brunstad the keynote speaker, has argued ten cases before the Supreme Court including this year’s RadLAX decision.  He noted that Justice Stevens had authored three bankruptcy opinions:   Marrama, Katz and Till.    He praised Justice Stevens for being willing to consider cases on a case by case basis rather than being bound by a fixed judicial philosophy.   

He said that Justice Stevens’ approach to the law was exemplified by his decision in Marrama, which denied a debtor’s ability to convert from chapter 7 to chapter 13 despite statutory language referring to an absolute right.   He said that Justice Stevens viewed the inherent power of the court as an extension of its powers in equity to deny relief to a party with unclean hands.    He believed that even though you may not be able to waive a right, you could forfeit it.

Justice Stevens was also a big fan of liberty, viewing it as an interest which transcended the written words of the Constitution.  

Mr. Brunstad told several anecdotes about the Supreme Court.   On one day, it had snowed particularly hard.   A lawyer received a call from the court clerk asking if he needed a right to court.  Much to his surprise, an SUV showed up with Chief Justice Rehnquist and Justice Kennedy.   The Chief fretted that they would be late and told the driver, “I order you to drive through all red lights” to which Justice Kennedy replied, “do you have that power?”

On another occasion, Chief Justice Rehnquist was quizzing an attorney about how to limit the discretion of bankruptcy judges.   Before the advocate could get a word out, Justice Breyer quipped, “Isn’t that what they’re paid to do?”    

On another occasion, one of the Justices had asked about a long and involved hypothetical which left the lawyer puzzled.   Justice Scalia told him, “Just say yes,” which the lawyer did.   The follow up question was “Why?”  When the puzzled lawyer turned to Justice Scalia, he said, “You’re on your own.”

Brunstad said that he takes his approach for arguing cases from Aristotle, focusing on Logos—which refers to logic, Athos—which refers to credibility of the speaker and Pathos—which refers to an emotional connection with the audience.

Pre-Bankruptcy Ethics:  How to Avoid the Minefields Before Combat Begins

Prof. Nancy Rapoport had some good perspective on the role played by counsel for the Debtor-in-Possession.   She pointed out that, on the one hand, counsel represents the Debtor-in-Possession, which is a fiduciary to the creditors.   While counsel is not a fiduciary to the creditors, counsel is an officer of the court.    This may impose higher duties on counsel for the DIP than counsel for a private party.   She noted that counsel is generally protected when advising the DIP between several acceptable courses of action.  On the other hand, she said of possibility.”

Richard Carmody of Adams & Reese discussed the importance of representing the interests of the DIP and not its principals.  He pointed out that in the Diocese of Spokane case, the attorneys who represented the Diocese in its chapter 11 have now been sued alleging that they represented the interest of the former Bishop rather than the Diocese.  

Chapter 11 Update:  Hot and Emerging Issues

This presentation discussed several important new cases in the chapter 11 arena.   Here are a few cases to be aware of.

In Marathon Petroleum Co., LLC v. Cohen (In re Delco Oil Co.), 599 F.3d 1255 (11^th Cir. 2010), the debtor used cash collateral without permission.  A supplier who was paid for goods actually delivered was required to repay the funds as an unauthorized post-petition transfer.   On the other hand, in Abbot v. Arch Wood Protection, Inc. (In re Wood Treaters, LLC), 2012 WL 3059379 (Bankr. M.D. Fla. 2012), a vendor who received payment from a debtor who obtained permission to use cash collateral but was not in compliance with the order escaped liability.   The cases raise the issue of how much due diligence a party dealing with a DIP must perform in order to qualify for a good faith defense to an action under Sec. 549.

In re Heritage Highgate, 679 F.3d 132 (3^rd Cir. 2012) raised an interesting valuation question.  An appraisal at the beginning of the case showed that the debtor’s property exceeded the value of both the first and second liens.  By confirmation, the starting value of the property less lots sold during the bankruptcy was less than the amount of the first lien.    However, the debtor’s cash flows showed that future sales of lots would bring in enough money to pay both liens.   Critically, the second lienholder did not offer any independent appraisal testimony.   The court held that the debtor’s cash flows, which assumed future appreciation in the value of the debtor’s property, was not a valuation as of confirmation.   As a result, the second lien was completely underwater.

In re Loop 76, LLC, 465 B.R. 541 (9^th Cir. BAP 2012) went against the majority of cases in allowing separate classification of a deficiency claim.   The court allowed separate classification because the deficiency claim had the benefit of personal guaranties.  

Several recent cases have applied the Till decision to chapter 11 cases.   In In re Cottonwood Corners Phase V, LLC, 2012 WL 566426 (Bankr. D. N.M. 2012), the debtor sought to reinstate the debt at the contract rate of 5.8%   Using a formula approach based on the 10 year treasury bill rate plus risk factor points, the court found that 7.0% was appropriate.   In In re North Valley Mall, LLC, 2012 WL  1071646 (Bankr. C.D. Cal. 2012), the Court used a blended “tranche” approach to come up with an interest rate of 8.5%.   Finally, in In re Walkabout Creek Limited Dividend Housing Association, LP, 460 B.R. 567 (Bankr. D. D.C. 2012), the court said that the interest rate should be at least 1% above the equivalent treasury bill rate.   Because this exceeded the rate proposed by the debtor, the court denied confirmation.    The court said that the prime + 1-3% formula in Till did not even rise to the level of dicta.   These cases strike me as wrongly decided.    The chapter 13 statuory language interpreted in Till is identical to the language in chapter 11.   Most chapter 11 cases are too small to support dueling experts.   As a result, the Till formula presents an appropriate starting point for most cases.

Two recent cases have rejected use of the “indubitable equivalent” prong of section 1129(b)(2)(A).   In In re River East Plaza, LLC, 669 F.3d 826 (7^th Cir. 2012), the court rejected replacing the debtor’s real property collateral with treasury bills.    If this is not the indubitable equivalent, I don’t know what would be.   In Cottonwood Corners Phase V, the debtor proposed to repay arrearages on the debt over time without interest on the basis that the arrearages already included default interest.   This did not work.

Gentry v. Siegel, 668 F.3d 83 (4^th Cir. 2012) is an interesting case on class proofs of claims.   If a party files a class proof of claim and the class is certified, the class is approved retroactively.   If the class is not certified, the court must allow class members additional time to file a claim.   Procedurally, a class claim is deemed allowed in the absence of an objection.   If there is an objection, the class rep must seek to invoke the adversary rules to obtain class certification.    In the specific case, the court did not certify the class because a class of several hundred employees was not necessary in a case with thousands of creditors.  

Two Supreme Court Decisions Turn on Statutory Language

In two bankruptcy appeals decided this summer, the Supreme Court faithfully followed congressional intent in one case, while finding that the language used by Congress did not quite do the job in the other.    In RadLAX Gateway Hotel, LLC v. Amalgamated Bank, 132 S.Ct. 2065, 182 L.Ed.2d 967 (2012), the Court put In re Philadelphia Newspapers, LLC, 599 F.3d 298 (3^rd Cir. 2010) to rest, holding that a chapter 11 plan which provided for sale of the debtors assets while denying lenders the right to credit bid could not be approved as providing the lender the “indubitable equivalent” of its collateral.     However, in Hall v. United States, 132 S.Ct. 1882, 182 L.Ed.2d 840 (2012), the Court held that a tax provision intended to benefit family farmers who sell their farm during a chapter 12 proceeding was ineffective in the particular case because chapter 12 cases do not create a separate taxable estate.    The two decisions point out the imprecision present in the English language.

Not So Rad for Debtors

In the RadLAX case, the Supreme Court had to consider whether one of three confirmation cram-down options could contradict another.   The debtor proposed to sell its property pursuant to a plan of reorganization, but did not want to allow the secured creditor to credit bid.    The bankruptcy court and the Seventh Circuit said no.   However, the Third Circuit had previously said yes.  The debtor and the Third Circuit said that it was possible to use the phrase “indubitable equivalent” to get in through the back door what would otherwise not be possible under the provision dealing with sales free and clear of liens.  Justice Scalia and seven of his brethren were not impressed.   (Justice Kennedy did not participate so the decision was a unanimous 8-0).

Under 11 U.S.C. Sec. 1129 (b)(1), a debtor seeking to overcome the dissenting class of claims must propose a plan that is “fair and equitable” and which does not discriminate “unfairly.”   The statute goes on to state that the requirement that a plan be “fair and equitable” “includes” certain requirements.   There may be more requirements to “fair and equitable” but Congress did not tell us what they are.    However, at a minimum, they include a checklist of items applicable to classes of secured claims, unsecured claims and interests.  

For secured claims, the checklist says that treatment must include one of the following options:

(       a. The creditor must retain its lien and receive payment of the present value of its secured claim;

(      b. The debtor may sell the property free and clear of liens subject to the creditor’s right to credit bid; or

(    c. The debtor must provide the creditor with the realization of the “indubitable equivalent” of its secured claim.

While the first two options are fairly specific, “indubitable equivalent” is neither a defined term nor one whose meaning is readily apparent with the use of a dictionary.   The term does have a very learned history, since it originated from Learned Hand’s opinion in In re Murel Holding Corp, 75 F.2d 941 (2^nd Cir. 1935). 

However, Justice Scalia did not find it necessary to wade into the thicket of what constituted the “indubitable equivalent” of a secured claim.    Instead, he invoked a canon of statutory interpretation.   

We find the debtor’s of §1129(b)(2)(A)—under which clause (iii) permits precisely what clause (ii) proscribes—to be hyperliteral and contrary to common sense.  A well established canon of statutory interpretation succinctly captures the problem:  “[I]t is a common place of statutory construction that the specific governs the general.”  (citation omitted).

132 S.Ct. at 2070-71.

Eric Brunstad, who successfully argued the case before the Supreme Court, described the case as “unsatisfying” in a keynote address to the National Conference of Bankruptcy Judges.  He compared canons of statutory interpretation to aphorisms, such as look before you leap and strike while the iron is hot—whoever chooses the canon to apply determines the outcome.

While the opinion goes on for some nineteen pages, these two sentences capture its essence.   cases, it simply was not necessary here.   Whatever else “indubitable equivalent” means, it does not mean that courts can make an end run around the more specific provisions of section 1129(b)(2)(A)(i) and (ii).

By the way, my preferred definition of “indubitable equivalent” is a treatment which causes the judge to don a monocle and remark “indubitably” in an upper-class British accent.

A Taxing Result

In Hall v. United States, the chapter 12 debtors were not able to save the farm or escape paying capital gains tax on its sale—despite Congressional efforts to the contrary.  The debtors filed chapter 12 and sold the family farm.   They sought to classify $29,000 in post-petition capital gains liability as a dischargeable pre-petition debt.   While this might seem audacious, the debtors were simply trying to take advantage of 2005 legislation meant to protect family farmers from crushing tax bills.   Under 11 U.S.C. Sec. 1222(a)(2)(A), a chapter 12 plan must pay priority claims under section 507 in full unless the claim:

arises as a result of a sale, transfer, exchange, or other disposition of any farm asset used in the debtor’s farming operation in which case the claim shall be treated as an unsecured claim that is not entitled to priority under section 507 . . . .

If Congress had simply stated that tax claims arising from sale of a farming asset shall be treated as unsecured claims, the Halls would have been protected.   However, because the exemption was included within a general section on priority claims, the provision interacted with other provisions to deny the debtors relief.    

      The provision classifying taxes from sale of farm assets as unsecured claims is included in an exception to the rule that a chapter 12 plan must pay priority claims under section 507 in full.

.     

Section 507 has two tax provisions within it. Section 507(a)(8) grants priority status to prepetition tax claims.   Section 507(a)(2) incorporates section 503(b) which refers to “any tax . . . incurred by the estate.” 

 a. Under 26 U.S.C. Sec. 1398 and 1399, filing chapter 12 does not create a separate taxable estate. 

 b. As a result, post-petition taxes in a chapter 12 case are incurred by the debtor, not the bankruptcy estate.  

c. Because post-petition taxes in a chapter 12 case are incurred by the debtor and not the estate, they do not qualify as priority claims under section 507. 

 d. Because they do not qualify as priority claims under section 507, they do not get the benefit of the exception to treatment of priority claims in chapter 12. 

This is undoubtedly a result contrary to Congressional intent.   Sen. Charles Grassley, who authored the legislation, is known to be an ardent advocate for family farmers.   However, under the Supreme Court’s decision, capital gains arising from sale of a family farm prior to bankruptcy would be dischargeable as general, unsecured claims, while claims arising from a sale during the bankruptcy would be a non-dischargeable post-petition debt.    

Furthermore, the proceeds from sale of the farm would be property of the estate which would be required to be used to pay creditors, even though the debtor could not use that same estate property to pay the taxes.   Even if the IRS wanted to allow the taxes to be paid through the plan, there is not a statutory mechanism for doing so.   While section 1305(a), allows a post-petition creditor in a chapter 13 proceeding to file a claim, there is no similar provision in chapter 12.

This is unfortunately a case where the statutory language used was not robust enough to do the job.   If Congress wants to fix the problem, they could do so by replacing section 1222(a)(2)(A) with the following language:

A claim owing to a governmental unit arising from a sale, transfer, exchange, or other disposition of any farm asset used in the debtor’s farming operation, regardless of whether such sale, transfer, exchange or other disposition occurs prior to the petition date or during the pendency of the bankruptcy case, shall be includable in the plan and shall be treated as an unsecured claim that is not entitled to priority under section 507, but the debt shall be treated in such manner only if the debtor receives a discharge.

Texas Court Limits Alter Ego Doctrine for Member of Limited Liability Company

Legislatures encourage entrepreneurial risk taking by allowing individuals to form artificial entities to limit their personal exposure for corporate debts.    Plaintiffs’ lawyers attempt to tear down those walls by piercing the corporate veil.   In recent years, the Texas legislature has moved away from a formulaic approach to veil piercing (i.e., did the entity keep regular minutes) toward one focusing on whether the corporate vehicle had been used by the owner to perpetuate a fraud.   A Texas court of appeals has now confirmed that this principle applies to limited liability companies even prior to the enactment of corrective legislation.    Shook v. Walden, 368 S.W.3d 604 (Tex. App.—Austin, 2012, pet. filed).   

The case involved a father who wanted to set up his new son-in-law in business.   Shook, the father, and Jahne, the son-in-law, formed S & J Endeavors, LLC.   S & J was supposed to build a home for the Waldens.    Problems ensued and the Waldens sued.   After a fourteen day trial, the jury rendered a verdict against S & J and Jahne for fraud but did not award damages.   The jury also found that S & J had breached its contract with the Waldens and awarded $80,000 in actual damages and $315,000 in attorney’s fees.   The jury imposed personal liability on both Shook and Jahne by finding that S & J was the alter ego of the individuals, that they constituted a “single-business entity” and that the LLC was a “sham.”   

On appeal, the Waldens conceded that “single-business entity” was no longer a viable theory for piercing the corporate veil under Texas law.  See SSP Partners v. Gladstrong Invs. (USA) Corp., 275 S.W.3d 444 (Tex. 2008).    This left the alter ego and sham findings.

The Court noted that the Texas legislature had restricted the alter ego doctrine in cases involving business corporations to cases where the defendant used the corporation to commit an “actual fraud” for his “direct personal benefit.”   This eliminated veil piercing based on failure to keep minutes and other technical violations.  

While this legislation was evolving over the period from 1989 to 1997, the legislature created the limited liability company as a new form of entity in 1991.   While the legislation contained general provisions that the members of an LLC were not liable for the entity’s debts, it did not address veil piercing principles until 2011.  See Business Organizations Code Sec. 21.223 and 21.224.    Unfortunately, this legislative change did not apply to Shook's case.

Nevertheless, after an extensive discussion, the Austin Court of Appeals concluded that the “actual fraud” for “direct personal benefit” standard should apply to a limited liability company even prior to the recent legislative amendments.    While this seems like a sensible conclusion, one Justice dissented and a petition for review is now pending before the Texas Supreme Court.  

For cases arising after September 1, 2011, the new legislation dictates the higher standard for veil piercing.   I would suggest that the facts of the Shook case illustrate why the legislature was right to make this change. 

  

Mr. Shook invested approximately $200,000 in the home-building business.    He was one of two members and managers.    The company used the Shook residence as its mailing address and he signed a few checks.    Shook contributed some nominal services to the company such as helping to install door hinges, door knobs and towel bars.   Mr. Shook would have been quite justified in asking, "Does this make me a bad guy?"

The issue submitted to the jury allowed them to find that “a corporation is the alter ego of a shareholder when there is such a unity between the corporation and the shareholder that the separateness of the corporation has ceased, or when a corporation operates as a mere tool or business conduit of its shareholder” as “shown from the total dealings” of the shareholder and the corporation.    The jury was also instructed to consider eight other factors including “the amount of financial interest, ownership and control the shareholder maintains over the corporation.”  Unfortunately, the instructions submitted to the jury gave them virtual carte blanche to impose liability based upon their subjective whims. 

In my personal view, if the legislature is going to allow persons to use artificial entities to do business, the Courts should respect that judgment by setting a high bar to impose personal liability.    While it is reassuring that the much-maligned Texas legislature has set standards to rein in the courts, it is also comforting that in this particular case, the appellate court (or at least 2/3 of its members) did the sensible thing.   

Note:  While the reader may discern that I have some personal opinions about the issue in this case, I did not have any involvement.

Fifth Circuit Affirms Stanford Receiver's Fraudulent Transfer Judgment Against Democratic and Republican Committees

In a display of pre-election bipartisanship, the Fifth Circuit affirmed a fraudulent transfer judgment in favor of Stanford International Bank Receiver Ralph Janvey against five Democratic and Republican campaign committees totaling approximately $1.6 million.    Janvey v. Democratic Senatorial Campaign Committee, Inc., No. 11-10704 (5th Cir. 10/23/12), which can be found here. While the opinion involved a receivership rather than a bankruptcy proceeding, the issues under the Texas Uniform Fraudulent Transfer Act have bankruptcy implications as well.

The District Court granted summary judgment to the Receiver on claims that the contributions were made with actual intent to hinder, delay or defraud creditors.    The Receiver alleged, and the District Court agreed, that payments made as part of a Ponzi scheme are presumptively made with intent to hinder, delay or defraud.   According to the Receiver, this shifted the burden to the committees to show a defense such as good faith or reasonably equivalent value.   The Committees did not argue on appeal that the Stanford entities received reasonably equivalent value for their political contributions.   Unfortunately this meant that the opinion did not contain what would have been an interesting discussion of what contributors receive for their donations.   The Committees no doubt concluded that the political risks of arguing that fraudsters receive a reasonably equivalent benefit for their contributions was too dangerous to advance (even if it could have been factually supported).

Instead, the Fifth Circuit addressed three issues.   First, the Court ruled that a Receiver, like a bankruptcy trustee, may pursue claims under the Texas Uniform Fraudulent Transfer Act on behalf of creditors.   The Committee had argued that the Receiver was not himself a creditor and therefore lacked standing to pursue the claims.

Next, the Court concluded that the transfers were made within the applicable limitations period.    Under Tex. Bus. & Com. Code Section 24.010(a)(1), a plaintiff must institute an action to recover transfers under the intent to defraud provision within one year after the later of when the transfers were made or when they "reasonably could have been discovered by the claimant."    In this case, the Receiver was appointed on February 16, 2009 and filed suit on February 20, 2010.    The Committees argued that because records of  the contributions were available online and had been discussed in the media, that the Receiver should have known about them not later than February 18, 2009, which would have made the suit untimely.   Because February 16 was President's Day, the Receiver was not able to gain access to the Stanford offices until February 17.    While this would have given the Receiver two days to discover the fraud, the Fifth Circuit applied a more sympathetic standard.   It stated:

 

Given the extent of the Stanford enterprises, the Receiver’s duties with regard to them, and the extent of the fraudulent transfers, it would not have been reasonable to expect him to immediately discover the fraud.

Opinion, p. 7.   Furthermore, the Court noted that it was the Defendants' burden to prove the limitations defense which meant that they were required to prove when the Receiver should have discovered the fraud.   Apparently, three days to discover a fraud, even one based on publicly available records, was reasonable.  

 

Because 11 U.S.C. Sec. 546 gives a bankruptcy trustee two years to commence an avoidance action, the benefit of the one year discovery rule is not readily apparent.    However, if a transfer took place more than one year prior to bankruptcy but was not readily discoverable during that time, a trustee could still file suit within two years after the order for relief.   Assume that a transfer was made on January 1, 2010 and the Debtor filed bankruptcy on January 1, 2012.    If creditors of the Debtor could not have discovered the transfer during the one year period prior to bankruptcy, then the trustee would have until January 1, 2014 to file suit.   While the discovery rule does not extend the trustee's period of time to file suit after bankruptcy is filed, it would extend the reach-back period for avoiding a transfer made prior to bankruptcy.   

 

Finally, the Fifth Circuit held that federal election law did not preempt TUFTA.    The Federal Campaign Act of 1971 preempts "any provision of State law with respect to election to federal office."    Unfortunately for the Committees, the Court held that generally applicable fraudulent transfer laws are not state laws "with respect to election to federal office."   The Court also held that the federal election laws do not occupy the field of election law so thoroughly as to preempt the suit.   The Court wrote that the federal election law did not apply to a contributor using an impermissible source of funds as opposed to the committee making an improper use of those funds.   Further, the Court noted that the committees' argument would lead to the absurd result that funds "stolen by force or fraud" would be protected so long as the committees otherwise complied with election law.

Because firms likely to fail have been known to curry favor by making political contributions, this opinion may help trustees avoid preemption arguments in the future.  

Fifth Circuit Declines to Apply Judicial Estoppel to Inconsistent Creditor Claims in Subsequent Case

The Fifth Circuit has added a new decision to its judicial estoppel jurisprudence, holding that a creditor that submitted claims in different amounts in successive cases was not estopped.   While it may seem that the court is applying the estoppel doctrine in an uneven manner, penalizing debtors but not creditors, the decision faithfully follows the elements laid out by the court.    Wells Fargo Bank, N.A. v. Oparaji (Matter of Oparaji), No. 11-20871 (5^th Cir. 10/5/12), which can be found here.   

What Happened

The Debtor Titus Chinedu Oparaji filed a chapter 13 proceeding on September 2, 2004 (“First Case”).   During the First Case, he fell behind on his mortgage payments to Wells Fargo.   Over time, Wells Fargo filed several amended claims and the Debtor filed several modified plans.   The amended claims filed by Wells Fargo understated the amount of the post-petition arrearages.  When the Debtor failed to complete his plan payments within five years, the First Case was dismissed.

After the First Case was dismissed, the Debtor continued to miss payments to Wells Fargo.  On February 1, 2010, the Debtor filed his second chapter 13 case (“Second Case”).   By this time, the arrearage owed to Wells Fargo had grown to $86,003.25.   The Debtor argued that based on the claims filed in the First Case that the arrearage could not possibly be that high.   The Bankruptcy Court found that Wells Fargo was bound by the claims filed in the First Case under the doctrine of judicial estoppel and the District Court affirmed.

The Ruling

The Fifth Circuit reversed, finding that Wells Fargo had not “asserted a legally inconsistent position that was accepted by the Bankruptcy Court.”   Opinion, p. 6.   

The elements of judicial estoppel are: (1)  a party asserts a legal position that is “plainly inconsistent” with the position taken in another case; (2) the court in the other case accepted the party’s original position; and (3) the inconsistent positions were not taken inadvertently.

The Court found that a creditor who files a post-petition claim in one case is not estopped from asserting a higher claim in a subsequent case.   Under section 1305(a), a creditor may file a post-petition claim but is not required to.   This contrasts with the common scenario where a debtor omits an asset.   While a debtor must list all assets in its schedules, the creditor is not under a duty to amend its proof of claim to include post-petition arrearages.   

The Debtor argued that while Wells Fargo was not required to file a post-petition claim, that once it did so, it was required to include all post-petition amounts.   The Fifth Circuit distinguished the Oparaji case from In re Burford, 231 B.R. 913 (N.D. Tex. 1999).  In Burford, the confirmation order required the creditor to create a payment schedule that would “fully retire the debt.”   However, in this case, the creditor submitted a claim without expressly representing that there were no additional amounts owing.

Because Wells Fargo never asserted that the amount contained in its post-petition claim constituted all the amounts owed, the Fifth Circuit found that it had not asserted inconsistent positions.   As a result, judicial estoppel did not apply.    The Court went further and found that even if Wells Fargo had asserted inconsistent positions, the dismissal of the First Case meant that the parties were returned to their position status quo ante.  

What It Means

Judicial estoppel is meant to prevent parties from gaming the system. While, on the surface, it might appear that Wells Fargo took inconsistent positions, its inconsistency was not legally significant.  Wells Fargo’s only fault was that they did not assert their rights in the First Case as aggressively as they could have.   Had the Debtor completed its plan in the First Case, the parties and the Court would have had a difficult time sorting out which post-petition defaults were included in the plan and which ones were not.   Had the Debtor filed an “all current” motion at the conclusion of its plan and obtained an order, it could have bound Wells Fargo.  However, neither one of these occurred.   The Debtor did not complete its plan and it did not obtain a determination that it was current on its mortgage.   

As a general rule, a dismissed case should rarely, if ever, give rise to judicial estoppel.   By definition, a dismissed case is one in which no party obtains relief (although the debtor enjoyed the benefits of the automatic stay for a period of time).    If a party does not obtain relief, then it is hard to say that the court accepted the party’s position in any meaningful respect.   The real benefit of this case may be for debtors who omit a creditor or an asset in an initial case and then accurately disclose it in a subsequent case.   In that instance, Oparaji should be good precedent that judicial estoppel will not apply.