Unhappily Ever After: Family Law Issues in Bankruptcy

This paper was originally presented to the West Texas Bankruptcy Institute on October 29, 2010.

Love and marriage,
Love and marriage
Go together
Like a horse and carriage
This I tell you brother
You can't have one without the other

--Frank Sinatra

While love and marriage may go together, divorce and bankruptcy are frequently companions as well. Spouses who have had financial difficulties prior to divorce will find that they only get worse once they split up. Then there are the couples who enjoy fighting so much that they will take the battle to any court they can find. The Bankruptcy Abuse Prevention and Consumer Protection Act shifted the battlefield in several areas, some of which are obvious and others of which are more subtle. This paper will examine the intersection between family law and bankruptcy law in the case of three recurring fact patterns:

(a) The couple who has gotten divorced where one spouse files bankruptcy to try to escape the consequences of the divorce (the “Pursued Ex-Spouse”);

(b) The couple who is still together where only one spouse files bankruptcy (the “Dilemma of the Non-Filing Spouse”); and

(c) The couple who transfers assets to the non-filing spouse (the “Friendly Break-Up).

However, before getting into the specific scenarios, it is necessary to define some terms. There are two types of marital-related debts in bankruptcy: Domestic Support Obligations and everything else. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 replaced the prior category of alimony, maintenance and support with the newly defined term of Domestic Support Obligation. The defined term “Domestic Support Obligation” appears in 11 U.S.C. §362(b)(2), 507(a)(1), 523(a)(5), 1129(a)(14) and 1325(a)(8).

Under 11 U.S.C. §101(14A):

(14A) The term “domestic support obligation” means a debt that accrues before, on, or after the date of the order for relief in a case under this title, including interest that accrues on that debt as provided under applicable nonbankruptcy law notwithstanding any other provision of this title, that is—

(A) owed to or recoverable by—

(i) a spouse, former spouse, or child of the debtor or such child’s parent, legal guardian, or responsible relative; or

(ii) a governmental unit;

(B) in the nature of alimony, maintenance, or support (including assistance provided by a governmental unit) of such spouse, former spouse, or child of the debtor or such child’s parent, without regard to whether such debt is expressly so designated;

(C) established or subject to establishment before, on, or after the date of the order for relief in a case under this title, by reason of applicable provisions of—

(i) a separation agreement, divorce decree, or property settlement agreement;

(ii) an order of a court of record; or

(iii) a determination made in accordance with applicable nonbankruptcy law by a governmental unit; and

(D) not assigned to a nongovernmental entity, unless that obligation is assigned voluntarily by the spouse, former spouse, child of the debtor, or such child’s parent, legal guardian, or responsible relative for the purpose of collecting the debt.

This definition contains a lot to digest. However, at its core, it still covers alimony, maintenance and support. The following chart summarizes the boundaries of a Domestic Support Obligation (DSO):

Who May Assert a DSO?	A spouse, former spouse, or child of the debtor or such child’s parent, legal guardian, or responsible relative or a governmental unit. While it is not expressly set out in the statute, some courts hold that an attorney for a spouse or child may also assert a Domestic Support Obligation.
What Can Make Up a DSO?	A debt in the nature of alimony, maintenance, or support (including assistance provided by a governmental unit)
When Can a DSO Arise?	Before, on or after the date of the petition.
Where Can a DSO Arise?	In a separation agreement, divorce decree, or property settlement agreement; an order of a court of record; or a determination made in accordance with applicable nonbankruptcy law by a governmental unit.
What Is Not a DSO?	A debt assigned to a nongovernmental entity, unless that obligation is assigned voluntarily for the purpose of collecting the debt.

Non-DSO marital debts are only referenced in 11 U.S.C. §523(a)(15). It applies to debts owed:

(15) to a spouse, former spouse, or child of the debtor and not of the kind described in paragraph (5) that is incurred by the debtor in the course of a divorce or separation or in connection with a separation agreement, divorce decree or other order of a court of record, or a determination made in accordance with State or territorial law by a governmental unit.

Using the same format, Non-DSO marital debts can be summarized as follows:

Who May Assert a Non-DSO marital debt?	A spouse, former spouse, or child of the debtor.
What Can Make Up a Non- DSO marital debt?	A debt that is not a DSO.
When Can a DSO Arise?	Before the date of the petition.
Where Can a DSO Arise?	In the course of a divorce or separation or in connection with a separation agreement, divorce decree or other order of a court of record, or a determination made in accordance with State or territorial law by a governmental unit.

I. The Pursued Ex-Spouse

The best advice that you could give to someone contemplating bankruptcy to escape obligations arising from a divorce is don’t. Generally bankruptcy will afford very little relief from divorce-related obligations and in some cases a debtor will be much worse off in bankruptcy court than in state court.

A. The Automatic Stay

The first thing that the Pursued Ex-Spouse will notice is that many actions related to a divorce may continue to proceed notwithstanding the automatic stay. Under 11 U.S.C. §362(b)(2), the automatic stay does not apply to:

(2) under subsection (a)—

(A) of the commencement or continuation of a civil action or proceeding—

(i) for the establishment of paternity;

(ii) for the establishment or modification of an order for domestic support obligations;

(iii) concerning child custody or visitation;

(iv) for the dissolution of a marriage, except to the extent that such proceeding seeks to determine the division of property that is property of the estate; or

(v) regarding domestic violence;

(B) of the collection of a domestic support obligation from property that is not property of the estate;

(C) with respect to the withholding of income that is property of the estate or property of the debtor for payment of a domestic support obligation under a judicial or administrative order or a statute;

(D) of the withholding, suspension, or restriction of a driver’s license, a professional or occupational license, or a recreational license, under State law, as specified in section 466(a)(16) of the Social Security Act;

(E) of the reporting of overdue support owed by a parent to any consumer reporting agency as specified in section 466(a)(7) of the Social Security Act;

(F) of the interception of a tax refund, as specified in sections 464 and 466(a)(3) of the Social Security Act or under an analogous State law; or

(G) of the enforcement of a medical obligation, as specified under title IV of the Social Security Act;

Most aspects of a divorce proceeding are not subject to the automatic stay. The non-bankruptcy court can issue orders establishing or modifying DSOs, establishing child custody and visitation and dissolving the marriage. The only thing that the non-bankruptcy court cannot do is determine the division of property of the estate.

If a DSO is already owed, §362(b)(2)(B) provides that wage withholding may continue and the creditor may collect the DSO from property that is not property of the estate, such as post-petition earnings in a chapter 7 proceeding or exempt property. In one recent case, the Bankruptcy Court found that a DSO creditor’s attempts to collect from exempt property did not violate the automatic stay because the debts were non-dischargeable and the automatic stay contains an exception for collecting DSOs from property which is not property of the estate. In re MacGibbon, 383 B.R. 749 (Bankr. W.D. Wash. 2008).

Section 362(b)(2)(C) goes further, allowing withholding from property of the estate under a judicial or administrative order or statute. In re Gellington, 363 B.R. 497 (Bankr. N.D. Tex. 2007)(although finding that garnishment by state violated confirmed chapter 13 plan).

In another case, the Court found that the State’s suspension of the debtor’s driver’s license for failure to pay support fell within the exception of section 362(b)(2)(D). In re Penaran, 424 B.R. 868 (Bankr. D. Kan. 2010).

B. Dischargeability of Divorce-Related Obligations

The Pursued Ex-Spouse will also learn that it is difficult if not impossible to discharge marital debts. The provisions governing dischargeability have evolved substantially over the years. When the Bankruptcy Code was adopted in 1979, obligations for alimony and support were non-dischargeable, but property settlement debts could be discharged. In 1994, the Bankruptcy Code was amended to include 11 U.S.C. §523(a)(15), which provided that divorce debts other than alimony and support would be non-dischargeable if a timely adversary proceeding was filed and a balancing test was not met. Finally, in 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 amended Section 523(a)(15) to eliminate the balancing test as well as the requirement to file an adversary proceeding. Thus, property settlement debts have gone from being always dischargeable to never dischargeable.

Given the broad scope of Sections 523(a)(5) and (a)(15) are there any marital debts which can be discharged in bankruptcy?

1. One narrow exception is that non-DSO marital debts may be discharged in chapter 13 proceedings, but not chapter 11 cases. Under 11 U.S.C. §1328(a)(2), debts under Section 523(a)(5)(DSOs) are expressly made non-dischargeable, but there is no similar provision for Section 523(a)(15). In re Young, 425 B.R. 811 (Bankr. E.D. Tex. 2010). On the other hand, 11 U.S.C. §1141(d)(2) provides that the discharge of an individual chapter 11 debtor does not extend to any debts covered by Section 523.

2. Some courts have found that third party debts are dischargeable. Prior to BAPCPA, the Fifth Circuit took an expansive view of what debts could fall within §523(a)(5), finding that debts owed to third parties, such as attorneys and guardians were nondischargeable so long as they were in the nature of support. Matter of Hudson, 107 F.3d 353 (5^th Cir. 1997); Matter of Dvorak, 986 F.2d 940 (5^th Cir. 1993). While the Fifth Circuit has not addressed the amendments made to §523(a)(5), several lower courts have found that the reference in the amended statute to debts “owed to or recoverable by (i) a spouse, former spouse, or child of the debtor or such child’s parent, legal guardian, or responsible relative; or (ii) a governmental unit” excludes debts owed to anyone not mentioned. Section 523(a)(15) is even more narrow, referring to debts owed to “a spouse, former spouse or child.”

In one case, the Court found that “(t)he Plain Meaning rule requires that assignees, like attorneys, are excluded from protection accorded members of the immediate family.” In re Thompson, 2009 Bankr. LEXIS 2985 (Bankr. D. Md. 2009)(construing §523(a)(15)). Judge Michael Lynn has also taken a plain meaning approach to the parties covered by sections 523(a)(5) and (a)(15). In a case involving a claim by a debtor’s ex-spouse to recover attorney’s fees, he noted that the law firm was not one of the parties listed in the statute.

Even assuming the Final Judgment is a debt "in the nature of alimony, maintenance, or support," the Firm is not Debtor's spouse, Debtor's former spouse, or Debtor's child; nor Debtor's child's parent, legal guardian, or responsible relative; nor a governmental unit. As none of these, the Firm does not fall within the ambit of section 101(14A) and is not an entity to whom a "domestic support obligation" may be owed under section 523(a)(5). Similarly, only a debt "to a spouse, former spouse, or child of the debtor" is non-dischargeable under section 523(a)(15) (emphasis added). Thus, applying the plain meaning rule, the Firm is not an entity to which may be owed a non-dischargeable divorce-related debt.

In re Brooks, 371 B.R. 761, 764-65 (Bankr. N.D. Tex. 2007). Judge Lynn reached the same result in a case involving a claim by an attorney ad litem, finding that an attorney ad litem was not the same as a guardian and thus was not covered by the statute. In re Densmore, 2009 Bankr. LEXIS 3416 (Bankr. N.D. Tex. 2009).

However, other courts have found that BAPCPA did not change prior case law which did not limit claims to the specific persons listed.

In line with those recent cases that continue to rely on Kline, this Court rejects any argument that BAPCPA's additional wording weakens the dispositive impact of Kline on the instant case. The partial phrases "owed to or recoverable by" clarify but do not alter the type of debt previously characterized as nondischargeable and entitled to priority under pre-BAPCPA law. Furthermore, the fact that BAPCPA does not add attorneys to the expanded list of specific payees does not overrule Kline. Attorneys were not mentioned as payees in the pre-BAPCPA statute under which Kline was decided, but the Eighth Circuit ruled that a fee owed to an attorney could nevertheless be a nondischargeable support debt. For these reasons, this Court will follow the rule established by Kline as binding precedent.

In re Andrews, 2010 Bankr. LEXIS 2071 (Bankr. W.D. Ark. 2010) at 11-12. Interestingly, Andrews suggests that the reason the attorney’s fees would be non-dischargeable is because they would take money needed for support away from the spouse, so that in the event that the spouse was not liable for the attorney’s fees (such as if limitations had run), that the fees might not be support. Other post-BAPCPA cases treating debts to parties not specifically named as non-dischargeable include In re Blackwell, 2010 Bankr. LEXIS 1918 (Bankr. M.D. Fl. 2010); In re Burnes, 405 B.R. 654, 659 (Bankr. W.D. Mo. 2009); In re Johnson, 397 B.R. 289, 296 (Bankr. M. D. N.C. 2008). While there is not definitive appellate precedent yet, the broad view of sections 523(a)(5) and(a)(15) seems to be the majority position at this time.

3. A debtor’s obligation to pay attorney’s fees to her own lawyer did not qualify as a DSO. In re Young, 425 B.R. 811 (Bankr. E.D. Tex. 2010).

4. A debtor’s obligation to refund excess payments of child support did not qualify as a DSO. In re Vanhook, 496 B.R. 296 (Bankr. N.D. Ill. 2010). In this case, the non-debtor paid child support to the debtor until it was determined that he was not the parent. At that point, the state court ordered repayment of the child support. While the obligation to pay child support was in the nature of alimony, maintenance or support, the repayment order was not.

5. While a hold-harmless agreement in a pre-petition divorce decree could be non-dischargeable under §523(a)(15), a hold harmless with regard to debts previously discharged in bankruptcy proceeding was an improper attempt to re-impose liability. In re Heilman, 430 B.R. 213 (9^th Cir. BAP 2010). The court rejected the argument that the post-petition divorce decree imposed a new obligation.

C. Exemptions

Yet another unpleasant consequence for the Pursued Ex-Spouse is that his exempt property may be reached to collect Domestic Support Obligations. Section 522(c)(1) was amended by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. The old language stated that property exempted under section 522 was not liable except for “a debt of a kind specified in section 523(a)(1) or 523(a)(5) of this title.” The amended language stated that property exempted under section 522 was not liable except for “a debt of a kind specified in paragraph (1) or (5) of section 523(a) (in which case notwithstanding any provision of applicable nonbankruptcy law to the contrary, such property shall be liable for a debt of a kind specified in section 523(a)(5)).”

The amendment was apparently intended to legislatively overrule the result in In re Davis, 170 F.3d 475 (5^th Cir. 1999). The Hon. Alan A. Ahart, “The Liability of Property Exempted in Bankruptcy for Pre-Petition Domestic Support Obligations After BAPCPA: Debtors Beware,” 81 Am. Bankr. L.J. 233 (Summer 2007). In the Davis case, an en banc Fifth Circuit held that the prior version of Sec. 522(c)(1) was not sufficient to pre-empt Texas law to the contrary. The amendment states that the property shall be liable “notwithstanding any provision of applicable non-bankruptcy law to the contrary.” This shows an express intent to pre-empt non-bankruptcy law. Furthermore, the amendment closely tracks a suggestion made by the Bankruptcy Judge in the Davis case as to how Congress could amend the statute to allow creditors to execute upon exempt property to satisfy domestic support obligations:

Had Congress intended to make exempt property liable for § 523(a)(5) family support obligations, it could have affirmatively legislated. For example, if Congress was concerned that the states have not adequately provided mechanisms for the collection of family support obligations, it could amend subsection § 522(c)(1) to read (boldface):

(c) Unless the case is dismissed, 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.

(1) Notwithstanding this or any other federal or state injunction of liability for exempt property, exempt property shall be liable for debts of a kind specified in section 523(a)(5) of this title.

Rather than affirmatively subjecting exempt property to liability for family support obligations, Congress did not extend the injunction against liability for family support obligations. This permits states like Texas to enact broader injunctions of liability of exempt property, protecting exempt property even from non-discharged family support obligations.

In re Davis, 170 B.R. 892, 898 (Bankr. N.D. Tex. 1994), aff’d, 188 B.R. 544 (N.D. Tex. 1995), aff’d en banc, 170 F.3d 475 (5^th Cir. 1999). In his article, Judge Ahart also notes that the legislative history supports this interpretation. See n. 20.

Several bankruptcy courts have ruled that Sec. 522(c)(1) does not allow a trustee to liquidate exempt property to satisfy a domestic support obligation. In re Duggan, 2007 Bankr. LEXIS 2750 (Bankr. M.D. Fl. 2007) and cases cited therein. However, these same cases suggest, or explicitly hold, that a domestic support creditor could do so.

In In re Quezada, 368 B.R. 44 (Bankr. S.D. Fl. 2007), the Court stated:

New §522(c) (1) creates a federal right entitling DSO creditors to execute against exempt assets even if those assets would be protected from execution under state law. Although, in theory, a state court judge is perfectly capable of applying federal law, in practical terms, it appears awkward for a DSO creditor to seek relief in state court to pursue assets which are exempt from execution under state law.

These potential practical problems have no effect on the statutory analysis which controls this decision. Moreover, the lack of authority for a trustee to administer exempt property does not mean that the bankruptcy court lacks jurisdiction if a DSO creditor seeks to enforce a DSO claim against exempt property in the bankruptcy court. Under 28 U.S.C. § 1334(b) the district courts have "original but not exclusive jurisdiction of civil proceedings arising under title 11, or arising in or related to cases under title 11." Section 522(c) (1) grants DSO creditors a federal right of action against exempt property. This federal right trumps state law which may otherwise shield the asset from execution. Since this federal right is provided in the Bankruptcy Code, a proceeding to enforce that right would be a proceeding arising under title 11, thus creating jurisdiction under § 1334(b).

In re Quezada, at 49. Thus, it is possible that both the ex-spouse and the Trustee could attempt to administer exempt property for the benefit of the DSO creditor.

II. The Dilemma of the Non-Filing Spouse

While joint petitions between husband and wife are common, there is no requirement that couples file together. When just one spouse files, it may be a calculated tactical move or it may be that the spouses are estranged. Whatever the reason, the decision can have serious consequences for the non-filing spouse.

A. Property of the Estate and the Disappearing Homestead

When a debtor files bankruptcy, the bankruptcy estate includes “all interests of the debtor and the debtor’s spouse in community property as of the commencement of the case that is . . . under the sole, equal or joint management and control of the debtor.” 11 U.S.C. §541(a)(2)(emphasis added). The practical effect of this section when only one spouse files bankruptcy is that the non-filing spouse loses control of all joint management community property owned by the couple.

Furthermore, the debtor is given the sole right to claim exempt property. 11 U.S.C. §522(l). This means that the non-filing spouse will lose control over the decision to exempt joint community property (although the statute allows a dependent of the debtor to claim exemptions if the debtor fails to do so).

Several cases illustrate the dilemma of the non-filing spouse. Musso v. Otashko, 468 F.3d 99 (2^nd Cir. 2006) is an extreme example. The marriage of Tanya and Vladimir Otashko was short and stormy. Married in Russia in 1992, they came to the United States, where they separated in 1997. Prior to separating, Vladimir purchased a home on Staten Island for $400,000 cash and a mortgage for $400,000. He then encumbered the property with a line of credit in favor of a Russian bank. A New York District Court found that the line of credit transaction was a fraudulent transfer designed to transfer marital assets out of the United States. Tanya then filed for divorce. After lengthy proceedings, the matrimonial court ruled that Tanya be awarded all of the marital assets, along with substantial sums for support and counsel fees. However, before the state court could enter the decree, Vladimir’s Russian creditor filed an involuntary petition against him. The order for relief was entered before the divorce decree. On appeal, the Second Circuit ruled that prior to entry of the divorce decree that the property remained joint community property. As a result, the bankruptcy trustee obtained superior title to the property to the detriment of Tanya.

Kim v. Kim, No. 3:09-CV-1082-N (N.D. Tex. 8/11/10) is another example of the pitfalls to the non-filing spouse. The Kims owned a homestead which would have been fully exempt under Texas law. However, Mr.Kim’s creditors filed an involuntary bankruptcy against him and objected to the exemption under §522(p) because the homestead was acquired within 1,215 days and had equity of more than $136,875. The District Court affirmed the Bankruptcy Court’s ruling that Mrs. Kim had no separate homestead interest entitled to protection. To add insult to injury, if the couple had filed together, they would have been entitled to an exemption of $273,750. However, because the involuntary petition was filed against only one of the spouses, they were only entitled to a single exemption.

In In re Douglass, 2008 WL 2944568 (Bankr. W.D. Tex. 2008), a husband filed a chapter 13 petition without the joinder of his wife. The homestead property was contaminated. The husband made a tactical decision not to claim the property as exempt and to cram down the value of the property (which could only be accomplished if it was not the principal residence). Years later, the house could be safely occupied once more and the wife returned to the property. If the husband had completed his chapter 13 plan, the couple would have been able to retain the property upon receiving a discharge. However, the husband sought to sell the property in order to pay off his plan early. The wife sought to be compensated for the value of her homestead interest under Texas law. The Bankruptcy Court ruled, as a matter of law, that the non-filing spouse was bound by the husband’s choice of exemptions and could not assert her own homestead interest.

Even the conclusion of a divorce is not enough to protect the ex-spouse where the parties continued to be co-tenants in former marital assets. In In re Keefe, 2009 Bankr. LEXIS 1205 (Bankr. E.D. Va. 2010), the Bankruptcy Court found that the trustee could seek a §363(h) sale of the property which was still jointly owned. However, the major difference in Keefe was that the ex-spouse was entitled to her share of the proceeds from the sale.

B. The Community Discharge Is Not Much of a Discharge

One small benefit to the non-filing spouse is the community discharge under §524(a)(3). This subsection provides that property acquired post-petition which is described in §541(a)(2)(that is, property under the sole or joint management of the filing spouse) is not liable for community claims. However, this section provides only an in rem discharge of the community property. It does not relieve that non-filing spouse from any personal liability.

C. When Will It Be Better for Only One Spouse to File?

While the cases cited above indicate the perils of only one spouse filing, there can be significant benefits. Where one spouse is liable for most of the debts and the other spouse has significant sole management or separate property, the spouse with the property will do well to remain outside of bankruptcy. However, as illustrated above, the non-filing spouse must bear the risk of loss of control over all joint property.

III. The Friendly Break-Up

Sometimes splitting spouses can remain very friendly, so friendly that their creditors might accuse them of collaborating to hide assets from creditors. Under 11 U.S.C. §541(a)(2), property of the estate includes all interests of the debtor and the debtor’s spouse that is under the sole, equal or joint management and control of the debtor. Under Texas law, married couples hold most of their property acquired during marriage as community property. Texas Fam. Code §3.002. However, community property can be transformed into separate property through gift, partition or a divorce. Tex. Fam. Code §3.001, 4.102 and 7.001. Where only one spouse is liable for the debts and there is significant non-exempt community property, spouses might be motivated to put all the good assets in the name of the non-liable spouse.

Whether this strategy works depends on when and how it is done. For example, a gift made on the eve of bankruptcy would be easily avoidable as a fraudulent conveyance. The most interesting scenarios are posed by partition and divorce.

It is worth noting that cases on marital property depend heavily on state law. As a result, the result in a case filed in Louisiana or New York might not be the same as for a case subject to Texas law.

A. Partition

Bankruptcy law will respect a legally valid partition between spouses.

We agree with the prevailing view that former community property which has been partitioned and classified as separate property of the debtor's former spouse under state law prior to the commencement of the case does not pass into the bankruptcy estate. Under section 541(a)(2) only "interests of the debtor and the debtor's spouse in community property as of the commencement of the case" may become part of the estate. Anderson's property interest in her separate property home was created and defined by state law prior to the commencement of this bankruptcy case. Unless the characterization of the property by state law conflicts with the Bankruptcy Code, "there is no reason why such interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding." (citation omitted). We see no such conflict between the plain meaning of section 541(a)(2) of the Bankruptcy Code and the classification of Anderson's home as her separate property under state law prior to the commencement of the Debtor's bankruptcy case.

Matter of Robertson, 203 F.3d 855, 862 (5^th Cir. 2000)(applying Louisiana law).

In Texas, Family Code §4.102 allows couples to partition their marital assets into separate property. However, there is a major limitation. Family Code §4.106(a) provides that: "A provision of a partition or exchange agreement made under this subchapter is void with respect to the rights of a preexisting creditor whose rights are intended to be defrauded by it."

The word “void” has serious implications as evidenced by Hinsley v. Boudloche, 201 F.3d 638 (5^th Cir. 2000). Mr. and Mrs. Hinsley executed partition agreements in January and February 1989. Judgments were entered against Mr. Hinsley in 1989 and 1992. Being a patient man, he waited until 1995 to file bankruptcy. At this point, the partition agreements were some six years in the past and would have been beyond the general statute of limitations for avoiding fraudulent transfers.

The Bankruptcy Trustee sued to avoid the partition. The first time the Trustee only sued Mr. Hinsley, resulting in the judgment being ineffectual against Mrs. Hinsley. The second time, the Trustee sued Mrs. Hinsley and was granted summary judgment by the District Court. The District Court rejected a defense of statute of limitations, finding that limitations never began to run because the transfers were void.

The Court of Appeals found that summary judgment was proper because fraudulent intent could be proven as a matter of law based on badges of fraud. In this case, the transfer was made to an insider for less than reasonably equivalent value while insolvent.

The Fifth Circuit held that even if the four year statute of limitations applied, Mrs. Hinsley had failed to establish when the cause of action accrued and therefore had failed to prove her affirmative defense. The Court of Appeals held that she was required to establish an issue of material fact on when the cause of action accrued and to show that the transfer was not concealed from creditors (even though the partitions were recorded). Thus, it seems likely that either limitations never runs on a fraudulent partition agreement or a partitioning spouse with existing creditors must advertise the existence of the partition in order for limitations to begin to run.

Partition can be used to exclude property from the bankruptcy estate. However, it must almost certainly be accomplished prior to incurring the debts which result in bankruptcy. As a result, this must be a very long-term strategy and won’t succeed for someone already in financial difficulty.

B. Divorce

One consequence of divorce is that the court divides the community property between the parties. Tex. Fam. Code §7.001. Property which was once community property becomes separate property. The court has the discretion to grant an unequal distribution of community property, Tex. Fam. Code §7.001, so that creditors may find that the pool of assets they could recover from is quite diminished. This creates the opportunity for mischief when a couple with financial difficulties and substantial community property attempts to use the divorce process to accomplish what could not be done with a partition of assets. This is known as a “friendly divorce.”

At the outset, there are two limitations on this strategy. First, a divorce court can allocate liabilities as between the spouses, but cannot relieve a spouse of liability as to the creditor. Blake v. Amoco Federal Credit Union, 900 S.W.2d 108 (Tex. App—Houston [14^th Dist.], 1995, no writ). Thus, if both spouses have guaranteed a business debt, awarding the debt to one spouse will not relieve the other spouse from liability. Second, the divorce court cannot award property to one spouse free and clear of liens. Boyd v. Ghent, 57 S.W. 25 (Tex. 1900). Both of these rules recognize that a legal proceeding cannot alter the rights of non-parties.

Some Texas cases go further and hold that former community property remains liable for “community debts.” Stewart Title Company v. Huddleston, 598 S.W.2d 321 (Tex. Civ. App.—San Antonio, 1980, writ ref. n.r.e)(“A spouse who receives property which would, absent a divorce, be subject to the claims of creditors remains personally liable, and the property so received remains subject to being taken to satisfy the claims of the community creditors.”). When the Texas Family Code was adopted, it did not include a category for “community claims.” As a result, these cases may no longer be valid.

Thus, where only one spouse is liable and the community property is not subject to a lien, property can be effectively placed beyond the reach of creditors. This was the scenario faced by the Fifth Circuit in Matter of Erlewine, 349 F.3d 305 (5^th Cir. 2003). In that case, the state court awarded the husband a disproportionate share of the community property after a trial which lasted several days. The state court’s reasons for doing this included the fact that the husband received custody of the children, that the wife’s drug treatment had drained the community estate and the unreasonable position taken by the wife in the divorce action. The Trustee sought to set aside the unequal distribution as a fraudulent conveyance.

The Fifth Circuit agreed that the divorce decree affected a transfer, but found that there was reasonably equivalent value. The Court gave particular weight to the principle that a federal court should not set aside the result of a regularly conducted proceeding under state law. The Fifth Circuit drew on both its own opinion in In re Besing, 981 F.2d 1488 (5^th Cir. 1993), which refused to set aside a dismissal of claims based on discovery abuse as a fraudulent transfer, and the Supreme Court’s opinion in BFP v. Resolution Trust Company, 511 U.S. 531 (1994), which refused to set aside a regularly conducted foreclosure action.

The Court distinguished the Hinsley case on the basis that the transfer was not made voluntarily, stating:

Whatever concerns might arise in other cases, the divorce before us--which was fully litigated, without any suggestion of collusion, sandbagging, or indeed any irregularity--should not be unwound by the federal courts merely because of its unequal division of marital property.

Erlewine, at 212-13. Thus, the Court left open the possibility that a collusive divorce decree could be set aside. In this context, a divorce settlement agreed to by the parties would likely be treated as a voluntary transfer. This raises the issue of how adverse the divorce must be. For example, if the wife put on evidence which would support an unequal distribution and the husband did not object, would this be considered collusive? What is the husband put on some defense, but didn’t introduce his most compelling evidence? Finally, there is the case where the wife puts on evidence and the husband’s evidence is excluded due to counsel’s malpractice. This claim would probably be barred by Besing.

The Ninth Circuit followed Erlewine in Matter of Bledsoe, 569 F.3d 1106 (9^th Cir. 2009). Anything that the Fifth and Ninth Circuits agree upon is probably good law.

New Opinion Raises Difficult Questions on Adequate Protection

A new opinion in the Scopac case raises difficult questions about adequate protection. In Matter of Scopac, No. 09-40307 (5^th Cir. 10/19/10), which can be found here, the Fifth Circuit ruled that secured creditors were entitled to a super priority claim for failure of adequate protection even though its pre-petition collateral had appreciated in value during the case. The court ruled that income collected from sale of timber during the pendency of the case was an additional item of collateral entitled to adequate protection. Because the proceeds were spent during the case, the creditors were entitled to a super priority claim.

What Happened

Scopac and related entities filed for chapter 11 in January 2007. Its primary assets were 200,000 acres of redwood timberland and cash on hand. There were three major groups of creditors. Bank of America had a senior lien on the Debtors’ assets in the amount of $36.2 million. The Noteholders had a junior lien on the Debtors’ assets in the amount of $714 million. Marathon, a private equity fund, was owed $160 million.

The Court entered a series of cash collateral orders during the case requiring that the creditors receive adequate protection.

After exclusivity expired, Marathon and Mendocino Redwood Company filed a creditors’ plan. The plan sought to impose a “low-ball valuation of the timberland.” In response, the Noteholders filed a motion for a super priority administrative claim under Sec. 507(b). The Court found that the value of the timberland was $510 million and that this value had actually increased while the case was pending. The court denied the motion for super priority claim.

The Noteholders filed separate appeals from the confirmation order and the order denying the 507(b) motion. The Fifth Circuit granted a direct appeal of the confirmation order and affirmed that order. The 507(b) appeal went to the District Court which dismissed it. The District Court ruled that the appeal of the confirmation order divested it of jurisdiction.

The appeal to the Fifth Circuit raised the following issues:

1. Was there jurisdiction for separate appeals of the confirmation order and the 507(b) order?

2. Was the appeal equitably moot?

3. Were the noteholders entitled to a super priority claim for failure of adequate protection?

Jurisdiction

The Fifth Circuit disagreed with the District Court on the jurisdiction issue. The court quite sensibly noted that it had “repeatedly recognized that when a notice of appeal has been filed in a bankruptcy case, the bankruptcy court retains jurisdiction to address elements of the bankruptcy proceeding that are not the subject of the appeal.” It also said that the bankruptcy court retained jurisdiction over issues which “touc(h) upon the issues involved in a pending appeal “ so long as they do not have “any impact on the appeal.”

Under this test, the court found that the 507(b) order would not undo the confirmation order and that the appeals could proceed separately.

Equitable Mootness

The Fifth Circuit also found that equitable mootness was not a silver bullet to dispatch the appeal. So long as there was some relief which could be granted and the appeal would not upset the rights of third parties, the appeal was not equitably moot. Here, Marathon and Mendocino did not qualify as “third parties,” since they were sophisticated parties who understood the risks involved in consummating the plan while an appeal was pending.

Failure of Adequate Protection

The court defined adequate protection as “a term of art in bankruptcy practice . . .; in short, it is a payment, replacement lien, or other relief sufficient to protect the creditor against diminution in the value of his collateral during the bankruptcy.” Opinion, p. 4, n. 1.

The court explained the relationship between adequate protection and failure of adequate protection as follows:

This court has explained that adequate protection of a secured creditor’s collateral and its fallback administrative priority claim are tradeoffs for the automatic stay that prevents foreclosure on debtors’ assets: the debtor receives “breathing room” to reorganize, while the present value of a creditor’s interests is protected throughout the reorganization. (citation omitted). A secured creditor whose collateral is subject to the automatic stay may first seek adequate protection for diminution of the value of the property, 11 U.S.C. §§ 362(d)(1), 363(e), 364(d), and then, if the protection ultimately proves inadequate, a priority administrative claim under § 507(b). Section 507(b) of the Bankruptcy Code allows an administrative expense claim under § 503(b) where adequate protection payments prove insufficient to compensate a secured creditor for the diminution in the value of its collateral. “It is an attempt to codify a statutory fail-safe system in recognition of the ultimate reality that protection previously determined the ‘indubitable equivalent’ . . . may later prove inadequate.” (citation omitted).

Opinion, pp. 12-13.

However, the Court’s actual analysis was based almost entirely on the language of the cash collateral orders. Cash Collateral was defined as including “(t)he proceeds and product of the Prepetition Collateral.” The cash collateral orders contained the following provisions with regard to super-priority liens:

Each of BofA and the Trustee . . . is also granted a superpriority cost of administration priority claim under 11 U.S.C. § 507(b) to the extent of the postpetition diminution of their respective interests in the Prepetition Collateral and the Cash Collateral.

. . . .

No costs or expenses of administration or other costs or expenses of Scopac that have been or may be incurred in its Chapter 11 case shall be charged either against BofA’s or the Trustee’s Prepetition Collateral or Cash Collateral pursuant to Section 506(c) of the Bankruptcy Code without the prior express written consent of each of BofA and the Trustee.

The Court reasoned that the Noteholders were entitled to adequate protection of both their original cash collateral and funds received from sales of timber.

The cash collateral orders protected the Noteholders in two ways. They protected against a diminution in the value of the $48.7 million cash collateral that existed at the date of filing. They also specifically granted a continuing lien in the proceeds of the prepetition collateral, i.e., the $29.7 million generated proceeds from timber sales during the reorganization. The bankruptcy court entirely omitted the second component from its calculations and failed to credit those proceeds to the Noteholders’ § 507(b) claim.

Opinion, at 14.

Under the Fifth Circuit’s opinion, the conclusion that the Noteholders were entitled to compensation for diminution of their collateral flowed from the following logic:

1. The Noteholders were entitled to be compensated for diminution of the Prepetition Collateral and Cash Collateral under the Cash Collateral Orders;

2. The proceeds from sale of timber were included in the definition of Cash Collateral.

3. Therefore, the Noteholders were entitled to be adequately protected for the value of post-petition sales of timber.

The conclusion appears to follow from the language of the cash collateral orders. However, the larger issue is whether the Noteholders should have been entitled to adequate protection of the value received from post-petition sales of timber. The Fifth Circuit’s prior opinion in Matter of Stembridge, 394 F.3d 383 (5^th Cir. 2004) held that a secured creditor was entitled to adequate protection of the value of its collateral as of the petition date. In this case, the value of the collateral actually appreciated during the pendency of the case. Was it simply a matter of bad drafting that the Noteholders were entitled to adequate protection for both the prepetition collateral and the postpetition income?

An argument advanced by the Noteholders in their Brief (but not mentioned by the Fifth Circuit) was that Section 552(a) provides for the secured creditor’s lien to extend to “proceeds and product” of prepetition collateral. The Fifth Circuit, on the other hand, mentioned that “proceeds and product” were included in the definition of cash collateral under Section 363(a). Does the definition of proceeds and product as collateral make these items pre-petition collateral entitled to adequate protection?

Consider two examples:

1) The debtor is a fast-food restaurant. On the petition date, the Debtor has $100 worth of hamburger meat and potatoes. The Debtor’s employees cook the hamburger meat and potatoes and sell $300 worth of combo meals. In order to generate this income, they must spend $100 on wages, utilities and supplies. Is the creditor entitled to be adequately protected for the original $100 value, the $300 in proceeds received or the $200 in net proceeds? If the secured creditor had foreclosed, it would have only recovered $100 worth of hamburger and potatoes. The increase in value from $100 to $300 is the result of the post-petition efforts of the Debtors’ employees. Thus, the creditor would only be entitled to adequate protection of the initial $100 in value.

2) The Debtor operates an apartment complex. The apartment complex is valued at $1 million on the petition date. Each month the apartment complex generates $10,000 in rents. It costs $5,000 per month to operate the apartment complex. The apartment complex has an economic life of 30 years. Each month, the apartment complex generates $5,000 in net rents. However, the project decreases in value by 1/360. So long as 1/360 is reinvested in the property and values remain constant, the property has the same capacity to generate rents. Therefore, the creditor would not be entitled to adequate protection of the net profits of $5,000 per month.

3) Apply these hypotheticals to the case of timber. On the petition date, the debtor owns timberland worth $500 million. During the pendency of the case, the Debtor harvests $30 million worth of timber. Assuming that market values remained constant, would the harvesting of $30 million worth of timber decrease the value of the remaining property by $30 million, thus entitling the creditor to adequate protection for the diminution in value? We don’t know. If the selective harvesting of timber allowed greater sunlight to reach the remaining timber so that it grew up to replace the timber which was cut, then the creditor did not lose any value. On the other hand, if vast areas were clear cut and not replaced, then the creditor would have suffered a substantial loss. Further complicating the hypothetical is the question of market forces. If during the pendency of the case, timber property appreciated by 20% due to forest fires in Russia, the secured creditor could not claim diminution in value. If the secured creditor had foreclosed on the petition date and immediately sold the collateral, it would not have received the benefit. Instead, the subsequent purchaser would have received the increased value. On the other hand, if global warming led to an overabundance of timberland reducing the value of all timberland, then the secured creditor would have suffered a diminution in value.

The opinion in Scopac may be defensible based upon the language of the cash collateral orders. However, it fails to answer the question of whether the timber proceeds were part of the pre-petition collateral or the debtor's post-petition efforts. The opinion should not be interpreted to mean that the secured creditor is entitled to adequate protection for both the value of the pre-petition collateral and any post-petition income received. In drafting cash collateral orders, practitioners should be careful to state that the secured creditor is entitled to be adequately protected for the value as of the petition date, nothing more and nothing less. Otherwise, the secured creditor could be granted a windfall as may have occurred in the Scopac case.

Schwab v. Reilly Places Homesteads at Risk Years After Filing

A new opinion from the Ninth Circuit illustrates the practical implications of Schwab v. Reilly, 130 S.Ct. 2652 (2010). In Matter of Gebhart, No. 07-16769 (9th Cir. 9/14/10), the Court held that the Trustee was entitled to reap the benefits of post-petition appreciation in the Debtor’s homestead. The opinion can be found here.

Two Homesteads Going Up Over the Years

Gebhart involved two consolidated appeals. In the first case, the Debtors filed chapter 7 in August 2003 and claimed the Arizona homestead exemption. On the petition date, the Debtor’s equity was less than the $100,000 exemption. The Trustee did not object. In November 2006, the Trustee sought to employ a broker to sell the home, contending that its value had appreciated beyond the exemption amount. In the second case, the Debtor filed bankruptcy in June 2004 and claimed the Washington homestead exemption. Two years later, the Trustee sought to sell the home, which had appreciated in value. Both Debtors cried foul. The Arizona court ruled that the property remained in the estate, while the Washington court ruled that the unopposed exemption removed the property from the estate.

It's Exempt But What Is "It"?

The Ninth Circuit acknowledged that “{q]uite simply, property that has been exempted belongs to the debtor.” However, the question is, just what was exempted and passed out of the estate? Following the Supreme Court, the Ninth Circuit stated that where an exemption was limited to a dollar amount (as was the case with both the Arizona and Washington exemption statutes):

Instead, what is removed from the estate is an “interest” in the property equal to the value of the exemption claimed at filing. (citation omitted). The implication for the cases at issue here are clear: the fact that the value of the claimed exemption plus the amount of the plus the amount of the encumbrances on the debtor’s residence was, in each case, equal to the market value of the residence at the time of filing the petition did not remove the entire asset from the estate.

Opinion, at 14071-72.

A Bad Result They Admit

The Ninth Circuit did not shy away from the implications of its decision.

The debtors argue that the result we reach today will lead to uncertainty about the status of exempt property and abuses by trustees. The facts of the Gebhart bankruptcy suggest that some of these concerns are legitimate. Gebhart remained in his home for five years after filing for bankruptcy, paying his mortgage and believing that his bankruptcy was finished when he received his discharge. Gebhart may have been mistaken in his belief, but his misapprehension was shared by his mortgage lender, which refinanced the home, apparently unaware of any claims on the property by the Trustee. A Chapter 7 debtor will not be certain about the status of a homestead property until the case is closed (something that may not happen for several years after bankruptcy filing) or the trustee abandons the property.

Opinion, at 14074.

Notwithstanding these concerns, the Court held that the Trustee was not stopped to claim the homestead property and could not be compelled to abandon the property.

Opening Pandora's Box

This case illustrates the Pandora’s box opened by Schwab v. Reilly. While that case involved a dispute over the value of property as of the petition date, these cases involved post-petition appreciation. Debtor’s attorneys cannot assume that an unobjected to exemption means that the debtor gets to keep the property. If the exemption is defined by a dollar amount, the Trustee can sit back and wait for appreciation.

How serious is the risk for Texas debtors? Texas is one of the minority of states which allow use of federal exemptions. Most of these exemptions are dollar limited. On the other hand, Texas law allows unlimited exemptions for the homestead, tax qualified retirement accounts, annuities and cash value of life insurance. Texas law allows an aggregate exemption of $60,000.00 for certain categories of personal property.

How could this issue arise in Texas? Here are a few possibilities:

1. The Debtor uses federal exemptions to claim a homestead with no equity and a business under the wildcard exemption. Subsequently, either real estate prices rebound or the debtor makes a success of the formerly languishing business. At that point, the Trustee could sell the now valuable asset.

2. The Debtor takes federal exemptions and undervalues an asset, such as tools of the trade. If the Trustee subsequently finds out that the asset had more value, he could sell it. That was the fact scenario in Schwab v. Reilly.

3. The Debtor claims Texas exemptions and claims $5,000 worth of jewelry. Subsequently, it turns out that the jewelry was worth $45,000. While that would still be under the $60,000 cap, Texas law limits the jewelry exemption to $15,000. Again, under-valuation can be remedied without a timely objection.

4. If the Debtor claims Texas exemptions, but acquired their homestead within 1,215 days, then the homestead is subject to a cap under Sec. 522(p). If the homestead subsequently appreciates, the Trustee could move to sell even though the property was under the cap on the petition date.

5. The most unlikely scenario is one where the debtor owns an asset such as artwork which has negligible value on the petition date. Post-petition, the artist dies and acquires a cult following. As a result, the total value of the Debtor’s personal property exceeds $60,000. However, in this instance, the debtor should be able to take advantage of depreciation in other personal property assets, such as vehicles, to offset the appreciation of the artwork. The challenging aspect of the Texas personal property exemption is that the cap applies to the overall group of assets. As a result, the change in value of one asset may be offset by the decline in value of another.

Second Circuit Holds That FDCPA Does Not Apply to Proof of Claim in Bankruptcy

The Second Circuit has held that an allegedly inflated proof of claim cannot form the basis for a claim under the Fair Debt Collection Practices Act. Simmons v. Roundup Funding, No. 09-4984 (2^nd Cir. 10/5/10). The opinion can be found here.

In Simmons, Roundup Funding filed a proof of claim for $2,039.21. After a hearing on claims objection, the court reduced the claim to $1,100.00, the amount that the debtors acknowledged to be owed.

Having achieved victory on the claims objection, the Debtors then sought to bring a class action under the FDCPA. The District Court was not impressed and not only dismissed the action, but awarded attorney's fees against the Debtors. The Second Circuit affirmed the dismissal, but reversed the award of attorney's fees.

The Court wrote:

Federal courts have consistently ruled that filing a proof of claim in bankruptcy court (even one that is somehow invalid) cannot constitute the sort of abusive debt collection practice proscribed by the FDCPA, and that such a filing therefore cannot serve as the basis for an FDCPA action (citations omitted).

We join these courts. The FDCPA is designed to protect defenseless debtors and to give them remedies against abuse by creditors. There is no need to protect debtors who are already under the protection of the bankruptcy court, and there is no need to supplement the remedies afforded by bankruptcy itself.

Slip Opinion, at 5-6.

It is interesting that the Court did not cite any provision of the FDCPA in affirming the dismissal. While the Fair Debt Collection Practices Act is designed to protect "defenseless debtors" from voracious collectors, this is typically not a requirement under the statute. The omission of a word or two can be the basis for an action regardless of whether the debtor was defenseless or not.

While the opinion achieves a common sense result, other courts have held that violations of the Bankruptcy Code may result in a claim under the FDCPA. Randolph vs. IMBS, Inc., 368 F.3^rd 726 (7^th Cir. 2004). The Randolph case allowed a debtor to bring an FDCPA claim based upon a violation of the discharge, holding that the Bankruptcy Code could not preempt the FDCPA. The distinction here may be between acts which take place outside of bankruptcy (such as violations of the discharge) and acts which take place within the bankruptcy court (such as filing a proof of claim). Unfortunately, the rationale is not stated as clearly as it could have been.

Highlights from the National Conference of Bankruptcy Judges Day 3

I only attended two panels today before heading for the airport, so this post will be considerably shorter than the previous ones.

Ethics

The panel on To Tweet or Not to Tweet: Ethical Issues in Utilizing Social Networking Tools provided the all important ethics credit. They walked through a series of hypotheticals. Some of the more interesting were whether it is ethical to use a tracking device on your associate’s phone to locate him, whether a second chair lawyer should tweet during trial and whether a judge should be Facebook friends with an attorney appearing in her court. The answers were: yes, if it is a real emergency and you have given prior notice; no, the associate should be paying attention to the trial, not divulging confidential information; and maybe, so long as you really are friends and you are prepared to recuse yourself.

The panel felt that you should not blog about a client’s case without their consent. This is a sensitive issue. I have blogged about a few of my cases, but only if they resulted in a published opinion which would not be embarrassing to the client. I am planning to blog about my experiences in an unusual case that is ongoing, but not until it is over.

Now you can claim self-study ethics credit for reading this post.

Supreme Court Review

This was a very interesting panel featuring Judge Margaret Mahoney, Eric Brunstad and Brett Weiss. I am not going to discuss the cases themselves, since I have already written about them, but will summarize some of the larger conclusions.

The panel was unsure whether Milavetz prohibited advice on pre-petition planning, such as buying a more expensive car to tip the means test. However, they did say that the opinion allow counsel to have “full and frank and robust discussions” with the client. So perhaps the line is that you can talk about it, but not recommend it.

The Lanning case proved that the Supreme Court can make for some unusual alliances. The Chapter 13 trustee, who argued for a mechanical approach to determining projected disposable income, was supported by NACBA, while the Debtor was supported by the United States.

Brett Weiss was kind enough to quote the following passage from this blog:

The majority wants the Bankruptcy Code to make sense. Justice Scalia is willing to be a minority of one for the proposition that when Congress passes laws that are foolish or just plain wrong, that the courts have an obligation to throw their words back at them and yield a foolish judgment

Then he said thank goodness the Supreme Court did not follow Justice Scalia.

Lanning showed the victory of pragmatism over formalism. The panel encouraged lawyers to take the time to educate appellate judges with how bankruptcy actually works because the way bankruptcy works in fact is more unspoken than in other areas of the law.

Schwab v. Reilly was dismissed as a case that could be overcome through better software. Justice Thomas said that the problem with the debtor’s claim of exemption was that she claimed a specific dollar value rather than saying she was claiming 100% of the value. Apparently the Rules Committee is considering a change to the Official Form to allow this. In the meantime, software vendors are already responding to the decision.

Espinosa was considered to be in line with other Supreme Court opinions on finality of confirmation orders. The issue to be considered in litigating these cases is notice. Did they clearly say what they were trying to accomplish? Did the creditor receive actual notice? The Court appeared to be saying that deviant plan provisions were not a major risk because courts would exercise their independent duty to review plans and weed out the bad ones even where there wasn’t an objection. The panel thought this ignored the practical realities of a bankruptcy judge’s docket.

Finally, a cute story to end with. The first time that Eric Brunstad argued before the Supreme Court, he brought his six year old daughter with him. She brought her teddy bear. However, the marshals would not allow a teddy bear in the Supreme Court and took the stuffed bear into custody. After the argument, his daughter ran up to him and said, “Teddy’s in prison. The Martians have him.” When you receive a bad ruling, you can always say “The Martians got my case.”

Highlights from the National Conference of Bankruptcy Judges Day 2

I started my day with a jog through New Orleans at sunrise. The Bernstein Law Firm from Pittsburgh sponsored the run. I managed to complete the run, although I was not moving very fast. My time may have had something to do with last night’s entertainment. Still, it was invigorating to see the sun come up over the Mississippi River and to hear St. Louis Cathedral chime 7am.

Meltdown Mania

Today’s topic du jour was the financial meltdown and bailout. Unlike yesterday, the three presentations on this topic complemented each other rather than plowing the same ground.

SIGTARP

However, to properly address the topic, it is necessary t o start with yesterday’s lunch speaker. On Thursday, IWIRC sponsored Neil M. Barofsky, who is the Special Inspector General for the Troubled Asset Relief Program. His department is a combination of TARP cop (he has a badge but not a gun) and oversight panel.

Barofsky spoke about two different topics: how well TARP has accomplished its goals and efforts to keep TARP honest. I did not take good notes, so any inaccuracies are due to my memory and not to the speaker.

According to SIGTARP Barofsky, TARP was sold to the public on the basis that it would accomplish three goals: 1) avoid a financial meltdown; 2) protect jobs; and 3) keep people in their homes. In his opinion, TARP accomplished the first goal, but failed at the second and third. This has contributed to public perceptions that TARP was nothing more than a bailout of Wall Street rather than Main Street.

He also talked about his department’s efforts to keep TARP honest. He explained the concept that fraudsters go through three stages: they incur a loss; they use creative accounting to cover the hole; and 3) they look for a “whale” to plug the hole. In the case of the TARP program, this meant that financial institutions who had undisclosed losses would apply for government money to try to solve their problems while lying about their actual finances. He gave several examples of prosecutions for submitting false applications to TARP. He estimated that SIGTARP had saved the government $500 million in funds not paid out and had recovered over $100 million from bad guys.

The Banks Are Not Fixed

Friday opened with “Bailout and the Fallout,” featuring moderator William Derrough and panelists Damon A. Silvers, Deputy Chair of the Congressional Oversight Panel, and Matthew Feldman, who helped Treasury with the auto bankruptcies.

The panel spent quite a bit of their time talking about the events leading up to TARP. The story beings in early 2007 with the collapse of the subprime mortgage market. Two Bear Stearns hedge funds were seized by Merrill Lynch in June 2007. The year 2007 ended with Lehman Brothers reporting a profit.

In March 2008, JP Morgan Chase Bank acquired Bear Stearns for $2 a share with a federal guaranty attached. According to Silvers, this violated the rule that we don’t bail out stock brokerages. However, the government did not know what the consequences of not bailing out Bear Stearns would be. While much has been made of the pressure placed on JP Morgan Chase Bank to make the acquisition, even greater pressure was placed on the Board of Bear Stearns. They were told that they could accept $2 a share or they could explain their failure to do so to FBI agents and SEC personnel in the next room.

In September 2008, the government seized Fannie Mae and Freddie Mac. Their problem was that they had strict lending standards. However, they were competing with lenders who had no standards (i.e., no doc loans). To solve this problem, they began buying the junk that others were producing.

Over the period September 12-13, 2008, the Bush administration decided not to bail out Lehman Brothers. A decision was made to let a brokerage fail based on the belief that the damage to the economy could be contained. According to one of the panelists, it was an experiment to see what would happen if a major brokerage went over the cliff.

On September 14, 2008, Lehman Brothers filed for bankruptcy and Merrill Lynch sold itself to Bank of America.

On September 15, 2008, Timothy Geithner summoned JPMorgan and Goldman Sachs to a meeting. He informed them that they would bail out AIG with an $80 billion loan. He gave them a term sheet and left. At 2am the next morning, an attorney for the two called the Fed and said they would not do the deal. Undeterred, the Fed scratched out the names of JP Morgan and Goldman Sachs and wrote in the Federal Reserve Bank of New York. The Fed went so far as to employ the attorney who had drafted the term sheet on behalf of the private parties.

The conclusion was that in September 2008, the government, Republicans and Democrats alike, made a decision to take an activist role in avoiding a financial meltdown. That policy continued with the Obama administration.

In March 2009, the Obama administration made the decision to save Chrysler and GM. The government made a decision that a private equity firm would not have made for the reason that eliminating millions of jobs during a financial crisis was too great of a risk to take.

The take away was that TARP succeeded in calming the financial panic but failed to “fix” the banks.

The following is pretty close to a direct quote from Damon Silvers, which drew a sustained ovation. He was comparing the decision to “fix” the failing automakers with the financial sector:

The banks are not fixed. The corrupt nature of the way they are poisoning our
financial sector has not been fixed. We will eventually have to step in and fix
them.

Regulation Is Not Our Friend

Friday’s lunch speaker was Fox Business Channel correspondent Charles Gasparino. His thesis was that the problem was not too little regulation, but too little trust in the market. The problem, in his view, was that the government intervenes to protect the market from the consequences of its bad decisions. Compounding the problem is that government regulators fail to recognize what is in front of them.

He said that regulation provides a sense of comfort that some all-knowing body is watching out for us. However, he said that regulation itself could have caused the financial crisis and that the recent Dodd-Frank financial reform legislation could lead to another financial crisis.

One problem he said was that regulators are always looking at the wrong stuff. The government investigated Bernard Madoff six times, but failed to verify any of his trades. Had they looked, they would have seen that they were non-existent and caught the fraud.

Gasparino also blamed a partnership between business and the government. He said that Wall Street was spared the pain of its mistakes time and time again. The Fed turned on the spigot in 1987, 1994 and 1998 to protect Wall Street. Lehmann Brothers was bailed out in 1994 and 1998. It survived until it took on so much risk that it nearly took down the financial system in 2008. Dick Fold, Chairman of Lehman Brothers believed that his firm would be bailed out up until the signed the bankruptcy petition. What if they hadn’t bailed them out, he asked. Would that have saved us from 2008? He also gave the example of Bear Stearns. In 1998, it was the company with the best risk controls. By 2008, it was the first to fail. His point was that the lesson Bear Stearns learned from the bailout of 1998 was that traders could receive the upside of risk taking while the government would protect them from the downside.

Gaparino claims that we put too much faith in regulation and not enough in the markets. Playing to the audience, he said that without all the bailouts, there would be more work for bankruptcy lawyers.

He also took aim at the Dodd-Frank financial reform bill. He argued that it enacts Too Big to Fail into law by allowing the government to take over (i.e. bailout) huge entities. He said that the bill’s problem was that it added more regulation when the system needed to be rebuilt from ground zero.

However, he did not criticize the decision to bail out AIG. He said that there was so much systemic risk built in by 2008 that the system could not have survived AIG going under. “When that toilet starts flushing, it takes everyone down.”

He had an interesting take on Glass-Steagall. His market-based solution was to allow combinations of banks and investment banks with the caveat that their deposits would not be insured. That way, they would have to pay more for deposits and the public would have to decide whether the increased return was worth the risk. He returned to his point that subsidizing risk is a bad idea. “They will gamble if you give them the incentive.”

Gasparino also suggested that bond rating agencies were worthless. They provided a false sense of security at the time that they were being pressured to give AAA ratings in order to generate fees. He suggested that investors should have been doing their own due diligence rather than relying on a third party.

He also suggested that political correctness may explain why business journalists didn’t point out the problems at Fannie Mae and Freddie Mac much earlier. He said that they were prodded by President Clinton’s Department of HUD to guarantee riskier loans, which led to a housing bubble. However, because giving working class people access to housing was deemed a worthy cause, the warning was not given.

Foreclosure Crisis

I attended a breakout session on the foreclosure crisis led by Alane Beckett, Judge Susan Barrett, Dillon Jackson and former ABI President Ford Elsaesser. They sounded a similar theme of an industry in shambles. On the one hand, you have Jeffrey Steffen signing 10,000 affidavits a month (one every 78 seconds). On the other hand, you have paperwork that may be hopelessly lost. There used to be mortgage brokers in every strip mall. When the bubble burst, they went away, leaving file cabinets full of original documentation that had never been forwarded on. The original notes may now be in a landfill somewhere.

Lenders are reluctant to sign a lost note affidavit because it requires them to indemnify the title company; it also requires that they had the note in the first place (prompting one of the audience members to quip that was affidavits that got us into the problem in the first place).

The other side of the foreclosure crisis is that it gives homeowners false hope. One family broke back into their home after it was foreclosed and they were evicted in the belief that the foreclosure was bogus. The problems in the mortgage industry do not mean that everyone gets a free home. However, failure to correct the problem will result in thousands of pro se parties filing pleadings they downloaded from the internet and class actions being brought to “spank” lenders, but which primarily benefit the lawyers.

Ford Elsaesser offered a ten point program to fix the problem:

1. The mortgage companies must hire real lawyers.
2. The real lawyers must sign the pleadings themselves.
3. No affidavits unless drafted by an attorney who personally speaks to the witness.
4. Motions to lift stay should have to meet the pleading requirements of Iqbal. This should be enforced by local rules.
5. No robo-signing, including by Judges. In other words, judges should stop signing default orders on defective lift stay motions.
6. MERS should go away.
7. Prior to filing a motion to lift stay, the mortgage company should contact the debtor to try to work out a modification or short sale or deed in lieu. This would allow homeowners to stay in their homes when feasible.
8. If the debtor has vacated the property, the mortgage company should contact the trustee to offer to purchase the property free and clear of liens for a small amount. This would give them good title.
9. There should be a national pre-mediation program on foreclosures.
10. Title companies will need to develop a standard for insuring foreclosed homes.

All of these proposals would increase the costs to mortgage companies. However, his point was that Sears had to pay to comply with the law. “Bringing mortgages into compliance is simply a financial cost.”

Gaming Industry Bankruptcies

My take away from this panel was that secured creditors can’t receive a lien on all the debtor’s assets, giving unsecured creditors more leverage. Lenders can’t foreclose upon and operate gaming machines. They can’t take a lien on gaming licenses or liquor licenses. The money in the teller cages is subject to control of the casino regulators. What do they have a lien on? “A big room with beds upstairs.” The highly regulated nature of the gaming industry means that regulators can insist that trade creditors get paid.

Chapter 9

The take away here is that the unique structure of chapter 9 is a compromise based on federalism. The federal government cannot exercise control over a municipality through the bankruptcy system. As a result, municipal bankruptcy must be authorized by state law. There can be no trustee, no creditors’ plan, no conversion to chapter 7 and no interference with the political or governmental powers of the municipality. Interestingly enough, there is also no requirement that counsel be formally retained or seek approval for their compensation.

Highlights from the National Conference of Bankruptcy Judges Day 1

I am attending the National Conference of Bankruptcy Judges meeting in New Orleans this week. Here are some highlights.

Lawrence P. King Award

The Commercial Law League of America presented the Lawrence P. King Award to Judge Burton Lifland from the Southern District of New York. In his acceptance speech, he stated that he has some concerns about the most recent phenomenon that has overtaken bankruptcy practice. According to judge Lifland, bankruptcy is becoming nothing more than a marketplace and that rehabilitation is on the back burner. He regretted that the pendulum has swung too far.

Philadelphia Newspapers and Credit Bidding

The topic du jour was credit bidding and inter-creditor agreements. Three out of six panels that I attended discussed some combination of these issues. There is another panel on Philadelphia Newspapers scheduled for Friday. (Note to planning committee: try to avoid duplication).

There was a lot of discussion of the Third Circuit opinion in In re Philadelphia Newspapers, 2010 U.S. App. LEXIS 5805 (3rd Cir. 2010), including a presentation from debtor’s counsel. In that case, the Third Circuit held that a sale pursuant to a plan of reorganization could eliminate the lender’s right to credit bid. Under 11 U.S.C. Sec. 1129(b)(2)(A), there are three alternatives for dealing with a secured claim separated by the word “or.” Option (iii) allows the realization of the “indubitable equivalent” of the lender’s collateral. The majority opinion held that a sale without the right to credit bid could provide the “indubitable equivalent.” The dissent argued that the more specific provision, which allowed credit bidding, should control.

I think the dissent had the better argument, but the more intriguing question is why it would be advantageous to avoid credit bidding. Lawrence McMichael, who represented the debtor, said that the rationale (apart from “torturing the lenders”) was to encourage bidders who would want to operate the newspaper, rather than simply sell it. The specter of a bidder with an unlimited right to credit bid was thought to be a deterrent to third party bidders. After the sale was allowed without credit bidding, the number of bidders who signed confidentiality agreements increased from three to thirty and the sale price went from the stalking horse bid of $30 million to $105 million. However, the winning bidder was still members of the bank group who had put together a cash bid.

The counter argument to eliminating credit bidding was that bank group relationships have grown so complex that a cash bid may be difficult to prepare. While the indenture trustee can make a credit bid on behalf of the group, it cannot require the members to advance new capital. Individual members of the group may be deterred from making a cash offer out of concerns about liability to the non-participating members.

An interesting side note is that section 363(k) allows the court to eliminate a right to credit bidding “for cause.” If there are compelling reasons for eliminating credit bidding, it seems more intellectually honest to do it directly.

International Insolvency

The panel on international insolvency included E. Bruce Leonard from Canada, Bankruptcy Judge Charles Case from Phoenix, Michael Crystal from England, Thomas Felsberg from Brazil and Prof. Jay Westbrook from the University of Texas Law School. They provided a good primer on chapter 15.

The purpose of chapter 15 is to allow an ancillary proceeding to be opened in the United States in support of a main proceeding in another country. Chapter 15 consists of two stages: recognition and relief. Recognition of a foreign proceeding is intended to be easy to obtain, although Prof. Westbrook pointed out the problem of haven countries, which incorporate companies but have no economic activity there.

The relief portion is highly discretionary and can include “any other relief than can be granted to a trustee” other than avoidance actions under the Bankruptcy Code. Judge Case stressed the importance of making a record to support the court in exercising its discretion. Any interesting example offered was a case where the chapter 15 proceeding sought to pursue fraudulent transfers under Nevis law. The Fifth Circuit ruled that only avoidance actions under the United States Bankruptcy Code were prohibited.

Individual Chapter 11s

The panel on individual chapter 11 cases included Judge Mary Diehl, Peter Lively, Sally Neely and Riley Walter. They approached the problem from the perspective of chapter 13 lawyers having to learn chapter 11 concepts and chapter 11 lawyers having to learn chapter 13 concepts which apply in individual chapter 11 cases.

They raised several interesting issues.

1. Can the same lawyer represent the debtor and the debtor in possession? What happens when a creditor files an objection to exemptions? Can the debtor’s lawyer defend the objection and get paid for it? In chapter 7 and chapter 11, the trustee may employ professionals, but the debtor may not. Can the attorney for the debtor in possession perform services for the benefit of the individual debtor? In re Dixon, 2010 Bankr. LEXIS 3305 (Bankr. N.D. Cal. 2010) was discussed as an extreme case, which held that not only could the attorneys not be compensated for defending the objection, but that they placed all of their fees at risk by taking a course of action adverse to the estate. Intellectually it is possible to connect the dots, but it is a terrible result practically. It would mean that an individual chapter 11 debtor would be required to hire one lawyer to represent the estate and a second attorney, who could not be paid from estate property, to represent him individually.

A better approach would be to recognize that the debtor in possession is a flesh and blood person with a right to claim exempt property. Once a creditor objects to the claim of exempt property, both the individual debtor and the debtor in possession have an interest in determining whether the property is exempt or not. My personal view is that if there is a conflict, it is one built into the structure of the Bankruptcy Code. An attorney has a duty to zealously represent his client which extends to both roles of the human being. Any other result means that a creditor could hold the debtor hostage by filing frivolous objections to exemptions or complaints to determine dischargeability, knowing that the debtor will be hamstrung in responding.

2. Is there an absolute priority rule for individual chapter 11 debtors? Three cases say no, holding that section 1129(a)(15)’s requirement to pay projected disposable income for five years overrides the absolute priority rule. In re Shat, 2010 WL 702443 (Bankr. D. Nev. 2010); In re Rodemeier, 374 B.R. 264 (Bankr. D. Kan. 2007); In re Tegeder, 369 B.R. 477 (Bankr. D. Neb. 2007). However, four cases have found that the absolute priority rule does apply. In re Gelin, 2010 Bankr. LEXIS 3217 (Bankr. M.D. Fl. 2010); In re Gbadeo, 431 B.R. 222 (Bankr. N.D. Cal. 2010); In re Mullins, 2010 Bankr. LEXIS 2826 (Bankr. W.D. Va. 2010); In re Steedley, 2010 Bankr. LEXIS 3113 (Bankr. S.D. Ga. 2010). Three of the cases finding that the absolute priority rule applies are so new that they came out after the materials were prepared.

3. How do you calculate “projected disposable income” under section 1129(a)(15)? The section says to look to section 1325(b)(2). However, section 1325(b)(2) defines defines “disposable income” as “current monthly income” less expenses reasonably necessary. “Current monthly income” is based on the means test form. However, the expense portion of the means test is contained in section 1325(b)(3), which is not incorporated. Both Collier on Bankruptcy and the Bankruptcy Forms take the position that the expense calculation under the means test is not incorporated so that the court retains discretion to determine which expenses are “reasonably necessary.”

4. Can you close the case prior to discharge to avoid paying U.S. Trustee fees? The panel stated that an increasing number of courts are allowing this practice. However, they cautioned that the automatic stay goes away when the case is closed and the discharge injunction does not apply until discharge is granted at the end of the plan. They recommended including an injunction in the closing order.

"The Document Speaks for Itself." Or Does It?

I just received this memorandum from Judge Pat E. Morgenstern-Clarren of the Northern District of Ohio and thought it was worth passing along.

M E M O R A N D U M

TO: All attorneys with bankruptcy cases on my docket
FROM: Judge Pat E. Morgenstern-Clarren
DATE: October 4, 2010
SUBJECT: “The document speaks for itself.” Or does it?

Recently, the court has seen a resurgence in the use of the phrase “the document speaks for itself.” Sometimes this is heard in the courtroom; at others, it is part of an answer or a response to discovery. Counsel are reminded that this is not an appropriate objection, in large measure because it does not have a basis in the Federal Rules of Evidence or the Federal Rules of Bankruptcy Procedure.

Some hypothetical examples may be helpful:

1. Assume that a complaint alleges that a document was signed on a certain date by a certain individual. The options for an answer under Federal Rule of Bankruptcy Procedure 7008 are generally “Admit” (if the date and individual are correctly identified), or “Deny” (if they are not), or “The party lacks knowledge or information sufficient to form a belief about the truth of the allegation” (if that is true). A response stating that “the document speaks for itself” is not part of this rule.

2. If there is a request to admit that a document contains quoted language, the alternatives contemplated by Federal Rule of Bankruptcy Procedure 7036 are to (a) do nothing within the required time frame (in which case the matter is admitted), (b) object to the request (stating legally sufficient grounds to support the objection), or (c) answer the request. If the responding party answers, the options are “Admit” (if the quotation is accurate), “Deny” (if the quotation is not accurate), give a qualified response (in good faith), or state that the party cannot truthfully admit or deny the request, giving detailed reasons in support. See KeyBank Natl’l Assoc. v. Mann (In re Mann), 220 B.R. 351, 357 (Bankr. N.D.Ohio 1998). “The document speaks for itself” does not fall into any of these categories.

3. If counsel asks a witness to read a document out loud during a hearing, there is no objection in the Federal Rules of Evidence called “the document speaks for itself.” A witness, with the court’s permission, may always read from a document during an evidentiary hearing or trial.

There are a number of cases and articles that address this issue. Counsel may want to review them to avoid the temptation of writing or saying “the document speaks for itself.”

As always, your cooperation in considering this issue is appreciated.