Circuits Split Over Impact of Stern on Counterclaims

Following last year’s Stern v. Marshall bombshell, cases are slowly trickling up to the Court of Appeals level. After I wrote about a recent Fifth Circuit opinion which held that the jurisdiction of U.S. Magistrate Judges was not invalidated, a commenter pointed out a recent Seventh Circuit decision. In this post, I will look at that case, In re Ortiz, 665 F.3d 906 (7^th Cir. 2011), in which the Seventh Circuit granted a direct appeal and then concluded that it did not have a final decision to review, as well as an even more recent First Circuit case which appears to reach the opposite conclusion.

The Seventh Circuit Undoes a Direct Appeal

Ortiz involved a health care provider that filed proofs of claim in an estimated 3,200 bankruptcy cases in the Eastern District of Wisconsin over a five year period which disclosed the debtors’ confidential medical information. Two sets of debtors filed class action proceedings under a Wisconsin non-disclosure statute.* Bankruptcy Judge Susan Kelley** granted summary judgment for the health care provider, finding that the debtors had not shown actual damages as required by the Wisconsin statute. Both parties requested a direct appeal to the Seventh Circuit, which was approved. However, in light of Stern v. Marshall, the Seventh Circuit concluded that it was not permitted to allow the direct appeal because there was not a “final” order.

Direct appeals to the Court of Appeals are authorized under 28 U.S.C. §158(d) in three instances:

*Final orders;

*Interlocutory orders increasing or decreasing the debtor’s exclusive period to file a plan; and

*With leave of court over interlocutory orders and decrees.

Even though no party had raised the jurisdictional issue, the Court concluded that it had “an independent duty to determine whether we have jurisdiction.”

The Court noted the schizophrenic nature of the Stern decision which, on the one hand, claims to be a narrow decision, but on the other hand, appears to prohibit the bankruptcy courts from going beyond the power to adjudicate claims. The Court wrote:

The first question (whether the bankruptcy court had authority to enter a final order) requires a close reading of Stern v. Marshall. Although the Court noted that the question presented was "narrow," it was quite significant as Congress "may no more lawfully chip away at the authority of the Judicial Branch than it may eliminate it entirely." (citation omitted). The Court held that Article III prohibited Congress from giving bankruptcy courts authority to adjudicate claims that went beyond the claims allowance process. (citation omitted). The decision rebuffed an intrusion into the Judicial Branch that would "compromise the integrity of the system of separated powers and the role of the Judiciary in that system, even with respect to challenges that may seem innocuous at first blush." (citation omitted).

665 F.3d at 911.

Prior to Stern, the bankruptcy court’s authority would have appeared clear for this was a matter “arising in” a title 11 case. Because proofs of claim only exist in title 11 proceedings, claims arising from proofs of claim could only arise in the bankruptcy context. However, the Court found that the Wisconsin non-disclosure claims were similar to the counterclaim filed by Vicki Lynn Marshall in the Stern case:

Just as Pierce's filing of a proof of claim in Vickie's bankruptcy did not give the bankruptcy judge authority to adjudicate her counterclaim, Aurora's act of filing proofs of claim in the debtors' bankruptcies did not give the bankruptcy judge authority to adjudicate the debtors' state-law claims. The debtors' claims seek "to augment the bankruptcy estate--the very type of claim that . . . must be decided by an Article III court." (citation omitted). Non-Article III judges may hear cases when the claim arises "as part of the process of allowance and disallowance of claims," (citation omitted), or when the claim becomes "integral to the restructuring of the debtor-creditor relationship," (citation omitted). Although there is some factual overlap between the debtors' claims and Aurora's proofs of claim, the bankruptcy judge "was required to and did make several factual and legal determinations that were not 'disposed of in passing on objections' to" Aurora's proofs of claim. (citation omitted). In granting Aurora's summary judgment motion, the bankruptcy judge interpreted a Wisconsin state law to require proof of actual damages as an essential element of the debtors' claims and found that there was no genuine issue of material fact as to the lack of actual damages. Nothing about these decisions involved an adjudication of Aurora's proofs of claim and there is no "reason to believe that the process of adjudicating [Aurora's] proof[s] of claim would necessarily resolve" the debtors' claims. (citation omitted). Stern reaffirmed that "Congress may not bypass Article III simply because a proceeding may have some bearing on a bankruptcy case; the question is whether the action at issue stems from the bankruptcy itself or would necessarily be resolved in the claims allowance process." (citation omitted). The debtors' action owes its existence to Wisconsin state law and will not necessarily resolve in the claims allowance process. That the circumstances giving rise to the claims involved procedures in the debtors' bankruptcies is insufficient to bypass Article III's requirements. Stern v. Marshall makes plain that the bankruptcy judge in our cases "exercised the 'judicial Power of the United States' in purporting to resolve and enter final judgment on" the debtors' Wisconsin state-law claims. (citation omitted). We thus hold that the bankruptcy judge lacked authority under Article III to enter final judgments on the disclosure claims.

665 F.3d at 914.

The Court of Appeals concluded that because the bankruptcy court lacked authority to enter a final order, that it lacked authority to grant a direct appeal. If the court had stopped there, its decision would have been clear. However, it added a cryptic comment suggesting that the bankruptcy court lacked any authority in the matter:

For the bankruptcy judge's orders to function as proposed findings of fact or conclusions of law under 28 U.S.C. § 157(c)(1), we would have to hold that the debtors' complaints were "not a core proceeding" but are "otherwise related to a case under title 11." (citation omitted). As we just concluded, the debtors' claims qualify as core proceedings and therefore do not fit under § 157(c)(1). The direct appeal provision in 28 U.S.C. § 158(d)(2)(A) also does not authorize us to review on direct appeal a bankruptcy judge's proposed findings of fact and conclusions of law.

665 F.3d at 915.

Many commentators have concluded that the Stern decision created a third category of claims to the core/non-core taxonomy: core claims in which the bankruptcy court could not enter a final judgment. The prevailing sentiment, indeed one fostered indirectly by the Stern decision itself, is that the bankruptcy courts may enter proposed findings of fact and conclusions of law in all matters in which they lack authority to enter a final judgment. The Ortiz opinion suggests that this may not be the case, but finds it unnecessary to decide the issue.

The First Circuit Shrugs Off Stern in a Footnote

The Ortiz opinion can be contrasted with a brief discussion contained in a First Circuit opinion. In re Divittorio, 2012 U.S. App. LEXIS 248 (1^st Cir. 1/6/12). In re Divittorio is another chapter in the home mortgage wars being fought in the courts. In that case, the debtor consented to an order conditioning the automatic stay and modifying the underlying loan. After the debtor defaulted, the creditor obtained relief from the automatic stay. The debtor then sought to “rescind” the loan. He filed an adversary proceeding for rescission under the Massachusetts Consumer Credit Cost Disclosure Act and sought to vacate the order lifting the automatic stay. The bankruptcy court declined to vacate the prior order, but stayed the foreclosure for 90 days to determine the rescission claim. The bankruptcy court concluded that the creditor had not violated the MCCCDA and the debtor appealed.

In a footnote, the court noted its belief that its jurisdiction was unimpaired.

We do not believe that the Supreme Court's recent decision in Stern v. Marshall, 131 S. Ct. 2594, 180 L. Ed. 2d 475 (2011), affects the jurisdiction of the bankruptcy court to render a decision in this matter. Stern held:

Article III of the Constitution provides that the judicial power of the United States may be vested only in courts whose judges enjoy the protections set forth in that Article. We conclude today that Congress, in one isolated respect, exceeded that limitation in the Bankruptcy Act of 1984. The Bankruptcy Court below lacked the constitutional authority to enter a final judgment on a state law counterclaim that is not resolved in the process of ruling on a creditor's proof of claim.

(citation omitted). Here, however, it first was necessary to resolve the validity of Mr. DiVittorio's claim under the MCCCDA to determine whether HSBC was entitled to relief from the automatic stay.

2012 U.S. App. LEXIS at *18, n. 4. The Court ultimately decided the appeal in favor of the creditor.

The First Circuit’s discussion is rather unsatisfying because it assumes that determination of the counterclaim was necessary to determine the motion to lift stay. However, how is this distinguishable from the argument that the Wisconsin non-disclosure claims were necessary to determine proofs of claim filed by the health provider? If anything, the automatic stay context is less compelling than determination of a proof of claim, since a motion to lift stay is a summary proceeding. Grella v. Salem Five Cent Savings Bank, 42 F.3d 26 (1^st Cir. 1994).

While the Court’s stated rationale may be unsound, it can probably be vindicated based on consent, since both parties litigated the matter through the bankruptcy court, district court and court of appeals without objection. The Ortiz court rejected consent. However, that case was factually distinguishable because BOTH parties objected to determination by the bankruptcy court. The debtors asked the bankruptcy court to abstain or remand, while the creditor sought to withdraw the reference.

What It Means

The two decisions may or may not signal a split between the circuits. The First Circuit’s decision is so perfunctory that it may be possible for the court to distinguish it away. However, the larger lesson for creditors is that Stern v. Marshall cuts both ways. If a creditor litigates and wins in bankruptcy court, an appellate court may decide that jurisdiction to enter a final judgment was lacking and send the creditor back to relitigate. Thus, the legacy of Stern may be unending litigation.

*--While Federal Rule of Bankruptcy Procedure 9037 imposes privacy restrictions with respect to bankruptcy court filings, including proofs of claim, courts are split over whether it creates a private right of action. Cases allowing a claim for sanctions, include Matthys v. Green Tree Servicing, LLC (In re Matthys), 2010 Bankr. LEXIS S.D. Ind. 2010); French v. American General Financial Services (In re French), 401 B.R. 295 (Bankr. E.D. Tenn. 2009), while cases rejecting such a right include Carter v. Flagler Hospital, Inc., 411 B.R. 730 (Bankr. S.D. Fl. 2009); Lentz v. Bureau of Medical Economics (In re Lentz), 405 B.R. 893 (Bankr. N.D. Ohio 2009); Cordier v. Plains Commerce Bank (In re Cordier), 2009 Bankr. LEXIS 2009).

**--Judge Kelley’s current claim to fame is that she is the judge presiding over the case of the Archdiocese of Milwaukee. As a woman and a practicing Catholic, she is in the unusual position of exercising at least some temporal authority over the male hierarchy of her own church.

Fifth Circuit Rules That Stern v. Marshall Does Not Invalidate Action By Magistrates

In a ruling that could shed some light (but not very much) on the authority of bankruptcy judges, the Fifth Circuit has ruled that a magistrate's ruling in an insurance coverage dispute did not run afoul of the Supreme Court ruling in Stern v. Marshall, ___ U.S. ___, 131 S.Ct. 2594 (2011). Technical Automation Services Corp. v. Liberty Surplus Insurance Corporation, No. 10-20640 (5th Cir. 3/5/12), which you can find here.

The Issue

Technical Automation Services Corp. involved whether an insurance company had a duty to defend an insured in an underlying lawsuit. The parties consented to trial before a U.S. Magistrate. The magistrate granted summary judgment in favor of the insured. On appeal, the Fifth Circuit requested briefing on the application of Stern v. Marshall to a magistrate. See "Fifth Circuit to Consider Impact of Stern v. Marshall on U.S. Magistrates" here.

In response to the question "whether Article III of the Constitution permits a federal magistrate judge, with the consent of the parties, to enter final judgment on a party's state law counterclaim," (opinion, p. 7), the Court answered "yes."

The Decision

By way of prelude, the Court noted that a prior panel of the Fifth Circuit had ruled in favor of the ability of a magistrate to proceed with consent. Puryear v. Ede's Ltd., 731 F.2d 1153, 1154 (5th Cir. 1984). Thus, the court was bound to follow the prior precedent "absent an intervening change in the law, such as by a statutory amendment, or the Supreme Court or by our en banc court." Opinion, p. 9. This framed the question of whether Stern v. Marshall overruled prior decisions about the power of magistrates.

While noting the many similarities between bankruptcy judges and magistrates, the Court chose to base its ruling on the Supreme Court's insistence that Stern was a narrow decision.

Accordingly, the Court reaffirmed that Congress may not withdraw “from judicial cognizance any matter which, from its nature, is the subject of a suit at the common law, or in equity, or admiralty.” (citation omitted). The Supreme Court emphasized that even the slightest “chipping” away of Article III can lead to “illegitimate and unconstitutional practices,” and accordingly held that the jurisdiction of the bankruptcy courts did not extend to most counterclaims based on common law. (citation omitted).

This holding can be translated to the many similarities of the statutory powers of federal magistrate judges. Whereas Article III judges “hold their offices during good behavior, without diminution of salary,” bankruptcy judges and federal magistrate judges are Article I judges who lack tenure and salary protection. (citation omitted). Moreover, the text of 18 U.S.C. § 157(b) (the statute addressed in Stern) and the text of the Magistrates Act, 28 U.S.C. § 636(c), allow Article I judges to enter final judgments, allow for judges’ final judgment to be binding without further action from an Article III judge, entitle the decisions to deference on appeal, and permit the courts to exercise “substantive jurisdiction reaching any area of the corpus juris.” (citation omitted).

Although the similarities between bankruptcy judges and magistrate judges suggest that the Court’s analysis in Stern could be extended to this case, the plain fact is that our precedent in Puryear is there, and the authority upon which it was based has not been overruled. Moreover, we are unwilling to say that Stern does that job sub silentio, especially when the Supreme Court repeatedly emphasized that Stern had very limited application. Id. at 2620. (emphasizing the limited scope of the decision, saying that the issue addressed was a “narrow one” that related only to “certain counterclaims in bankruptcy”) (internal quotation omitted) see also id. (“Article III of the Constitution provides that the judicial power of the United States may be vested only in courts whose judges enjoy the protection set forth in that Article. We conclude today that Congress, in one isolated respect, exceeded that limitation in the Bankruptcy Act of 1984.”) (emphasis added). Article III jurisprudence is complex, requiring the court to do an examination of every delegation of judicial authority. (citation omitted). Notwithstanding that this constitutional question may be seen in a different light post Stern, we will follow our precedent and continue to hold, until such time as the Supreme Court or our court en banc overrules our precedent, that federal magistrate judges have the constitutional authority to enter final judgments on state-law counterclaims. (emphasis added).

Opinion, pp. 11-12.

What It Means

On the most basic level, Technical Automation Services says very little about the authority of bankruptcy judges. It simply holds that Stern does not upset prior Fifth Circuit precedent governing the authority of magistrate judges. However, it provides advocates of bankruptcy court authority with two valuable arguments:

1. The Fifth Circuit is willing to take Chief Justice Roberts at his word when he says that Stern is a narrow decision. While many were concerned that Stern could be another Marathon Pipeline and could signal a return to the old summary/plenary distinction under the Bankruptcy Act, the Fifth Circuit is willing to take it slow. If the other circuits slow play the decision and the Supreme Court strategically declines to grant cert, it could be decades before the issue reaches the Supreme Court again.

2. Since a central feature of magistrate jurisdiction is consent, Technical Automation provides a powerful rebuttal to parties who want to consent to bankruptcy court decision making and then cry "Stern" when they don't like the result.

If nothing else, Technical Automation is significant because it didn't change anything significant.

Post-Script: Although I edited it from the quote above for purposes of brevity, the opinion contains a wonderful quote from Chief Justice Rehnquist's concurrence in Northern Pipeline where he referred to Article III cases as "but landmarks on a judicial 'darkling plain' where ignorant armies have clashed by night." Northern Pipeline Construction Company v. Marathon Pipe Line Company, 458 U.S. 50, 91 (1982)(Rehnquist, J. concurring). I know that I will be looking for ways to include this language in future Stern briefs.

Texas State Court Gets Judicial Estoppel Right

The Dallas Court of Appeals has published a new decision correctly applying the doctrines of judicial estoppel and standing relating to a cause of action omitted from a bankruptcy filing. Norris v. Brookshire Grocery Company, ___. S.W.3d ___ (Tex. App.--Dallas, 2/29/12, no pet.). You can find the opinion here.

In Norris, the plaintiff filed suit against Brookshire Grocery prior to filing bankruptcy. Upon filing bankruptcy, the plaintiff/debtor neglected to mention the suit in either the Schedules or the Statement of Financial Affairs. However, just thirteen days after filing bankruptcy, the debtors filed a motion to dismiss their bankruptcy case on the ground that they "desire to work a payout with creditors." No party objected and the case was dismissed.

After the bankruptcy case was dismissed, Brookshire moved for summary judgment based on judicial estoppel and lack of standing. The trial court granted the motion.

On appeal the Dallas Court of Appeals reversed finding:

1. In order for judicial estoppel to apply, the Bankruptcy Court must have "actually accepted" the debtors' non-disclosure of the asset. Where the debtors dismissed their case without receiving a discharge, there was not an opportunity for the bankruptcy court to "actually accept" their position.

2. Normally, an undisclosed asset remains property of the bankruptcy estate and is not abandoned when the trustee closes the case. This is not the case when the case is dismissed, since the estate ceases to exist. As a result, the debtors had standing to pursue their cause of action.

The opinion by the Dallas Court of Appeals should be commended for correctly applying difficult principles of bankruptcy law. The purpose of judicial estoppel is to prevent debtors from gaming the system and reaping a benefit from taking inconsistent positions. Reading between the lines, it seems likely that when debtors' counsel learned of the cause of action, he gave them a choice: proceed with the bankruptcy and lose the cause of action or dismiss the bankruptcy and keep the cause of action. Because the debtors effectively undid the omission by dismissing their bankruptcy, judicial estoppel did not apply.

Hat tip to St. Clair Newbern.

Inherited IRA Protected Under Section 522(d)(12)

Joining the majority position, U.S. District Judge Walter Smith has ruled that inherited IRA accounts may be exempted as "retirement funds" under 11 U.S.C. Sec. 522(d)(12). Hill v. Studensky, No. W-11-CA-00214 (W.D. Tex. 2/22/12), which can be found here. (PACER registration required).

The issue on appeal was whether an inherited IRA continued to constitute "retirement funds" once the person for whose retirement they had been saved was no longer alive. The Court found that there were two elements to be satisfied: (1) whether the account contained "retirement funds"; and (2) whether the funds were exempt from taxation.

When an IRA is inherited, the beneficiary may receive the funds immediately, in which case they are recognized as ordinary income. Alternatively, they may be transferred to a new trustee. The account will still be in the name of the decedent and the beneficiary must begin receiving distributions within one year or withdraw the entire amount within five years.

Turning to the issue of whether the inherited IRA constituted "retirement funds," the Court noted that both parties' interpretations were reasonable. However, section (d)(12)'s relation to the other subsections of section 522(d) proved important. The other subsections of section 522(d) referred to the debtor's interest in property, but section 522(d)(12) did not.

The issue of inherited IRAs is presently pending before the Fifth Circuit Court of Appeals. The Eastern District of Texas reached the same result as Judge Smith in Chilton v. Moser, No. 4:10-CV-180 (E.D. Tex. 3/16/11). The case is pending before the Fifth Circuit as Case No. 11-40377, Chilton v. Moser. The case was argued before the panel on February 8, 2012.

Stating a Cause of Action on an Avoidance Action After Iqbal

Pleading a claim to recover a preferential transfer is one of the most basic bankruptcy causes of action. Merely by establishing the date, amount and recipient of the transfer, the plaintiff can establish that a transfer was made, within 90 days before bankruptcy while the debtor was presumed to be insolvent. Most preference complaints include this basic information and then the conclusions that the payment was made on account of an antecedent debt and that the transferee received more than it would have received in a hypothetical chapter 7. Anyone who has practiced bankruptcy law for any period of time has seen (or drafted) the form complaint with an exhibit A describing the transfer. Preference complaints are sometimes paired with fraudulent conveyance claims making skeletal allegations.

After Ashcroft v. Iqbal, 129 S.Ct. 1937 (2009) and Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007), the Supreme Court signaled that a higher standard would be required for pleading, one of plausibility. Instead of pleading the bare elements of a cause of action, the pleading must contain sufficient facts to make the claim plausible.

How does that apply to common avoidance actions? Judge Craig Gargotta addressed that question in Crescent Resources Litigation Trust v. Nexen Pruet, LLC, Adv. No. 11-1082 (Bankr. W.D. Tex. 1/23/12), which can be found here.

In Nexen Pruet, the Litigation Trust filed a complaint which alleged two causes of action: a preference claim and a fraudulent transfer claim. The complaint included the following:

*A description of the debtors’ cash management system;

*A statement that the debtors’ schedules, statement of financial affairs, disclosure statement and a declaration of the debtors’ CFO (none of which were attached) indicated that the debtors were insolvent at all relevant times;

*An exhibit describing the transfers by date, amount, invoice number and date the check cleared; and

*A statement of each cause of action.

The defendant filed a motion to dismiss for failure to state a cause of action, alleging that the claims were based on “naked assertions devoid of further factual enhancement.” The Court found that both claims should be dismissed without prejudice.

The Court relied extensively upon In re Careamerica, Inc., 409 B.R. 737 (Bankr. E.D. N.C. 2009).

In the case of the preference claim, the Court found that the plaintiff had failed to allege sufficient facts to show that the transfer was made on account of an antecedent debt:

Notwithstanding the Court’s finding that the Trust has sufficiently pleaded the majority of the elements of a preferential transfer action, the Court finds that the Trust has not sufficiently pleaded the existence of an antecedent debt. By contrast to the cases cited above, including those which espouse even the most lenient of pleading standards, the Trust’s Complaint contains no description whatsoever of the Defendant, Nexen Pruet, much less a description of the nature of the relationship between Nexsen Pruet and the Debtors. The Complaint merely contains the conclusory allegation that “[t]he Transfers were made . . . for or on account of an antecedent debt owed by the particular Debtor to the Defendant before such Transfers were made,” with no factual allegations to support this contention (id. at 6). Without more, the Court is unable to infer the existence of an antecedent debt based on the conclusory allegations presented under Count I of the Complaint.

Opinion, p. 12.

With respect to the fraudulent conveyance claim, the Court found that the pleadings with regard to both insolvency and lack of reasonably equivalent had not been adequately pled, concluding:

In this case, like in Caremerica, the Trust’s allegations with respect to the fraudulent transfer claim contained in Count Two of the Complaint do no more than mirror the elements of § 548(a)(1)(B) (see docket no. 1, at 7). The Trust argues that the Complaint, read in its entirety, contains a “detailed pleading of insolvency” and a “clear pleading of reasonably equivalent value.” (Docket no 1 at 9.) Like in Caremerica, however, “other than dates, amounts, and names of transferees included in Exhibit B,” along with general conclusory allegations of insolvency and reasonably equivalent value, the Trust fails to support its allegations with factual assertions. (citation omitted).

First, with regard to insolvency, the Trust alleges that the Debtors’ Schedules, Statements of Financial Affairs, and Disclosure Statement, along with the declaration of the Debtors’ chief financial officer, reflect that the Debtors were “deeply insolvent at all times relevant to the complaint.” (Docket no. 1 at 5.) The Trust did not attach any of these documents to its Complaint nor did it refer the Court to any specific facts provided in these documents that would allow the Court to draw a reasonable inference of insolvency. The Trust further alleges that the Debtors were insolvent “under a number of tests” and then proceeds to describe each test, without providing the applicable facts to support a finding of insolvency under any of them (id.). Second, with regard to reasonably equivalent value, the Complaint contains only one sentence, which states, “The Debtor or Debtors identified on Exhibit B received less than the reasonably equivalent value in exchange for the Transfer(s).” (Docket no. 1, at 7.) In light of Iqbal and Twombly, this Court will not accept such “threadbare recitals of a cause of action’s elements, supported by mere conclusory statements.” (citation omitted).

Opinion, pp. 14-15.

The Nexen Pruet opinion has much different implications for the two causes of actions involved. With regard to preference claims, the opinion imposes only a minor burden. In performing its due diligence before filing suit, the plaintiff should have investigated the relationship between the debtor and the creditor and, in particular, should have reviewed the invoices submitted by the creditor. Thus, pleading facts with regard to an antecedent debt should not impose a significant burden. By the same token, it does not provide that much more information to the defendant, who presumably would know this information as well.

The fraudulent conveyance claim is another matter. A preference is a preference primarily because of timing. On the other hand, a fraudulent conveyance could be based on any number of scenarios from a payment made on the debt of another to a payment made to an insider based on made-up invoices. In this regard, the heightened pleading requirements provide useful information to the defendant, as well as requiring the plaintiff to have a theory which would survive scrutiny under Rule 9011. In many cases, a preference claim and a fraudulent conveyance claim will be mutually exclusive. Generally, an antecedent debt implies value. Thus, only an antecedent debt in a transaction for less than reasonably equivalent value could be actionable under both statutes. By requiring a higher standard for pleading fraudulent conveyance claims, the Court protects defendants from having to respond to potentially spurious claims.

When An Argument Doesn't Turn Out As Well As Expected

Sometimes a legal argument which seems clever in the abstract can look downright silly when placed in context. That was the case with several arguments rejected by the court in Smith v. Citimortgage, Inc., et al, Adv. No. 11-5136 (Bankr. W.D. Tex. 2/21/12), which can be found here.

Argument #1:

39. None of the Plaintiffs’ first three (3) claims, which assert that the Defendants are in “breach” or “violation” of the Court’s orders entered in the Plaintiffs’ bankruptcy, come close to meeting the facial plausibility standard. The Plaintiffs have already settled and released these claims through the Court-approved Settlement. Specifically, through the Settlement, they have “release[d]” “Citimortgage . . . and [its] agents and employees . . . from all claims of any kind . . . that [the Plaintiffs’] may have with respect to the . . . [Plaintiffs’] Bankruptcy . . . or any other matters[.]”

40. The Plaintiffs’ allegations that the Defendants are in violation of the Court’s orders are claims with respect to the Plaintiffs’ bankruptcy. Even if the Plaintiffs’ factual allegations are taken as true for the moment, through the Court-approved Settlement, the Plaintiffs’ (sic) traded their rights to enforce the related orders for a contract right to enforce the Settlement pursuant to Texas-state law. They have no right to rescission of the Settlement and cannot now assert claims against any of the Defendants that they affirmatively gave up through the Settlement.

Renewed Motion to Dismiss, pp. 14-15, Dkt #17.

At first blush, the argument that the Debtors released certain claims and are now attempting to pursue them appears to be quite plausible. However, the Bankruptcy Court’s opinion adds the relevant context.

The court declines to read this provision as precluding claims for breach of the settlement agreement itself and violation of the court order approving it. The court also declines to read this provision as precluding claims for violation of the discharge injunction that arise after execution of the settlement agreement. The provision above is best understood as applying to claims that the Smiths had at the time of execution of the settlement agreement.

Opinion, p. 9.

While the argument appeared plausible on its face, it quickly turned outrageous when it became manifestly clear that the plaintiffs were suing for violation of the settlement agreement and the order approving the settlement agreement, each of which necessarily occurred after execution of the underlying agreement. While the power to compromise claims is broad, an agreement which negates its own enforcement is no agreement at all. To put it another way, a release, no matter how broad, cannot release the right to enforce the agreement in which it is contained. Also, I am not aware of any legal principal which would allow a party to release wrongs yet to occur. What is really insidious about the argument in this case is that it appears that Citimortgage was arguing that because the discharge occurred in the bankruptcy case, that the Debtors released their right to ever enforce the discharge against Citimortgage. That is an audacious claim.

Argument #2:

28. The Fifth Circuit has long recognized that in order for a bankruptcy court to have jurisdiction over a matter, “the outcome of that proceeding [must] conceivably have an[] effect on the estate being administered in bankruptcy. (citation omitted). Once administration of a case concludes and a Court closes the case, no bankruptcy case is “being administered”—the bankruptcy court’s jurisdiction over all matters therefore ends at closure of the case. (citations omitted).

29. The Court’s closure of the Plaintiffs’ bankruptcy on September 1, 2011 ended its jurisdiction over any and all related matters. Even if the Adversary were “related to” the Plaintiffs’ bankruptcy for the purposes of 28 U.S.C. Section 157 when filed (which the Defendants deny), the Court’s jurisdiction over the Adversary would have terminated on September 1.

Renewed Motion to Dismiss, p. 11.

Close, but no cigar as noted by the Bankruptcy Court:

None of the cases relied on by Citimortgage involve a debtor’s post-discharge attempt to hold a defendant in contempt for violating court orders. For this reason, Citimortgage’s argument can be easily dispensed with. Bankruptcy courts always retain jurisdiction to interpret and enforce their own orders. (lengthy list of citations omitted). (emphasis added).

Opinion, p. 7.

Never tell a judge that he lacks authority to enforce his own order. By arguing that the court lacked authority to enforce its own orders, Citimortgage struck at the court’s authority. Orders issued by a court which cannot enforce them are not worth the paper they are written on (or in the case of electronically stored data, the PDFs into which they are converted).

What of Citimortgage’s other arguments? They were on the money. Ten out of eleven statutes relied upon by the Plaintiffs for jurisdiction were either not jurisdictional at all or were inapplicable. The court found that it lacked jurisdiction over the Plaintiffs’ Fair Debt Collection Practices Act claim and its state law claims. The court dismissed the claims brought against two employees of Citimortgage. It could be said that the Plaintiffs’ claims contained several grains of wheat among an excess of chaff.

Had the defendants excluded just two arguments from their motion, they would have done a valuable service in helping the court separate the wheat from the chaff. However, by overreaching with grimace-inducing* arguments, they attacked the very integrity of the court from which they sought relief. Better to accept a strong half-victory than to generate an opinion which is equal parts rebuke to both sides.

*--Readers, can you come up with a better term? Originally, I was going to use OMG-inducing, but when I looked it up in the Urban Dictionary, it was defined as a term overused by teenage girls in chat rooms who are incapable of spelling out entire words. I tried forehead-slap, as in Homer Simpson saying "Doh!" but that didn't quite work either. I went with grimace-inducing, even though it is a bit staid, because I could not come up with something more powerful.

Contumacious Case of Coercion or Merely Rude? Fifth Circuit Judges Debate the Meaning of Section 523(a)(6)

The case of a former corporate officer who demanded to be bought out for an alleged ownership interest and said some really nasty things resulted in a split decision with Fifth Circuit Judges Edith Jones and Catharina Haynes on opposite sides. Matter of Schcolnik, No. 10-20800 (5th Cir. 2/8/12), which can be found here.

What Happened

This statement of facts is synthesized from the two opinions in the case. Each judge referenced facts that the other did not. I am taking both opinions at face value.

Scott Schcolnik was Vice-President of Capstone Associated Services, Limited and President of Rapid Settlements, Ltd. Though the owners of the Companies occasionally referred to him as a partner, he allegedly rejected an offer to become an owner of Rapid. Nevertheless, he claimed to be a partial owner and was fired. At this point, things got colorful. Schcolnik allegedly absconded with corporate documents. He threatened to disclose alleged criminal and regulatory violations by the two Companies if they did not “buy out” his “ownership interests.” He threatened a “doomsday plan” if Stuart Feldman, the primary owner of the Companies did not “properly compensate” him for his ownership interests “which appear to be worth in excess of $1,000,000.” He threatened a “massive series of legal attacks . . . which will likely leave you disbarred, broke, professionally disgraced, and rotting in a prison cell.” He also expressed his hope that Feldman would be raped in prison.

The nasty grams* were sent on May 25 and 27, 2005. The Companies swiftly moved for a TRO, which they obtained on May 27, 2005. The TRO, which was later extended by agreement, prohibited Schcolnik from carrying out his campaign of mass destruction.

*--Nasty gram is a term of art in the Austin Division of the Western District of Texas referring to a particularly vituperative communication. While I am not completely certain, I believe I first heard the expression from Joe Martinec.

Six months later, the Companies instituted an arbitration proceeding against Schcolnik, seeking a declaration that he was not an owner. The Companies prevailed on the ownership issue, although the arbitrator noted that the Companies had held Schcolnik out as a partner, which was characterized as “excusable mistakes.”

The Companies requested attorney’s fees of $70,000 and received an award of $50,000. The fees were awarded as “equitable and just,” which is apparently a low standard.

Schcolnik filed for chapter 7 bankruptcy four days after the state court confirmed the arbitration award. The Companies filed a non-dischargeability complaint under 11 U.S.C. sections 523(a)(4)( and (a)(6). Both parties moved for summary judgment. Bankruptcy Judge Karen Brown granted summary judgment to Schcolnik on both claims. She conducted a trial on the creditors’ objection to discharge and ruled in favor of Schcolnik as well. The Companies appealed the dischargeability findings to the District Court which affirmed.

The Majority Opinion—Contumacious and Coercive

The majority opinion, written by Chief Judge Jones and joined in by District Judge Crone, affirmed the lower court holdings that the claim under section 523(a)(4) was properly denied. Although the Debtor was an officer of the Companies and owed them a fiduciary duty, the debt for attorney’s fees did not arise out of a fraud or defalcation in a fiduciary capacity. Judge Haynes concurred in this ruling.

However, the majority opinion found that summary judgment on the willful and malicious claim under section 523(a)(6) was premature. The District Court had found that the Debtor’s behavior was not “willful” as a matter of law because he did not intend to impose litigation expenses on the Companies, a contention they did not dispute.

However, Judge Jones pointed out that under Fifth Circuit precedent, an act can be considered “willful” if there was subjective bad intent or “an objective substantial certainty of harm.” The Court noted that “it would seem peculiar to deem an action causing injury not ‘willful’ when the tortfeasor’s action was in fact motivated by a desire to cause injury.” Judge Jones also noted In re Keaty, 397 F.3d 264 (5th Cir. 2005), where sanctions for baseless litigation were found to be a willful and malicious injury.

Having laid out this background, Judge Jones reached the penultimate point of her opinion:

Shcolnik allegedly engaged in a course of contumacious conduct that required the Appellants to file meritorious litigation against him, resulting in the instant fee award; whereas in Keaty, the debtors pursued the burdensome suit that provoked a sanctions award against them. This is a distinction without a difference, however. It would make no sense for the infliction of expense in litigating a meritless legal claim to constitute willful and malicious injury to the creditor, as in Keaty, while denying the same treatment here to the infliction of expense by a debtor’s attempt to leverage an equally baseless claim through a campaign of coercion. That Texas law may allow the arbitrator to assess attorneys’ fees in favor of a party without specifically finding a willful and malicious injury is not conclusive. If the facts are as Appellants allege, Shcolnik either had the motive to inflict harm or acted so as to create “an objective substantial certainty of harm” to the Appellants. Id.

Viewed in light of our precedents, there is a genuine, material fact issue for trial. Shcolnik’s behavior resulted in willful and malicious injury if his claims of ownership were made in bad faith as a pretense to extract money from the Appellants. See Keaty, 397 F.3d at 273 (willful and malicious injury to intentionally “pursu[e] meritless litigation for the purpose of harassment[.]”). The litigation costs he forced upon them are different from the million dollar claim he made against them, but they were neither attenuated nor unforeseeable from his alleged intentionally injurious conduct. (emphasis added).

Opinion, pp. 6-7.

The Dissent—Insulting and Demeaning Is Not Enough

Judge Haynes concurred in the ruling on section 523(a)(4), but dissented with regard to willful and malicious injury. She cited three grounds for dissent:

The effect of the majority opinion is to transform all litigation precipitated by aggressive demand letters into potential “malicious” acts for purposes of nondischargeability. Additionally, the effect of the majority opinion is to allow an end-run around an arbitration proceeding in which both parties willingly participated. Finally, the majority opinion glosses over the lack of connection between the allegedly malicious acts and the arbitration award of attorneys’ fees now sought to be rendered non-dischargeable. Because the bankruptcy and district courts reached the correct result under our existing precedents, I would affirm.

Haynes Dissenting, p. 9.

Judge Haynes elaborated on her first point as follows:

Debtors often come to bankruptcy with judgments against them. It is certainly not an unusual occurrence for parties to make claims in litigation or arbitration that do not carry the day. Nonetheless, the majority opinion transforms the ordinary litigation loser into one who has caused “willful and malicious injury” to another. It does so, apparently, because of the colorful language used by Shcolnik, without the assistance of legal counsel, in his emailed demand letters that preceded litigation which in turn was followed by the arbitration proceeding in question. So, I start there.

No doubt the e-mail letters Shcolnik wrote are insulting and demeaning. I would not write such a document nor countenance another to do so. However, we are not here to teach a course in professionalism or civility. The majority opinion transforms incivility into “a campaign of coercion” or “contumacious conduct” by ipse dixit. The question arises – were these “nasty demand letters,” in fact, “coercive” or “contumacious?” We do not have a case setting out a test for where the quintessential demand letter ends and the parade of horrible suggested by the majority opinion begins. Wherever that line is, it is not crossed here, and I disagree with transforming the regrettable unpleasantness and aggressiveness that often attend the prelude to litigation into “coercive” or “contumacious” conduct so easily. Shcolnick’s e-mail letters, however reprehensible they undeniably are, do not. (emphasis added).

Haynes Dissenting, p. 10.

Between judges, “ipse dixit” is a strong term. Known as the “Bare Assertion Fallacy,” it literally translates as “he himself said it.” It is used to refer to an argument that is made without any support. The terms that were said to be ipse dixit were “coercive” and “contumacious.” “Contumacious” is defined as stubbornly defiant or rebellious, while “coercive” means serving or intending to coerce. While contumacious is closely associated with contempt of court, Shcolnik’s words were no doubt stubbornly defiant, but the question is “So what?” There does not seem to be a logical connection between stubbornly defiant and willful and malicious. Coercive is a more difficult question and I will return to that later.

Next, Judge Haynes turned to the results of the arbitration proceeding. Noting the strong federal policy of deferring to arbitration, she pointed out that the arbitrator had only awarded fees as “equitable and just” rather than for wrongdoing, malice or bad faith. She also noted that the arbitrator implicitly found that Shcolnik’s position had some merit when he found that the references to Shcolnik as a partner were “excusable mistakes.”

As to the first ground, Judge Haynes is probably wrong. Where a court makes a finding on a lesser standard but does not expressly negate the higher standard, the parties are free to establish whether the higher standard could have been met. Archer v. Warner, 538 U.S. 314 (2003) is not completely on point, but it allowed a plaintiff who had received a promissory note in settlement of a fraud claim to go behind the note and prove fraud in the original transaction. However, Judge Haynes is closer on the second point. If the arbitrator found that the Debtor did not assert a baseless claim, then the Companies would be precluded from relitigating that point in bankruptcy court. Here, the finding is implicit so that it is a close call.

Finally, Judge Haynes found that the connection between the nasty emails and the arbitration proceeding was to remote to connect them. She wrote:

Indeed, even if the e-mail letters were “coercive” or “contumacious” and even if we ignore the lack of arbitration findings to support the majority opinion, the undisputed facts show that any burden imposed on Appellants by the e-mail letters was quickly removed – the purportedly wrongful documents were sent on May 25 and 27, 2005. On May 27, 2005, the state district court granted a temporary restraining order that was later extended and continued by agreement throughout the litigation and arbitration, barring Shcolnik from taking the actions Appellants claimed put them in immediate fear. It was not until six months later that the matter was referred to the arbitration at issue here, breaking any purported causal connection between the claimed wrongful behavior and the fee award here at issue.

Moreover, the lack of causal connection is precisely why the arbitrator made no specific finding of wrongfulness. Indeed, the allegedly wrongful acts caused the arbitration of the ownership/partnership dispute, in which case, the arbitrator’s lack of a specific finding to that effect (and findings inconsistent with that) is meaningful, or they did not, in which case, the alleged “campaign of coercion” or “contumacious conduct” did not cause the attorneys’ fees award.

The majority opinion concludes that “Shcolnik’s behavior resulted in willful and malicious injury if his claims of ownership were made in bad faith as a pretense to extract money from the Appellants.” Maj. Op. at 7. The opinion rests on a misconstruction of Keaty. Moreover, it is undeniable that the majority opinion’s conclusion is not supported by the record, the arbitrator’s decision, or, indeed, the events that actually transpired below. As we gave effect to the sanctions in Keaty, we should give effect to the arbitrator’s ruling here. The attorneys’ fees awarded as equitable and just in the arbitration were for resolution of the ownership/partnership dispute, not for anything else.

Haynes Dissenting, pp. 13-14.

What It Means

This case is significant for several reasons. The fact that two bright, articulate and conservative judges reached diametrically opposite results shows both the independence of the judges involved and the difficulty of the question.

The opinions by Judge Jones and Judge Haynes recall the story of the blind men and the elephant. They are both describing the same thing, but they are describing different parts of it. Judge Jones focused on the apparent intent of the original emails. It is not unreasonable to construe the emails as a blatant attempt at extortion. It would be illegal to demand money in exchange for not releasing damaging information, so the debtor demanded a buyout instead. However, the fact that he demanded a buyout under the threat of destroying his former employer says volumes about his intent.

On the other hand, Judge Haynes focused more on the disconnect between the “nasty” emails and the arbitration proceeding. Yes, the emails were reprehensible. However, the campaign was brought to a half within two days and the arbitration was not even commenced for another six months. The Companies would have had a good claim for a willful and malicious injury if the Debtor had actually used the purloined documents to wreak havoc. The Companies probably would have had a good claim for their costs in obtaining the TRO. However, the Companies sought to recover their attorney’s fees for what Judge Haynes characterized as “resolution of the ownership/partnership dispute, not for anything else.” While the ownership dispute may have been commenced for sinister reasons, unlike the sanctionable conduct in Keaty, it was not baseless.

I think Judge Haynes has the better argument. While the opening salvos of the campaign clearly could have resulted in willful and malicious injury, they did not. It is like someone who threatens to shoot but after considering the consequences puts the gun down. The conduct could be characterized as a terroristic threat, but it is not murder. Both judges are right to focus on Keaty. However, the important question is whether the legal position taken was baseless. If the position taken, although asserted for ulterior motives, was not baseless, then it should not give rise to a nondischargeable debt.

It will be interesting to see whether the en banc court steps in to resolve the dispute.