In one of the first decisions construing the Debt Relief Agency provisions of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, the U.S. District Court for the Northern District of Texas has held that one specific provision of the statute is unconstitutional but denied relief on several other claims. No. 3:05-CV-2330-N, Susan B. Hersch vs. United States of America, et al (N.D. Tex. 7/26/06).
Attorney Susan B. Hersch of Dallas filed suit seeking a determination that attorneys did not fall within the definition of Debt Relief Agencies and that several provisions of BAPCPA were facially unconstitutional. On July 26, 2006, District Judge David C. Godbey released a 15 page Memorandum Opinion and Order. The Court’s ruling was a mixed bag for debtor’s attorneys. On the one hand, the Court found that Sec. 526(a)(4), which prohibits attorneys from advising clients to incur debt in contemplation of bankruptcy, was unconstitutional. However, the court rejected a challenge to the compelled disclosures required by Sec. 527 and held that attorneys were clearly within the scope of Debt Relief Agencies.
Attorneys Are Debt Relief Agencies
The Court found that the plain meaning of Sec. 101(4A) and 101(12A) provided that attorneys were included within the meaning of debt relief agencies. Debt relief agencies were defined as persons providing “bankruptcy assistance” in return for money, while bankruptcy assistance was defined as including “providing legal representation with respect to a case or proceeding under this title.” The court stated:
“A reading of the text for plain meaning indicates that the term ‘debt relief agency’ includes bankruptcy attorneys such as Hersch. Plain meaning is the preferred method for interpreting statutory language (citation omitted). Here, as only attorneys are authorized to provide legal advice and ‘providing legal advice’ is part of the definition of bankruptcy assistance, it seems clear that bankruptcy attorneys such as Hersch fit within the definition of ‘persons providing bankruptcy assistance.’ Attorneys also provide most of the other functions defined as ‘bankruptcy assistance.’”
It is hard to argue with the judge’s plain meaning analysis. While some courts have tortured the language into a conclusion that attorneys are not covered, In re Attorneys at Law and Debt Relief Agencies, 332 B.R. 66 (Bankr. S.D. Ga. 2005), this argument is probably a dead letter.
Section 526(a)(4) Impermissibly Limits Free Speech
Section 526(a)(4) was found unconstitutional under the First Amendment. However, this part of the opinion was a little procedurally confused. The plaintiff apparently did not plead that Sec. 526(a)(4) was unconstitutional. However, both parties briefed this issue extensively. As a result, the court ruled on the substantive issue subject to the plaintiff amending her pleadings to raise the issue which had already been decided.
Section 526(a)(4) states that a debt relief agency shall not “advise an assisted person . . . to incur more debt in contemplation of such person filing a case under this title or to pay an attorney or bankruptcy petition preparer fee or charge for services performed as part of preparing for or representing a debtor in a case under this title.” The plaintiff argued that the statute should be subject to strict scrutiny, which is the standard generally applied to content based restrictions on speech. The government, on the other hand, argued that Sec. 526(a)(4) was an ethical restriction and should be reviewed under the more lenient standard contained in Gentile v. State Bar of Nevada, 501 U.S. 1030 (1991). The District Court noted that there was nothing in Sec. 526(a)(4) which would indicate that it was an ethical prohibition. However, it noted that even under the more lenient standard, that the statute was not constitutional.
Under the Gentile standard, the statute must (1) serve “the State’s legitimate interest in regulating the activity in question” and (2) “impose only narrow and necessary limitations on lawyer’s speech.” The Court noted that both the strict and lenient standards require that the restriction be narrowly tailored. Here, the court found that Sec. 526(a)(4) was not “narrow and necessary.” In this respect, the government was hoist on its own petard. The government argued that taking on additional debt “may” harm a debtor in some cases. As a result, the Court concluded that in other cases, it may not. The Court stated: “Section 526(a)(4), therefore, is overinclusive in at least two respects: (1) it prevents lawyers from advising clients to take lawful actions; and (2) it extends beyond abuse to prevent advice to take prudent actions.”
Section 527 Is Constitutional
Section 527 requires attorneys to give mandatory discloses to clients. The Plaintiff argued that this section unconstitutionally compelled speech. The court dismissed this argument finding that it was permissible to require the disclosure of accurate information. In this case, the court noted that even though the disclosures could be misleading in certain specific circumstances, the attorney was allowed to tailor the disclosure so long as it contained the required substance.
Final Thoughts
This appears to be a cogent and well-reasoned opinion. The court rejected weak arguments from both parties and cut to the heart of the issues. Judge Godbey was appointed by the current President Bush so that he cannot easily be dismissed as a liberal activist. This opinion is merely persuasive authority rather than binding precedent. However, until the circuit courts weigh in, Hersch is likely to be very persuasive.
Monday, July 31, 2006
Tuesday, July 18, 2006
Opinions Regarding Failure to Obtain Credit Counseling Underscore Dissatisfaction With Law
Mandatory pre-bankruptcy credit counseling was one of the reforms enacted by BAPCPA. Its drafters intended for credit counseling to be a prophylactic step which would prevent avoidable bankruptcies. In practice, it has become a formality for some and a stumbling block for others. Several recent opinions from the Western District of Texas highlight differing approaches to this issue.
Approach One: This Is Stupid, I’m Going to Say It’s Stupid, But I Am Going to Enforce This Stupid Law
On December 22, 2005, Judge Frank Monroe from the Austin Division of the Western District of Texas released his opinion in In re Sosa, 336 B.R. 115 (Bankr. W.D. Tex. 2005). Judge Monroe did not mince words about the wisdom of the credit counseling requirement.
"One of the more absurd provisions of the new Act makes an individual ineligible for relief unless such individual, 'has during the 180-day period preceding the date of filing of the petition by such individual, received from an approved nonprofit budget and credit counseling agency described in §111(a) an individual or group briefing (including a briefing conducted by telephone or on the Internet) that outlined the opportunities for available credit counseling and assisted such individual in performing a related budget analysis.' See 11 U.S.C. § 109(h)(1). No doubt this is a truly exhaustive budget analysis."
Judge Monroe goes on to describe the circumstances in which a certificate of exigent circumstances can be filed and approving, concluding:
"Simply stated, if a debtor does not request the required credit counseling services from an approved nonprofit budget and credit counseling service before the petition is filed, that person is ineligible to be a debtor no matter how dire the circumstances the person finds themselves in at that moment.
"This Court views this requirement as inane. However, it is a clear and unambiguous provision obviously designed by Congress to protect consumers."
Approach Two: This Is Foolish But Congress Gave Me Room to Avoid a Foolish Result
Judge Monroe seemed pretty definitive, but things were not so clear in San Antonio. On June 27, 2006, Judge Leif Clark released his Order on Motion for Exigent Circumstances in In re Navarro, No. 06-51007 (available at www.txwb.uscourts.gov/opinions). Judge Clark was faced with a pro se debtor who “was unable to obtain counseling within the five day window because she did not know that she needed to obtain counseling as a prerequisite to filing for bankruptcy.”
Judge Clark, like Judge Monroe, did not view the credit counseling requirement as particularly helpful Judge Clark stated:
"The credit counseling briefing is superficially designed to discourage people from filing for bankruptcy on the theory that, if they but knew of the alternatives, they might pursue those instead. In practice, however, the briefing has little or no effect on the actual decision to file because, by that time, the person’s financial condition has deteriorated too far for any alternative other than bankruptcy to be effective. The 'briefing' called for by section 109(h)(1) does little more than make the debtor aware of credit counseling as an alternative. But credit counselors attempt to negotiate a payment plan with the consent of the debtor’s creditors, for a fee, and their success will depend on whether they can get all creditors to cooperate…The actual negotiation of an alternative thus requires a voluntary “standstill” by the creditors while an arrangement is worked out. In practice, that will not happen. (citation omitted). What is more, the debtor may well be actually discouraged from filing when filing might be the right thing to do—by a credit counselor who is not lawyer effectively giving the debtor legal advice. (citation omitted). The result is that the credit counseling briefing ends up being a useless formality.
"It also operates as a trap for the unwary, potentially causing the dismissal of so-called 'ineligible' debtors from bankruptcy. (citation omitted). While certain private financial interests may be rewarded as a result, (citation omitted), no genuine public interest appears to be served."
Judge Clark then turns his thoughtful mind to the court’s role in policing eligibility. Judge Clark notes that eligibility is not jurisdictional. Thus, an ineligible debtor may proceed in bankruptcy unless someone timely objects. In this case, the court is appointed as gatekeeper. The clerk may not refuse to accept a petition which is not accompanied by a certificate of credit counseling. The clerk may bring any deficiency to the attention of the court, which, under Rule 1007(e) “may” dismiss the case, but is not required to. If the debtor files a certificate of exigent circumstances, the court “may” conduct a hearing, but is not required to. Further, “If the court finds the certificate of exigent circumstances to be satisfactory, then the issue of eligibility under section 109(h) is deemed resolved for all purposes, and the debtor is henceforth eligible for relief as a debtor under title 11, no further questions asked.”
Judge Clark seems to be saying that he has the discretion to ignore a failure to obtain credit counseling as well as the discretion to accept any explanation of exigent circumstances. In a footnote, he states:
"Section 707(a) permits (but does not require) the court to dismiss a case for failure to file the information required by section 521(a)(1), but the certificate of credit counseling briefing is not one of the documents required to be filed by section 521(a)(1). …Thus, while some courts have elected to dismiss cases that do not comply with Interim Rule 1007(b)(3)(including my colleague in this division), they apparently do so as a matter of judicial housekeeping, but not as a matter of statutory or rule construction."
Judge Clark concludes that not knowing about credit counseling was an exigent circumstance in the case before him.
"The court finds that this debtor, a non-lawyer, was justified in not knowing about the credit counseling briefing requirement as a pre-condition to eligibility for bankruptcy. That justifiable lack of knowledge, in turn, satisfies the court as an exigent circumstance."
While Judge Clark’s logic is elegant and his heart is clearly in the right place, the result seems to be a bit off. The exigent circumstances provision is part of a clause which has three parts connected by an “and.” Judge Clark’s ruling appears to state that a person may be a debtor if they submit a certificate describing exigent circumstances which is satisfactory to the court. While this satisfies the first and third requirements, it appears to read out the second one. The middle provision requires that the “debtor requested credit counseling services from an approved non-profit budget and credit counseling agency, but was unable to obtain the services … during the five-day period beginning on the date on which the debtor made that request.” If the debtor did not request credit counseling at all, the debtor would not be able to establish that credit counseling was not available within five days. Therefore, the debtor would not be able to establish exigent circumstances. However, in the Navarro case, that is exactly what happened.
Approach Three: The Law Seems Clear to Me
The final salvo in this round of cases comes from Judge Ronald King from San Antonio, who weighed in with an opinion on July 7, 2006. Like Judge Clark, Judge King was faced with a pro se debtor. In In re Gallardo, No. 06-50724 (available at www.txwb.uscourts.gov/opinions), the debtor sought to reconsider dismissal of his case. The debtor contended that he had looked on the internet for requirements to file bankruptcy but did not discover the credit counseling provision. Judge King was not impressed. He said:
"This Court cannot control publication of the United States Code on internet websites. The fact that the Debtor could not locate section 109(h) of the Bankruptcy Code on a particular website does not make the amendments made by BAPCPA inapplicable to this Debtor. Section 109(h) of the United States Bankruptcy Code, as amended by BAPCPA effective October 17, 2005, requires that credit counseling must be taken prior to the filing of a new bankruptcy case by an individual debtor and certification of such credit counseling must be filed with the petition. There are certain exceptions for exigent circumstances, incapacity, disability or active military duty which are not applicable in this case. This Court must follow the law as enacted by Congress and signed by the President."
It seems obvious that Judge King considers dismissal of a non-complying case to be mandatory rather than a matter of judicial housekeeping. The fact that Judge King would publish this scant 1 ½ page opinion just ten days after Judge Clark’s opinion in Navarro could be read as an attempt to stake out his own position on this issue.
Defying Congress
Both Judge Monroe and Judge Clark seem intent on lecturing Congress. By referring to the credit counseling requirements as absurd, inane and a useless formality, the judges have made it clear what they think. They have also expressed what a sizeable contingent of the practicing bar (including this author) thinks. By lending the prestige of their office to the critiques voiced by many, the judges may spur corrective action by Congress (although this is probably wishful thinking). However, Judge Clark’s ruling is a bit more troubling. By claiming that he is the gatekeeper who may admit whom he finds worthy and by stating that he can make a debtor eligible “no further questions asked,” Judge Clark appears to take a very aggressive position. No party filed a timely appeal from Navarro, so that the debtor in that case will likely be able to complete her case without pre-petition credit counseling. It remains to be seen whether a creditor or the U.S. Trustee will take up the gauntlet in a future case.
Approach One: This Is Stupid, I’m Going to Say It’s Stupid, But I Am Going to Enforce This Stupid Law
On December 22, 2005, Judge Frank Monroe from the Austin Division of the Western District of Texas released his opinion in In re Sosa, 336 B.R. 115 (Bankr. W.D. Tex. 2005). Judge Monroe did not mince words about the wisdom of the credit counseling requirement.
"One of the more absurd provisions of the new Act makes an individual ineligible for relief unless such individual, 'has during the 180-day period preceding the date of filing of the petition by such individual, received from an approved nonprofit budget and credit counseling agency described in §111(a) an individual or group briefing (including a briefing conducted by telephone or on the Internet) that outlined the opportunities for available credit counseling and assisted such individual in performing a related budget analysis.' See 11 U.S.C. § 109(h)(1). No doubt this is a truly exhaustive budget analysis."
Judge Monroe goes on to describe the circumstances in which a certificate of exigent circumstances can be filed and approving, concluding:
"Simply stated, if a debtor does not request the required credit counseling services from an approved nonprofit budget and credit counseling service before the petition is filed, that person is ineligible to be a debtor no matter how dire the circumstances the person finds themselves in at that moment.
"This Court views this requirement as inane. However, it is a clear and unambiguous provision obviously designed by Congress to protect consumers."
Approach Two: This Is Foolish But Congress Gave Me Room to Avoid a Foolish Result
Judge Monroe seemed pretty definitive, but things were not so clear in San Antonio. On June 27, 2006, Judge Leif Clark released his Order on Motion for Exigent Circumstances in In re Navarro, No. 06-51007 (available at www.txwb.uscourts.gov/opinions). Judge Clark was faced with a pro se debtor who “was unable to obtain counseling within the five day window because she did not know that she needed to obtain counseling as a prerequisite to filing for bankruptcy.”
Judge Clark, like Judge Monroe, did not view the credit counseling requirement as particularly helpful Judge Clark stated:
"The credit counseling briefing is superficially designed to discourage people from filing for bankruptcy on the theory that, if they but knew of the alternatives, they might pursue those instead. In practice, however, the briefing has little or no effect on the actual decision to file because, by that time, the person’s financial condition has deteriorated too far for any alternative other than bankruptcy to be effective. The 'briefing' called for by section 109(h)(1) does little more than make the debtor aware of credit counseling as an alternative. But credit counselors attempt to negotiate a payment plan with the consent of the debtor’s creditors, for a fee, and their success will depend on whether they can get all creditors to cooperate…The actual negotiation of an alternative thus requires a voluntary “standstill” by the creditors while an arrangement is worked out. In practice, that will not happen. (citation omitted). What is more, the debtor may well be actually discouraged from filing when filing might be the right thing to do—by a credit counselor who is not lawyer effectively giving the debtor legal advice. (citation omitted). The result is that the credit counseling briefing ends up being a useless formality.
"It also operates as a trap for the unwary, potentially causing the dismissal of so-called 'ineligible' debtors from bankruptcy. (citation omitted). While certain private financial interests may be rewarded as a result, (citation omitted), no genuine public interest appears to be served."
Judge Clark then turns his thoughtful mind to the court’s role in policing eligibility. Judge Clark notes that eligibility is not jurisdictional. Thus, an ineligible debtor may proceed in bankruptcy unless someone timely objects. In this case, the court is appointed as gatekeeper. The clerk may not refuse to accept a petition which is not accompanied by a certificate of credit counseling. The clerk may bring any deficiency to the attention of the court, which, under Rule 1007(e) “may” dismiss the case, but is not required to. If the debtor files a certificate of exigent circumstances, the court “may” conduct a hearing, but is not required to. Further, “If the court finds the certificate of exigent circumstances to be satisfactory, then the issue of eligibility under section 109(h) is deemed resolved for all purposes, and the debtor is henceforth eligible for relief as a debtor under title 11, no further questions asked.”
Judge Clark seems to be saying that he has the discretion to ignore a failure to obtain credit counseling as well as the discretion to accept any explanation of exigent circumstances. In a footnote, he states:
"Section 707(a) permits (but does not require) the court to dismiss a case for failure to file the information required by section 521(a)(1), but the certificate of credit counseling briefing is not one of the documents required to be filed by section 521(a)(1). …Thus, while some courts have elected to dismiss cases that do not comply with Interim Rule 1007(b)(3)(including my colleague in this division), they apparently do so as a matter of judicial housekeeping, but not as a matter of statutory or rule construction."
Judge Clark concludes that not knowing about credit counseling was an exigent circumstance in the case before him.
"The court finds that this debtor, a non-lawyer, was justified in not knowing about the credit counseling briefing requirement as a pre-condition to eligibility for bankruptcy. That justifiable lack of knowledge, in turn, satisfies the court as an exigent circumstance."
While Judge Clark’s logic is elegant and his heart is clearly in the right place, the result seems to be a bit off. The exigent circumstances provision is part of a clause which has three parts connected by an “and.” Judge Clark’s ruling appears to state that a person may be a debtor if they submit a certificate describing exigent circumstances which is satisfactory to the court. While this satisfies the first and third requirements, it appears to read out the second one. The middle provision requires that the “debtor requested credit counseling services from an approved non-profit budget and credit counseling agency, but was unable to obtain the services … during the five-day period beginning on the date on which the debtor made that request.” If the debtor did not request credit counseling at all, the debtor would not be able to establish that credit counseling was not available within five days. Therefore, the debtor would not be able to establish exigent circumstances. However, in the Navarro case, that is exactly what happened.
Approach Three: The Law Seems Clear to Me
The final salvo in this round of cases comes from Judge Ronald King from San Antonio, who weighed in with an opinion on July 7, 2006. Like Judge Clark, Judge King was faced with a pro se debtor. In In re Gallardo, No. 06-50724 (available at www.txwb.uscourts.gov/opinions), the debtor sought to reconsider dismissal of his case. The debtor contended that he had looked on the internet for requirements to file bankruptcy but did not discover the credit counseling provision. Judge King was not impressed. He said:
"This Court cannot control publication of the United States Code on internet websites. The fact that the Debtor could not locate section 109(h) of the Bankruptcy Code on a particular website does not make the amendments made by BAPCPA inapplicable to this Debtor. Section 109(h) of the United States Bankruptcy Code, as amended by BAPCPA effective October 17, 2005, requires that credit counseling must be taken prior to the filing of a new bankruptcy case by an individual debtor and certification of such credit counseling must be filed with the petition. There are certain exceptions for exigent circumstances, incapacity, disability or active military duty which are not applicable in this case. This Court must follow the law as enacted by Congress and signed by the President."
It seems obvious that Judge King considers dismissal of a non-complying case to be mandatory rather than a matter of judicial housekeeping. The fact that Judge King would publish this scant 1 ½ page opinion just ten days after Judge Clark’s opinion in Navarro could be read as an attempt to stake out his own position on this issue.
Defying Congress
Both Judge Monroe and Judge Clark seem intent on lecturing Congress. By referring to the credit counseling requirements as absurd, inane and a useless formality, the judges have made it clear what they think. They have also expressed what a sizeable contingent of the practicing bar (including this author) thinks. By lending the prestige of their office to the critiques voiced by many, the judges may spur corrective action by Congress (although this is probably wishful thinking). However, Judge Clark’s ruling is a bit more troubling. By claiming that he is the gatekeeper who may admit whom he finds worthy and by stating that he can make a debtor eligible “no further questions asked,” Judge Clark appears to take a very aggressive position. No party filed a timely appeal from Navarro, so that the debtor in that case will likely be able to complete her case without pre-petition credit counseling. It remains to be seen whether a creditor or the U.S. Trustee will take up the gauntlet in a future case.
Monday, July 17, 2006
The Empire Strikes Back: The Government Files Its Reply Brief in the Suit Over BAPCPA's Debt Relief Agency Provisions
I have previously written about the suit filed by the Connecticut Bar Assocation and the National Association of Consumer Bankruptcy Attorneys seeking to overturn the debt relief agency provisions of BAPCPA.
Blaming Attorneys
The United States has now responded to that suit and its defense of BAPCPA focuses largely upon the perceived ethical shortcomings of consumer debtors’ attorneys.
“In enacting the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”), Congress found that there was ‘abuse by attorneys and other professionals.’ (citation omitted). To correct this abuse, Congress included in BAPCPA ‘provisions strengthening professionalism standards for attorneys and others who assist consumer debtors with their bankruptcy cases.’”
Memorandum in Support of Motion to Dismiss and in Opposition to Plaintiff’s Motion for Preliminary Injunction, p.1, filed on June 30, 2006 in Case No. 3:06CV729 (U.S. District Court for the District of Connecticut).
The USA goes on to quote from the legislative history to BAPCPA:
“Looking for the source of this meteoric increase in bankruptcy filings, Congress determined that the bankruptcy system “ha[d] loopholes and incentives that allow[ed] and—sometimes-- even encourage[d] opportunistic personal filings and abuse (citation omitted) and that attorneys sometimes played a role in exploiting these “opportunities.”
Memorandum, pp. 8-9.
The U.S. Trustee program is quoted for the proposition that “[a]buse of the system is more widespread than many would have estimated.” Another witness testified that some debtors are told that they are consolidating their debts and do not know that they have filed bankruptcy, while the Fifth Circuit’s own Judge Edith Jones is cited for the statement that “many” bankruptcy lawyers never talk to their clients; another witness testified that bankruptcy practices are run like mills and that clients do not receive adequate disclosures. Finally, Bankruptcy Judge Carol Kenner is cited for the proposition that many debtors sign reaffirmation agreements without adequate disclosure.
The picture painted here is one of out of control lawyers causing a national bankruptcy crisis. It is disheartening that a Congress full of lawyers found it necessary to blame lawyers for the level of bankruptcy filings. Of course, neither the Justice Department nor the legislative history discuss the studies finding a direct correlation between the amount of consumer debt in the economy and the number of consumer bankruptcies filed.
Tempering the Language of BAPCPA
However, the news is not all bad. In several instances, the lawyers for the Justice Department argue that the provisions applicable to attorneys are not really as bad as they appear.
BAPCPA prevents attorneys from advising prospective to incur debt “in contemplation of” bankruptcy. The plaintiffs (the Connecticut Bar Association, the National Association of Consumer Bankruptcy Attorneys and others) argued that this gagged attorneys from advising their clients about how to beneficially structure their debts, such as refinancing a high interest loan. The USA contends that “in contemplation of” bankruptcy means because of filing bankruptcy. Under this construction, the only advice which would be prohibited would be to incur debt for the sole purpose of having it discharged in bankruptcy.
In another instance, BAPCPA requires attorneys to state, “We are a debt relief agency. We help people file for bankruptcy under the Bankruptcy Code” in certain advertisements directed to the general public. While this requirement is patently offensive in any circumstance, the attorneys for the government try to minimize its effect, claiming that it only applies to advertisements directed to prospective consumer debtors. If the government is correct, then attorneys who represent debtors, creditors and trustees would not be required to place this disclaimer on their websites or other material generally promoting the firm. However, this is still a silly requirement. When an attorney says “We are a debt relief agency,” it suggests that he is affiliated with a government or non-profit agency.
The irony with the mandatory debt relief agency statement is that Congress identified a legitimate problem and then failed to fix it. There are some persons who advertise credit repair or debt consolidation when they mean bankruptcy. I would suspect that many of the people doing this are not lawyers and will not be affected by the statute. Congress could have fixed a legitimate problem by simply prohibiting deceptive advertisements. Instead, it mandated a silly slogan which does little to fix the problem while dissuading legitimate attorneys from representing consumer debtors.
Post-Script
The District Court heard oral argument on July 13 and has taken the matter under advisement.
Blaming Attorneys
The United States has now responded to that suit and its defense of BAPCPA focuses largely upon the perceived ethical shortcomings of consumer debtors’ attorneys.
“In enacting the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”), Congress found that there was ‘abuse by attorneys and other professionals.’ (citation omitted). To correct this abuse, Congress included in BAPCPA ‘provisions strengthening professionalism standards for attorneys and others who assist consumer debtors with their bankruptcy cases.’”
Memorandum in Support of Motion to Dismiss and in Opposition to Plaintiff’s Motion for Preliminary Injunction, p.1, filed on June 30, 2006 in Case No. 3:06CV729 (U.S. District Court for the District of Connecticut).
The USA goes on to quote from the legislative history to BAPCPA:
“Looking for the source of this meteoric increase in bankruptcy filings, Congress determined that the bankruptcy system “ha[d] loopholes and incentives that allow[ed] and—sometimes-- even encourage[d] opportunistic personal filings and abuse (citation omitted) and that attorneys sometimes played a role in exploiting these “opportunities.”
Memorandum, pp. 8-9.
The U.S. Trustee program is quoted for the proposition that “[a]buse of the system is more widespread than many would have estimated.” Another witness testified that some debtors are told that they are consolidating their debts and do not know that they have filed bankruptcy, while the Fifth Circuit’s own Judge Edith Jones is cited for the statement that “many” bankruptcy lawyers never talk to their clients; another witness testified that bankruptcy practices are run like mills and that clients do not receive adequate disclosures. Finally, Bankruptcy Judge Carol Kenner is cited for the proposition that many debtors sign reaffirmation agreements without adequate disclosure.
The picture painted here is one of out of control lawyers causing a national bankruptcy crisis. It is disheartening that a Congress full of lawyers found it necessary to blame lawyers for the level of bankruptcy filings. Of course, neither the Justice Department nor the legislative history discuss the studies finding a direct correlation between the amount of consumer debt in the economy and the number of consumer bankruptcies filed.
Tempering the Language of BAPCPA
However, the news is not all bad. In several instances, the lawyers for the Justice Department argue that the provisions applicable to attorneys are not really as bad as they appear.
BAPCPA prevents attorneys from advising prospective to incur debt “in contemplation of” bankruptcy. The plaintiffs (the Connecticut Bar Association, the National Association of Consumer Bankruptcy Attorneys and others) argued that this gagged attorneys from advising their clients about how to beneficially structure their debts, such as refinancing a high interest loan. The USA contends that “in contemplation of” bankruptcy means because of filing bankruptcy. Under this construction, the only advice which would be prohibited would be to incur debt for the sole purpose of having it discharged in bankruptcy.
In another instance, BAPCPA requires attorneys to state, “We are a debt relief agency. We help people file for bankruptcy under the Bankruptcy Code” in certain advertisements directed to the general public. While this requirement is patently offensive in any circumstance, the attorneys for the government try to minimize its effect, claiming that it only applies to advertisements directed to prospective consumer debtors. If the government is correct, then attorneys who represent debtors, creditors and trustees would not be required to place this disclaimer on their websites or other material generally promoting the firm. However, this is still a silly requirement. When an attorney says “We are a debt relief agency,” it suggests that he is affiliated with a government or non-profit agency.
The irony with the mandatory debt relief agency statement is that Congress identified a legitimate problem and then failed to fix it. There are some persons who advertise credit repair or debt consolidation when they mean bankruptcy. I would suspect that many of the people doing this are not lawyers and will not be affected by the statute. Congress could have fixed a legitimate problem by simply prohibiting deceptive advertisements. Instead, it mandated a silly slogan which does little to fix the problem while dissuading legitimate attorneys from representing consumer debtors.
Post-Script
The District Court heard oral argument on July 13 and has taken the matter under advisement.
Sunday, July 16, 2006
The Sad Case of John Gellene or What It Feels Like to Get Hit By Lightning
One of the interesting features of this year’s State Bar of Texas Bankruptcy Section Meeting was a lunch time presentation by Milton C. Regan, Jr., author of Eat What You Kill: The Fall of a Wall Street Lawyer (The University of Michigan Press 2006). This is the story of John Gellene, the only attorney ever to go to jail for submitting an incomplete Rule 2014 disclosure. Although the book is a bit of a difficult read (you can read more about that in my review on Amazon.com), it is an interesting case study in the dangers of cutting corners. (The book does a really good job of documenting the pressure to cut corners, so I won’t discuss that in any detail here).
A Lawyer Walks Into A Minefield
For those who don’t remember the story from the newspaper, here is what happened. Milbank, Tweed was hired to represent Bucyrus –Erie Corporation in its bankruptcy proceeding. The bankruptcy was very contentious because the largest unsecured creditor, Jackson National Life, had accused the company’s investment banker, Goldman Sachs, with manipulating the company’s financial affairs to their own benefit. Things got worse when a Goldman Sachs partner, Mikael Salovaara, started his own firm, South Street Fund, and that firm made a deal with Bucyrus-Erie which put them ahead of all the other creditors. In order to avoid limits on debt which the company could incur, South Street engineered a sale-leaseback of the company’s principal assets. The sale-leaseback left South Street in control of the company’s principal assets and subjected the company to outrageous payments.
All this happened before bankruptcy lawyer John Gellene entered the picture. However, it created an adversarial situation between the company and the different factions. The debtor’s attorney would be caught in the middle of this conflict and would have to navigate it in order to successfully reorganize the company. One example of these pressures was Jackson National Life’s demand that every major creditor but itself should have its debt written off or subordinated.
Connections vs. Conflicts
John Gellene began representing Bucyrus-Erie a year before its bankruptcy at a time when his law firm was not representing either Salovaara or South Street. However, before the case was filed, Milbank, Tweed began representing South Street in another bankruptcy and also represented Salovaara in a dispute with his partner. Both of these were “connections” with creditors. However, Gellene failed to disclose these relationships in either of two affidavits filed with the court.
Disclosing these “connections” should have been a no-brainer. However, there were probably a lot of reasons why he could rationalize not doing it (as brought out in his subsequent criminal trial). First, Salovaara was not a creditor himself. He was just a partner of a creditor. Therefore, his representation should not be disclosed. Second, Milbank, Tweed represented South Street as a small player in a completely unrelated matter. This was not a conflict.
If this was Gellene’s thought process, he made the mistake of focusing on the purpose of the Rule 2014 disclosure rather than its language. Rule 2014 requires disclosure of “connections” with the debtor, creditors, attorneys and accountants for the debtor and creditors and employees of the U.S. Trustee. This is a requirement honored more in the breach. The requirement to disclose connections could be taken to absurd levels. For example, in a case with IRS debt, the attorneys should disclose the “connection” that they pay taxes to the IRS. In a case with credit card debt, the attorneys should disclose which attorneys hold credit cards issued by creditors in the case. However, the connections in this case were a bit more obvious. They involved major players who were at odds with Jackson National Life, the company’s main antagonist. However, if Gellene focused on conflicts, then there was an argument that they did not have to be disclosed.
Gellene may have also reasoned that disclosing the connection to South Street and Salovaara would merely provide leverage to Jackson National Life. If the case was to be concluded successfully, it would need to be confirmed quickly. Having a lengthy delay over employment of counsel would endanger the case’s prospects. If that were Gellene’s thinking, he made the mistake of (to use Joe Martinec’s phrase) pledging his loyalty to the deal rather than any other obligation.
It is also possible that Gellene made a quick cost-benefit analysis. In the recent Leslie Fay case, Weil Gotshal had made a very big failure to disclose. They were allowed to continue to represent the debtor and had to forfeit a “mere” $1 million out of their fees. They certainly did not go to jail. If Gellene had weighed the likely consequence of being caught against the possibility of being disqualified on the front end, he likely would have chosen to take the risk.
It is also possible that the failure to disclose was inadvertent. Gellene began working on the Bucyrus-Erie case in February 1993. However, the case was not filed until February 2004. The representations of Salovaara and South Street did not come up until December 2003. Therefore, it is possible that disclosures were drafted before the connection arose and were never updated during the hustle and bustle to prepare the case for filing.
From Triumph to Tragedy
Gellene successfully guided Bucyrus-Erie through its reorganization and his firm was paid nearly $2 million in fees for doing so. Unfortunately, his successful plan put the company’s old adversary, Jackson National Life, in control of the company. Years later, Jackson found out about the failure to disclose and sued Milbank, Tweed to return its fees and for malpractice. This proved to be very costly for Milbank, Tweed but it was worse for John Gellene. The publicity spawned by the fee litigation prompted the U.S. Attorney to file criminal charges against Gellene. A deal to plead to a misdemeanor fell through and the case went to trial. The prosecution sought to portray the failure to disclose as black and white, the while the defense attempted to put the statement in context. The jury sided with the U.S. Attorney and Gellene was convicted and sentenced to 15 months in prison. Gellene went from being a highly respected bankruptcy attorney to a convicted felon in a relatively short period of time.
Why John Gellene?
So, what happened? In some respects, Gellene was the victim of extremely bad luck. The Asst. U.S. Trustee in the case had previously been the U.S. Attorney (not an Asst. U.S. Attorney, but the U.S. Attorney). Therefore, he was more likely to look at the case from a criminal viewpoint than with bankruptcy eyes. He was also likely to have the informal clout needed to get a criminal referral taken seriously. Additionally, the Bucyrus-Erie case was filed in Wisconsin rather than New York or Delaware. Here, a big firm came swooping into Wisconsin, took a respected company into bankruptcy and walked away with nearly $2 million in fees. There had to be a little bit of jealousy of and distrust toward the outsiders. (Let’s face it, no one likes it when big firms poach all the good cases). Finally, Gellene’s own work product was part of his undoing. The confirmed plan left Jackson National Life in control of the company and allowed it to prosecute claims on behalf of the estate. Jackson National Life was still plenty upset toward Goldman, Sachs, Salovaara, South Street and Milbank, Tweed. Being left in a position to investigate the claims while having control of the company’s attorney-client privilege, made it likely that they would discover the non-disclosure and would be unhappy. This case proves that just because lightning may only strike one in a million times, doesn’t mean that it won’t hurt the person who gets hit.
Lessons to Be Learned
The lessons to be learned may be fairly simple. As Jay Westbrook is quoted as saying in the book, “Disclosure should be like voting in Chicago—early and often. Disclose, disclose, disclose. It’s hard to get in trouble when you follow that rule.” Eat What You Kill, p. 228. Attorneys rarely have to make statements under penalty of perjury. Since Rule 2014 is one of the few cases, it should be treated seriously. However, there is a significant temptation not to. The Rule 2104 disclosure is filed toward the beginning of the case. As a result, there is a temptation to get it on file quickly and to copy the disclosure from the previous case with a few modifications. This would be a mistake. As I have read 2014 again recently, I was surprised to learn not only that it required disclosure of connections rather than conflicts, but that it required disclosure of connections to other attorneys and accountants in the case. Sometimes it is easy to get so familiar with something that you respect for it. That would be a mistake.
Another lesson would be that it is better to tattle on yourself than to get caught. John Gellene could have submitted an amended disclosure at any point during the case, but did not. Even if he had brought it up at the hearing on his own fees, he probably would have received little more than a slap on the wrist. Instead, the issue didn’t come up until Jackson National Life brought it up and by that time, they were plenty mad so that the time for a slap on the wrist was gone.
A Lawyer Walks Into A Minefield
For those who don’t remember the story from the newspaper, here is what happened. Milbank, Tweed was hired to represent Bucyrus –Erie Corporation in its bankruptcy proceeding. The bankruptcy was very contentious because the largest unsecured creditor, Jackson National Life, had accused the company’s investment banker, Goldman Sachs, with manipulating the company’s financial affairs to their own benefit. Things got worse when a Goldman Sachs partner, Mikael Salovaara, started his own firm, South Street Fund, and that firm made a deal with Bucyrus-Erie which put them ahead of all the other creditors. In order to avoid limits on debt which the company could incur, South Street engineered a sale-leaseback of the company’s principal assets. The sale-leaseback left South Street in control of the company’s principal assets and subjected the company to outrageous payments.
All this happened before bankruptcy lawyer John Gellene entered the picture. However, it created an adversarial situation between the company and the different factions. The debtor’s attorney would be caught in the middle of this conflict and would have to navigate it in order to successfully reorganize the company. One example of these pressures was Jackson National Life’s demand that every major creditor but itself should have its debt written off or subordinated.
Connections vs. Conflicts
John Gellene began representing Bucyrus-Erie a year before its bankruptcy at a time when his law firm was not representing either Salovaara or South Street. However, before the case was filed, Milbank, Tweed began representing South Street in another bankruptcy and also represented Salovaara in a dispute with his partner. Both of these were “connections” with creditors. However, Gellene failed to disclose these relationships in either of two affidavits filed with the court.
Disclosing these “connections” should have been a no-brainer. However, there were probably a lot of reasons why he could rationalize not doing it (as brought out in his subsequent criminal trial). First, Salovaara was not a creditor himself. He was just a partner of a creditor. Therefore, his representation should not be disclosed. Second, Milbank, Tweed represented South Street as a small player in a completely unrelated matter. This was not a conflict.
If this was Gellene’s thought process, he made the mistake of focusing on the purpose of the Rule 2014 disclosure rather than its language. Rule 2014 requires disclosure of “connections” with the debtor, creditors, attorneys and accountants for the debtor and creditors and employees of the U.S. Trustee. This is a requirement honored more in the breach. The requirement to disclose connections could be taken to absurd levels. For example, in a case with IRS debt, the attorneys should disclose the “connection” that they pay taxes to the IRS. In a case with credit card debt, the attorneys should disclose which attorneys hold credit cards issued by creditors in the case. However, the connections in this case were a bit more obvious. They involved major players who were at odds with Jackson National Life, the company’s main antagonist. However, if Gellene focused on conflicts, then there was an argument that they did not have to be disclosed.
Gellene may have also reasoned that disclosing the connection to South Street and Salovaara would merely provide leverage to Jackson National Life. If the case was to be concluded successfully, it would need to be confirmed quickly. Having a lengthy delay over employment of counsel would endanger the case’s prospects. If that were Gellene’s thinking, he made the mistake of (to use Joe Martinec’s phrase) pledging his loyalty to the deal rather than any other obligation.
It is also possible that Gellene made a quick cost-benefit analysis. In the recent Leslie Fay case, Weil Gotshal had made a very big failure to disclose. They were allowed to continue to represent the debtor and had to forfeit a “mere” $1 million out of their fees. They certainly did not go to jail. If Gellene had weighed the likely consequence of being caught against the possibility of being disqualified on the front end, he likely would have chosen to take the risk.
It is also possible that the failure to disclose was inadvertent. Gellene began working on the Bucyrus-Erie case in February 1993. However, the case was not filed until February 2004. The representations of Salovaara and South Street did not come up until December 2003. Therefore, it is possible that disclosures were drafted before the connection arose and were never updated during the hustle and bustle to prepare the case for filing.
From Triumph to Tragedy
Gellene successfully guided Bucyrus-Erie through its reorganization and his firm was paid nearly $2 million in fees for doing so. Unfortunately, his successful plan put the company’s old adversary, Jackson National Life, in control of the company. Years later, Jackson found out about the failure to disclose and sued Milbank, Tweed to return its fees and for malpractice. This proved to be very costly for Milbank, Tweed but it was worse for John Gellene. The publicity spawned by the fee litigation prompted the U.S. Attorney to file criminal charges against Gellene. A deal to plead to a misdemeanor fell through and the case went to trial. The prosecution sought to portray the failure to disclose as black and white, the while the defense attempted to put the statement in context. The jury sided with the U.S. Attorney and Gellene was convicted and sentenced to 15 months in prison. Gellene went from being a highly respected bankruptcy attorney to a convicted felon in a relatively short period of time.
Why John Gellene?
So, what happened? In some respects, Gellene was the victim of extremely bad luck. The Asst. U.S. Trustee in the case had previously been the U.S. Attorney (not an Asst. U.S. Attorney, but the U.S. Attorney). Therefore, he was more likely to look at the case from a criminal viewpoint than with bankruptcy eyes. He was also likely to have the informal clout needed to get a criminal referral taken seriously. Additionally, the Bucyrus-Erie case was filed in Wisconsin rather than New York or Delaware. Here, a big firm came swooping into Wisconsin, took a respected company into bankruptcy and walked away with nearly $2 million in fees. There had to be a little bit of jealousy of and distrust toward the outsiders. (Let’s face it, no one likes it when big firms poach all the good cases). Finally, Gellene’s own work product was part of his undoing. The confirmed plan left Jackson National Life in control of the company and allowed it to prosecute claims on behalf of the estate. Jackson National Life was still plenty upset toward Goldman, Sachs, Salovaara, South Street and Milbank, Tweed. Being left in a position to investigate the claims while having control of the company’s attorney-client privilege, made it likely that they would discover the non-disclosure and would be unhappy. This case proves that just because lightning may only strike one in a million times, doesn’t mean that it won’t hurt the person who gets hit.
Lessons to Be Learned
The lessons to be learned may be fairly simple. As Jay Westbrook is quoted as saying in the book, “Disclosure should be like voting in Chicago—early and often. Disclose, disclose, disclose. It’s hard to get in trouble when you follow that rule.” Eat What You Kill, p. 228. Attorneys rarely have to make statements under penalty of perjury. Since Rule 2014 is one of the few cases, it should be treated seriously. However, there is a significant temptation not to. The Rule 2104 disclosure is filed toward the beginning of the case. As a result, there is a temptation to get it on file quickly and to copy the disclosure from the previous case with a few modifications. This would be a mistake. As I have read 2014 again recently, I was surprised to learn not only that it required disclosure of connections rather than conflicts, but that it required disclosure of connections to other attorneys and accountants in the case. Sometimes it is easy to get so familiar with something that you respect for it. That would be a mistake.
Another lesson would be that it is better to tattle on yourself than to get caught. John Gellene could have submitted an amended disclosure at any point during the case, but did not. Even if he had brought it up at the hearing on his own fees, he probably would have received little more than a slap on the wrist. Instead, the issue didn’t come up until Jackson National Life brought it up and by that time, they were plenty mad so that the time for a slap on the wrist was gone.
Wednesday, June 28, 2006
Houston Judges Crack Down on Attorney Conduct
At the beginning of each episode of Hill Street Blues, the Sergeant used to admonish the officers "Let's be careful out there." The same can be said for practicing law in the Houston bankruptcy courts. Over the past 15 months, the Houston judges have written at least six opinions dealing with attorney conduct and sanctions, including one where a firm was sanctioned $65,000 and another which drew a criminal referral. There are some new judges in Houston and they apparently don’t like some of what they are seeing.
Bad News For Creditors’ Lawyers
There are three recent cases dealing with attorney fees on motions to lift stay.
In the case of In re Nair, 320 B.R. 119 (Bankr. S.D. Tex. 2005), Judge Marvin Isgur determined that it was sanctionable for a creditor's lawyer to include attorney's fees in an agreed order on a motion to lift stay where the creditor was undersecured and would not be entitled to fees under Sec. 506(b). This opinion from March 2005 is a bit surprising, not for the result, but for the way it came up. Under Sec. 506(b), undersecured creditors are not generally entitled to recover their fees and costs. However, this had been a common practice for many creditors’ attorneys and debtors’ lawyers had not been challenging. Arguably, it could be justified as a quid pro quo for allowing the stay to remain in effect following a default, especially where the creditor could have argued for a full lifting of the stay. Instead, the court imposed sanctions on its own motion. However, despite writing a harsh opinion concerning the attorney, the court decided not to impose monetary sanctions.
Judge Isgur stated:
"The Court has considered whether monetary sanctions are appropriate in this case. To be sure, this matter has taken substantial court time and monetary sanctions could be imposed to reflect the use of judicial resources and court time. Nevertheless, the Court believes that monetary sanctions need not be imposed in this case. The proposed order was an agreed and the Court believes that should ameliorate the sanctions to be imposed. Moreover, the Court does not believe that mild monetary sanctions would serve to protect against future violations or that this violation justifies severe monetary sanctions.
"Rather than imposing monetary sanctions, the Court merely requires that Mr. (Attorney) discontinue practices that violate his duties under Fed. R. Bank. P. 9011."
In re Nair, at 129.
While the Nair attorney got off with a bad scolding, an entire firm was taken to task and sanctioned in In re Porcheddu, 338 B.R. 729 (Bankr. S.D. Tex. 2006). If a creditor is entitled to recover attorney's fees on a motion to lift stay and is seeking over $500, local practice in the Southern District requires that the creditor's lawyer submit a fee statement justifying its fees. However, if a creditor's firm chooses to do this, they need to be very forthcoming about how they kept their time and how they calculated the fees. In Porcheddu, a large law firm which engages in a substantial amount of lift stay practice asked for attorney’s fees. The opinion does not state how much they requested. However, by the time the case was over, the law firm ended up paying.
When the question of fees came up, the initial attorney to appear for the firm stated that time records were kept contemporaneously and that she was the custodian of records. Something did not smell right and the court sought more information. After additional hearings, the court concluded that while project records were kept contemporaneously, that fee statements were only created after the fact if there was a need to apply to the court for approval.
The court stated:
"Taken as a whole, (the firm) designed a system that was intended to create after-the-fact time entries--and to present those time entries to the Court as business records. (Trial attorney) is an integral part of (the firm’s) team of lawyers. Following this Court's October 1, 2004 announcement, (the firm) could have chosen to come forth and advise the Court that it did not maintain contemporaneous time records but that it believed that its fees should nevertheless be approved. It did not do so. Instead, it devised a "template" that looked like a fee statement. The Court concludes that (the firm) and (the attorney) presented the template (time and again) for the purpose of having the template accepted as a (firm) business record."
In re Porcheddu, at 740.
The court found that the firm determined what a reasonable fee would be and then created time records to support that conclusion. Judge Isgur found that this procedure was backwards and undermined the entire process of court review of fees. The Court found that the law firm and its attorney had violated Rule 9011 and assessed sanctions of $65,000. The court calculated this amount much like the jury did in awarding exemplary damages against McDonald's in the notorious coffee burn case. The court concluded that the firm recovered approximately $125,000 in attorney's fees on motions to lift stay every two weeks. The court found that this was the starting point for assessing sanctions. The court cut the sanction in half because the firm behaved responsibly in the fast majority of its cases (although it had been the subject of several negative published opinions) and because the firm's reputation had already been damaged by the case. As a result, the court reduced the sanctions award to $65,000. The individual attorney was sanctioned $1,000.
On the more mundane side is In re Valdez, 324 B.R. 296 (Bankr. S.D. Tex. 2005). In that case, Judge Isgur denied fees to a creditor's lawyer who lost a motion for relief from stay. The court ruled that merely because the creditor was oversecured and thus potentially able to recover fees did not mean that they would be automatically awarded. In order to recover fees, they had to be reasonable. Where the creditor only sought relief based on lack of equity and there clearly was equity, not only should the motion be denied, but the creditor was not entitled to fees either. While this can be viewed as an application of the rule that success is the most important factor in awarding fees, it is also a reminder that secured creditors do not automatically get everything they want.
Bad News for a Debtor’s Lawyer
A debtor's lawyer who was creative in scheduling IRS claims drew the wrath of Judge Wesley Steen. In In re Thomas, 337 B.R. 879 (Bankr. S.D. Tex. 2006), the debtor filed a tax return showing a liability of $4,661 and then paid it. The IRS then audited and assessed over $32,000 in taxes and penalties. The Debtor scheduled this claim variously at $0, $20,000 and $5,000. When the IRS did not file a claim, the debtor's lawyer filed one for it in the amount of $5,000 and obtained confirmation of a plan. When the IRS filed a late claim based on the audit, the Debtor objected. This was a bad move.
At the hearing on the claims objection, the court wanted to know why the debtor had listed the claim in several different amounts which had no relation to the assessed liability. The debtor's lawyer stated that the $20,000 figure was a rough average between the $32,000 figure claimed by the IRS on the audit and the $4,661 figure listed on the return. The attorney then said that the $5,000 claim was based on the amount listed on the return of $4,661. The attorney could not explain why he had rounded it up to an even $5,000 and stated that he was unaware that the amount listed on the return had been paid.
Judge Steen was not amused. He revoked confirmation of the plan based on fraud. He relied on his inherent powers under section 105 to get around the fact that confirmation orders may only be revoked within 180 days. He then assessed three-fold sanctions against the attorney. First, he ordered the attorney to obtain ten hours in tutoring in ethics from a law professor who teaches in this area. Then he referred the attorney to the State Bar. Finally, he made a criminal referral.
Unauthorized Practice of Law Is Not Good
Judge Jeff Bohm addressed unauthorized practice of law in the case of In re Zuniga, 332 B.R. 760 (Bankr. S.D. Tex. 2005) . In that case, a debt restructuring agency advertised on Spanish language TV. When prospective customers called, they would be referred to a law firm in the same building if they did not qualify for a repayment plan. That law firm would then collect the paperwork from the debtor and farm it out to local counsel. In this case, the local counsel they sent it to was practicing on a probationary license, did not speak Spanish and was not admitted to practice in the Southern District. The court found this to be unauthorized practice of law by both the referring counsel and the local counsel as well as improper fee splitting. Local counsel was ordered to disgorge fees of $500 and pay $5,000 to the clerk. The California firm was required to disgorge $699 in fees, pay his client $176 in damages and pay the trustee’s lawyer $2,022.
Finally, if your license is suspended and you are required to associate a "bankruptcy specialist," you should notify the court of this restriction, you should actually associate a bankruptcy specialist (defined as someone board certified or who regularly appears in bankruptcy court) and should not draft documents for your corporate client to file on a pro se basis. All of these faux pas earned the suspended creditor’s lawyer sanctions totaling $11,290.05 in In re Cash Media Systems, 326 B.R. 655 (Bankr. S.D. Tex. 2005).
Final Thoughts
Most of the infractions covered here were pretty obvious. Lying to the tribunal, as occurred in Porcheddu and Thomas, is a prescription for disaster. Unauthorized practice of law and improper fee splitting are similarly dangerous. Although bankruptcy court may seem informal at times, it is still a federal court. Incurring the wrath of a federal judge is likely to be costly, as the attorneys in this article discovered.
Bad News For Creditors’ Lawyers
There are three recent cases dealing with attorney fees on motions to lift stay.
In the case of In re Nair, 320 B.R. 119 (Bankr. S.D. Tex. 2005), Judge Marvin Isgur determined that it was sanctionable for a creditor's lawyer to include attorney's fees in an agreed order on a motion to lift stay where the creditor was undersecured and would not be entitled to fees under Sec. 506(b). This opinion from March 2005 is a bit surprising, not for the result, but for the way it came up. Under Sec. 506(b), undersecured creditors are not generally entitled to recover their fees and costs. However, this had been a common practice for many creditors’ attorneys and debtors’ lawyers had not been challenging. Arguably, it could be justified as a quid pro quo for allowing the stay to remain in effect following a default, especially where the creditor could have argued for a full lifting of the stay. Instead, the court imposed sanctions on its own motion. However, despite writing a harsh opinion concerning the attorney, the court decided not to impose monetary sanctions.
Judge Isgur stated:
"The Court has considered whether monetary sanctions are appropriate in this case. To be sure, this matter has taken substantial court time and monetary sanctions could be imposed to reflect the use of judicial resources and court time. Nevertheless, the Court believes that monetary sanctions need not be imposed in this case. The proposed order was an agreed and the Court believes that should ameliorate the sanctions to be imposed. Moreover, the Court does not believe that mild monetary sanctions would serve to protect against future violations or that this violation justifies severe monetary sanctions.
"Rather than imposing monetary sanctions, the Court merely requires that Mr. (Attorney) discontinue practices that violate his duties under Fed. R. Bank. P. 9011."
In re Nair, at 129.
While the Nair attorney got off with a bad scolding, an entire firm was taken to task and sanctioned in In re Porcheddu, 338 B.R. 729 (Bankr. S.D. Tex. 2006). If a creditor is entitled to recover attorney's fees on a motion to lift stay and is seeking over $500, local practice in the Southern District requires that the creditor's lawyer submit a fee statement justifying its fees. However, if a creditor's firm chooses to do this, they need to be very forthcoming about how they kept their time and how they calculated the fees. In Porcheddu, a large law firm which engages in a substantial amount of lift stay practice asked for attorney’s fees. The opinion does not state how much they requested. However, by the time the case was over, the law firm ended up paying.
When the question of fees came up, the initial attorney to appear for the firm stated that time records were kept contemporaneously and that she was the custodian of records. Something did not smell right and the court sought more information. After additional hearings, the court concluded that while project records were kept contemporaneously, that fee statements were only created after the fact if there was a need to apply to the court for approval.
The court stated:
"Taken as a whole, (the firm) designed a system that was intended to create after-the-fact time entries--and to present those time entries to the Court as business records. (Trial attorney) is an integral part of (the firm’s) team of lawyers. Following this Court's October 1, 2004 announcement, (the firm) could have chosen to come forth and advise the Court that it did not maintain contemporaneous time records but that it believed that its fees should nevertheless be approved. It did not do so. Instead, it devised a "template" that looked like a fee statement. The Court concludes that (the firm) and (the attorney) presented the template (time and again) for the purpose of having the template accepted as a (firm) business record."
In re Porcheddu, at 740.
The court found that the firm determined what a reasonable fee would be and then created time records to support that conclusion. Judge Isgur found that this procedure was backwards and undermined the entire process of court review of fees. The Court found that the law firm and its attorney had violated Rule 9011 and assessed sanctions of $65,000. The court calculated this amount much like the jury did in awarding exemplary damages against McDonald's in the notorious coffee burn case. The court concluded that the firm recovered approximately $125,000 in attorney's fees on motions to lift stay every two weeks. The court found that this was the starting point for assessing sanctions. The court cut the sanction in half because the firm behaved responsibly in the fast majority of its cases (although it had been the subject of several negative published opinions) and because the firm's reputation had already been damaged by the case. As a result, the court reduced the sanctions award to $65,000. The individual attorney was sanctioned $1,000.
On the more mundane side is In re Valdez, 324 B.R. 296 (Bankr. S.D. Tex. 2005). In that case, Judge Isgur denied fees to a creditor's lawyer who lost a motion for relief from stay. The court ruled that merely because the creditor was oversecured and thus potentially able to recover fees did not mean that they would be automatically awarded. In order to recover fees, they had to be reasonable. Where the creditor only sought relief based on lack of equity and there clearly was equity, not only should the motion be denied, but the creditor was not entitled to fees either. While this can be viewed as an application of the rule that success is the most important factor in awarding fees, it is also a reminder that secured creditors do not automatically get everything they want.
Bad News for a Debtor’s Lawyer
A debtor's lawyer who was creative in scheduling IRS claims drew the wrath of Judge Wesley Steen. In In re Thomas, 337 B.R. 879 (Bankr. S.D. Tex. 2006), the debtor filed a tax return showing a liability of $4,661 and then paid it. The IRS then audited and assessed over $32,000 in taxes and penalties. The Debtor scheduled this claim variously at $0, $20,000 and $5,000. When the IRS did not file a claim, the debtor's lawyer filed one for it in the amount of $5,000 and obtained confirmation of a plan. When the IRS filed a late claim based on the audit, the Debtor objected. This was a bad move.
At the hearing on the claims objection, the court wanted to know why the debtor had listed the claim in several different amounts which had no relation to the assessed liability. The debtor's lawyer stated that the $20,000 figure was a rough average between the $32,000 figure claimed by the IRS on the audit and the $4,661 figure listed on the return. The attorney then said that the $5,000 claim was based on the amount listed on the return of $4,661. The attorney could not explain why he had rounded it up to an even $5,000 and stated that he was unaware that the amount listed on the return had been paid.
Judge Steen was not amused. He revoked confirmation of the plan based on fraud. He relied on his inherent powers under section 105 to get around the fact that confirmation orders may only be revoked within 180 days. He then assessed three-fold sanctions against the attorney. First, he ordered the attorney to obtain ten hours in tutoring in ethics from a law professor who teaches in this area. Then he referred the attorney to the State Bar. Finally, he made a criminal referral.
Unauthorized Practice of Law Is Not Good
Judge Jeff Bohm addressed unauthorized practice of law in the case of In re Zuniga, 332 B.R. 760 (Bankr. S.D. Tex. 2005) . In that case, a debt restructuring agency advertised on Spanish language TV. When prospective customers called, they would be referred to a law firm in the same building if they did not qualify for a repayment plan. That law firm would then collect the paperwork from the debtor and farm it out to local counsel. In this case, the local counsel they sent it to was practicing on a probationary license, did not speak Spanish and was not admitted to practice in the Southern District. The court found this to be unauthorized practice of law by both the referring counsel and the local counsel as well as improper fee splitting. Local counsel was ordered to disgorge fees of $500 and pay $5,000 to the clerk. The California firm was required to disgorge $699 in fees, pay his client $176 in damages and pay the trustee’s lawyer $2,022.
Finally, if your license is suspended and you are required to associate a "bankruptcy specialist," you should notify the court of this restriction, you should actually associate a bankruptcy specialist (defined as someone board certified or who regularly appears in bankruptcy court) and should not draft documents for your corporate client to file on a pro se basis. All of these faux pas earned the suspended creditor’s lawyer sanctions totaling $11,290.05 in In re Cash Media Systems, 326 B.R. 655 (Bankr. S.D. Tex. 2005).
Final Thoughts
Most of the infractions covered here were pretty obvious. Lying to the tribunal, as occurred in Porcheddu and Thomas, is a prescription for disaster. Unauthorized practice of law and improper fee splitting are similarly dangerous. Although bankruptcy court may seem informal at times, it is still a federal court. Incurring the wrath of a federal judge is likely to be costly, as the attorneys in this article discovered.
Friday, June 09, 2006
Fifth Circuit Rules In Favor Of Due Process In Two Recent Opinions
Due process is an important protection against arbitrary government action. However, it is often given reduced priority in post-judgment collection matters. Once judgment is recovered against a debtor, remedies seeking to attach the debtor’s assets are deemed to require less process than was given to recover the original judgment. Regardless of whether this rationale is valid as applied to the judgment debtor, it does not apply to proceedings against third parties. As a result it is heartening to see two recent Fifth Circuit decisions which reversed lower court actions based upon failure to follow basic procedural rules.
No Turnover Actions Against Third Parties
Bollore, S.A., et al vs. Import Warehouse, Inc., et al, 2006 U.S. Lexis App. 10591 (5th Cir. 4/28/06) concerned an attempt to use a turnover order to reach the assets of a corporation which was not a judgment debtor.
Ali Mackie was the individual behind a scheme to sell counterfeit cigarette rolling papers. Despite having an $11 million judgment rendered against him, Mr. Mackie apparently continued his counterfeiting ways. This angered the plaintiffs to the point where they wanted to collect upon their judgment. The plaintiffs filed an Application for Order Setting Hearing Regarding Turnover Relief Against Ali Mackie and Freetown Mini Mart, Inc. The Application sought to reach the assets of Freetown Mini Mart, Inc. by claiming that it was the alter ego of Ali Mackie. Ali Mackie did not own an interest in Freetown Mini Mart, Inc. However, his mother, Najat Mackie, did. The plaintiffs served Ali Mackie and his mother Najat Mackie with subpoenas in Michigan compelling them to attend the hearing in Texas and produce documents.
Neither of the Mackies appeared in response to the subpoenas. However, their lawyer filed motions to quash the subpoenas and dismiss the motion for lack of personal jurisdiction. The District Court was not amused and denied the motions. He stated, “When the Mackies have shown up for a hearing, they have lied on each occasion, and I have found them in contempt of court for that. I do have jurisdiction over them, and I will enter the orders that Plaintiffs request.” The court went on to do more than that, ordering not only that Freetown Mini Mart’s assets be turned over, but that Najat Mackie turn over her assets as well. Apparently the court decided that Freetown was the alter ego of both Ali and Najat so that the assets of Najat and Freetown could be reached by Ali’s creditors. As a result, the court found that Freetown and Najat were also liable on the $11 million judgment, ordered their assets frozen and ordered a receiver for their assets.
Najat and Freetown were not happy about being “added” to an $11 million judgment and having their assets frozen, so they appealed. The Fifth Circuit did not have much trouble determining that they got a raw deal. The court held that (1) a turnover order may not be used to adjudicate the rights of non-judgment debtors and (2) the plaintiffs never established their case for alter ego. The court also noted that it was wrong to enter judgment against parties who had never been served with a summons. However, since this was not identified as an issue or briefed, it did not furnish an independent ground for relief. It has long been the law that a turnover action may not be used to determine the rights of someone who is not a judgment debtor. Therefore, this result was not very surprising. The court also held that the mere fact that Ali exercised managerial control over a corporation owned by his mother did not state a case for alter ego or reverse veil piercing.
Nothing here is surprising. The only surprise here is that it took an appeal to the Fifth Circuit to undo this mess. A turnover action is not a silver bullet which allows the judgment creditor to recover whatever he wants against whomever he wants without the necessity of following the laws of procedure or evidence. This case points out a weakness in the appellate system. A party who files a frivolous appeal may be subject to sanctions. On the other hand, a party who obtains a frivolous judgment has no such risk. The appellants in this case were forced to incur substantial expense in order to undo relief which should never have been granted. However, they do not seem to have any remedy for their harm aside from ultimate vindication.
No Indefinite TROs Against Non-Parties In the War Against Terror
One result of the war against terror has been new remedies to undermine the financial backing of the bad guys. However, the Fifth Circuit’s recent opinion in USA vs. Holy Land Foundation, 445 F.3d 771 (5th Cir. 2006) was not about a conflict between good guys and bad guys. Rather, it was about whether the United States could obtain an indefinite, ex parte TRO to freeze the assets of a foundation alleged to have aided terrorism in order to keep those assets from being reached by a judgment creditor who was a victim of terrorism.
The Ungars were victims of a terrorist attack. Their estate sued Hamas and not surprisingly got a default judgment. They then got a court order determining that property held by Holy Land Foundation belonged to Hamas. They obtained writs of execution in New York, South Carolina and Washington state.
Meanwhile, the United States brought a criminal proceeding against Holy Land Foundation. When they learned about the Ungar estate's actions, they went in to U.S. District Court in Dallas and got an ex parte TRO under the criminal forfeiture statute freezing the assets of the Holy Land Foundation. The TRO application stated that it was intended to stop the Ungars from executing. However, the Ungars were not made parties and the TRO was issued for an indefinite period.
The Ungar estate appealed the TRO. They claimed that the District Court in Dallas lacked jurisdiction over the bank accounts because the funds were in custodia legis. The Fifth Circuit examined the laws of New York, South Carolina and Washington state and concluded that the writs of execution were not sufficient to place funds in custodia legis. Of particular interest is the analysis with regard to Washington state. There, the Fifth Circuit held that a writ of garnishment would have placed the funds in the custody of the court, but that a writ of execution did not. This sounds just like Texas law and is an important distinction to note.
Then the USA claimed that under the criminal forfeiture statute only the criminal defendant had standing to challenge the injunction. Fifth Circuit discussed standing rules and said no.
Then the USA claimed that their super terrorism laws exempted them from complying with Rule 65 in obtaining an injunction. The Fifth Circuit had previously ruled that Rule 65 did apply. However, this opinion was reversed on other grounds and had been criticized. However, the Fifth Circuit ruled that it was still good law. You can't get an indefinite ex parte injunction against a third party.
It is kind of sad when the good guys feel that due process does not apply to them. Due process should be one of the things which distinguishes us from the bad guys. To contradict Machiavelli, the ends do not justify the means.
No Turnover Actions Against Third Parties
Bollore, S.A., et al vs. Import Warehouse, Inc., et al, 2006 U.S. Lexis App. 10591 (5th Cir. 4/28/06) concerned an attempt to use a turnover order to reach the assets of a corporation which was not a judgment debtor.
Ali Mackie was the individual behind a scheme to sell counterfeit cigarette rolling papers. Despite having an $11 million judgment rendered against him, Mr. Mackie apparently continued his counterfeiting ways. This angered the plaintiffs to the point where they wanted to collect upon their judgment. The plaintiffs filed an Application for Order Setting Hearing Regarding Turnover Relief Against Ali Mackie and Freetown Mini Mart, Inc. The Application sought to reach the assets of Freetown Mini Mart, Inc. by claiming that it was the alter ego of Ali Mackie. Ali Mackie did not own an interest in Freetown Mini Mart, Inc. However, his mother, Najat Mackie, did. The plaintiffs served Ali Mackie and his mother Najat Mackie with subpoenas in Michigan compelling them to attend the hearing in Texas and produce documents.
Neither of the Mackies appeared in response to the subpoenas. However, their lawyer filed motions to quash the subpoenas and dismiss the motion for lack of personal jurisdiction. The District Court was not amused and denied the motions. He stated, “When the Mackies have shown up for a hearing, they have lied on each occasion, and I have found them in contempt of court for that. I do have jurisdiction over them, and I will enter the orders that Plaintiffs request.” The court went on to do more than that, ordering not only that Freetown Mini Mart’s assets be turned over, but that Najat Mackie turn over her assets as well. Apparently the court decided that Freetown was the alter ego of both Ali and Najat so that the assets of Najat and Freetown could be reached by Ali’s creditors. As a result, the court found that Freetown and Najat were also liable on the $11 million judgment, ordered their assets frozen and ordered a receiver for their assets.
Najat and Freetown were not happy about being “added” to an $11 million judgment and having their assets frozen, so they appealed. The Fifth Circuit did not have much trouble determining that they got a raw deal. The court held that (1) a turnover order may not be used to adjudicate the rights of non-judgment debtors and (2) the plaintiffs never established their case for alter ego. The court also noted that it was wrong to enter judgment against parties who had never been served with a summons. However, since this was not identified as an issue or briefed, it did not furnish an independent ground for relief. It has long been the law that a turnover action may not be used to determine the rights of someone who is not a judgment debtor. Therefore, this result was not very surprising. The court also held that the mere fact that Ali exercised managerial control over a corporation owned by his mother did not state a case for alter ego or reverse veil piercing.
Nothing here is surprising. The only surprise here is that it took an appeal to the Fifth Circuit to undo this mess. A turnover action is not a silver bullet which allows the judgment creditor to recover whatever he wants against whomever he wants without the necessity of following the laws of procedure or evidence. This case points out a weakness in the appellate system. A party who files a frivolous appeal may be subject to sanctions. On the other hand, a party who obtains a frivolous judgment has no such risk. The appellants in this case were forced to incur substantial expense in order to undo relief which should never have been granted. However, they do not seem to have any remedy for their harm aside from ultimate vindication.
No Indefinite TROs Against Non-Parties In the War Against Terror
One result of the war against terror has been new remedies to undermine the financial backing of the bad guys. However, the Fifth Circuit’s recent opinion in USA vs. Holy Land Foundation, 445 F.3d 771 (5th Cir. 2006) was not about a conflict between good guys and bad guys. Rather, it was about whether the United States could obtain an indefinite, ex parte TRO to freeze the assets of a foundation alleged to have aided terrorism in order to keep those assets from being reached by a judgment creditor who was a victim of terrorism.
The Ungars were victims of a terrorist attack. Their estate sued Hamas and not surprisingly got a default judgment. They then got a court order determining that property held by Holy Land Foundation belonged to Hamas. They obtained writs of execution in New York, South Carolina and Washington state.
Meanwhile, the United States brought a criminal proceeding against Holy Land Foundation. When they learned about the Ungar estate's actions, they went in to U.S. District Court in Dallas and got an ex parte TRO under the criminal forfeiture statute freezing the assets of the Holy Land Foundation. The TRO application stated that it was intended to stop the Ungars from executing. However, the Ungars were not made parties and the TRO was issued for an indefinite period.
The Ungar estate appealed the TRO. They claimed that the District Court in Dallas lacked jurisdiction over the bank accounts because the funds were in custodia legis. The Fifth Circuit examined the laws of New York, South Carolina and Washington state and concluded that the writs of execution were not sufficient to place funds in custodia legis. Of particular interest is the analysis with regard to Washington state. There, the Fifth Circuit held that a writ of garnishment would have placed the funds in the custody of the court, but that a writ of execution did not. This sounds just like Texas law and is an important distinction to note.
Then the USA claimed that under the criminal forfeiture statute only the criminal defendant had standing to challenge the injunction. Fifth Circuit discussed standing rules and said no.
Then the USA claimed that their super terrorism laws exempted them from complying with Rule 65 in obtaining an injunction. The Fifth Circuit had previously ruled that Rule 65 did apply. However, this opinion was reversed on other grounds and had been criticized. However, the Fifth Circuit ruled that it was still good law. You can't get an indefinite ex parte injunction against a third party.
It is kind of sad when the good guys feel that due process does not apply to them. Due process should be one of the things which distinguishes us from the bad guys. To contradict Machiavelli, the ends do not justify the means.
Wednesday, June 07, 2006
From Seminole to Katz: What A Long Strange Trip It's Been
On the surface, jurisdiction and immunity doctrines are deadly dull. However, over the past 14 years the extent to which non-consenting states can be subjected to bankruptcy court jurisdiction has been hotly debated based on a number of Supreme Court decisions which did not involve bankruptcy. For most of that time, states seemed to hold the upper hand. Now, a pair of recent Supreme Court decisions have apparently stripped states of most of their immunity and left them in much the same position as other litigants.
The Eleventh Amendment Means More Than It Says
Governmental entities generally enjoy sovereign immunity, which is the right of government not to be sued without its consent. Under the Supremacy Clause, Congress arguably has the right to waive sovereign immunity through legislation. However, states enjoy a second immunity doctrine under the Eleventh Amendment. On the surface, the Eleventh Amendment states that a state cannot be sued by a resident of another state in federal court. However, for over one hundred years, the Supreme Court has said that the Eleventh Amendment means more than it says. Idaho v. Couer D’Alene Tribe of Idaho, 521 U.S. 261 (1997); Hans v. Louisiana, 134 U.S. 1 (1890). Instead, the Eleventh Amendment reflects a larger immunity doctrine which is part of the very fabric of federalism. As a result, the contours of the Eleventh Amendment must be fleshed out through constant litigation.
Congress Sets the Stage for a Constitutional Confrontation
Prior to 1994, the law was clear that sovereign immunity prevented a non-consenting governmental body from being sued for a money judgment in bankruptcy court. United States v. Nordic Village, Inc., 503 U.S. 30 (1992); Hoffman v. Connecticut Department of Income Maintenance, 492 U.S. 96 (1989). However, in 1994, Congress revised 11 U.S.C. §106(a) to expressly “abrogate” the sovereign immunity of governmental units with regard to a number of specific sections of the Bankruptcy Code. Because the listed sections included the avoidance provisions of the Code, it became theoretically possible to sue a state to recover a preference or a fraudulent conveyance.
The Seminole Surprise
The efficacy of the immunity abrogation was abruptly questioned when the Supreme Court decided Seminole Tribe of Florida v. Florida, 517 U.S. 44 (1996). In that case, the Supreme Court held that Congress could not abrogate the Eleventh Amendment immunity of a state under the Indian Commerce Clause. Essentially, the Supreme Court held that the Indian Commerce Clause, being adopted prior to the Eleventh Amendment, could not provide authority for Congress to abrogate the immunity enjoyed by the states. Because the Indian Commerce Clause is located at art. I, §8, cl. 3 and the Bankruptcy Clause is found at art. I, §8, cl. 4, it appeared likely that Congress’s abrogation under 11 U.S.C. §106(a) would be invalid as well.
The Seminole decision prompted a lot of speculation as to the degree to which states would continue to be subject to bankruptcy laws. Were states subject to federal bankruptcy law at all? Could bankruptcy law be enforced indirectly through injunctive relief against state officials? To what extent did the bankruptcy court’s in rem jurisdiction apply against states? Could bankruptcy law be enforced in a non-federal forum?
States Protected From Florida to Alabama
During the period from Seminole in 1996 to University of Alabama v. Garrett, 531 U.S. 356 (2001), the answer appeared to be that states were subject to bankruptcy law but that enforcement against a state was problematic. In Idaho v. Coeur D’Alene Tribe of Idaho, decided in 1997, the Supreme Court held that state officials could be enjoined from violating federal law under the doctrine of Ex Parte Young, but that the doctrine did not apply in the specific case. In that case, the injunctive relief sought did not seek to enforce an unambiguous right, but rather, to determine a dispute between the tribe and the state. The injunctive relief sought in Coeur D’Alene rested on the legal fiction that a state official who violates federal law is acting outside of the scope of his duties and is not entitled to protection. However, a state official who is pursuing state policy acts on behalf of the state and a suit against that official is a de facto suit against the state. The doctrine also stated that relief could only be sought on a prospective basis.
As with Seminole, Coueur D’Alene was not a bankruptcy case, but appeared to have bankruptcy implications. It suggested that state officials were not still subject to federal laws, such as bankruptcy. Thus, a state official could be prospectively enjoined from violating the automatic stay. However, this remedy was cumbersome and largely symbolic. If a state official seized a debtor’s business in violation of the automatic stay, an injunction not to violate the stay in the future would be little help to the specific debtor whose property was seized. Additionally, unless the state had a policy of never recognizing the automatic stay, a violation in one case would not form the basis for relief in another case.
Alden v. Maine, 527 U.S. 706 (1999) also appeared to close another avenue for relief. Because the Eleventh Amendment foreclosed relief against non-consenting states in federal court, it was theoretically possible to enforce federal law in state court. Forcing a state to obey federal law in its own courts could be construed as less offensive to a state’s sovereignty. However, this door was shut as well. In Alden, the Supreme Court held that it would violate the sovereignty of a state to be subjected to a private suit to enforce federal rights even if the suit was brought in the state courts. This posed a real quandary. If a state could not be sued under federal law in either federal court or state court, to what extent was the state actually bound to obey federal law? The bankruptcy implication from Alden was that a trustee could not file an action to recover a preferential transfer from a state in either state court or federal court.
In the same year, the Supreme Court held that a state could not be sued for patent infringement, declining a suggestion to find that this was a deprivation of property without due process of law which would be actionable under the Fourteenth Amendment. Florida Pre-Paid Postsecondary Ed. Expense Board v. College Savings Bank, 527 U.S. 627 (1999). The Court also declined to enforce the Age Discrimination Employment Act, Kimel v. Florida Board of Regents, 528 U.S. 62 (2000) and the Americans with Disabilities Act, University of Alabama v. Garrett, 531 U.S. 356 (2001). The upshot of these cases appeared to be that, while federal law may apply against the states, enforcement of federal rights depended on the voluntary consent of those same states.
States Hood-winked By In Rem Jurisdiction
During the five years from Seminole to Garrett, bankruptcy lawyers watched as bankruptcy jurisdiction was apparently chipped away in non-bankruptcy cases. However, that was to change once the Supreme Court began to consider cases under Title 11. In Tennessee Student Assistance Corporation v. Hood, 544 U.S. ___, 124 S. Ct. 1905; 158 L. Ed. 2d 764; 2004 U.S. LEXIS 3387 (2004), the Supreme Court considered a bankruptcy issue for the first time since 1992. Hood involved whether a debtor could receive a determination that a student loan was dischargeable based on undue hardship over the objection of the state. This case did not look promising for the debtor. It involved an adversary proceeding brought against a non-consenting state in federal court seeking to enforce federal law. However, unlike most of the cases which preceded it, the plaintiff did not seek a money judgment against the state. Instead, the debtor sought declaratory relief that a debt should be discharged. The problem here was that bankruptcy law did not make discharge of student loan debts automatic. Instead, it required that the debtor prove “undue hardship.” 11 U.S.C. §523(a)(8). The procedural rules required that an adversary proceeding be filed and that the defendant be served with a summons. Fed.R.Bankr. Pro. 7001. Under the prior decisions of the court, this appeared to be a loser of a case for the debtor. However, it was not.
The Supreme Court ruled in favor of the debtor based upon the in rem jurisdiction of the federal courts. At first glance, there is nothing wrong with this rationale. Bankruptcy courts possess exclusive jurisdiction over the property of the estate and federal courts had previously recognized their in rem jurisdiction. However, this case did not involve property. Instead, it involved a declaration of the state’s right to enforce a debt against a debtor. The Supreme Court blatantly disregarded the difference between in rem relief (which would apply to specific property) and declaratory relief (which would apply to the parties). While declaratory relief does not impose a financial burden against the state, it clearly limits the ability of the state to seek in personam relief against the debtor. Here, the Supreme Court relied on a legal fiction to overrule the non-textual interpretation of the Eleventh Amendment which had prevailed for the prior 100 years.
Supreme Court Reverses Course To Allow Avoidance
The Supreme Court’s most recent decision on Eleventh Amendment immunity is nothing less than surprising. After multiple decisions invalidating claims for monetary relief against states, the Court allowed a claim to avoid a preference against a non-consenting state. Central Virginia Community College v. Katz, __ U.S. __ (2006). The Supreme Court relied in part upon Hood to suggest that recovering a preference was nothing more than exercising in rem jurisdiction over the payment. In doing so, it implicitly overruled its decision in Begier v. United States, 496 U.S. 53 (1990) which held that dollars were fungible and not subject to in rem relief. However, it also held that the power to establish uniform bankruptcy laws included the power to subject non-consenting states to avoidance actions. This was not a clear repudiation of the cases precluding money judgments. However, even the remedy of avoiding a transfer without necessarily recovering it was a dramatic break from the past. In dissent, Justice Thomas suggested that the Court at least have the decency to admit that they were overruling Seminole.
Katz represents a clear break with prior Eleventh Amendment jurisprudence. Unlike its predecessors, it does not hold that states are independent sovereigns who may ignore federal law with impunity. Instead, it continues the mis-reading of in rem jurisdiction found in Hood and seizes upon the word “uniform” in the Bankruptcy Clause to suggest that states surrendered their historical immunity when they acquiesced in the power to create uniform bankruptcy laws. Perhaps this decision does not allow a money judgment against a non-consenting state. However, that does not seem to be far away.
The Eleventh Amendment Means More Than It Says
Governmental entities generally enjoy sovereign immunity, which is the right of government not to be sued without its consent. Under the Supremacy Clause, Congress arguably has the right to waive sovereign immunity through legislation. However, states enjoy a second immunity doctrine under the Eleventh Amendment. On the surface, the Eleventh Amendment states that a state cannot be sued by a resident of another state in federal court. However, for over one hundred years, the Supreme Court has said that the Eleventh Amendment means more than it says. Idaho v. Couer D’Alene Tribe of Idaho, 521 U.S. 261 (1997); Hans v. Louisiana, 134 U.S. 1 (1890). Instead, the Eleventh Amendment reflects a larger immunity doctrine which is part of the very fabric of federalism. As a result, the contours of the Eleventh Amendment must be fleshed out through constant litigation.
Congress Sets the Stage for a Constitutional Confrontation
Prior to 1994, the law was clear that sovereign immunity prevented a non-consenting governmental body from being sued for a money judgment in bankruptcy court. United States v. Nordic Village, Inc., 503 U.S. 30 (1992); Hoffman v. Connecticut Department of Income Maintenance, 492 U.S. 96 (1989). However, in 1994, Congress revised 11 U.S.C. §106(a) to expressly “abrogate” the sovereign immunity of governmental units with regard to a number of specific sections of the Bankruptcy Code. Because the listed sections included the avoidance provisions of the Code, it became theoretically possible to sue a state to recover a preference or a fraudulent conveyance.
The Seminole Surprise
The efficacy of the immunity abrogation was abruptly questioned when the Supreme Court decided Seminole Tribe of Florida v. Florida, 517 U.S. 44 (1996). In that case, the Supreme Court held that Congress could not abrogate the Eleventh Amendment immunity of a state under the Indian Commerce Clause. Essentially, the Supreme Court held that the Indian Commerce Clause, being adopted prior to the Eleventh Amendment, could not provide authority for Congress to abrogate the immunity enjoyed by the states. Because the Indian Commerce Clause is located at art. I, §8, cl. 3 and the Bankruptcy Clause is found at art. I, §8, cl. 4, it appeared likely that Congress’s abrogation under 11 U.S.C. §106(a) would be invalid as well.
The Seminole decision prompted a lot of speculation as to the degree to which states would continue to be subject to bankruptcy laws. Were states subject to federal bankruptcy law at all? Could bankruptcy law be enforced indirectly through injunctive relief against state officials? To what extent did the bankruptcy court’s in rem jurisdiction apply against states? Could bankruptcy law be enforced in a non-federal forum?
States Protected From Florida to Alabama
During the period from Seminole in 1996 to University of Alabama v. Garrett, 531 U.S. 356 (2001), the answer appeared to be that states were subject to bankruptcy law but that enforcement against a state was problematic. In Idaho v. Coeur D’Alene Tribe of Idaho, decided in 1997, the Supreme Court held that state officials could be enjoined from violating federal law under the doctrine of Ex Parte Young, but that the doctrine did not apply in the specific case. In that case, the injunctive relief sought did not seek to enforce an unambiguous right, but rather, to determine a dispute between the tribe and the state. The injunctive relief sought in Coeur D’Alene rested on the legal fiction that a state official who violates federal law is acting outside of the scope of his duties and is not entitled to protection. However, a state official who is pursuing state policy acts on behalf of the state and a suit against that official is a de facto suit against the state. The doctrine also stated that relief could only be sought on a prospective basis.
As with Seminole, Coueur D’Alene was not a bankruptcy case, but appeared to have bankruptcy implications. It suggested that state officials were not still subject to federal laws, such as bankruptcy. Thus, a state official could be prospectively enjoined from violating the automatic stay. However, this remedy was cumbersome and largely symbolic. If a state official seized a debtor’s business in violation of the automatic stay, an injunction not to violate the stay in the future would be little help to the specific debtor whose property was seized. Additionally, unless the state had a policy of never recognizing the automatic stay, a violation in one case would not form the basis for relief in another case.
Alden v. Maine, 527 U.S. 706 (1999) also appeared to close another avenue for relief. Because the Eleventh Amendment foreclosed relief against non-consenting states in federal court, it was theoretically possible to enforce federal law in state court. Forcing a state to obey federal law in its own courts could be construed as less offensive to a state’s sovereignty. However, this door was shut as well. In Alden, the Supreme Court held that it would violate the sovereignty of a state to be subjected to a private suit to enforce federal rights even if the suit was brought in the state courts. This posed a real quandary. If a state could not be sued under federal law in either federal court or state court, to what extent was the state actually bound to obey federal law? The bankruptcy implication from Alden was that a trustee could not file an action to recover a preferential transfer from a state in either state court or federal court.
In the same year, the Supreme Court held that a state could not be sued for patent infringement, declining a suggestion to find that this was a deprivation of property without due process of law which would be actionable under the Fourteenth Amendment. Florida Pre-Paid Postsecondary Ed. Expense Board v. College Savings Bank, 527 U.S. 627 (1999). The Court also declined to enforce the Age Discrimination Employment Act, Kimel v. Florida Board of Regents, 528 U.S. 62 (2000) and the Americans with Disabilities Act, University of Alabama v. Garrett, 531 U.S. 356 (2001). The upshot of these cases appeared to be that, while federal law may apply against the states, enforcement of federal rights depended on the voluntary consent of those same states.
States Hood-winked By In Rem Jurisdiction
During the five years from Seminole to Garrett, bankruptcy lawyers watched as bankruptcy jurisdiction was apparently chipped away in non-bankruptcy cases. However, that was to change once the Supreme Court began to consider cases under Title 11. In Tennessee Student Assistance Corporation v. Hood, 544 U.S. ___, 124 S. Ct. 1905; 158 L. Ed. 2d 764; 2004 U.S. LEXIS 3387 (2004), the Supreme Court considered a bankruptcy issue for the first time since 1992. Hood involved whether a debtor could receive a determination that a student loan was dischargeable based on undue hardship over the objection of the state. This case did not look promising for the debtor. It involved an adversary proceeding brought against a non-consenting state in federal court seeking to enforce federal law. However, unlike most of the cases which preceded it, the plaintiff did not seek a money judgment against the state. Instead, the debtor sought declaratory relief that a debt should be discharged. The problem here was that bankruptcy law did not make discharge of student loan debts automatic. Instead, it required that the debtor prove “undue hardship.” 11 U.S.C. §523(a)(8). The procedural rules required that an adversary proceeding be filed and that the defendant be served with a summons. Fed.R.Bankr. Pro. 7001. Under the prior decisions of the court, this appeared to be a loser of a case for the debtor. However, it was not.
The Supreme Court ruled in favor of the debtor based upon the in rem jurisdiction of the federal courts. At first glance, there is nothing wrong with this rationale. Bankruptcy courts possess exclusive jurisdiction over the property of the estate and federal courts had previously recognized their in rem jurisdiction. However, this case did not involve property. Instead, it involved a declaration of the state’s right to enforce a debt against a debtor. The Supreme Court blatantly disregarded the difference between in rem relief (which would apply to specific property) and declaratory relief (which would apply to the parties). While declaratory relief does not impose a financial burden against the state, it clearly limits the ability of the state to seek in personam relief against the debtor. Here, the Supreme Court relied on a legal fiction to overrule the non-textual interpretation of the Eleventh Amendment which had prevailed for the prior 100 years.
Supreme Court Reverses Course To Allow Avoidance
The Supreme Court’s most recent decision on Eleventh Amendment immunity is nothing less than surprising. After multiple decisions invalidating claims for monetary relief against states, the Court allowed a claim to avoid a preference against a non-consenting state. Central Virginia Community College v. Katz, __ U.S. __ (2006). The Supreme Court relied in part upon Hood to suggest that recovering a preference was nothing more than exercising in rem jurisdiction over the payment. In doing so, it implicitly overruled its decision in Begier v. United States, 496 U.S. 53 (1990) which held that dollars were fungible and not subject to in rem relief. However, it also held that the power to establish uniform bankruptcy laws included the power to subject non-consenting states to avoidance actions. This was not a clear repudiation of the cases precluding money judgments. However, even the remedy of avoiding a transfer without necessarily recovering it was a dramatic break from the past. In dissent, Justice Thomas suggested that the Court at least have the decency to admit that they were overruling Seminole.
Katz represents a clear break with prior Eleventh Amendment jurisprudence. Unlike its predecessors, it does not hold that states are independent sovereigns who may ignore federal law with impunity. Instead, it continues the mis-reading of in rem jurisdiction found in Hood and seizes upon the word “uniform” in the Bankruptcy Clause to suggest that states surrendered their historical immunity when they acquiesced in the power to create uniform bankruptcy laws. Perhaps this decision does not allow a money judgment against a non-consenting state. However, that does not seem to be far away.
Tuesday, June 06, 2006
The Other Shoe Drops on Pro-Snax
Here is an article which I wrote that was recently published in the Bankruptcy Law Section Newsletter published by the Bankruptcy Law Section of the State Bar of Texas.
When the Fifth Circuit decided Matter of Pro-Snax Distributors, Inc[1].,the court devoted most of its analysis to the issue of whether debtor’s counsel could be compensated from the estate after appointment of a chapter 11 trustee. The Fifth Circuit ruled that the statutory language of 11 U.S.C. §330(a) prohibited such compensation and the Supreme Court subsequently adopted the same position.[2] However, the Fifth Circuit also addressed the broader issue of the proper standard to be used in awarding compensation. In a few short paragraphs, the Fifth Circuit rejected a standard of objective reasonableness and required that legal services result in “an identifiable, tangible and material benefit to the bankruptcy estate.”[3] Courts are only just now starting to focus on the meaning of this second holding.
The Pro-Snax Holding
In addressing the proper standard for awarding compensation, the court stated:
The other task to which this appeal commends us it deciding which standard we must apply to A & K’s services rendered before the appointment of the trustee. A & K argues that a reasonableness test is appropriate—whether the services were objectively beneficial toward the completion of the case at the time they were performed. The Petitioning Creditors, by contrast, advocate a more stringent test—whether A & K’s services resulted in an identifiable, tangible and material benefit to the bankruptcy estate. We determine today that the stricter test is the appropriate measure.[4]
The court went on to state that “we are disinclined to hold that any service performed at any time need only be reasonable to be compensable[5]” and added that “we believe it is important to stress that any work performed by legal counsel on behalf of a debtor must be of material benefit to the estate.[6]”
Thus, the court appears to have held that:
1. Services must result in an identifiable, tangible and material benefit to the estate to be compensable; and
2. Services which were objectively reasonable at the time they were performed, but did not result in an identifiable, tangible and material benefit are not compensable.
These holdings are problematic because they appear to contradict the language of 11 U.S.C. §330(a). The statute provides that courts shall not allow compensation for “services that were not … reasonably likely to benefit the debtor’s estate or …necessary to the administration of the estate.[7]” Because Congress prohibited payment for services not “reasonably likely to benefit the debtor’s estate,” it seems that they approved payment for services which were reasonably likely to benefit the estate. However, Pro-Snax would amend the statute to require that the services rendered an actual, material benefit as judged in hindsight. Congress also stated that courts should consider “whether the services were necessary to the administration of, or beneficial at the time at which the service was rendered toward the completion of a case under this title.”[8] How can Pro-Snax be reconciled with a requirement to look at whether services necessary or beneficial at the time at which they were rendered?
The Pro-Snax ruling is also difficult because it fails to address services, which are necessary to the administration of the case, but do not result in an identifiable, tangible and material benefit. For example, the bankruptcy estate does not receive a direct benefit from filing schedules, attending the first meeting of creditors or filing monthly operating report. However, each of these functions is required by Title 11. While these services do not render a direct benefit, they avoid a direct detriment, that is, having the case dismissed or converted.
Applying Pro-Snax in Chapter 11
While the Pro-Snax material benefit standard has been rejected by some courts in other circuits,[9] it has been applied in a handful of cases within the Fifth Circuit.[10] The most extensive discussion is found in the recent Evans Weaver [11]case from the Western District of Texas. Weaver involved representation of an individual in a failed chapter 11 case described by the judge as “one of the most contentious cases that the Court has involved with since being licensed as a lawyer in 1969.[12]” The case was precarious for debtor’s counsel due to the nastiness of the case, the ultimate conversion to chapter 7 and the inherent conflict present in representing an individual as both debtor and debtor-in-possession.[13]
The Court followed Pro-Snax despite an argument that it was contrary to clear statutory authority.[14] The court separately analyzed each project that the debtor’s counsel and special counsel worked upon to see whether it was compensable.[15] The Court generally divided the fee requests into several categories: those which represented mandatory duties for Debtor’s counsel, which would be allowed subject to reasonableness; those which were for the benefit of the individual debtor, which would not be allowed; those which were not mandatory and did not benefit the estate, for which no compensation would be allowed; and those which were not mandatory but did benefit the estate, for which compensation would be allowed based on reasonableness and the results obtained.
Mandatory Services
The Court found that benefit must be presumed on those matters “necessary to the administration of the case.[16]” Judge Monroe stated that, “The Court believes that is the only exception to the Pro-Snax pronouncement that all services rendered by persons representing the estate have the ability to show the identifiable, tangible and material benefit that has come from their efforts. With regard to ‘mandatory’ work, the benefit must be presumed and the inquiry is one of the reasonableness of the fees charged on such mandatory matters.[17]” Mandatory services were found to include such items as preparing the initial filing, matters related to case administration such as filing schedules and attending the creditors’ meeting[18] and “investigating whether property of the estate has value.[19]” There were also a number of small items which arguably fell into this category.
Services for Debtor’s Benefit
This category illustrates the perils of representing an individual debtor. While the debtor was in chapter 11, he was a party to a pending divorce action and was sued by several creditors to determine dischargeability of debts. These are both areas where the debtor required counsel and which could impact the reorganization case. For example, the divorce action could create new obligations for maintenance or support which would limit the debtor’s funds to pay creditors and could attempt to divide or dispose of property of the estate. Similarly, it would be difficult to negotiate a plan with a creditor without addressing the dischargeability of that creditor’s claim.
However, the court denied or substantially reduced fees in this area reasoning that they were for the benefit of the individual debtor and not the estate. The court completely denied fees with regard to the dischargeability actions. The court was more generous with regard to the divorce action. The court allowed a small portion of special counsel’s fees which brought an asset into the estate which was later bought back from the chapter 7 trustee by the individual debtor. The court also allowed bankruptcy counsel to recover for fees incurred in connection with the motion to lift stay to allow the divorce to go forward and allowed reduced fees for matters relating to coordination between the divorce and bankruptcy.
These rulings, while true to Pro-Snax, raise difficult practical problems. If debtor must have counsel for a dispute, but is not allowed to pay counsel out of the estate, how will debtor obtain qualified counsel? The choices are limited. A debtor can liquidate exempt property, can use funds which are not property of the estate or can borrow funds from outside the estate. However, under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, the debtor’s post-petition earnings in a chapter 11 case are now property of the estate.[20] Therefore, these funds are no longer available to pay counsel for matters which can’t be paid out of the estate.
Non-Mandatory Services Without Benefit
This category resulted in denial of a substantial amount of fees. A non-mandatory service is one that debtor’s counsel is not required to perform under the code. Debtor’s counsel does not have to propose a plan or respond to respond to a motion to dismiss or convert the case. As a practical matter, counsel must perform these duties if the debtor is to emerge from bankruptcy with a confirmed plan. However, these are areas which might not be appropriate in a specific case. As a result, counsel is subject to being second-guessed at fee application time.
The two main areas where the court denied fees for this reason related to the plan and the motion to convert. The court found that the facts relating to the plan were very close to those of Pro Snax in that the debtor was attempting to propose a plan over the vehement objection of his main creditors. However, the court also stated that it could not understand why the creditors would prefer trying to seek a non-dischargeable judgment in chapter 7 to the debtor’s plan. Thus, even though the debtor was objectively trying to benefit his creditors, the fact that they did not want to be benefited meant that these services were not compensable.[21] With regard to the motion to convert, the court found that the debtor’s resistance was simply an attempt to keep the debtor in control at a point where the case had become hopeless.[22]
Non-Mandatory Services With Benefit
In an unsuccessful case, this category is likely to be slim. However, in the Weaver case, the debtor’s counsel pursued a preference claim against the major creditor in the case which the trustee successfully settled for a large sum. The court allowed these fees after noting that it had to prod the debtor to pursue the action in the first place.
Applying Pro-Snax Beyond Chapter 11 Debtor’s Counsel
Nearly all of the cases applying Pro-Snax have involved compensation of debtor’s counsel in a chapter 11 case. However, the statute being interpreted, 11 U.S.C. §330(a), also applies to compensation of a chapter 11 trustee, an ombudsman, an examiner and counsel for a trustee. If the identifiable, tangible material benefit standard is part of the statute, then it must apply to these parties as well. How exactly does an examiner benefit the estate? If an examiner is appointed to investigate the debtor’s transactions with insiders and concludes that no wrongdoing occurred, should compensation be denied on the basis that no benefit was received? If trustee’s counsel investigates 100 potential preference actions, chooses to pursue ten and is successful on five, should compensation be limited to the time spent on the five successful actions or should compensation be allowed for the entire project on the theory that it was necessary to wade through 95 potential claims to find the five meritorious ones?
The second Pro-Snax holding is difficult to reconcile with the statute it sought to interpret. Perhaps the Fifth Circuit was reacting to the specific facts before it and would not apply the same standard to a consumer privacy ombudsman (a position which did not exist at the time of the opinion) or an examiner. It also may be that the Fifth Circuit, like Judge Monroe, would find an exception for “mandatory” services which would mitigate the potential harshness of its ruling. In the alternative, all professionals employed by bankruptcy estates may find themselves under a one-sided contingent fee arrangement[23] and should negotiate their fees accordingly.
End-Notes:
[1] 125 F.3d 414 (5th Cir. 1998).
[2] Lamie v. United States Trustee, 540 U.S. 526, 124 S.Ct. 1023, 157 L.Ed.2d 1024 (2004).
[3] 157 F.3d at 426.
[4] Id.
[5] Id.
[6] Id.
[7] 11 U.S.C. §330(a)(4)(A).
[8] 11 U.S.C. §330(a)(3)(C).
[9] In re Ames Department Stores, Inc., 76 F.3d 66 (2nd Cir. 1996)(while this opinion pre-dates Pro-Snax, it adopts the position rejected by the Fifth Circuit); In re Mednet, 251 B.R. 103 (9th Cir. BAP 2000).
[10] In re Condit, 2003 Bankr. LEXIS 601 (Bankr. N.D. Tex. 2003); In re Needham, 279 B.R. 519 (Bankr. W.D. La. 2001).
[11] In re Evans Weaver, 336 B.R. 115 (Bankr. W.D. Tex. 2005).
[12] In re Evans Weaver, 336 B.R. at 118.
[13] Representation of an individual chapter 11 debtor requires counsel to represent a single individual who is both the individual debtor and the representative of the estate. Some matters, such as exemption disputes, place counsel in a conflict between duties to the debtor and to the estate. Other areas, such as objections to discharge and determination of dischargeability, benefit the debtor without affecting the estate. The state disciplinary rules require counsel to sealously represent both interests. This is less of a problem in chapter 12 and 13 cases because the statute allows compensation for services reasonably benefiting the debtor. 11 U.S.C. §330(a)(4)(B).
[14] “Applicant Borsheim argues that Pro-Snax is at odds with the statute and misinterprets it since the statute plainly authorizes fees ‘for actual, necessary services” (citation omitted) as well as services that are ‘reasonably likely to benefit the debtor’s estate.” (citation omitted). Even if such be true, this Court is constrained to follow the 5th Circuit’s interpretation.” 336 B.R. at 119.
[15] The Local Rules of the Western District require that fee applications contain a description of the categories of services rendered stating the nature and purpose of each category and the results obtained. W. D. Tex. Local Bankr. R. 2016(a)(1).
[16] 11 U.S.C. §330(a)(4)(A)(ii)(II).
[17] In re Evans Weaver, 336 B.R. at 122.
[18] The Condit court approached this area somewhat differently, finding that items such as preparation of schedules and attendance at the first meeting of creditors “inures to the estate’s benefit” and “may confer an actual benefit on the estate” and were therefore compensable. In re Condit, at 8.
[19] “(I)t is mandatory that counsel should spend some time investigating whether property of the estate has value. He should not be required to simply roll over.” 336 B.R. at 123.
[20] 11 U.S.C. §1115.
[21] Other courts have fudged on this issue and have allowed partial compensation for unsuccessful attempts to propose a plan. In re Condit, supra (50% of requested fees allowed); In re Needham, supra (20 hours out of 98.25 allowed).
[22] In contrast, the court allowed fees for resisting a motion to appoint trustee which was “wholly without merit.” It is unclear whether this was allowed as a mandatory item or whether preventing something bad from happening counts as an identifiable, tangible and material benefit.
[23] A one-sided contingent fee arrangement is one where the hourly rate is paid if counsel is successful and no compensation is paid if counsel is unsuccessful. It lacks the upside potential of a traditional contingent fee contract.
When the Fifth Circuit decided Matter of Pro-Snax Distributors, Inc[1].,the court devoted most of its analysis to the issue of whether debtor’s counsel could be compensated from the estate after appointment of a chapter 11 trustee. The Fifth Circuit ruled that the statutory language of 11 U.S.C. §330(a) prohibited such compensation and the Supreme Court subsequently adopted the same position.[2] However, the Fifth Circuit also addressed the broader issue of the proper standard to be used in awarding compensation. In a few short paragraphs, the Fifth Circuit rejected a standard of objective reasonableness and required that legal services result in “an identifiable, tangible and material benefit to the bankruptcy estate.”[3] Courts are only just now starting to focus on the meaning of this second holding.
The Pro-Snax Holding
In addressing the proper standard for awarding compensation, the court stated:
The other task to which this appeal commends us it deciding which standard we must apply to A & K’s services rendered before the appointment of the trustee. A & K argues that a reasonableness test is appropriate—whether the services were objectively beneficial toward the completion of the case at the time they were performed. The Petitioning Creditors, by contrast, advocate a more stringent test—whether A & K’s services resulted in an identifiable, tangible and material benefit to the bankruptcy estate. We determine today that the stricter test is the appropriate measure.[4]
The court went on to state that “we are disinclined to hold that any service performed at any time need only be reasonable to be compensable[5]” and added that “we believe it is important to stress that any work performed by legal counsel on behalf of a debtor must be of material benefit to the estate.[6]”
Thus, the court appears to have held that:
1. Services must result in an identifiable, tangible and material benefit to the estate to be compensable; and
2. Services which were objectively reasonable at the time they were performed, but did not result in an identifiable, tangible and material benefit are not compensable.
These holdings are problematic because they appear to contradict the language of 11 U.S.C. §330(a). The statute provides that courts shall not allow compensation for “services that were not … reasonably likely to benefit the debtor’s estate or …necessary to the administration of the estate.[7]” Because Congress prohibited payment for services not “reasonably likely to benefit the debtor’s estate,” it seems that they approved payment for services which were reasonably likely to benefit the estate. However, Pro-Snax would amend the statute to require that the services rendered an actual, material benefit as judged in hindsight. Congress also stated that courts should consider “whether the services were necessary to the administration of, or beneficial at the time at which the service was rendered toward the completion of a case under this title.”[8] How can Pro-Snax be reconciled with a requirement to look at whether services necessary or beneficial at the time at which they were rendered?
The Pro-Snax ruling is also difficult because it fails to address services, which are necessary to the administration of the case, but do not result in an identifiable, tangible and material benefit. For example, the bankruptcy estate does not receive a direct benefit from filing schedules, attending the first meeting of creditors or filing monthly operating report. However, each of these functions is required by Title 11. While these services do not render a direct benefit, they avoid a direct detriment, that is, having the case dismissed or converted.
Applying Pro-Snax in Chapter 11
While the Pro-Snax material benefit standard has been rejected by some courts in other circuits,[9] it has been applied in a handful of cases within the Fifth Circuit.[10] The most extensive discussion is found in the recent Evans Weaver [11]case from the Western District of Texas. Weaver involved representation of an individual in a failed chapter 11 case described by the judge as “one of the most contentious cases that the Court has involved with since being licensed as a lawyer in 1969.[12]” The case was precarious for debtor’s counsel due to the nastiness of the case, the ultimate conversion to chapter 7 and the inherent conflict present in representing an individual as both debtor and debtor-in-possession.[13]
The Court followed Pro-Snax despite an argument that it was contrary to clear statutory authority.[14] The court separately analyzed each project that the debtor’s counsel and special counsel worked upon to see whether it was compensable.[15] The Court generally divided the fee requests into several categories: those which represented mandatory duties for Debtor’s counsel, which would be allowed subject to reasonableness; those which were for the benefit of the individual debtor, which would not be allowed; those which were not mandatory and did not benefit the estate, for which no compensation would be allowed; and those which were not mandatory but did benefit the estate, for which compensation would be allowed based on reasonableness and the results obtained.
Mandatory Services
The Court found that benefit must be presumed on those matters “necessary to the administration of the case.[16]” Judge Monroe stated that, “The Court believes that is the only exception to the Pro-Snax pronouncement that all services rendered by persons representing the estate have the ability to show the identifiable, tangible and material benefit that has come from their efforts. With regard to ‘mandatory’ work, the benefit must be presumed and the inquiry is one of the reasonableness of the fees charged on such mandatory matters.[17]” Mandatory services were found to include such items as preparing the initial filing, matters related to case administration such as filing schedules and attending the creditors’ meeting[18] and “investigating whether property of the estate has value.[19]” There were also a number of small items which arguably fell into this category.
Services for Debtor’s Benefit
This category illustrates the perils of representing an individual debtor. While the debtor was in chapter 11, he was a party to a pending divorce action and was sued by several creditors to determine dischargeability of debts. These are both areas where the debtor required counsel and which could impact the reorganization case. For example, the divorce action could create new obligations for maintenance or support which would limit the debtor’s funds to pay creditors and could attempt to divide or dispose of property of the estate. Similarly, it would be difficult to negotiate a plan with a creditor without addressing the dischargeability of that creditor’s claim.
However, the court denied or substantially reduced fees in this area reasoning that they were for the benefit of the individual debtor and not the estate. The court completely denied fees with regard to the dischargeability actions. The court was more generous with regard to the divorce action. The court allowed a small portion of special counsel’s fees which brought an asset into the estate which was later bought back from the chapter 7 trustee by the individual debtor. The court also allowed bankruptcy counsel to recover for fees incurred in connection with the motion to lift stay to allow the divorce to go forward and allowed reduced fees for matters relating to coordination between the divorce and bankruptcy.
These rulings, while true to Pro-Snax, raise difficult practical problems. If debtor must have counsel for a dispute, but is not allowed to pay counsel out of the estate, how will debtor obtain qualified counsel? The choices are limited. A debtor can liquidate exempt property, can use funds which are not property of the estate or can borrow funds from outside the estate. However, under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, the debtor’s post-petition earnings in a chapter 11 case are now property of the estate.[20] Therefore, these funds are no longer available to pay counsel for matters which can’t be paid out of the estate.
Non-Mandatory Services Without Benefit
This category resulted in denial of a substantial amount of fees. A non-mandatory service is one that debtor’s counsel is not required to perform under the code. Debtor’s counsel does not have to propose a plan or respond to respond to a motion to dismiss or convert the case. As a practical matter, counsel must perform these duties if the debtor is to emerge from bankruptcy with a confirmed plan. However, these are areas which might not be appropriate in a specific case. As a result, counsel is subject to being second-guessed at fee application time.
The two main areas where the court denied fees for this reason related to the plan and the motion to convert. The court found that the facts relating to the plan were very close to those of Pro Snax in that the debtor was attempting to propose a plan over the vehement objection of his main creditors. However, the court also stated that it could not understand why the creditors would prefer trying to seek a non-dischargeable judgment in chapter 7 to the debtor’s plan. Thus, even though the debtor was objectively trying to benefit his creditors, the fact that they did not want to be benefited meant that these services were not compensable.[21] With regard to the motion to convert, the court found that the debtor’s resistance was simply an attempt to keep the debtor in control at a point where the case had become hopeless.[22]
Non-Mandatory Services With Benefit
In an unsuccessful case, this category is likely to be slim. However, in the Weaver case, the debtor’s counsel pursued a preference claim against the major creditor in the case which the trustee successfully settled for a large sum. The court allowed these fees after noting that it had to prod the debtor to pursue the action in the first place.
Applying Pro-Snax Beyond Chapter 11 Debtor’s Counsel
Nearly all of the cases applying Pro-Snax have involved compensation of debtor’s counsel in a chapter 11 case. However, the statute being interpreted, 11 U.S.C. §330(a), also applies to compensation of a chapter 11 trustee, an ombudsman, an examiner and counsel for a trustee. If the identifiable, tangible material benefit standard is part of the statute, then it must apply to these parties as well. How exactly does an examiner benefit the estate? If an examiner is appointed to investigate the debtor’s transactions with insiders and concludes that no wrongdoing occurred, should compensation be denied on the basis that no benefit was received? If trustee’s counsel investigates 100 potential preference actions, chooses to pursue ten and is successful on five, should compensation be limited to the time spent on the five successful actions or should compensation be allowed for the entire project on the theory that it was necessary to wade through 95 potential claims to find the five meritorious ones?
The second Pro-Snax holding is difficult to reconcile with the statute it sought to interpret. Perhaps the Fifth Circuit was reacting to the specific facts before it and would not apply the same standard to a consumer privacy ombudsman (a position which did not exist at the time of the opinion) or an examiner. It also may be that the Fifth Circuit, like Judge Monroe, would find an exception for “mandatory” services which would mitigate the potential harshness of its ruling. In the alternative, all professionals employed by bankruptcy estates may find themselves under a one-sided contingent fee arrangement[23] and should negotiate their fees accordingly.
End-Notes:
[1] 125 F.3d 414 (5th Cir. 1998).
[2] Lamie v. United States Trustee, 540 U.S. 526, 124 S.Ct. 1023, 157 L.Ed.2d 1024 (2004).
[3] 157 F.3d at 426.
[4] Id.
[5] Id.
[6] Id.
[7] 11 U.S.C. §330(a)(4)(A).
[8] 11 U.S.C. §330(a)(3)(C).
[9] In re Ames Department Stores, Inc., 76 F.3d 66 (2nd Cir. 1996)(while this opinion pre-dates Pro-Snax, it adopts the position rejected by the Fifth Circuit); In re Mednet, 251 B.R. 103 (9th Cir. BAP 2000).
[10] In re Condit, 2003 Bankr. LEXIS 601 (Bankr. N.D. Tex. 2003); In re Needham, 279 B.R. 519 (Bankr. W.D. La. 2001).
[11] In re Evans Weaver, 336 B.R. 115 (Bankr. W.D. Tex. 2005).
[12] In re Evans Weaver, 336 B.R. at 118.
[13] Representation of an individual chapter 11 debtor requires counsel to represent a single individual who is both the individual debtor and the representative of the estate. Some matters, such as exemption disputes, place counsel in a conflict between duties to the debtor and to the estate. Other areas, such as objections to discharge and determination of dischargeability, benefit the debtor without affecting the estate. The state disciplinary rules require counsel to sealously represent both interests. This is less of a problem in chapter 12 and 13 cases because the statute allows compensation for services reasonably benefiting the debtor. 11 U.S.C. §330(a)(4)(B).
[14] “Applicant Borsheim argues that Pro-Snax is at odds with the statute and misinterprets it since the statute plainly authorizes fees ‘for actual, necessary services” (citation omitted) as well as services that are ‘reasonably likely to benefit the debtor’s estate.” (citation omitted). Even if such be true, this Court is constrained to follow the 5th Circuit’s interpretation.” 336 B.R. at 119.
[15] The Local Rules of the Western District require that fee applications contain a description of the categories of services rendered stating the nature and purpose of each category and the results obtained. W. D. Tex. Local Bankr. R. 2016(a)(1).
[16] 11 U.S.C. §330(a)(4)(A)(ii)(II).
[17] In re Evans Weaver, 336 B.R. at 122.
[18] The Condit court approached this area somewhat differently, finding that items such as preparation of schedules and attendance at the first meeting of creditors “inures to the estate’s benefit” and “may confer an actual benefit on the estate” and were therefore compensable. In re Condit, at 8.
[19] “(I)t is mandatory that counsel should spend some time investigating whether property of the estate has value. He should not be required to simply roll over.” 336 B.R. at 123.
[20] 11 U.S.C. §1115.
[21] Other courts have fudged on this issue and have allowed partial compensation for unsuccessful attempts to propose a plan. In re Condit, supra (50% of requested fees allowed); In re Needham, supra (20 hours out of 98.25 allowed).
[22] In contrast, the court allowed fees for resisting a motion to appoint trustee which was “wholly without merit.” It is unclear whether this was allowed as a mandatory item or whether preventing something bad from happening counts as an identifiable, tangible and material benefit.
[23] A one-sided contingent fee arrangement is one where the hourly rate is paid if counsel is successful and no compensation is paid if counsel is unsuccessful. It lacks the upside potential of a traditional contingent fee contract.
Friday, June 02, 2006
NACBA and Connecticut Bar Association File Suit Over Debt Relief Agency Provisions of BAPCPA
One of the least popular aspect of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) has been its provisions governing "debt relief agencies." It is fairly apparent that Congress believed that one cause for growing bankruptcy filings was unethical attorneys. Their answer was to define and regulate "debt relief agencies." The Connecticut Bar Association and the National Association of Consumer Bankruptcy Attorneys have filed suit to invalidate BAPCPA's regulation of attorney debt relief agencies. More on that later, but first a little background on why this matters.
Who is a Debt Relief Agency?
Under the statute, a debt relief agency is a person who provides "bankruptcy assistance" to an "assisted person" in return for money or other valuable consideration. 11 U.S.C. Sec. 101(12A). "Bankruptcy assistance" consists of providing goods or services to an assisted person with the purpose of "providing information, advice, counsel, document preparation, or filing, or attendance at a creditors' meeting or appearing in a case or proceeding on behalf of another or providing legal representation with respect to a case or proceeding under this title." 11 U.S.C. Sec. 101(4A). An "assisted person" is a person whose debts consist primarily of consumer debts and whose non-exempt property is worth less than $150,000. 11 U.S.C. Sec. 101(3). A debt relief agency does not include an officer, director or employee of a debt relief agency, a non-profit organization exempt from taxation, a creditor who is assisting a debt with restructuring a debt, a depository institution or an author acting in his capacity as author.
Put it together and what do you have? If you accept money for providing legal advice or representation to a person with primarily consumer debts and non-exempt property worth less than $150,000, then your firm is a "debt relief agency." Conversely, if you want to avoid being a debt relief agency, you must limit your practice to pro bono work or only accept clients with non-consumer debts.
An opinion released on the first day that BAPCPA took effect held that attorneys were not debt relief agencies. In re Attorneys at Law and Debt Relief Agencies, 332 B.R. 66 (Bankr. S.D. Ga. 2005). However, this opinion is almost certainly wishful thinking. When the statute defines bankruptcy assistance as providing legal representation, it is hard to conclude that lawyers are not implicated.
What Requirements Apply to Debt Relief Agencies?
Congress devoted three full sections to regulation of debt relief agencies. 11 U.S.C. Sec. 526-528. In my copy of the Code, these sections take up 3 1/2 pages of small text. Obviously, Congress wanted to make sure that there were a lot of standards applied to debt relief agencies. Among the more onerous requirements are the following:
(a) A debt relief agency may not make a statement in a document filed in a case that is untrue or misleading. 11 U.S.C. Sec. 526(a)(2). Why is this bad? It makes the attorney guaranty the accuracy of his client's statements. Thus, if the client fails to inform the attorney about his bank account in the Cayman Islands and the attorney files schedules which omit that asset, the attorney has just violated federal law. There does not appear to be any requirement that the false statement be made knowingly or that it be material. The mere existence of any false statement is a violation. To make things more egregious, the same requirement does not apply to creditor's lawyers. They can make false statements on behalf of their clients so long as they don't violate Rule 9011.
(b) A debt relief agency may not advise a client to incur more debt in contemplation of a bankruptcy. 11 U.S.C. Sec. 526(a)(4). Why is this bad? It limits the advice an attorney can give his client. Does the client have a worn out car that gets low mileage and costs a lot of money to repair? Getting a new full-efficient vehicle at a low interest rate might be a good idea. However, the attorney can't suggest that to his client or even give an answer when the client asks the question.
(c) No later than five days after the first date on which a debt relief agency provides any bankruptcy assistance to a client, the debt relief agency must execute a written contract with the client. 11 U.S.C. Sec. 528(a)(1). Why is this bad? It assumes that a client will know whether he wants to hire the attorney within five days from the first consultation. What happens if the attorney charges $50 for an initial consultation and the client decides not to file bankruptcy based on the attorneys advice? In this scenario, the attorney is clearly a debt relief agency because he charged money for providing bankruptcy advice. Therefore, he must execute a written contract with the assisted person within five days. He must do this even if no future services are contemplated. Another common scenario applies where an attorney gives an initial consultation without charge and does not hear back from the prospective client again for months. In this situation, the attorney is still required to execute a written contract because he provided bankruptcy assistance to an assisted person. So what is the attorney to do? The attorney must prepare a series of different contracts for each stage of the process. If nothing else, this is overregulation and needless creation of paperwork.
(d) If the attorney chooses to advertise bankruptcy assistance services or the benefits of bankruptcy to the general public, the attorney must use the words "We are a debt relief agency. We help people file for bankruptcy under the Bankruptcy Code" or similar words in the advertisement. 11 U.S.C. Sec. 528(a)(3) and (b)(2)(B). Why is this bad? It mandates that specific, stilted language be used regardless of whether it is appropriate. The term "debt relief agency" is likely to mislead the public, since it suggests that the attorney is something other than an attorney. Governments have agencies. Insurance and advertising professionals have agencies. However, attorneys in private practice rarely, if ever, describe themselves as being with an agency. Thus, to comply with the law, an attorney must make a misleading statement and run the risk of discipline from his state bar association. Taking it further, if an attorney has a practice which includes representing both debtors and creditors, he must include specific language which gives the impression that he only represents debtors. In an even more extreme example, an attorney who limits his practice to representing creditors in bankruptcy would have to include the false statement "We help people file for bankruptcy" in his ad. Why is this? If the advertisement offers to help creditors in bankruptcy, it is still an ad for bankruptcy assistance services. Therefore, the required disclaimer must be made even if it is false.
To sum it all up, the provisions governing "debt relief agencies" impose nonsensical requirements which do little to assist the general public.
The Connecticut Suit
On May 11, 2006, The Connecticut Bar Association, the National Association of Consumer Bankruptcy Attorneys and several individual attorneys and law firms filed suit in United States District Court seeking to overturn the provisions of BAPCPA governing debt relief agencies. A copy of the petition can be found at http://nacba.com/files/main_page/complaint.pdf. The Plaintiffs argue alternatively that the debt relief agency provisions do not apply to attorneys or that, if they do, they are unconstitutional under the First and Fifth Amendments and the constitutional principles of federalism and separation of powers. The legal basis for their arguments is set out in a memorandum filed in support of their request for preliminary injunction. NACBA has considerately posted the document in Word format so that anyone who wants to make similar arguments can cut and paste. It is available on the NACBA home page. http://nacba.com.
The Commercial Law League, a leading creditors' rights organization, has filed an amicus brief in support of the plaintiffs.
Who is a Debt Relief Agency?
Under the statute, a debt relief agency is a person who provides "bankruptcy assistance" to an "assisted person" in return for money or other valuable consideration. 11 U.S.C. Sec. 101(12A). "Bankruptcy assistance" consists of providing goods or services to an assisted person with the purpose of "providing information, advice, counsel, document preparation, or filing, or attendance at a creditors' meeting or appearing in a case or proceeding on behalf of another or providing legal representation with respect to a case or proceeding under this title." 11 U.S.C. Sec. 101(4A). An "assisted person" is a person whose debts consist primarily of consumer debts and whose non-exempt property is worth less than $150,000. 11 U.S.C. Sec. 101(3). A debt relief agency does not include an officer, director or employee of a debt relief agency, a non-profit organization exempt from taxation, a creditor who is assisting a debt with restructuring a debt, a depository institution or an author acting in his capacity as author.
Put it together and what do you have? If you accept money for providing legal advice or representation to a person with primarily consumer debts and non-exempt property worth less than $150,000, then your firm is a "debt relief agency." Conversely, if you want to avoid being a debt relief agency, you must limit your practice to pro bono work or only accept clients with non-consumer debts.
An opinion released on the first day that BAPCPA took effect held that attorneys were not debt relief agencies. In re Attorneys at Law and Debt Relief Agencies, 332 B.R. 66 (Bankr. S.D. Ga. 2005). However, this opinion is almost certainly wishful thinking. When the statute defines bankruptcy assistance as providing legal representation, it is hard to conclude that lawyers are not implicated.
What Requirements Apply to Debt Relief Agencies?
Congress devoted three full sections to regulation of debt relief agencies. 11 U.S.C. Sec. 526-528. In my copy of the Code, these sections take up 3 1/2 pages of small text. Obviously, Congress wanted to make sure that there were a lot of standards applied to debt relief agencies. Among the more onerous requirements are the following:
(a) A debt relief agency may not make a statement in a document filed in a case that is untrue or misleading. 11 U.S.C. Sec. 526(a)(2). Why is this bad? It makes the attorney guaranty the accuracy of his client's statements. Thus, if the client fails to inform the attorney about his bank account in the Cayman Islands and the attorney files schedules which omit that asset, the attorney has just violated federal law. There does not appear to be any requirement that the false statement be made knowingly or that it be material. The mere existence of any false statement is a violation. To make things more egregious, the same requirement does not apply to creditor's lawyers. They can make false statements on behalf of their clients so long as they don't violate Rule 9011.
(b) A debt relief agency may not advise a client to incur more debt in contemplation of a bankruptcy. 11 U.S.C. Sec. 526(a)(4). Why is this bad? It limits the advice an attorney can give his client. Does the client have a worn out car that gets low mileage and costs a lot of money to repair? Getting a new full-efficient vehicle at a low interest rate might be a good idea. However, the attorney can't suggest that to his client or even give an answer when the client asks the question.
(c) No later than five days after the first date on which a debt relief agency provides any bankruptcy assistance to a client, the debt relief agency must execute a written contract with the client. 11 U.S.C. Sec. 528(a)(1). Why is this bad? It assumes that a client will know whether he wants to hire the attorney within five days from the first consultation. What happens if the attorney charges $50 for an initial consultation and the client decides not to file bankruptcy based on the attorneys advice? In this scenario, the attorney is clearly a debt relief agency because he charged money for providing bankruptcy advice. Therefore, he must execute a written contract with the assisted person within five days. He must do this even if no future services are contemplated. Another common scenario applies where an attorney gives an initial consultation without charge and does not hear back from the prospective client again for months. In this situation, the attorney is still required to execute a written contract because he provided bankruptcy assistance to an assisted person. So what is the attorney to do? The attorney must prepare a series of different contracts for each stage of the process. If nothing else, this is overregulation and needless creation of paperwork.
(d) If the attorney chooses to advertise bankruptcy assistance services or the benefits of bankruptcy to the general public, the attorney must use the words "We are a debt relief agency. We help people file for bankruptcy under the Bankruptcy Code" or similar words in the advertisement. 11 U.S.C. Sec. 528(a)(3) and (b)(2)(B). Why is this bad? It mandates that specific, stilted language be used regardless of whether it is appropriate. The term "debt relief agency" is likely to mislead the public, since it suggests that the attorney is something other than an attorney. Governments have agencies. Insurance and advertising professionals have agencies. However, attorneys in private practice rarely, if ever, describe themselves as being with an agency. Thus, to comply with the law, an attorney must make a misleading statement and run the risk of discipline from his state bar association. Taking it further, if an attorney has a practice which includes representing both debtors and creditors, he must include specific language which gives the impression that he only represents debtors. In an even more extreme example, an attorney who limits his practice to representing creditors in bankruptcy would have to include the false statement "We help people file for bankruptcy" in his ad. Why is this? If the advertisement offers to help creditors in bankruptcy, it is still an ad for bankruptcy assistance services. Therefore, the required disclaimer must be made even if it is false.
To sum it all up, the provisions governing "debt relief agencies" impose nonsensical requirements which do little to assist the general public.
The Connecticut Suit
On May 11, 2006, The Connecticut Bar Association, the National Association of Consumer Bankruptcy Attorneys and several individual attorneys and law firms filed suit in United States District Court seeking to overturn the provisions of BAPCPA governing debt relief agencies. A copy of the petition can be found at http://nacba.com/files/main_page/complaint.pdf. The Plaintiffs argue alternatively that the debt relief agency provisions do not apply to attorneys or that, if they do, they are unconstitutional under the First and Fifth Amendments and the constitutional principles of federalism and separation of powers. The legal basis for their arguments is set out in a memorandum filed in support of their request for preliminary injunction. NACBA has considerately posted the document in Word format so that anyone who wants to make similar arguments can cut and paste. It is available on the NACBA home page. http://nacba.com.
The Commercial Law League, a leading creditors' rights organization, has filed an amicus brief in support of the plaintiffs.
Interesting Opinion on Dischargeability of Student Loans
Judge Larry Kelly of the Western District of Texas has just written an opinion on dischargeability of student loans. This is must reading for anyone trying a case under Sec. 523(a)(8) because it is very comprehensive. A few interesting points.
Burden of Proof:
The conventional wisdom has been that the Debtor has the burden of proof on all issues in a student loan discharge case. However, in Ford v. Texas Higher Education Coordinating Board, Judge Kelly held that it is the creditor’s burden to prove (1) the existence of a debt (2) made for an educational loan and (3) made, insured or guaranteed by a governmental unit or made under any program funded in whole or in party by a governmental unit or nonprofit institution. If the creditor meets its burden, then the debtor must prove that excepting the debt from discharge will impose an undue hardship. This poses an interesting conundrum. What happens if neither side offers any evidence? Does it mean that the debtor automatically wins, since the creditor did not meet its burden? I think that Judge Kelly has it right. There are two different ways that a student loan might be dischargeable. The first is if one of the elements of non-dischargeability is not present. For example, if the debtor ran up a big tab to Starbucks for coffee which enabled her to study, his would arguably an educational loan (or at least a loan for educational purposes). However, since it was not made, insured or guaranteed by a governmental unit or non-profit it does not meet the first test. The second way for it to be dischargeable would be if undue hardship was shown. This raises a pleading issue. If the debtor alleges that the first part of the test is met, then the debtor would be judicially estopped from denying that the creditor had met its burden. However, if the debtor disputes it in a clear case, debtor’s counsel may violate Rule 9011.
The Bruner Test
Judge Kelly found that Bruner v. New York Higher Education Services Corp., 831 F.2d 395 (2nd Cir. 1987) applies. Several years ago in In re Speer, 272 B.R. 186 (Bankr. W.D. Tex. 2001) Judge Monroe had questioned whether Bruner was good law in the Fifth Circuit. Since that time, the Fifth Circuit has adopted Bruner, which is a shame because it imposes a very high standard. The Fifth Circuit opinion is In re Gerhardt, 348 F.3d 89 (5th Cir. 2003).
Applying Bruner
Bruner has three prongs: (1) that the debtor cannot maintain a minimal lifestyle if forced to repay the loans; (2) that additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period and (3) that the debtor has made good faith efforts to repay the loans.
In this case, the Debtor ran up $250,000 in loans attending Texas Lutheran College (my alma mater) and St. Mary’s Law School. Apparently St. Mary’s is very expensive. Unfortunately, she was not able to pass the bar. She worked at a series of progressively better jobs but capped out at $45,000.
Judge Kelly found that the third prong was satisfied despite the fact that the debtor had never made a payment and had not applied to the Ford Federal Direct Loan Program. The court found that it is not bad faith to fail to make payments if you don’t have any money to make them with. Further, the debtor had explored avenues to receive help from elected officials and charitable organizations.
However, Judge Kelly found that the second prong was not present. According to the Fifth Circuit, this prong requires proof that the debtor has a total incapacity in the future to pay his debts for reasons not within his control. The additional factors that the Fifth Circuit said could apply would be psychiatric problems, lack of usable job skills and severely limited education. It would appear that some of these factors were arguably present. The debtor had gotten depressed and attempted suicide in 2002 and she was not able to use her education for its intended purpose. However, the pro se plaintiff showed herself to be highly educated and well-spoken; she presented her claims in an organized manner with supporting documentation and made a good presentation of her position. Normally, this would be high praise. However, here it spelled defeat when combined with her continuous employment.
The message here is that Bruner requires something much more than persistent inability to pay. To paraphrase the old Saturday Night Live sketch, the person has to end up living in a van down by the river (which was very close to the facts in Judge Monroe’s Speer case).
Because the Court found that the second prong was not satisfied, it never reached the first prong.
Constitutionality
At trial, the Debtor tried to argue that Sec. 523(a)(8) was unconstitutional. If you are going to make this request, be sure to include it in your pleadings and also be sure to join the Attorney General of the United States as a party. Trying to make a trial amendment on a constitutional issue is not a good idea and was not successful here.
The judgment in this case is located at http://www.txwb.uscourts.gov/opinions/opdf/05-06023-lek_Ford%20v.%20Sallie%20Mae%20Servicing%20et%20al.pdf. However, to get the opinion, you will need to go on to PACER at https://ecf.txwb.uscourts.gov/cgi-bin/login.pl?315066890217586-L_786_0-1 (PACER registration required).
Burden of Proof:
The conventional wisdom has been that the Debtor has the burden of proof on all issues in a student loan discharge case. However, in Ford v. Texas Higher Education Coordinating Board, Judge Kelly held that it is the creditor’s burden to prove (1) the existence of a debt (2) made for an educational loan and (3) made, insured or guaranteed by a governmental unit or made under any program funded in whole or in party by a governmental unit or nonprofit institution. If the creditor meets its burden, then the debtor must prove that excepting the debt from discharge will impose an undue hardship. This poses an interesting conundrum. What happens if neither side offers any evidence? Does it mean that the debtor automatically wins, since the creditor did not meet its burden? I think that Judge Kelly has it right. There are two different ways that a student loan might be dischargeable. The first is if one of the elements of non-dischargeability is not present. For example, if the debtor ran up a big tab to Starbucks for coffee which enabled her to study, his would arguably an educational loan (or at least a loan for educational purposes). However, since it was not made, insured or guaranteed by a governmental unit or non-profit it does not meet the first test. The second way for it to be dischargeable would be if undue hardship was shown. This raises a pleading issue. If the debtor alleges that the first part of the test is met, then the debtor would be judicially estopped from denying that the creditor had met its burden. However, if the debtor disputes it in a clear case, debtor’s counsel may violate Rule 9011.
The Bruner Test
Judge Kelly found that Bruner v. New York Higher Education Services Corp., 831 F.2d 395 (2nd Cir. 1987) applies. Several years ago in In re Speer, 272 B.R. 186 (Bankr. W.D. Tex. 2001) Judge Monroe had questioned whether Bruner was good law in the Fifth Circuit. Since that time, the Fifth Circuit has adopted Bruner, which is a shame because it imposes a very high standard. The Fifth Circuit opinion is In re Gerhardt, 348 F.3d 89 (5th Cir. 2003).
Applying Bruner
Bruner has three prongs: (1) that the debtor cannot maintain a minimal lifestyle if forced to repay the loans; (2) that additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period and (3) that the debtor has made good faith efforts to repay the loans.
In this case, the Debtor ran up $250,000 in loans attending Texas Lutheran College (my alma mater) and St. Mary’s Law School. Apparently St. Mary’s is very expensive. Unfortunately, she was not able to pass the bar. She worked at a series of progressively better jobs but capped out at $45,000.
Judge Kelly found that the third prong was satisfied despite the fact that the debtor had never made a payment and had not applied to the Ford Federal Direct Loan Program. The court found that it is not bad faith to fail to make payments if you don’t have any money to make them with. Further, the debtor had explored avenues to receive help from elected officials and charitable organizations.
However, Judge Kelly found that the second prong was not present. According to the Fifth Circuit, this prong requires proof that the debtor has a total incapacity in the future to pay his debts for reasons not within his control. The additional factors that the Fifth Circuit said could apply would be psychiatric problems, lack of usable job skills and severely limited education. It would appear that some of these factors were arguably present. The debtor had gotten depressed and attempted suicide in 2002 and she was not able to use her education for its intended purpose. However, the pro se plaintiff showed herself to be highly educated and well-spoken; she presented her claims in an organized manner with supporting documentation and made a good presentation of her position. Normally, this would be high praise. However, here it spelled defeat when combined with her continuous employment.
The message here is that Bruner requires something much more than persistent inability to pay. To paraphrase the old Saturday Night Live sketch, the person has to end up living in a van down by the river (which was very close to the facts in Judge Monroe’s Speer case).
Because the Court found that the second prong was not satisfied, it never reached the first prong.
Constitutionality
At trial, the Debtor tried to argue that Sec. 523(a)(8) was unconstitutional. If you are going to make this request, be sure to include it in your pleadings and also be sure to join the Attorney General of the United States as a party. Trying to make a trial amendment on a constitutional issue is not a good idea and was not successful here.
The judgment in this case is located at http://www.txwb.uscourts.gov/opinions/opdf/05-06023-lek_Ford%20v.%20Sallie%20Mae%20Servicing%20et%20al.pdf. However, to get the opinion, you will need to go on to PACER at https://ecf.txwb.uscourts.gov/cgi-bin/login.pl?315066890217586-L_786_0-1 (PACER registration required).
Supreme Court Rules in Favor of Federal Jurisdiction in Anna Nicole Smith Case; Few Prurient Details in Opinion
In a victory for advocates of expansive federal jurisdiction, the Supreme Court ruled on May 1 that the probate exception to federal jurisdiction did not preclude the Bankruptcy Court in California from considering counterclaims brought by Vickie Lynn Marshall a/k/a Anna Nicole Smith in response to a dischargeability action.
The tabloids and talk radio have made a big deal about the salacious aspects of this case (you know, stripper marries old guy, old guy dies, stripper doesn't get the money, stripper sues and gets half a billion dollars). However, it is really a study in federalism involving a shootout between the Bankruptcy Court for the Central District of California and a Texas Probate Court.
Lower Court Proceedings
When J. Howard Marshall (Dead Husband) died in 1995, his bereaved widow, Vickie Lynn a/k/a Anna Nicole (Bereaved Widow) did not receive an inheritance or the large gift that Dead Husband had promised during his lifetime. This lack of funding, along with a default judgment for same-sex sexual harassment, caused Bereaved Widow to file bankruptcy. See In re Marshall, 253 B.R. 550 (Bankr. C.D. Cal. 2000). Before filing bankruptcy, Bereaved Widow said some unkind things about Dead Husband's son, E. Pierce (Angry Son). Angry Son objected to dischargeability of his claims against Bereaved Widow claiming willful and malicious injury. Bereaved Widow counterclaimed asserting that Angry Son had tortiously interfered with a gift that Dead Husband had intended to make to Bereaved Widow. The Bankruptcy Court granted a take-nothing summary judgment on the dischargeability claim. It then conducted a trial on the counterclaim, where it ruledled in favor of Bereaved Widow (although its ruling was largely based upon discovery abuse). Angry Son then sought to vacate the judgment on the ground that the Bankruptcy Court lacked subject matter jurisdiction and also filed suit in Texas Probate Court. On appeal, the U.S. District Court concluded that this was a non-core proceeding but that the Bankruptcy Court was right. The District Court entered an original judgment against Angry Son. The District Court opinion contains a fascinating discussion of the relations between the parties. In re Marshall, 275 B.R. 5 (C.D. Cal. 2002). Among other things, we learn that because Bereaved Widow was large-boned, she did not qualify to work the night shift at the strip club. However, her relegation to the "B Team" allowed her to meet Dead Husband, so that it all worked out.
Meanwhile, back in Texas, the Texas Probate Court entered judgment that Bereaved Widow was entitled to nothing and that it had exclusive jurisdiction to settle the dispute since it related to a dead guy. To complicate things, the Probate Court made its ruling one month before the District Court entered its judgment. Thus, there were two competing judgments, one federal and one state each reaching opposite results. The Ninth Circuit reversed the District Court holding that the probate exception to federal jurisdiction precluded the Bankruptcy Court and District Court from exercizing federal jurisdiction. That set the stage for the Supreme Court, which reversed the Ninth Circuit.
The Supreme Court Opinion
The Supreme Court held that neither the "domestic relations" exception nor the "probate" exception are mandated by the Constitution or federal law and pointed out out its own efforts to "rein in" these exceptions. Because this case did not seek to invalidate a will or otherwise interfere with the administration of the probate estate, it did not fall within the probate exception to federal jurisdiction. Additionally, the Supreme Court held that the federal courts were not bound by the decision of the Texas Probate Court that it had exclusive jurisdiction to consider the tortious interference claims. Federal courts get to decide their own jurisction; state courts cannot claim exlusive jurisdiction over something that would otherwise fall within federal jurisdiction.
After all this, it looked pretty good for Bereaved Widow. However, in the last section of the opinion, the Supreme Court pointed out that the state court was arguably the first one to enter a final judgment. It remanded to the Ninth Circuit to determine (1) whether Bereaved Widow's claims were core proceedings and (2) whether res judicata or collateral estoppel applied. If Bereaved Widow had core claims, then the Bankruptcy Court's judgment was first in time. If they were non-core, then the Probate Court judgment was first in time (since there wouldn't be a final federal judgment until the District Court ruled). The core proceeding issue could go either way. If the Ninth Circuit finds that Bereaved Widow's claims were non-core, will the federal court give res judicata or collateral estoppel effect to the state court ruling?
Forum Shopping
While the Supreme Court ruled based on the narrow issue of jurisdiction, there is a much larger issue of forum shopping. Even before Dead Husband died, Bereaved Widow had filed suit against Angry Son in probate court accusing him of intefering with the support she was to receive. After his death, she filed suit to invalidate his will and determine that he died intestate. According to the Ninth Circuit, Bereaved Widow then filed bankruptcy in California "claiming" to be a resident of California. In re Marshall, 392 F.3d 1118 (9th Cir. 2004). After she received a favorable judgment from the Bankruptcy Court, she nonsuited her claims in the Probate Court despite being warned by the Probate Court that she would not be able to refile them. Shortly after that, Angry Son filed an amended counterclaim against Bereaved Widow in Probate Court seeking a determination of her rights against the estate. The Probate Court then conducted a five month trial in which all the parties participated. In fact, Bereaved Widow's counsel told that the court that she was seeking to litigate tortious interference with a gift, the same issue that had already been decided in bankruptcy court. The jury ruled in favor of Angry Son and against Bereaved Widow. The Probate Court found that Bereaved Widow had waived her claims when she filed the nonsuit. It also awarded $541,000 in attorney's fees against her. So who is guilty of forum shopping here? You have both parties participating in proceedings brought in both forums. The probate case was first in time. The bankruptcy case was first to trial. Depending on the resolution of the core proceeding issue, either court could be first to judgment. It is somewhat astonishing that the parties and the courts allowed both proceedings to continue and reach conflicting results. It certainly looks like the parties are setting themselves up for Round Two in the Supreme Court.
Final Thoughts
There are two lessons here. (1) Don't file a dischargeability claim against someone who has a half a billion dollar counterclaim against you. (2) The Supreme Court will usually reverse the Ninth Circuit.
The full opinion can be found at http://caselaw.lp.findlaw.com/cgi-bin/getcase.pl?court=US&navby=case&vol=000&invol=04-1544.
Post-script: This post was revised on June 7 in response to the helpful comment received from Cato Younger below.
The tabloids and talk radio have made a big deal about the salacious aspects of this case (you know, stripper marries old guy, old guy dies, stripper doesn't get the money, stripper sues and gets half a billion dollars). However, it is really a study in federalism involving a shootout between the Bankruptcy Court for the Central District of California and a Texas Probate Court.
Lower Court Proceedings
When J. Howard Marshall (Dead Husband) died in 1995, his bereaved widow, Vickie Lynn a/k/a Anna Nicole (Bereaved Widow) did not receive an inheritance or the large gift that Dead Husband had promised during his lifetime. This lack of funding, along with a default judgment for same-sex sexual harassment, caused Bereaved Widow to file bankruptcy. See In re Marshall, 253 B.R. 550 (Bankr. C.D. Cal. 2000). Before filing bankruptcy, Bereaved Widow said some unkind things about Dead Husband's son, E. Pierce (Angry Son). Angry Son objected to dischargeability of his claims against Bereaved Widow claiming willful and malicious injury. Bereaved Widow counterclaimed asserting that Angry Son had tortiously interfered with a gift that Dead Husband had intended to make to Bereaved Widow. The Bankruptcy Court granted a take-nothing summary judgment on the dischargeability claim. It then conducted a trial on the counterclaim, where it ruledled in favor of Bereaved Widow (although its ruling was largely based upon discovery abuse). Angry Son then sought to vacate the judgment on the ground that the Bankruptcy Court lacked subject matter jurisdiction and also filed suit in Texas Probate Court. On appeal, the U.S. District Court concluded that this was a non-core proceeding but that the Bankruptcy Court was right. The District Court entered an original judgment against Angry Son. The District Court opinion contains a fascinating discussion of the relations between the parties. In re Marshall, 275 B.R. 5 (C.D. Cal. 2002). Among other things, we learn that because Bereaved Widow was large-boned, she did not qualify to work the night shift at the strip club. However, her relegation to the "B Team" allowed her to meet Dead Husband, so that it all worked out.
Meanwhile, back in Texas, the Texas Probate Court entered judgment that Bereaved Widow was entitled to nothing and that it had exclusive jurisdiction to settle the dispute since it related to a dead guy. To complicate things, the Probate Court made its ruling one month before the District Court entered its judgment. Thus, there were two competing judgments, one federal and one state each reaching opposite results. The Ninth Circuit reversed the District Court holding that the probate exception to federal jurisdiction precluded the Bankruptcy Court and District Court from exercizing federal jurisdiction. That set the stage for the Supreme Court, which reversed the Ninth Circuit.
The Supreme Court Opinion
The Supreme Court held that neither the "domestic relations" exception nor the "probate" exception are mandated by the Constitution or federal law and pointed out out its own efforts to "rein in" these exceptions. Because this case did not seek to invalidate a will or otherwise interfere with the administration of the probate estate, it did not fall within the probate exception to federal jurisdiction. Additionally, the Supreme Court held that the federal courts were not bound by the decision of the Texas Probate Court that it had exclusive jurisdiction to consider the tortious interference claims. Federal courts get to decide their own jurisction; state courts cannot claim exlusive jurisdiction over something that would otherwise fall within federal jurisdiction.
After all this, it looked pretty good for Bereaved Widow. However, in the last section of the opinion, the Supreme Court pointed out that the state court was arguably the first one to enter a final judgment. It remanded to the Ninth Circuit to determine (1) whether Bereaved Widow's claims were core proceedings and (2) whether res judicata or collateral estoppel applied. If Bereaved Widow had core claims, then the Bankruptcy Court's judgment was first in time. If they were non-core, then the Probate Court judgment was first in time (since there wouldn't be a final federal judgment until the District Court ruled). The core proceeding issue could go either way. If the Ninth Circuit finds that Bereaved Widow's claims were non-core, will the federal court give res judicata or collateral estoppel effect to the state court ruling?
Forum Shopping
While the Supreme Court ruled based on the narrow issue of jurisdiction, there is a much larger issue of forum shopping. Even before Dead Husband died, Bereaved Widow had filed suit against Angry Son in probate court accusing him of intefering with the support she was to receive. After his death, she filed suit to invalidate his will and determine that he died intestate. According to the Ninth Circuit, Bereaved Widow then filed bankruptcy in California "claiming" to be a resident of California. In re Marshall, 392 F.3d 1118 (9th Cir. 2004). After she received a favorable judgment from the Bankruptcy Court, she nonsuited her claims in the Probate Court despite being warned by the Probate Court that she would not be able to refile them. Shortly after that, Angry Son filed an amended counterclaim against Bereaved Widow in Probate Court seeking a determination of her rights against the estate. The Probate Court then conducted a five month trial in which all the parties participated. In fact, Bereaved Widow's counsel told that the court that she was seeking to litigate tortious interference with a gift, the same issue that had already been decided in bankruptcy court. The jury ruled in favor of Angry Son and against Bereaved Widow. The Probate Court found that Bereaved Widow had waived her claims when she filed the nonsuit. It also awarded $541,000 in attorney's fees against her. So who is guilty of forum shopping here? You have both parties participating in proceedings brought in both forums. The probate case was first in time. The bankruptcy case was first to trial. Depending on the resolution of the core proceeding issue, either court could be first to judgment. It is somewhat astonishing that the parties and the courts allowed both proceedings to continue and reach conflicting results. It certainly looks like the parties are setting themselves up for Round Two in the Supreme Court.
Final Thoughts
There are two lessons here. (1) Don't file a dischargeability claim against someone who has a half a billion dollar counterclaim against you. (2) The Supreme Court will usually reverse the Ninth Circuit.
The full opinion can be found at http://caselaw.lp.findlaw.com/cgi-bin/getcase.pl?court=US&navby=case&vol=000&invol=04-1544.
Post-script: This post was revised on June 7 in response to the helpful comment received from Cato Younger below.
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