“Traditionally, trials of family conflicts often involve emotion and controversy, yet are short on reason, logic and admissible evidence. These adversary proceedings share these traits.” Thus, began Judge Larry Kelly’s Memorandum Opinion in which he sought to sort out the tangled mother-daughter disputes in Rose Douso Petro v. Irene E. Holland, et al, Adv. No. 06-6001, 06-6002 and 06-6004 (Bankr. W.D. Tex. 1/12/07). This opinion is significant both because it was one of Judge Kelly’s final opinions prior to retirement (after 20+ years on the bench) and because it offers an object lesson in the difficulty in translating informal family dealings into legal proceedings.
Some Background
In better times, Irene Holland was married to Scottie Holland and Irene’s parents advanced money to her. These borrowings were later documented in a promissory note in the amount of $305,000 in 1988. The debt was evidenced by a note which was payable on November 1, 1993 or when the Hollands sold a piece of property they owned in San Antonio. Seven years later, the Hollands sold the San Antonio property but neglected to pay off the note. According to Irene’s mother Rose Petro, they also failed to inform her of the sale. Rose contended that she did not learn of the sale until spring 2002, some 14 years after the date of the loan and seven years after the sale.
In the spring of 2003, the Hollands sold a residence they owned in Hawaii for $1.6 million. Around the same time, they divorced. In connection with the divorce, the Hollands agreed that Rose would receive $286,568.53 out of the sales proceeds to be paid on her note. Judge Kelly noted that there is no explanation for why they chose this amount rather than the full face amount of the note (although apparently this is what Irene believed was owing). The Title Company issued the check payable to Rose, but wrote it in care of Irene. It is not explained why the check went to Irene. However, a lot of subsequent litigation could have been avoided if the check had gone straight to Rose. In apparent violation of the divorce agreement, Irene returned the check to the title company and requested that it be voided. In its place, she requested that four new checks be issued. One of the four checks was issued to Rose in the amount of $110,000 and was received by Rose. In a development which would become important later, Irene contended that Rose gave her permission to do this.
Rose was not happy when she found out what had happened. In June 2004, she sued Irene, Scottie and the title company in District Court in Bell County. The state court found that it lacked jurisdiction over the title company and dismissed all claims against it. Irene engaged Waco attorney John Montez and filed bankruptcy during the October 2005 bankruptcy rush. At this point, adversary proceedings began to get filed left and right. Rose removed the state court litigation to bankruptcy court where it was assigned Adv. No. 06-6001. She then filed a complaint against Irene seeking to except her debt from discharge under Sec. 523(a)(2), (4) and (6) and objecting to Irene’s general discharge under Sec. 727(a)(2)-(5). This became Adv. No. 06-6002. Scottie filed his own adversary proceeding based on breach of the Agreement Incident to Divorce, which was docketed as Adv. No. 06-6004. Prior to trial, Scottie settled his claims against Irene as well as Rose’s claims against him. Thus, the sole issues which remained for trial were Rose’s claims against Irene.
The Trial
Prior to trial, it appeared as though Irene had not gone out of her way to repay the note to her parents. However, it was unclear whether this would translate into a non-dischargeable debt.
Before determining whether the debt was non-dischargeable, the court had to decide whether there was even an enforceable debt. The promissory note was due within four years after the property sold. Since the property was sold on March 29, 2000, the deadline to file suit would have expired on March 29, 2004, approximately three months before suit was actually filed. The court found that Irene had not fraudulently concealed the sale of the property from her mother and that her mother knew about the sale by 2002. As a result, the court concluded that the original debt was barred by limitations. However, under Texas law, a debt barred by limitations can be revived by a written agreement signed by the obligor. Even though Rose was apparently unaware of the terms of the Agreement Incident to Divorce, the Court found that Rose was a third party beneficiary of this agreement and that it was sufficient to revive the debt. Thus, but for Irene and Scottie’s agreement to provide for Rose in their divorce, the debt would have been unenforceable and the court’s opinion would have been much shorter.
Having overcome the limitations defense, Rose still needed to prove one of the grounds for non-dischargeability which she alleged.
Fraud
The court had no trouble dispatching the fraud ground under Sec. 523(a)(2). There was simply no evidence that Irene had made a false representation at the time that the note was executed or that Rose had relied upon any false representation. Since Rose did not know about the Agreement Incident to Divorce, it was not possible for her to rely upon this agreement as a false representation. While Irene very likely made a false representation to Scottie, she wisely resolved her dispute with him.
This illustrates an important distinction between “fraud” in the popular sense and the legal sense. If I make a promise to pay you with the best of intentions and then later make a capricious and whimsical decision not to pay, even though I had the ability to do so, you would feel defrauded. However, legally this constitutes nothing more than a breach of contract. The essence of fraud is a false representation made with bad intent which is relied upon by the other party to their detriment. If the representation is originally made with good intent, all the subsequent bad faith in the world will not transform the original representation into fraud. Thus, where the original promise is made honestly and there is subsequent bad conduct, the plaintiff must be able to show a subsequent false representation which they relied upon.
In a series of informal dealings over a lengthy period of time, such as in this case, proving anyone’s intent at the outset is nearly impossible.
Fraud or Defalcation in a Fiduciary Capacity
Fraud or defalcation in a fiduciary capacity under Sec. 523(a)(4) did not present much difficulty either. A fiduciary under federal law requires a much higher standard than under state law. A federal fiduciary must be akin to a trustee. The mother-daughter bond simply does not rise to this level. Judge Kelly found that there were no other factors, such as control over Rose’s finances, which would give rise to a fiduciary relationship. An argument could have been made that the Agreement Incident to Divorce imposed trustee-like duties upon Irene with respect to the cashiers check which was later voided. However, this claim would have likely failed based on Irene’s unrebutted testimony that Rose gave her permission to use the funds.
Embezzlement
The claim for embezzlement failed for the reason that the funds from the real estate closing were never property of Rose. In order for embezzlement to take place, there must be an appropriation of another person’s property for the debtor’s benefit with fraudulent intent. Here, Irene exercised control over a cashiers check made payable to Rose. However, once again, the popular wisdom parts company with the legal test. Under Texas law, a cashier’s check remains the property of the person who purchased it until it is delivered. Judge Kelly found that because the check for $286,568.53 was never delivered to Rose, it was never her property. Thus, while it looks bad that Irene canceled out the check and didn’t give the funds to Rose, it didn’t constitute embezzlement.
Willful and Malicious Injury
Finally, Judge Kelly found that the claim for willful and malicious injury under Sec. 523(a)(6) failed. Of all the claims, this one appeared to have the greatest chance of success. If the court had believed that Irene had voided the cashiers check from the real estate closing for the purpose of harming Rose, then the court might have been able to find willful and malicious injury. However, Irene testified at trial that she had oral permission from Rose to void the check. This testimony came out on direct examination from Rose’s attorney and was not rebutted. As a result, the testimony stood without contradiction and was accepted by the court. The result might have been different on a claim by Scottie, since he was certainly harmed by the failure to pay Rose. However, he had already settled with Rose and Irene prior to trial.
Conclusion
This case shows why the bankruptcy discharge is an imperfect screen for unethical or immoral behavior. Some observers would probably conclude that Irene behaved badly, or at least selfishly. Despite the fact that she had received a huge sum of money from her parents and signed a written promise to pay, she always found other things to spend her money on when she had the opportunity. Her conduct in agreeing to repay her mom out of the Hawaii sales proceeds and then voiding the check appears to constitute double dealing. Thus, it could be argued that good lawyering and weak laws helped Irene escape her just desserts.
However, a counter argument can be made that this was much ado about nothing. Irene’s parents did not treat the “loan” like a business transaction. They apparently advanced funds first and documented the transaction later. According to Irene, the note was never intended to be collected, but would be used to adjust the sisters’ share of the inheritance later. As found by Judge Kelly, the note would have been barred by limitations and become unenforceable were it not for Irene and Scottie’s decision to include it in the Agreement Incident to Divorce. While the decision to void the cashier’s check looks bad, the unrebutted testimony about verbal consent supports an inference that the mother may have initially approved the transaction and then changed her mind.
This case is a good example of why informal dealings based on trust make for bad legal cases. Rose could have protected herself if she had tried to enforce the note when it matured or when she found out about the sale of the San Antonio property. She did not do so, perhaps hoping that her daughter would eventually do the right thing. Or perhaps she never intended to enforce the note at the time it came due and only changed her mind after the fact. The Court had an unenviable job in trying to sort all the sort out the mother-daughter brawl. However, the resulting opinion provides a good primer on the law of dischargeability.
Wednesday, April 25, 2007
Wednesday, March 28, 2007
Houston Judges Continue Inquiry Into Practices of Prominent Creditors' Firm
Proceedings involving a prominent Houston creditors’ firm (hereafter referred to as the Firm)* heated up recently as two bankruptcy judges considered sanctions issues arising out of the Firm’s extensive bankruptcy practice. The Firm feuded publicly with the U.S. Trustee’s office while seeking to demonstrate the sincerity of its repentance. While a significant amount of information was added to the public record, no resolution is likely until mid-summer.
Background
The firm in question operates a high volume foreclosure and bankruptcy practice. Its recent spate of difficulties began on February 3, 2006, when U.S. Bankruptcy Judge Marvin Isgur assessed sanctions of $65,000 against the Firm in connection with its requests for attorney’s fees in connection with motions for relief from stay. In re Porcheddu, 338 B.R. 729 (Bankr. S.D. Tex. 2006). In the opinion, the court estimated that the firm filed 5,000 motions for relief from stay per year in the Southern District of Texas alone and estimated the Firm’s revenues from motions for relief from stay at $125,000 every two weeks.
U.S. Bankruptcy Judge Wesley Steen issued a series of orders arising out of objections to a chapter 13 plan filed by the Firm on behalf of its client, Countrywide Home Lending, Inc., which culminated in an opinion finding that sanctions should be assessed against the Firm. In re Allen, 2007 Bankr. LEXIS 231 (Bankr. S.D. Tex. 1/9/07). See “Court Rejects Defense of The Computer Made Me Do It” (1/10/07). The Court bemoaned the fact that prior warnings and the Porcheddu sanction had not caused the firm to change its behavior. The Court scheduled a hearing at which the Firm was ordered to appear and report what sanctions would deter future repetition of the conduct.
Meanwhile, Judge Jeff Bohm issued his own show cause order after the Firm filed a motion for relief from stay and then withdrew it following allegations that it was based on a flawed payment history. In re Parsley, No. 05-90374 (Bankr. S.D. Tex. 2/12/07). This case involved Countrywide as well. (Note: The specific allegations regarding the accuracy of the pay history are disputed. Apparently the debtor would have been in default even if the two disputed payments were disregarded). Judge Bohm scheduled a hearing for March 5, 2007.
Thus, by the end of February 2007, one Houston judge had assessed sanctions against the Firm, a second Houston judge was preparing to assess sanctions and a third Houston judge was considering whether sanctions should be imposed. The stage was set for March madness.
The Parsley Hearing
Judge Bohm’s case was the first to be scheduled for a hearing. On March 2, 2007, the U.S. Trustee appeared and submitted a nine page Statement. The U.S. Trustee suggested that the Court should investigate whether Countrywide and its counsel had engaged in similar conduct in the past and should consider that information when deciding whether to assess sanctions. The U.S. Trustee concluded that “additional inquiry is needed to determine with certainty whether conduct at issue involves bad faith.” On the day of the hearing, the Firm's counsel filed an Emergency Motion to Strike, or in the alternative to Limit Issues and/or to Continue Hearing. The Firm objected that the U.S. Trustee had “at the eleventh hour” requested that the Court’s inquiry “be exponentially expanded.” The Firm also questioned the trustee’s ability to participate and criticized its failure to confer prior to filing its Statement.
The Bankruptcy Court declined to strike the U.S. Trustee’s Statement. The Court heard some testimony and then continued the remainder of the hearing until June 26, 2007. Some of the testimony received at the hearing related to the relationship between the Firm and its client. Specifically, testimony was received which indicated that Countrywide Home Lending, Inc. did not allow the Firm to communicate directly with it, but instead required that all communications be routed through another law firm.
In a post-hearing brief, the Firm argued that it had acted simply as local counsel for the referring law firm and had acted reasonably in relying upon the information provided to it.
The Allen Hearing
Shortly after the Parsley hearing, Judge Steen invited the U.S. Trustee to submit a statement in his case as well. When the U.S. Trustee submitted its statement one week later, it had grown to 35 pages and included selections from the transcript of the Parsley hearing. The U.S. Trustee suggested that the court expand its inquiry to examine the relationship between the Firm, Countrywide Home Lending and the national firm identified as the go-between. The U.S. Trustee pointed to specific statements by the Firm which referenced direct communications with Countrywide and suggested that these statements could not be correct if the Firm were not allowed to speak directly with its client.
The Firm's attorneys were not amused by the U.S. Trustee’s comments. They stated, “It is at once poignant and disturbing to witness the U.S. Trustee – in connection with a Rule 9011 sanction hearing – file a pleading containing reckless and untrue allegations concerning (the Firm) and third parties.” The Firm's counsel sent a Rule 9011 safe harbor letter to the U.S. Trustee demanding that it withdraw its allegations and attached a copy to its response. Apparently, there were only certain types of loans where Countrywide required that all of its law firms communicate through a single law firm. The Parsley case involved a no direct contact case, where the Allen case apparently involved a case where direct contact was allowed. The bemused U.S. Trustee pointed out that it had simply quoted from the transcript in the Parsley case.
In preparation for the Allen hearing, the Firm's attorneys filed several pleadings designed to show the sincerity of the Firm's repentance. In response to an order from Judge Steen requiring it to disclose “all similar occurrences and proceedings involving the firm” in the prior five years, the Firm submitted a list of nine proceedings which it contended were directly relevant (including Porcheddu, Allen and Parsley), as well as five other incidents which it contended were not directly relevant but were submitted in the interest of full disclosure.
The Firm also submitted a Response in which it accepted responsibility for its actions. It suggested that the Court consider the damage to the Firm’s reputation in assessing a sanction** and detailed a list of actions taken subsequent to the Porcheddu opinion. Among other things, the Firm stated through its counsel that:
• It had hired an experienced Managing Bankruptcy Attorney in April 2006;
• It had retained former bankruptcy judge Bill Brister as an independent “legal” auditor;
• It had conducted in-house trainings, including training in ethics and attorney due diligence as well as the specific issues raised by the Allen case;
• It had required additional CLE for its staff;
• It made 211 changes to its software during 2006;
• It had developed new payment tracking software;
• It had required that its motions include payment histories certified by its clients;
• It had required greater involvement and review by senior attorneys; and
• It had terminated two attorneys.
The Firm estimated the compliance costs which it had incurred at over $2 million.
On March 22, 2007, Judge Steen conducted a hearing on the sanction to be imposed. However, he did not make a ruling at that time. Instead, he entered an Order for Continuance, Supplemental Report, and Discovery. The Court made the following rulings:
• It required the U.S. Trustee and the Firm to confer about whether discovery was required with regard to the Certificate of Conference attached to the Firm’s first objection to plan confirmation;
• It allowed the U.S. Trustee to file a revised Statement based upon the testimony received and the discussion regarding the Certificate of Conference;
• It allowed the Firm to respond to the U.S. Trustee’s revised Statement and to respond to issues addressed in open court with regard to Case No. 04-50312; and
• It stated that it might enter an order stating that it would rule without any further hearings or it might hold a hearing to consider an update from Judge Brister and to determine the issues surrounding the Certificate of Conference.
The Court’s order indicates concern in two specific areas. The objection to confirmation contained a Certificate of Conference which recited that “I, (Attorney), an attorney employed by the offices of (the Firm) made a good faith effort to negotiate a settlement of the dispute with Debtor’s counsel. Resolution of this dispute was not successful and the filing of this Objection to Confirmation is therefore necessary.” If the parties had conferred and the Debtor’s counsel failed to raise the issue subsequently raised in its response, then the mistakes in the subsequent pleadings would be more innocent. On the other hand, if no conference occurred, then the subsequent errors would appear more serious. A false certificate combined with an erroneous pleading would be more serious than an erroneous pleading standing alone.
The Court also focused attention on prior proceedings in In re Cordova. Cordova was a case in which an objection to confirmation had been filed and then withdrawn. On January 12, 2005, Judge Steen issued an Order Continuing Hearing and Requiring Attendance at Hearing to Show Case Why Sanctions Under Rule 9011 Are Not Appropriate. According to the docket, Judge Steen admonished the Firm, but declined to issue sanctions at that time. Curiously, the Cordova case was not mentioned by the Firm in its self-disclosure of “similar occurrences and proceedings” despite the fact that Judge Steen's Allen opinion had specifically referred to a prior instance in which he had admonished the Firm.
What Does It All Mean?
In the short-term, there has been a lot of attention focused on the Firm without any resolution of the issues. However, the cases raise several important questions.
How does a firm handle a high volume of cases and still satisfy its professional obligations? That seems to be the question raised by the Houston judges. It is also seems to be the issue which the Firm has addressed in its responses.
There is also a question as to the extent that the Firm must assume responsibility for the information provided by its clients. In the Parsley case, the Firm apparently submitted inaccurate information which it received from its client (although the extent to which the information was inaccurate is a matter of dispute). To what extent should the Firm be responsible for policing the accuracy of the information received from its clients? Under the new procedure proposed by the Firm, the Firm’s clients must certify as to the accuracy of its pay histories. At what point does any attorney have an affirmative obligation to question the information being provided by his client?
What is the Firm’s obligation to disclose that it is merely acting as local counsel and does not have direct contact with its client? In at least the Parsley case, it appears to be undisputed that the Firm accepted referrals from another law firm on the condition that all communications go through that law firm. However, the Firm filed pleadings in which the identity of the other firm was not disclosed. If a Firm files pleadings on behalf of a client, is it representing that it has had direct contact with that client?
___________________________
*The identity of the firm involved is widely known. However, it is this blog’s policy not to specifically name attorneys involved in sanctions issues.
**In a separate pleading, the Firm stated that “The spoken and written comments by the Court are widely read, blogged, and commented on by practitioners and other courts as well as clients and potential clients.”
Background
The firm in question operates a high volume foreclosure and bankruptcy practice. Its recent spate of difficulties began on February 3, 2006, when U.S. Bankruptcy Judge Marvin Isgur assessed sanctions of $65,000 against the Firm in connection with its requests for attorney’s fees in connection with motions for relief from stay. In re Porcheddu, 338 B.R. 729 (Bankr. S.D. Tex. 2006). In the opinion, the court estimated that the firm filed 5,000 motions for relief from stay per year in the Southern District of Texas alone and estimated the Firm’s revenues from motions for relief from stay at $125,000 every two weeks.
U.S. Bankruptcy Judge Wesley Steen issued a series of orders arising out of objections to a chapter 13 plan filed by the Firm on behalf of its client, Countrywide Home Lending, Inc., which culminated in an opinion finding that sanctions should be assessed against the Firm. In re Allen, 2007 Bankr. LEXIS 231 (Bankr. S.D. Tex. 1/9/07). See “Court Rejects Defense of The Computer Made Me Do It” (1/10/07). The Court bemoaned the fact that prior warnings and the Porcheddu sanction had not caused the firm to change its behavior. The Court scheduled a hearing at which the Firm was ordered to appear and report what sanctions would deter future repetition of the conduct.
Meanwhile, Judge Jeff Bohm issued his own show cause order after the Firm filed a motion for relief from stay and then withdrew it following allegations that it was based on a flawed payment history. In re Parsley, No. 05-90374 (Bankr. S.D. Tex. 2/12/07). This case involved Countrywide as well. (Note: The specific allegations regarding the accuracy of the pay history are disputed. Apparently the debtor would have been in default even if the two disputed payments were disregarded). Judge Bohm scheduled a hearing for March 5, 2007.
Thus, by the end of February 2007, one Houston judge had assessed sanctions against the Firm, a second Houston judge was preparing to assess sanctions and a third Houston judge was considering whether sanctions should be imposed. The stage was set for March madness.
The Parsley Hearing
Judge Bohm’s case was the first to be scheduled for a hearing. On March 2, 2007, the U.S. Trustee appeared and submitted a nine page Statement. The U.S. Trustee suggested that the Court should investigate whether Countrywide and its counsel had engaged in similar conduct in the past and should consider that information when deciding whether to assess sanctions. The U.S. Trustee concluded that “additional inquiry is needed to determine with certainty whether conduct at issue involves bad faith.” On the day of the hearing, the Firm's counsel filed an Emergency Motion to Strike, or in the alternative to Limit Issues and/or to Continue Hearing. The Firm objected that the U.S. Trustee had “at the eleventh hour” requested that the Court’s inquiry “be exponentially expanded.” The Firm also questioned the trustee’s ability to participate and criticized its failure to confer prior to filing its Statement.
The Bankruptcy Court declined to strike the U.S. Trustee’s Statement. The Court heard some testimony and then continued the remainder of the hearing until June 26, 2007. Some of the testimony received at the hearing related to the relationship between the Firm and its client. Specifically, testimony was received which indicated that Countrywide Home Lending, Inc. did not allow the Firm to communicate directly with it, but instead required that all communications be routed through another law firm.
In a post-hearing brief, the Firm argued that it had acted simply as local counsel for the referring law firm and had acted reasonably in relying upon the information provided to it.
The Allen Hearing
Shortly after the Parsley hearing, Judge Steen invited the U.S. Trustee to submit a statement in his case as well. When the U.S. Trustee submitted its statement one week later, it had grown to 35 pages and included selections from the transcript of the Parsley hearing. The U.S. Trustee suggested that the court expand its inquiry to examine the relationship between the Firm, Countrywide Home Lending and the national firm identified as the go-between. The U.S. Trustee pointed to specific statements by the Firm which referenced direct communications with Countrywide and suggested that these statements could not be correct if the Firm were not allowed to speak directly with its client.
The Firm's attorneys were not amused by the U.S. Trustee’s comments. They stated, “It is at once poignant and disturbing to witness the U.S. Trustee – in connection with a Rule 9011 sanction hearing – file a pleading containing reckless and untrue allegations concerning (the Firm) and third parties.” The Firm's counsel sent a Rule 9011 safe harbor letter to the U.S. Trustee demanding that it withdraw its allegations and attached a copy to its response. Apparently, there were only certain types of loans where Countrywide required that all of its law firms communicate through a single law firm. The Parsley case involved a no direct contact case, where the Allen case apparently involved a case where direct contact was allowed. The bemused U.S. Trustee pointed out that it had simply quoted from the transcript in the Parsley case.
In preparation for the Allen hearing, the Firm's attorneys filed several pleadings designed to show the sincerity of the Firm's repentance. In response to an order from Judge Steen requiring it to disclose “all similar occurrences and proceedings involving the firm” in the prior five years, the Firm submitted a list of nine proceedings which it contended were directly relevant (including Porcheddu, Allen and Parsley), as well as five other incidents which it contended were not directly relevant but were submitted in the interest of full disclosure.
The Firm also submitted a Response in which it accepted responsibility for its actions. It suggested that the Court consider the damage to the Firm’s reputation in assessing a sanction** and detailed a list of actions taken subsequent to the Porcheddu opinion. Among other things, the Firm stated through its counsel that:
• It had hired an experienced Managing Bankruptcy Attorney in April 2006;
• It had retained former bankruptcy judge Bill Brister as an independent “legal” auditor;
• It had conducted in-house trainings, including training in ethics and attorney due diligence as well as the specific issues raised by the Allen case;
• It had required additional CLE for its staff;
• It made 211 changes to its software during 2006;
• It had developed new payment tracking software;
• It had required that its motions include payment histories certified by its clients;
• It had required greater involvement and review by senior attorneys; and
• It had terminated two attorneys.
The Firm estimated the compliance costs which it had incurred at over $2 million.
On March 22, 2007, Judge Steen conducted a hearing on the sanction to be imposed. However, he did not make a ruling at that time. Instead, he entered an Order for Continuance, Supplemental Report, and Discovery. The Court made the following rulings:
• It required the U.S. Trustee and the Firm to confer about whether discovery was required with regard to the Certificate of Conference attached to the Firm’s first objection to plan confirmation;
• It allowed the U.S. Trustee to file a revised Statement based upon the testimony received and the discussion regarding the Certificate of Conference;
• It allowed the Firm to respond to the U.S. Trustee’s revised Statement and to respond to issues addressed in open court with regard to Case No. 04-50312; and
• It stated that it might enter an order stating that it would rule without any further hearings or it might hold a hearing to consider an update from Judge Brister and to determine the issues surrounding the Certificate of Conference.
The Court’s order indicates concern in two specific areas. The objection to confirmation contained a Certificate of Conference which recited that “I, (Attorney), an attorney employed by the offices of (the Firm) made a good faith effort to negotiate a settlement of the dispute with Debtor’s counsel. Resolution of this dispute was not successful and the filing of this Objection to Confirmation is therefore necessary.” If the parties had conferred and the Debtor’s counsel failed to raise the issue subsequently raised in its response, then the mistakes in the subsequent pleadings would be more innocent. On the other hand, if no conference occurred, then the subsequent errors would appear more serious. A false certificate combined with an erroneous pleading would be more serious than an erroneous pleading standing alone.
The Court also focused attention on prior proceedings in In re Cordova. Cordova was a case in which an objection to confirmation had been filed and then withdrawn. On January 12, 2005, Judge Steen issued an Order Continuing Hearing and Requiring Attendance at Hearing to Show Case Why Sanctions Under Rule 9011 Are Not Appropriate. According to the docket, Judge Steen admonished the Firm, but declined to issue sanctions at that time. Curiously, the Cordova case was not mentioned by the Firm in its self-disclosure of “similar occurrences and proceedings” despite the fact that Judge Steen's Allen opinion had specifically referred to a prior instance in which he had admonished the Firm.
What Does It All Mean?
In the short-term, there has been a lot of attention focused on the Firm without any resolution of the issues. However, the cases raise several important questions.
How does a firm handle a high volume of cases and still satisfy its professional obligations? That seems to be the question raised by the Houston judges. It is also seems to be the issue which the Firm has addressed in its responses.
There is also a question as to the extent that the Firm must assume responsibility for the information provided by its clients. In the Parsley case, the Firm apparently submitted inaccurate information which it received from its client (although the extent to which the information was inaccurate is a matter of dispute). To what extent should the Firm be responsible for policing the accuracy of the information received from its clients? Under the new procedure proposed by the Firm, the Firm’s clients must certify as to the accuracy of its pay histories. At what point does any attorney have an affirmative obligation to question the information being provided by his client?
What is the Firm’s obligation to disclose that it is merely acting as local counsel and does not have direct contact with its client? In at least the Parsley case, it appears to be undisputed that the Firm accepted referrals from another law firm on the condition that all communications go through that law firm. However, the Firm filed pleadings in which the identity of the other firm was not disclosed. If a Firm files pleadings on behalf of a client, is it representing that it has had direct contact with that client?
___________________________
*The identity of the firm involved is widely known. However, it is this blog’s policy not to specifically name attorneys involved in sanctions issues.
**In a separate pleading, the Firm stated that “The spoken and written comments by the Court are widely read, blogged, and commented on by practitioners and other courts as well as clients and potential clients.”
Saturday, March 24, 2007
Mental Incapacity Excuses Debtor From Credit Counseling; Prior History Proves Insufficient Grounds for Dismissal
Judge Robert Jones from the Northern District of Texas was recently faced with a situation which looked like an easy candidate for dismissal. The debtor filed pro se, did not obtain credit counseling, had previously filed ten unsuccessful bankruptcy cases and had filed over 100 suits against various parties. Despite the debtor's unsympathetic profile, the court carefully read the statute and considered the circumstances in determining not to dismiss the case. In re Jarrell, No. 06-10409 (Bankr. N.D. Tex. 3/9/07).
The Incapacity Exception to Credit Counseling
While the requirement to obtain credit counseling is well known, the exceptions are somewhat more obscure. Under Sec. 109(h)(4), a debtor may be excused from credit counseling if he has an incapacity or a disability. Incapacity is defined as meaning that the debtor "is impaired by reason of mental illness or mental deficiency so that he is incapable of realizing and making rational decisions with respect to his financial responsibilities." Disability means that "the debtor is so physically impaired as to be unable, after reasonable effort, to participate in an in person, telephone, or Internet briefing."
At the hearing on the motion to dismiss, the debtor's psychologist testified he had diagnosed the debtor with bipolar disorder, schizophrenia and clinical depression. The psychologist testified that the debtor "is severely impaired to the point where he is unable to make rational decisions regarding his financial responsibilities and ... doesn't have the mental ability to realize his decisions are irresponsible." On the other hand, the debtor had sufficient capacity to recognize his income and specific assets and debts. The court was satisfied that the debtor had a mental illness and commented that his filing of over 100 lawsuits "may in and of itself be evidence of mental illness." Based on the undisputed testimony of the psychologist, the court found that the debtor's mental incapacity was sufficient to justify a waiver of the pre-filing credit counseling briefing.
Judge Jones's ruling should be unremarkable for the reason that he read the statute and applied it as written. However, the exception which the court applied highlights a weakness in the statute itself. The credit counseling requirement has been described as "absurd," "a meaningless formality" and "a trap for the unwary" by Texas judges. In re Sosa, 336 B.R. 115 (Bankr. W.D. Tex. 2005); In re Navarro, No. 06-51007 (Bankr. W.D. Tex. 6/27/06). While the mentally ill may escape credit counseling due to the fact that they would not receive a benefit from it, other debtors must still fulfill the requirement regardless of whether it serves a useful purpose.
Dismissal for Bad Faith/Totality of the Circumstances
The court also considered whether the case should be dismissed under Sec. 707(b)(3) based on bad faith or totality of the circumstances. The court noted that there was certainly plenty of evidence to raise the specter of bad faith. Double-digit bankruptcy filings, triple-digit lawsuits and dilatory conduct in dealing with his major creditor all pointed to a debtor who was out of control and gaming the system. However, Judge Jones made an admirable effort to go below the surface and analyze the significance of the facts.
First, the court examined the circumstances of the present case. The debtor filed after Huntington State Bank obtained a judgment against him. The debtor testified that he was concerned that the judgment could cause him to lose his home and social security payments. The court found that this was a legitimate reason for filing.
It was true that the debtor filed many unsuccessful bankruptcies and frivolous lawsuits. However, this conduct occurred before the debtor moved to Texas and incurred the debt which ultimately caused him to file bankruptcy. As a result, the court found that there no connection between the prior pattern of bad conduct and the present case. Additionally, the present case was distinguishable from the typical serial filing abuser. As Judge Jones noted, the modus operendi of a serial filer involves the filing and dismissal of multiple cases. Failure to follow through with the bankruptcy case is part and parcel of what makes it abusive. Here, the debtor, after filing pro se, retained qualified counsel, filed schedules and the statement of financial affairs and appeared at his first meeting of creditors. Thus, the debtor was faced with possible dismissal for bad faith at the point where he was finally taking his obligations to the bankruptcy court seriously.
The court considered the effect of allowing the bankruptcy case to proceed on each of the constituent parties. The court found that creditors would not be harmed since it was unlikely that the debtor would ever accumulate significant wealth. (Left unasked was the question of what the bank was thinking when it extended credit to a person who had previously filed ten bankruptcies, whose only income consisted of social security and who had serious mental health issues.).
The court found that the debtor would benefit:
"Jarrell has more problems than should be visited upon any human being. His wife and four children suffer from various illnesses; Jarrell is very sick. While no one deserves a free pass by simply offering up the excuse that he does not know wht he is doing, Jarrell's situation is unique. This bankruptcy will not begin to address the majority of the many problems that Jarrell has, but it may provide token relief from some of his debts."
Finally, the court considered the interests of the court and judicial process. The court found that Mr. Jarrell's conduct had burdened both the state and federal courts and the public at large. Nevertheless, the court decided to give him one last chance. "The Court concludes that it will take Jarrell with his many problems and issues, at least one more time, and allow him the opportunity to pursue some modicum of relief." Thus, the court decided to retain the case even though it was undesirable.
Recognition to Debtor's Counsel
Debtor's counsel, Dick Harris, should be commended for taking on a difficult and unsympathetic client. While he may not be paid much (or at all) for his efforts, the court's opinion recognizes him as a "competent counsel (who) has for many years practiced before this Court representing both creditors and debtors in a professional manner."
The Incapacity Exception to Credit Counseling
While the requirement to obtain credit counseling is well known, the exceptions are somewhat more obscure. Under Sec. 109(h)(4), a debtor may be excused from credit counseling if he has an incapacity or a disability. Incapacity is defined as meaning that the debtor "is impaired by reason of mental illness or mental deficiency so that he is incapable of realizing and making rational decisions with respect to his financial responsibilities." Disability means that "the debtor is so physically impaired as to be unable, after reasonable effort, to participate in an in person, telephone, or Internet briefing."
At the hearing on the motion to dismiss, the debtor's psychologist testified he had diagnosed the debtor with bipolar disorder, schizophrenia and clinical depression. The psychologist testified that the debtor "is severely impaired to the point where he is unable to make rational decisions regarding his financial responsibilities and ... doesn't have the mental ability to realize his decisions are irresponsible." On the other hand, the debtor had sufficient capacity to recognize his income and specific assets and debts. The court was satisfied that the debtor had a mental illness and commented that his filing of over 100 lawsuits "may in and of itself be evidence of mental illness." Based on the undisputed testimony of the psychologist, the court found that the debtor's mental incapacity was sufficient to justify a waiver of the pre-filing credit counseling briefing.
Judge Jones's ruling should be unremarkable for the reason that he read the statute and applied it as written. However, the exception which the court applied highlights a weakness in the statute itself. The credit counseling requirement has been described as "absurd," "a meaningless formality" and "a trap for the unwary" by Texas judges. In re Sosa, 336 B.R. 115 (Bankr. W.D. Tex. 2005); In re Navarro, No. 06-51007 (Bankr. W.D. Tex. 6/27/06). While the mentally ill may escape credit counseling due to the fact that they would not receive a benefit from it, other debtors must still fulfill the requirement regardless of whether it serves a useful purpose.
Dismissal for Bad Faith/Totality of the Circumstances
The court also considered whether the case should be dismissed under Sec. 707(b)(3) based on bad faith or totality of the circumstances. The court noted that there was certainly plenty of evidence to raise the specter of bad faith. Double-digit bankruptcy filings, triple-digit lawsuits and dilatory conduct in dealing with his major creditor all pointed to a debtor who was out of control and gaming the system. However, Judge Jones made an admirable effort to go below the surface and analyze the significance of the facts.
First, the court examined the circumstances of the present case. The debtor filed after Huntington State Bank obtained a judgment against him. The debtor testified that he was concerned that the judgment could cause him to lose his home and social security payments. The court found that this was a legitimate reason for filing.
It was true that the debtor filed many unsuccessful bankruptcies and frivolous lawsuits. However, this conduct occurred before the debtor moved to Texas and incurred the debt which ultimately caused him to file bankruptcy. As a result, the court found that there no connection between the prior pattern of bad conduct and the present case. Additionally, the present case was distinguishable from the typical serial filing abuser. As Judge Jones noted, the modus operendi of a serial filer involves the filing and dismissal of multiple cases. Failure to follow through with the bankruptcy case is part and parcel of what makes it abusive. Here, the debtor, after filing pro se, retained qualified counsel, filed schedules and the statement of financial affairs and appeared at his first meeting of creditors. Thus, the debtor was faced with possible dismissal for bad faith at the point where he was finally taking his obligations to the bankruptcy court seriously.
The court considered the effect of allowing the bankruptcy case to proceed on each of the constituent parties. The court found that creditors would not be harmed since it was unlikely that the debtor would ever accumulate significant wealth. (Left unasked was the question of what the bank was thinking when it extended credit to a person who had previously filed ten bankruptcies, whose only income consisted of social security and who had serious mental health issues.).
The court found that the debtor would benefit:
"Jarrell has more problems than should be visited upon any human being. His wife and four children suffer from various illnesses; Jarrell is very sick. While no one deserves a free pass by simply offering up the excuse that he does not know wht he is doing, Jarrell's situation is unique. This bankruptcy will not begin to address the majority of the many problems that Jarrell has, but it may provide token relief from some of his debts."
Finally, the court considered the interests of the court and judicial process. The court found that Mr. Jarrell's conduct had burdened both the state and federal courts and the public at large. Nevertheless, the court decided to give him one last chance. "The Court concludes that it will take Jarrell with his many problems and issues, at least one more time, and allow him the opportunity to pursue some modicum of relief." Thus, the court decided to retain the case even though it was undesirable.
Recognition to Debtor's Counsel
Debtor's counsel, Dick Harris, should be commended for taking on a difficult and unsympathetic client. While he may not be paid much (or at all) for his efforts, the court's opinion recognizes him as a "competent counsel (who) has for many years practiced before this Court representing both creditors and debtors in a professional manner."
Tuesday, March 20, 2007
Supreme Court Allows Recovery of Post-Petition Attorney's Fees Based On Pre-Petition Contract
In a unanimous opinion, the Supreme Court ruled that nothing in the Bankruptcy Code prohibits a creditor from asserting an unsecured claim for attorney's fees incurred post-petition where such fees would have been recoverable outside of bankruptcy. Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co., No. 05-1429 (U.S. 3/20/07).
Travelers had issued a surety bond to Pacific Gas & Electric. In connection with the bond, the parties executed a series of indemnity agreements which allowed recovery of attorney's fees incurred in protecting Travelers rights. Travelers filed a claim to protect itself in the event that the debtor defaulted in the future. The debtor's plan preserved Travelers right to subrogation and indemnity in the event of a default, but Travelers disputed whether the language was sufficient. As part of a settlement, PG & E agreed that Travelers could assert an unsecured claim for its attorney's fees. However, when Travelers amended its claim to add the attorney's fees, the debtor objected. The Bankruptcy Court sustained the objection based upon a Ninth Circuit decision which held that attorney's fees were not recoverable for litigating issues unique to bankruptcy. In re Fobian, 951 F.2d 1149 (9th Cir. 1991). Not surprisingly, the District Court and the Ninth Circuit affirmed.
The Supreme Court reversed, finding that Sec. 502(b)(1) generally allows claims to the same extent that they would be allowable outside of bankruptcy. The only subsection of Sec. 502(b) which addresses recovery of attorney's fees is Sec. 502(b)(4), which limits claims by an attorney for the debtor to the reasonable value of such services. Thus, where the Code contained a specific limitation on attorney's fees, the Court would not imply a broader one.
The Supreme Court found that Fobian did not have any support in the language of the Bankruptcy Code. Travelers did not attempt to defend the Fobian rule. Instead, it argued that because Sec. 506(b) only allows attorney's fees to oversecured creditors, that unsecured creditors should not be entitled to recover them at all. The Supreme Court declined to address this argument on the basis that it had not been raised in the lower courts.
This ruling is important for what is decides and for what it does not decide. The first important point is that this case was determined with regard to unsecured claims under Sec. 502(b). Even though the litigation in this case took place post-petition, the creditor did not attempt to assert a post-petition administrative claim. The Supreme Court's broad reading of claims allowable under Sec. 502 would not apply to administrative claims under Sec. 503, which have a much narrower scope. Although it was not discussed in the Supreme Court's opinion, it appears that the parties recognized that litigation under a pre-petition contract created a pre-petition claim even though the litigation occurred during the bankruptcy. The Travelers opinion will create more opportunities for parties who could have recovered attorney's fees pre-petition to amend their unsecured claims to include post-petition attorney's fees. For example, if the debtor unsuccessfully objects to a proof of claim which had a contractual attorney's fees provision, the creditor could add the fees for defending the claim to its unsecured claim. In most cases, adding additional amounts to the unsecured pot will not have a major effect on the case. However, the potential for amending claims after the bar date could create administrative headaches in cases.
The opinion also creates potential tension between Sec. 502(b) and Sec. 506(b). Sec. 502(b)(2) disallows claims for unmatured interest, while Sec. 506(b) allows interest to oversecured claimants. Thus, these two sections are consistent. On the other hand, Sec. 502(b) is silent as to allowance of attorney's fees while Sec. 506(b) allows such fees only to oversecured creditors. Thus, there is a potential for claims for post-petition attorney's fees to be allowed under Sec. 502(b) and disallowed under Sec. 506(b). Because the Sec. 506(b) issue on attorney's fees was not addressed by the Supreme Court, lower courts will have to guess at how it would resolve this issue. However, it may be a safe bet to assume that with all nine justices silent, it might be reasonable to assume that the Supreme Court would find a way to reconcile the two statutes as opposed to overruling a recent precedent.
Travelers had issued a surety bond to Pacific Gas & Electric. In connection with the bond, the parties executed a series of indemnity agreements which allowed recovery of attorney's fees incurred in protecting Travelers rights. Travelers filed a claim to protect itself in the event that the debtor defaulted in the future. The debtor's plan preserved Travelers right to subrogation and indemnity in the event of a default, but Travelers disputed whether the language was sufficient. As part of a settlement, PG & E agreed that Travelers could assert an unsecured claim for its attorney's fees. However, when Travelers amended its claim to add the attorney's fees, the debtor objected. The Bankruptcy Court sustained the objection based upon a Ninth Circuit decision which held that attorney's fees were not recoverable for litigating issues unique to bankruptcy. In re Fobian, 951 F.2d 1149 (9th Cir. 1991). Not surprisingly, the District Court and the Ninth Circuit affirmed.
The Supreme Court reversed, finding that Sec. 502(b)(1) generally allows claims to the same extent that they would be allowable outside of bankruptcy. The only subsection of Sec. 502(b) which addresses recovery of attorney's fees is Sec. 502(b)(4), which limits claims by an attorney for the debtor to the reasonable value of such services. Thus, where the Code contained a specific limitation on attorney's fees, the Court would not imply a broader one.
The Supreme Court found that Fobian did not have any support in the language of the Bankruptcy Code. Travelers did not attempt to defend the Fobian rule. Instead, it argued that because Sec. 506(b) only allows attorney's fees to oversecured creditors, that unsecured creditors should not be entitled to recover them at all. The Supreme Court declined to address this argument on the basis that it had not been raised in the lower courts.
This ruling is important for what is decides and for what it does not decide. The first important point is that this case was determined with regard to unsecured claims under Sec. 502(b). Even though the litigation in this case took place post-petition, the creditor did not attempt to assert a post-petition administrative claim. The Supreme Court's broad reading of claims allowable under Sec. 502 would not apply to administrative claims under Sec. 503, which have a much narrower scope. Although it was not discussed in the Supreme Court's opinion, it appears that the parties recognized that litigation under a pre-petition contract created a pre-petition claim even though the litigation occurred during the bankruptcy. The Travelers opinion will create more opportunities for parties who could have recovered attorney's fees pre-petition to amend their unsecured claims to include post-petition attorney's fees. For example, if the debtor unsuccessfully objects to a proof of claim which had a contractual attorney's fees provision, the creditor could add the fees for defending the claim to its unsecured claim. In most cases, adding additional amounts to the unsecured pot will not have a major effect on the case. However, the potential for amending claims after the bar date could create administrative headaches in cases.
The opinion also creates potential tension between Sec. 502(b) and Sec. 506(b). Sec. 502(b)(2) disallows claims for unmatured interest, while Sec. 506(b) allows interest to oversecured claimants. Thus, these two sections are consistent. On the other hand, Sec. 502(b) is silent as to allowance of attorney's fees while Sec. 506(b) allows such fees only to oversecured creditors. Thus, there is a potential for claims for post-petition attorney's fees to be allowed under Sec. 502(b) and disallowed under Sec. 506(b). Because the Sec. 506(b) issue on attorney's fees was not addressed by the Supreme Court, lower courts will have to guess at how it would resolve this issue. However, it may be a safe bet to assume that with all nine justices silent, it might be reasonable to assume that the Supreme Court would find a way to reconcile the two statutes as opposed to overruling a recent precedent.
Judge Clark Protects the Brooklyn Bridge
The prolific Judge Leif Clark, who has written many memorable footnotes, including one quoted here yesterday, has written another one which is both quotable and addresses an important point. In In re Rendon, No. 06-52501 (Bankr. W.D. Tex. 3/15/07), a party who claimed to be purchasing a home from the debtors filed a Motion to Create Equitable Lien/Motion for Expedited or Emergency Hearing. The court found that the motion requested three forms of relief: an order quieting title, an injunction and an objection to the debtors’ claim of exemption. The court found that the first two forms of relief must be brought in an adversary proceeding and dismissed the motion without prejudice. The court found that the objection to exemptions was untimely and must be denied. Even though the purchasers were not listed as creditors in the bankruptcy, they admitted that they had actual knowledge of the bankruptcy case prior to the 341 meeting.
The court noted that the mere fact that the debtors had successfully claimed the property as exempt did not establish their ownership of the property. In a footnote, the court added the following comment:
"Just in case there is any confusion, let’s suppose I claim an exemption on the Brooklyn Bridge, and you fail to timely object to my exemption claim. Is the sainted bridge thus exempt? Technically, section 522(l) says it is. But of course, what difference does my exemption claim make if Hizzoner, Mayor Bloomberg, comes to court and successfully establishes that, in fact, the Brooklyn Bridge is not my bridge to claim, but is safely still the property of the City of New York, safely untarnished by my exercise in hubris? None at all you correctly reply, none whatsoever.”
It is important to note that an exemption merely determines whether property is excluded from the estate. However, it does not operate to grant title to the property. Mayor Bloomberg will no doubt sleep more soundly.
The court noted that the mere fact that the debtors had successfully claimed the property as exempt did not establish their ownership of the property. In a footnote, the court added the following comment:
"Just in case there is any confusion, let’s suppose I claim an exemption on the Brooklyn Bridge, and you fail to timely object to my exemption claim. Is the sainted bridge thus exempt? Technically, section 522(l) says it is. But of course, what difference does my exemption claim make if Hizzoner, Mayor Bloomberg, comes to court and successfully establishes that, in fact, the Brooklyn Bridge is not my bridge to claim, but is safely still the property of the City of New York, safely untarnished by my exercise in hubris? None at all you correctly reply, none whatsoever.”
It is important to note that an exemption merely determines whether property is excluded from the estate. However, it does not operate to grant title to the property. Mayor Bloomberg will no doubt sleep more soundly.
Monday, March 19, 2007
Forum Shopping Is Bad--Or Is It???
Judge Leif Clark recently wrote a very brief opinion with regard to jury demands and forum shopping. He ruled that the defendant's good or bad faith was not relevant to whether a jury could be demanded. Osherow v. Clonch Industries, Adv. No. 06-5200 (Bankr. W.D. Tex. 2/5/07). He stated:
"Congress has authorized bankruptcy courts to adjudicate matters involving trial by jury, but only with the consent of all the parties. A party can thus easily obtain a change of fourm by the fiat of first demanding a jury then refusing to consent to the bankruptcy court's conduct of the trial. (citation omitted). A pleading filed for the purpose of forum shopping is potentially sanctionable. Then again, it might not be (citation omitted)."
In support of the proposition that forum shopping might not be bad, Judge Clark cited this wonderful comment from Judge Rubin of the Fifth Circuit:
"Forum-shopping is sanctioned by our judicial system. It is as American as the Constitition, peremptory challenges to jurors, and our dual system of state and federal courts."
McCuin v. Texas Power & Light Co., 714 F.2d 1255, 1261 (5th Cir. 1983).
So, the next time someone hurls the charge of forum-shopping, be sure to point out that you are defending the Constitition and the American way (although you might still want to have an argument as to why you are engaging in good forum-shopping as opposed to the other kind).
"Congress has authorized bankruptcy courts to adjudicate matters involving trial by jury, but only with the consent of all the parties. A party can thus easily obtain a change of fourm by the fiat of first demanding a jury then refusing to consent to the bankruptcy court's conduct of the trial. (citation omitted). A pleading filed for the purpose of forum shopping is potentially sanctionable. Then again, it might not be (citation omitted)."
In support of the proposition that forum shopping might not be bad, Judge Clark cited this wonderful comment from Judge Rubin of the Fifth Circuit:
"Forum-shopping is sanctioned by our judicial system. It is as American as the Constitition, peremptory challenges to jurors, and our dual system of state and federal courts."
McCuin v. Texas Power & Light Co., 714 F.2d 1255, 1261 (5th Cir. 1983).
So, the next time someone hurls the charge of forum-shopping, be sure to point out that you are defending the Constitition and the American way (although you might still want to have an argument as to why you are engaging in good forum-shopping as opposed to the other kind).
Friday, March 16, 2007
Lunchtime Conversation Prompts Judicial Inquiry, Pt. 3
Previous posts discussed the independent investigation initiated by Judge Marvin Isgur with regard to a credit counseling firm in the Southern District of Texas. Judge Isgur was concerned with regard to statements made at a lunchtime presentation which suggested that Money Management International refused to hire individuals who had filed bankruptcy as credit counselors.
At the hearing on March 1, 2007, MMI appeared and informed the court that "it does hire individuals notwithstanding any prior bankruptcy filing." The court was not completely satisfied and wanted to know whether they had hired former debtors in the past and whether they would in the future. As a result, the court continued the status conference to March 30, 2007.
Subsequent to the hearing, MMI submitted a new affidavit which represented that at least 24 of its current employees, including a manager and two supervisors, had filed for bankruptcy in the past. The affidavit also represented that "MMI intends to continue the practice of hiring qualified persons as credit counselors, including qualified persons who have been in bankruptcy." Thus, it would appear that the court's inquiry corrected a misunderstanding and most likely provided some job security for former bankrupts employed as credit counselors.
At the hearing on March 1, 2007, MMI appeared and informed the court that "it does hire individuals notwithstanding any prior bankruptcy filing." The court was not completely satisfied and wanted to know whether they had hired former debtors in the past and whether they would in the future. As a result, the court continued the status conference to March 30, 2007.
Subsequent to the hearing, MMI submitted a new affidavit which represented that at least 24 of its current employees, including a manager and two supervisors, had filed for bankruptcy in the past. The affidavit also represented that "MMI intends to continue the practice of hiring qualified persons as credit counselors, including qualified persons who have been in bankruptcy." Thus, it would appear that the court's inquiry corrected a misunderstanding and most likely provided some job security for former bankrupts employed as credit counselors.
Administrative Insolvency, Professional Responsibility and the Art of Judging
Recently I was involved in a heavily litigated chapter 11 case. The professional fees (which included fees from two sets of debtors’ counsel, a chapter 11 trustee, an examiner, various special counsel and parties claiming substantial contribution fees) threatened to consume the estate until the lawyers agreed to limit their take and leave some funds for the pre-petition creditors. In a remarkable display of good sense, the attorneys then compromised on how the professional fees would be allocated rather than continuing the fight. (I can’t claim any credit here since others did the heavy lifting).
At the hearing to approve the fees, the judge commended the lawyers for their professionalism. However, while everyone was basking in good spirits (or at least as good as you can feel after having agreed to a fee reduction), the court asked what could have been done to stop the bleeding before everything got so expensive. Waxing philosophical, the court questioned whether the traditional ethical rules with regard to professional billing work in the bankruptcy context and whether the court should play a more activist role in managing troublesome cases. The court raised a good question.
In the traditional two-party litigation model, professional responsibility is primarily a matter of consumer protection. Fees are governed by a limitation that they may not be unconscionable, Texas Disciplinary Rules of Professional Conduct 1.04, but beyond that, the rates and amounts charged are largely a function of the client’s ability and willingness to pay. Fee shifting distorts the traditional model, since one party can shift its costs onto the other party. However, there are still some limits since there is no guarantee that the party who is on the receiving end of the fee award will have the ability to pay.
In a complex bankruptcy, the dynamic is far different than the two party litigation model. In this context, a “complex” bankruptcy is one where there is a pot of unencumbered assets worth fighting over and multiple parties with an interest in the pot. In an efficient bankruptcy, the pot is maximized for the benefit of the residual claimants, who are typically the unsecured creditors. On the other hand, in an inefficient bankruptcy, the post-petition claimants (such as professionals, committees, secured lenders and parties claiming a “substantial contribution”) consume the estate at the expense of the residual claimants.
An inefficient bankruptcy poses both an ethical challenge for the professionals and a management challenge for the court. Professionals employed by the estate have a duty to maximize value for the estate (and thus to ultimately benefit the creditors) rather than to simply run up their own fees. The Fifth Circuit has held that professionals may not be compensated unless their efforts result in an “an identifiable, tangible and material benefit to the bankruptcy estate.” Matter of Pro-Snax Distributors, Inc., 125 F.3d 414, 426 (5th Cir. 1998). Thus, there should be a practical deterrent to pursuing inefficient litigation on the part of the estate’s professionals.
However, there are several important limitations on the ability of the estate’s professionals to act efficiently and ethically when it comes to incurring fees. First, contested fee applications are fairly unusual. As a result, the deterrent effect is more theoretical than real. Second, efficiency is much easier to judge in hindsight than in the heat of battle. As a result, decisions which result in unproductive fees may have appeared reasonable at the time. Finally and perhaps most importantly, third parties can impose costs on the estate through their litigation tactics quite independently of the good judgment and ethical decision making of the debtor’s professionals. If a creditor decides to pursue a program of expensive discovery and objects to every action proposed by the debtor, the estate’s professionals will often have little choice but to participate to the same extent, resulting in an escalation of professional fees.
So, since the professionals have an imperfect ability to avoid a train wreck, what can the court do?
1. Watch out for ugly cases. While this sounds fairly trite and self-evident, some cases bear closer watching than others. In some cases, the parties and personalities involved have a greater potential for spiraling out of control. Becky McElroy likes to say that you should watch out for any case with an “ex” in it, whether it is an ex-wife, ex-partner, ex-employee and so on. In the business context, this can apply to a rebuffed purchaser, a competitor or a debt buyer whose strategy is to cause trouble until someone buys them off. Of course, litigiousness can be a management style for the debtor as well. If the court is able to see the warning signs, it can step in sooner to manage the case more closely.
2. Monitor Fees. In a particularly ugly case, the parties may be reluctant to submit fee applications for fear of retaliatory objections. However, in a case where no one is submitting their fees for approval, the court may not be aware that the case is approaching administrative insolvency.
3. Send the Parties to Mediation. Not all problems can be solved through litigation. If the parties are using litigation as a negotiating strategy, the court may be able to save costs by requiring the parties to negotiate directly. Of course, mediation can also be another opportunity for delay and expense if the parties aren’t ready to negotiate.
4. Set Deadlines/Force the Issue. All lawyers want more time and some cases require time to find a business solution. However, time also creates more opportunities for mischief. If the debtor’s lawyers are asking to continue the hearing on the disclosure statement for the fifth time and no creditor is stepping up to propose a plan, then perhaps the case is in a stalemate which won’t be resolved unless the court sets deadlines and forces the parties to litigate, reach an agreement or go away.
5. Appoint a Trustee/Change the Parties. Some cases are basically a two party dispute with the remaining creditors held hostage to the main dispute. While appointing a trustee is normally reserved for situations where the debtor has misbehaved, perhaps it is appropriate to appoint a trustee in cases where the parties’ irrational hatred for each other threatens to consume the estate to the detriment of the third party creditors. By appointing a trustee, the court may deprive one of the factions of its motivation to fight. Of course, the opposite could be true as well. If the non-debtor party has an irrational to inflict its will on others, then appointing a trustee may simply create another opponent for the malevolent party while defunding the former debtor-in-possession (who can no longer bill the estate for its fees).
The suggestions offered here are imperfect and incomplete. Please feel free to use the comments function to offer your own suggestions.
At the hearing to approve the fees, the judge commended the lawyers for their professionalism. However, while everyone was basking in good spirits (or at least as good as you can feel after having agreed to a fee reduction), the court asked what could have been done to stop the bleeding before everything got so expensive. Waxing philosophical, the court questioned whether the traditional ethical rules with regard to professional billing work in the bankruptcy context and whether the court should play a more activist role in managing troublesome cases. The court raised a good question.
In the traditional two-party litigation model, professional responsibility is primarily a matter of consumer protection. Fees are governed by a limitation that they may not be unconscionable, Texas Disciplinary Rules of Professional Conduct 1.04, but beyond that, the rates and amounts charged are largely a function of the client’s ability and willingness to pay. Fee shifting distorts the traditional model, since one party can shift its costs onto the other party. However, there are still some limits since there is no guarantee that the party who is on the receiving end of the fee award will have the ability to pay.
In a complex bankruptcy, the dynamic is far different than the two party litigation model. In this context, a “complex” bankruptcy is one where there is a pot of unencumbered assets worth fighting over and multiple parties with an interest in the pot. In an efficient bankruptcy, the pot is maximized for the benefit of the residual claimants, who are typically the unsecured creditors. On the other hand, in an inefficient bankruptcy, the post-petition claimants (such as professionals, committees, secured lenders and parties claiming a “substantial contribution”) consume the estate at the expense of the residual claimants.
An inefficient bankruptcy poses both an ethical challenge for the professionals and a management challenge for the court. Professionals employed by the estate have a duty to maximize value for the estate (and thus to ultimately benefit the creditors) rather than to simply run up their own fees. The Fifth Circuit has held that professionals may not be compensated unless their efforts result in an “an identifiable, tangible and material benefit to the bankruptcy estate.” Matter of Pro-Snax Distributors, Inc., 125 F.3d 414, 426 (5th Cir. 1998). Thus, there should be a practical deterrent to pursuing inefficient litigation on the part of the estate’s professionals.
However, there are several important limitations on the ability of the estate’s professionals to act efficiently and ethically when it comes to incurring fees. First, contested fee applications are fairly unusual. As a result, the deterrent effect is more theoretical than real. Second, efficiency is much easier to judge in hindsight than in the heat of battle. As a result, decisions which result in unproductive fees may have appeared reasonable at the time. Finally and perhaps most importantly, third parties can impose costs on the estate through their litigation tactics quite independently of the good judgment and ethical decision making of the debtor’s professionals. If a creditor decides to pursue a program of expensive discovery and objects to every action proposed by the debtor, the estate’s professionals will often have little choice but to participate to the same extent, resulting in an escalation of professional fees.
So, since the professionals have an imperfect ability to avoid a train wreck, what can the court do?
1. Watch out for ugly cases. While this sounds fairly trite and self-evident, some cases bear closer watching than others. In some cases, the parties and personalities involved have a greater potential for spiraling out of control. Becky McElroy likes to say that you should watch out for any case with an “ex” in it, whether it is an ex-wife, ex-partner, ex-employee and so on. In the business context, this can apply to a rebuffed purchaser, a competitor or a debt buyer whose strategy is to cause trouble until someone buys them off. Of course, litigiousness can be a management style for the debtor as well. If the court is able to see the warning signs, it can step in sooner to manage the case more closely.
2. Monitor Fees. In a particularly ugly case, the parties may be reluctant to submit fee applications for fear of retaliatory objections. However, in a case where no one is submitting their fees for approval, the court may not be aware that the case is approaching administrative insolvency.
3. Send the Parties to Mediation. Not all problems can be solved through litigation. If the parties are using litigation as a negotiating strategy, the court may be able to save costs by requiring the parties to negotiate directly. Of course, mediation can also be another opportunity for delay and expense if the parties aren’t ready to negotiate.
4. Set Deadlines/Force the Issue. All lawyers want more time and some cases require time to find a business solution. However, time also creates more opportunities for mischief. If the debtor’s lawyers are asking to continue the hearing on the disclosure statement for the fifth time and no creditor is stepping up to propose a plan, then perhaps the case is in a stalemate which won’t be resolved unless the court sets deadlines and forces the parties to litigate, reach an agreement or go away.
5. Appoint a Trustee/Change the Parties. Some cases are basically a two party dispute with the remaining creditors held hostage to the main dispute. While appointing a trustee is normally reserved for situations where the debtor has misbehaved, perhaps it is appropriate to appoint a trustee in cases where the parties’ irrational hatred for each other threatens to consume the estate to the detriment of the third party creditors. By appointing a trustee, the court may deprive one of the factions of its motivation to fight. Of course, the opposite could be true as well. If the non-debtor party has an irrational to inflict its will on others, then appointing a trustee may simply create another opponent for the malevolent party while defunding the former debtor-in-possession (who can no longer bill the estate for its fees).
The suggestions offered here are imperfect and incomplete. Please feel free to use the comments function to offer your own suggestions.
Wednesday, March 14, 2007
Now for Something Completely Different: A Salute to Success
I took my family to the rodeo last night. It was not because I wanted to put on my boots and watch bull riding or mutton bustin’ (although those were my favorite events). No, we went to the rodeo because Aly & AJ were the featured performers last night. If you have a daughter between the ages of 10-14 and own a television, you likely know who I’m talking about, while the rest of you may be scratching your heads. For those of you who are unfamiliar with Aly & AJ, I will take a break from writing about bankruptcy to talk about the Disney/Nickelodeon teen machine.
In case, you may have missed this trend, there are now about a million shows aimed at middle school girls on Disney and Nickelodeon. As a result of aggressive marketing, the teen stars of these shows, rather than being snickered at for being modern Mouseketeers, are plastered all over the pages of Tiger Beat, Pop Star and similar teen girl fan magazines. (In case you may be thinking that it is really weird that I would know this, I need to point out that I spend a lot of time helping my eighth grade daughter with homework and the posters from these magazines cover every available inch of wallspace in her room).
So, what is the secret to this success?
1. The first step is finding the right niche market. Here, it is all girls all the time. .If you flip through the offerings on Disney and Teen Nick, you will find that they are predominately aimed at middle school girls. If boys have a lead role in a show, they must be cute and non-threatening and be part of a cast with strong girl characters (e.g., Dylan and Cole Sprouse from the Suite Life of Zack and Cody or Ricky Ullman in Phil of the Future). Maybe guys of this age are too glued to their Xbox to watch TV. However, middle school girls provide an eager audience. Since they are too young to drive, they spend a lot of time in front of the TV (usually while talking on the phone at the same time). They also buy the magazines, CDs and movie tickets which spin off from these shows and spend hours discussing them with their friends.
2. Second, is that it helps to have some vaguely familiar names. Thus, you will find Julia Roberts’s niece (Emma Roberts of Unfabulous), Billy Ray Cyrus’s daughter (Miley Cyrus of Hannah Montana), Haley Joel Osment’s sister (Emily Osment also of Hannah Montana) and Britney Spears’s sister (Jamie Lynn Spears of Zoey 101). I’m not sure how this helps with the kids, but perhaps it means something to the parents to know that their kids are watching the daughter of the guy who sang “Achy Breaky Heart.” (By the way, Billy Ray also appears in the show).
3. Third, cross-marketing is key. Disney in particular has mastered the three pillars of middle school girl society: music, movies and television (if they could just find a way to bring the telephone into the equation, they would be unstoppable). Aly & AJ are a prime example. The blonde sisters began performing songs on Radio Disney and in Disney movies such as Ice Princess and Herbie: Fully Loaded. The music videos from these songs play constantly on the Disney channel, promoting both the singers and the movies. Alyson Michalka played the female lead in Phil of the Future (which was tragically cut short when Phil’s father unexpectedly fixed the time machine parting the star crossed couple). The Michalka sisters also appeared in their own made for TV movie, Cow Belles, and will be appearing in a movie released for the big screen by MTV this summer. Their debut CD "Into the Rush" quickly went gold (or is it platinum by now?). Last year, I took my daughter to Houston to see Hannah Montana in concert. Hannah Montana is not an actual person, but is a character played by Miley Cyrus. In the show she plays a teen who has a secret life as a pop star. Reality imitated art when the actress had a concert tour playing her character (along with the Cheetah Girls, another made for TV singing group). Brenda Song plays a supporting role in The Suite Life of Zack and Cody, but got to be the star of her own made for TV movie, Wendy Wu: Homecoming Warrior (no, I am not making this up).
For those of you who didn’t know this world was out there, you probably could have lived without this information. However, it is important to acknowledge genius. Only time will tell whether these stars will retain their luster after they turn 18. However, for now they are certainly enjoying their moment in the sun. My next post will be on the somewhat drier topic of administrative insolvency, professional responsibility and the art of judging.
In case, you may have missed this trend, there are now about a million shows aimed at middle school girls on Disney and Nickelodeon. As a result of aggressive marketing, the teen stars of these shows, rather than being snickered at for being modern Mouseketeers, are plastered all over the pages of Tiger Beat, Pop Star and similar teen girl fan magazines. (In case you may be thinking that it is really weird that I would know this, I need to point out that I spend a lot of time helping my eighth grade daughter with homework and the posters from these magazines cover every available inch of wallspace in her room).
So, what is the secret to this success?
1. The first step is finding the right niche market. Here, it is all girls all the time. .If you flip through the offerings on Disney and Teen Nick, you will find that they are predominately aimed at middle school girls. If boys have a lead role in a show, they must be cute and non-threatening and be part of a cast with strong girl characters (e.g., Dylan and Cole Sprouse from the Suite Life of Zack and Cody or Ricky Ullman in Phil of the Future). Maybe guys of this age are too glued to their Xbox to watch TV. However, middle school girls provide an eager audience. Since they are too young to drive, they spend a lot of time in front of the TV (usually while talking on the phone at the same time). They also buy the magazines, CDs and movie tickets which spin off from these shows and spend hours discussing them with their friends.
2. Second, is that it helps to have some vaguely familiar names. Thus, you will find Julia Roberts’s niece (Emma Roberts of Unfabulous), Billy Ray Cyrus’s daughter (Miley Cyrus of Hannah Montana), Haley Joel Osment’s sister (Emily Osment also of Hannah Montana) and Britney Spears’s sister (Jamie Lynn Spears of Zoey 101). I’m not sure how this helps with the kids, but perhaps it means something to the parents to know that their kids are watching the daughter of the guy who sang “Achy Breaky Heart.” (By the way, Billy Ray also appears in the show).
3. Third, cross-marketing is key. Disney in particular has mastered the three pillars of middle school girl society: music, movies and television (if they could just find a way to bring the telephone into the equation, they would be unstoppable). Aly & AJ are a prime example. The blonde sisters began performing songs on Radio Disney and in Disney movies such as Ice Princess and Herbie: Fully Loaded. The music videos from these songs play constantly on the Disney channel, promoting both the singers and the movies. Alyson Michalka played the female lead in Phil of the Future (which was tragically cut short when Phil’s father unexpectedly fixed the time machine parting the star crossed couple). The Michalka sisters also appeared in their own made for TV movie, Cow Belles, and will be appearing in a movie released for the big screen by MTV this summer. Their debut CD "Into the Rush" quickly went gold (or is it platinum by now?). Last year, I took my daughter to Houston to see Hannah Montana in concert. Hannah Montana is not an actual person, but is a character played by Miley Cyrus. In the show she plays a teen who has a secret life as a pop star. Reality imitated art when the actress had a concert tour playing her character (along with the Cheetah Girls, another made for TV singing group). Brenda Song plays a supporting role in The Suite Life of Zack and Cody, but got to be the star of her own made for TV movie, Wendy Wu: Homecoming Warrior (no, I am not making this up).
For those of you who didn’t know this world was out there, you probably could have lived without this information. However, it is important to acknowledge genius. Only time will tell whether these stars will retain their luster after they turn 18. However, for now they are certainly enjoying their moment in the sun. My next post will be on the somewhat drier topic of administrative insolvency, professional responsibility and the art of judging.
Friday, February 23, 2007
Lunchtime Conversation Prompts Judicial Inquiry, Pt. 2
An alert reader, Jim Hoeffner with Thompson Coe in Austin, pointed out that Sec. 525(b) has been interpreted to permit private employers to refuse to hire persons who have filed bankruptcy. Pastore v. Medford Savings Bank, 186 B.R. 553 (D. Mass. 1995); In re Hendrik, 2004 Bankr. LEXIS 1649 (Bankr. M.D. Fla. 2004)("It is well established now by several cases that Section 525(b) of the Code applies only to actions taken after an employment relationship has been established and does not cover a situation which might be a discriminatory hiring practice by private employers"); In re Stinson, 285 B.R. 239 (Bankr. W.D. Va. 2002).
As a result, my statement that "an entity which which functions as a gatekeeper for the bankruptcy process appeared to be violating the Bankruptcy Code" was more a statement of what the law should be than a statement of what the law currently is. A plain reading of the text "No private employer may ... discriminate with respect to employment against, an individual who is or has been a debtor under this title ...." would seem to prohibit refusal to employ as well as discrimination after an employment relationship has been established. However, that is not what the cases say.
Thus, in reading the tea leaves from Judge Isgur's brief opinion, we are left with the following possibilities:
1. Judge Isgur may be signaling a break with the existing case law on Sec. 525(b) and is willing to entertain a cause of action for failure to hire;
2. Judge Isgur may find that discrimination in employment by credit counseling agencies, while lawful, reflects negatively upon their fitness to provide services to potential debtors; or
3. Judge Isgur may find that cause has been shown and take no further action.
Obviously, the first two possibilities are more interesting. We will have to wait and see what happens.
As a result, my statement that "an entity which which functions as a gatekeeper for the bankruptcy process appeared to be violating the Bankruptcy Code" was more a statement of what the law should be than a statement of what the law currently is. A plain reading of the text "No private employer may ... discriminate with respect to employment against, an individual who is or has been a debtor under this title ...." would seem to prohibit refusal to employ as well as discrimination after an employment relationship has been established. However, that is not what the cases say.
Thus, in reading the tea leaves from Judge Isgur's brief opinion, we are left with the following possibilities:
1. Judge Isgur may be signaling a break with the existing case law on Sec. 525(b) and is willing to entertain a cause of action for failure to hire;
2. Judge Isgur may find that discrimination in employment by credit counseling agencies, while lawful, reflects negatively upon their fitness to provide services to potential debtors; or
3. Judge Isgur may find that cause has been shown and take no further action.
Obviously, the first two possibilities are more interesting. We will have to wait and see what happens.
Thursday, February 22, 2007
Lunchtime Conversation Prompts Judicial Inquiry
Over the past year, the Houston bankruptcy court judges have written quite a number of opinions calling attention to unprofessional practices. These opinions have reacted to proceedings coming before their courts, many of which have been quite disturbing. However, now Judge Marvin Isgur has gone one step further. He has initiated a proceeding to investigate a credit counseling agency based upon a lunchtime presentation he attended. In re Credit Counseling in the Southern District of Texas, No. MC-07-301 (Bankr. S.D. Tex. 2/15/07).
Judge Isgur Gets Indigestion and Issues An Order
According to Judge Isgur:
"On January 26, 2007, the undersigned judge attended the monthly meeting of the Houston Association of Debtors Attorneys. At that meeting, the speaker was the chief executive officer of Money Management International. In responding to a question from the audience, the speaker told the assembled group that Money Management International had an employment policy that barred the employment of any credit counselor who had previously been in bankruptcy."
This concerned Judge Isgur because 11 U.S.C. Sec. 525 provides that "no private employer may ... discriminate with respect to employment against an individual who is or has been a debtor under this title ... solely because such debtor or bankrupt" has been a debtor. Thus, an entity which functions as a gatekeeper for the bankruptcy process appeared to be violating the Bankruptcy Code.
Judge Isgur noted that the U.S. Trustee is given responsibility for regulating credit counseling agencies, but surmised that "the United States Trustee would not necessarily have inquired into Money Management International's employment practices as regulated by Sec. 525 of the Bankruptcy Code." In response to this concern, the court issued an order which "requires that the United States trustee determine whether Money Management International should remain on its approved list of counseling agencies." The court scheduled a hearing for March 1, 2007 for the U.S. Trustee to advise the court as to the current status of Money Management International.
By What Authority?
Judge Isgur's concern for the integrity of the bankruptcy system is commendable. It seems apparent that he wants to encourage Money Management International to amend its ways and comply with Title 11. However, the procedure followed is somewhat novel.
Congress gave the power to regulate credit counseling agencies to the United States Trustee, a division of the Department of Justice. Under 11 U.S.C. Sec. 111(b), the United States Trustee is given authority to approve a credit counseling agency for a probationary period of six months and then for successive one year periods. Any person who disagrees with a final decision to approve or deny a subsequent one year appointment may seek review from the appropriate district court of the United States within 30 days.
If this were the entirety of the statutory scheme, then Judge Isgur would appear to be on shaky ground. However, there is another curious provision. Sec. 111(e) states that:
"The district court may, at any time, investigate the qualifications of a nonprofit budget and credit counseling agency referred to in subsection (a) above, and request production of documents to ensure the integrity and effectiveness of such agency. The district court may, at any time, remove from the approved list under subsection (a) a nonprofit budget and credit counseling agency upon finding such agency does not meet the qualifications of subsection (b)."
Thus, the "district court" is given almost blanket authority to review the status of credit counseling agencies "at any time." 28 U.S.C. Sec. 157(a)allows the District Court to refer proceedings arising under Title 11 to the Bankruptcy Court. Thus, unless the term "district court" is intended to refer to the actual U.S. District Court rather than the Bankruptcy Court acting under referral from the District Court, Judge Isgur acted exactly as Congress intended.
Who Is the District Court?
The choice of the words "district court" in Sec. 111 is unusual. In most instances, Title 11 refers to "the court" or "the bankruptcy court." The term "district court" is found in only a few sections. In a few cases, it is used to refer to the U.S. District Court appointed under Article III. For example, under the pre-BAPCPA version of 11 U.S.C. Sec. 110, the bankruptcy court was permitted to certify certain violations by bankruptcy petition preparers to the district court. (Under BAPCPA, this provision was changed to refer to "the court" and eliminate the need to certify the fact to a higher court). In Sec. 524(g)(3)(A), the issuance of certain channeling injunctions are valid if the confirmation order is issued or affirmed by the district court. Both of these sections clearly referred to the Article III court.
Two other provisions are more ambiguous. Sec. 526(c)(4) grants concurrent jurisdiction to the district courts of the state in situations where a state official could bring an action against a debt relief agency. However, other subsections within Sec. 526 refer to "the court" or "a Federal court" such that the context is not clear. In Sec. 1116(4), the debtor must file other documents required by a local rule of the district court. Bankruptcy court local rules are adopted under the authority of the district court. As a result, the reference to district court rules clearly refers to bankruptcy court rules.
While the use of the term "district court" in section 111(e) is ambiguous, it probably refers to the bankruptcy court acting under reference from the district court. The subsection contemplates the court initiating an investigation and making findings with regard to the suitability of a credit counseling agency. It is unlikely that a U.S. District Court, which has no direct dealings with credit counseling agencies, would have the time or inclination to launch such an investigation.
Conclusion
When I began this article, I expected to conclude that Judge Isgur had initiated a well-intentioned but unauthorized Star Chamber proceeding. I believed that the U.S. Trustee had the sole authority to regulate credit counseling agencies and that this case raised a separation of powers issue. Therefore, I was surprised to find that Congress had authorized this type of independent inquiry. This is a remarkable section of the Code and one which has received little attention.
Thus, what is really remarkable about Judge Isgur initating a Miscellaneous Case to investigate comments made at a bankruptcy luncheon is that it seems to be exactly what Congress intended. Sec. 111(e) appears to authorize the bankruptcy judge to launch independent investigations based on whatever facts come to his attention, whether in court, at a luncheon or in cocktail party chatter. This marks a dramatic shift in the role of the court. One of the hallmarks of the Bankruptcy Code of 1979 is that it removed the court from the role of administrator. Now, under BAPCPA, the same Congress which took away much of the Court's discretion with regard to means testing, has given the bankruptcy court an independent administrative role.
Judge Isgur Gets Indigestion and Issues An Order
According to Judge Isgur:
"On January 26, 2007, the undersigned judge attended the monthly meeting of the Houston Association of Debtors Attorneys. At that meeting, the speaker was the chief executive officer of Money Management International. In responding to a question from the audience, the speaker told the assembled group that Money Management International had an employment policy that barred the employment of any credit counselor who had previously been in bankruptcy."
This concerned Judge Isgur because 11 U.S.C. Sec. 525 provides that "no private employer may ... discriminate with respect to employment against an individual who is or has been a debtor under this title ... solely because such debtor or bankrupt" has been a debtor. Thus, an entity which functions as a gatekeeper for the bankruptcy process appeared to be violating the Bankruptcy Code.
Judge Isgur noted that the U.S. Trustee is given responsibility for regulating credit counseling agencies, but surmised that "the United States Trustee would not necessarily have inquired into Money Management International's employment practices as regulated by Sec. 525 of the Bankruptcy Code." In response to this concern, the court issued an order which "requires that the United States trustee determine whether Money Management International should remain on its approved list of counseling agencies." The court scheduled a hearing for March 1, 2007 for the U.S. Trustee to advise the court as to the current status of Money Management International.
By What Authority?
Judge Isgur's concern for the integrity of the bankruptcy system is commendable. It seems apparent that he wants to encourage Money Management International to amend its ways and comply with Title 11. However, the procedure followed is somewhat novel.
Congress gave the power to regulate credit counseling agencies to the United States Trustee, a division of the Department of Justice. Under 11 U.S.C. Sec. 111(b), the United States Trustee is given authority to approve a credit counseling agency for a probationary period of six months and then for successive one year periods. Any person who disagrees with a final decision to approve or deny a subsequent one year appointment may seek review from the appropriate district court of the United States within 30 days.
If this were the entirety of the statutory scheme, then Judge Isgur would appear to be on shaky ground. However, there is another curious provision. Sec. 111(e) states that:
"The district court may, at any time, investigate the qualifications of a nonprofit budget and credit counseling agency referred to in subsection (a) above, and request production of documents to ensure the integrity and effectiveness of such agency. The district court may, at any time, remove from the approved list under subsection (a) a nonprofit budget and credit counseling agency upon finding such agency does not meet the qualifications of subsection (b)."
Thus, the "district court" is given almost blanket authority to review the status of credit counseling agencies "at any time." 28 U.S.C. Sec. 157(a)allows the District Court to refer proceedings arising under Title 11 to the Bankruptcy Court. Thus, unless the term "district court" is intended to refer to the actual U.S. District Court rather than the Bankruptcy Court acting under referral from the District Court, Judge Isgur acted exactly as Congress intended.
Who Is the District Court?
The choice of the words "district court" in Sec. 111 is unusual. In most instances, Title 11 refers to "the court" or "the bankruptcy court." The term "district court" is found in only a few sections. In a few cases, it is used to refer to the U.S. District Court appointed under Article III. For example, under the pre-BAPCPA version of 11 U.S.C. Sec. 110, the bankruptcy court was permitted to certify certain violations by bankruptcy petition preparers to the district court. (Under BAPCPA, this provision was changed to refer to "the court" and eliminate the need to certify the fact to a higher court). In Sec. 524(g)(3)(A), the issuance of certain channeling injunctions are valid if the confirmation order is issued or affirmed by the district court. Both of these sections clearly referred to the Article III court.
Two other provisions are more ambiguous. Sec. 526(c)(4) grants concurrent jurisdiction to the district courts of the state in situations where a state official could bring an action against a debt relief agency. However, other subsections within Sec. 526 refer to "the court" or "a Federal court" such that the context is not clear. In Sec. 1116(4), the debtor must file other documents required by a local rule of the district court. Bankruptcy court local rules are adopted under the authority of the district court. As a result, the reference to district court rules clearly refers to bankruptcy court rules.
While the use of the term "district court" in section 111(e) is ambiguous, it probably refers to the bankruptcy court acting under reference from the district court. The subsection contemplates the court initiating an investigation and making findings with regard to the suitability of a credit counseling agency. It is unlikely that a U.S. District Court, which has no direct dealings with credit counseling agencies, would have the time or inclination to launch such an investigation.
Conclusion
When I began this article, I expected to conclude that Judge Isgur had initiated a well-intentioned but unauthorized Star Chamber proceeding. I believed that the U.S. Trustee had the sole authority to regulate credit counseling agencies and that this case raised a separation of powers issue. Therefore, I was surprised to find that Congress had authorized this type of independent inquiry. This is a remarkable section of the Code and one which has received little attention.
Thus, what is really remarkable about Judge Isgur initating a Miscellaneous Case to investigate comments made at a bankruptcy luncheon is that it seems to be exactly what Congress intended. Sec. 111(e) appears to authorize the bankruptcy judge to launch independent investigations based on whatever facts come to his attention, whether in court, at a luncheon or in cocktail party chatter. This marks a dramatic shift in the role of the court. One of the hallmarks of the Bankruptcy Code of 1979 is that it removed the court from the role of administrator. Now, under BAPCPA, the same Congress which took away much of the Court's discretion with regard to means testing, has given the bankruptcy court an independent administrative role.
Wednesday, February 21, 2007
Supreme Court Limits "Absolute" Right to Convert to Chapter 13
In the first bankruptcy opinion of the term, the Supreme Court held in a 5-4 decision that a misbehaving Chapter 7 debtor does not have an absolute right to convert his case to Chapter 13. Marrama v. Citizens Bank of Massachusetts, No. 05-996, 549 U.S. ___ (2007). The Supreme Court stated that a debtor whose case could be converted or dismissed for cause under 11 U.S.C. Sec. 1307(c) had forfeited the right to proceed under Chapter 13 and thus was not a person eligible to convert to Chapter 13.
According to Justice Stevens writing for the majority:
"An issue that has arisen with disturbing frequency is whether a debtor who acts in bad faith prior to, or in the course of, filing a Chapter 13 petition by, for example, fraudulently concealing significant assets, thereby forfeits his right to obtain Chapter 13 relief. The issue may arise at the outset of a Chapter 13 case in response to a motion by creditors or by the United States trustee either to dismiss the case or to convert it to Chapter 7, see Sec. 1307(c). It also may arise in a Chapter 7 case when a debtor files a motion under Sec. 706(a) to convert to Chapter 13. In the former context, despite the absence of any statutory provision specifically addressing the issue, the federal courts are virtually unanimous that prepetition bad faith conduct may cause a forfeiture of any right to proceed with a Chapter 13 case. In the latter context, however, some courts have suggested that even a bad-faith debtor has an absolute right to convert at least one Chapter 7 proceeding into a Chapter 13 case even though the case will thereafter be dismissed or immediately returned to Chapter 7."
The Supreme Court took the course of pragmatism, finding that the bankruptcy court could skip to the ultimate result and deny the conversion where the Debtor would not be able to maintain the Chapter 13 case. However, to do this, they had to get around some apparently clear statutory language.
Sec. 706(a) states that "The debtor may convert a case under this chapter to a case under chapter 11, 12 or 13 of this title at any time, if the case has not been converted under section 1112, 1208, or 1307 of this title. Any waiver of the right to convert a case under this subsection is unenforceable." This language seems pretty straightforward. The debtor may convert "at any time." The right to convert cannot be waived. Not so fast said the nimble Justice Stevens. Section 706(d) states that "a case may not be converted to a case under another chapter of this title unless the debtor may be a debtor under such chapter." According to Justice Stevens, a person might not be eligible for Chapter 13 relief on one of two grounds. First, Sec. 109(e) might provide that the person was not eligible. Second, Sec. 1307(c) might allow the case to be dismissed for "cause." Since a case could possibly be dismissed for cause, a person committing an act constituting cause was never eligible to be a debtor under Chapter 13 and his request for conversion could be denied.
In a display of consistent dedication to text, Justice Alito, joined by Chief Justice Roberts and Justices Scalia and Thomas, dissented. They pointed out that the statutory language is "clear" and "unambiguously provides that a debtor who has filed a bankruptcy petition under Chapter 7 has a broad right to convert the case to another chapter." He also pointed out that the word "eligible" under Sec. 706(d) refers to eligibility under Sec. 109(e), which is appropriately titled "Who may be a debtor." Sec. 1307(c) is not an eligibility provision, but rather a device for weeding out eligible but deficient cases. "...Sec. 1307(c) plainly does not set out requirements that an individual must meet in order to 'be a debtor' under Chapter 13. Instead, Sec. 1307(c) sets out the standard ('cause') that a bankruptcy court must apply in deciding whether, in its discretion, an already filed Chapter 13 case should be dismissed or converted to Chapter 7."
The dissent also points out that the majority mistakenly decided that "following the literal terms of the Code would be pointless." Justice Alito pointed out that by denying the right to convert, the majority would deprive a debtor of the ability to propose a plan and convince the court that the plan was filed in good faith. He concluded that, "Today's opinion renders these questions academic, and little is left to guide what a bankruptcy court must consider, or may disregard in blocking a Sec. 706(a) conversion."
This is a case where the conservative justices, with their emphasis on following the text, have the better argument. In trying to simplify procedure in the specific circumstance before them, the majority has muddied the law in several important respects:
1. The court has confused eligibility to file a case with the ability to remain in that case once filed. An ineligible debtor has no right to file. However, a debtor who has committed acts which could rise to the level of cause is at least entitled to file his case and try to convince creditors and the court that he can do better for them in the current chapter. Whether "cause" exists will not be readily apparent until after the court examines the debtor's conduct in the current chapter, i.e., whether he is using chapter 13 for the good faith purpose of paying his creditors or as a continuation of his efforts to evade creditors. Because "cause" often cannot be determined at the outset of a case, it should not form the basis for eligibility to file or convert.
2. From a procedural point of view, the Supreme Court has required the "cause" determination to be made too early. If the court must determine whether "cause" to reconvert the case exists at the time of the original request for conversion, the court is making its decision based on a hypothetical set of facts. While the debtor may be able to talk about what he would do in a potential Chapter 13 case, the court would not have the benefit of seeing the actual plan proposed by the debtor or gaining the input of the Chapter 13 Trustee on that plan.
3. Finally, the Supreme Court blithely stated that federal courts are "virtually unanimous" that pre-petition bad faith conduct may forfeit the right to proceed in Chapter 13. This is not really very accurate. Indeed, some of the "virtually unanimous" cases cited by the Supreme Court dealing with pre-petition bad faith conduct do not actually support the proposition. For example, In re Alt, 305 F.3d 413 (6th Cir. 2002) relied upon a totality of the circumstances test and focused primarily upon the debtor's failure to schedule a known claim. Similarly In re Leavitt, 171 F.3d 1219 (9th Cir. 1999) relied upon a totality of the circumstances test and gave the most emphasis to the debtor's failure to schedule assets, overstated expenses and refusal to amend his plan. Most bad-faith cases rely on a combination of both pre-petition and post-petition conduct. It seems that the Supreme Court has confused general bad faith with pre-petition bad faith. This would be a huge mistake. While bankruptcy is generally designed to benefit the "honest but unfortunate" debtor, Chapter 13 has traditionally been a forum where the previously dishonest debtor may repent and amend his ways to the benefit of both himself and his creditors. Allowing Chapter 13 cases to be dismissed solely based upon pre-petition conduct would be a significant shift in bankruptcy policy.
According to Justice Stevens writing for the majority:
"An issue that has arisen with disturbing frequency is whether a debtor who acts in bad faith prior to, or in the course of, filing a Chapter 13 petition by, for example, fraudulently concealing significant assets, thereby forfeits his right to obtain Chapter 13 relief. The issue may arise at the outset of a Chapter 13 case in response to a motion by creditors or by the United States trustee either to dismiss the case or to convert it to Chapter 7, see Sec. 1307(c). It also may arise in a Chapter 7 case when a debtor files a motion under Sec. 706(a) to convert to Chapter 13. In the former context, despite the absence of any statutory provision specifically addressing the issue, the federal courts are virtually unanimous that prepetition bad faith conduct may cause a forfeiture of any right to proceed with a Chapter 13 case. In the latter context, however, some courts have suggested that even a bad-faith debtor has an absolute right to convert at least one Chapter 7 proceeding into a Chapter 13 case even though the case will thereafter be dismissed or immediately returned to Chapter 7."
The Supreme Court took the course of pragmatism, finding that the bankruptcy court could skip to the ultimate result and deny the conversion where the Debtor would not be able to maintain the Chapter 13 case. However, to do this, they had to get around some apparently clear statutory language.
Sec. 706(a) states that "The debtor may convert a case under this chapter to a case under chapter 11, 12 or 13 of this title at any time, if the case has not been converted under section 1112, 1208, or 1307 of this title. Any waiver of the right to convert a case under this subsection is unenforceable." This language seems pretty straightforward. The debtor may convert "at any time." The right to convert cannot be waived. Not so fast said the nimble Justice Stevens. Section 706(d) states that "a case may not be converted to a case under another chapter of this title unless the debtor may be a debtor under such chapter." According to Justice Stevens, a person might not be eligible for Chapter 13 relief on one of two grounds. First, Sec. 109(e) might provide that the person was not eligible. Second, Sec. 1307(c) might allow the case to be dismissed for "cause." Since a case could possibly be dismissed for cause, a person committing an act constituting cause was never eligible to be a debtor under Chapter 13 and his request for conversion could be denied.
In a display of consistent dedication to text, Justice Alito, joined by Chief Justice Roberts and Justices Scalia and Thomas, dissented. They pointed out that the statutory language is "clear" and "unambiguously provides that a debtor who has filed a bankruptcy petition under Chapter 7 has a broad right to convert the case to another chapter." He also pointed out that the word "eligible" under Sec. 706(d) refers to eligibility under Sec. 109(e), which is appropriately titled "Who may be a debtor." Sec. 1307(c) is not an eligibility provision, but rather a device for weeding out eligible but deficient cases. "...Sec. 1307(c) plainly does not set out requirements that an individual must meet in order to 'be a debtor' under Chapter 13. Instead, Sec. 1307(c) sets out the standard ('cause') that a bankruptcy court must apply in deciding whether, in its discretion, an already filed Chapter 13 case should be dismissed or converted to Chapter 7."
The dissent also points out that the majority mistakenly decided that "following the literal terms of the Code would be pointless." Justice Alito pointed out that by denying the right to convert, the majority would deprive a debtor of the ability to propose a plan and convince the court that the plan was filed in good faith. He concluded that, "Today's opinion renders these questions academic, and little is left to guide what a bankruptcy court must consider, or may disregard in blocking a Sec. 706(a) conversion."
This is a case where the conservative justices, with their emphasis on following the text, have the better argument. In trying to simplify procedure in the specific circumstance before them, the majority has muddied the law in several important respects:
1. The court has confused eligibility to file a case with the ability to remain in that case once filed. An ineligible debtor has no right to file. However, a debtor who has committed acts which could rise to the level of cause is at least entitled to file his case and try to convince creditors and the court that he can do better for them in the current chapter. Whether "cause" exists will not be readily apparent until after the court examines the debtor's conduct in the current chapter, i.e., whether he is using chapter 13 for the good faith purpose of paying his creditors or as a continuation of his efforts to evade creditors. Because "cause" often cannot be determined at the outset of a case, it should not form the basis for eligibility to file or convert.
2. From a procedural point of view, the Supreme Court has required the "cause" determination to be made too early. If the court must determine whether "cause" to reconvert the case exists at the time of the original request for conversion, the court is making its decision based on a hypothetical set of facts. While the debtor may be able to talk about what he would do in a potential Chapter 13 case, the court would not have the benefit of seeing the actual plan proposed by the debtor or gaining the input of the Chapter 13 Trustee on that plan.
3. Finally, the Supreme Court blithely stated that federal courts are "virtually unanimous" that pre-petition bad faith conduct may forfeit the right to proceed in Chapter 13. This is not really very accurate. Indeed, some of the "virtually unanimous" cases cited by the Supreme Court dealing with pre-petition bad faith conduct do not actually support the proposition. For example, In re Alt, 305 F.3d 413 (6th Cir. 2002) relied upon a totality of the circumstances test and focused primarily upon the debtor's failure to schedule a known claim. Similarly In re Leavitt, 171 F.3d 1219 (9th Cir. 1999) relied upon a totality of the circumstances test and gave the most emphasis to the debtor's failure to schedule assets, overstated expenses and refusal to amend his plan. Most bad-faith cases rely on a combination of both pre-petition and post-petition conduct. It seems that the Supreme Court has confused general bad faith with pre-petition bad faith. This would be a huge mistake. While bankruptcy is generally designed to benefit the "honest but unfortunate" debtor, Chapter 13 has traditionally been a forum where the previously dishonest debtor may repent and amend his ways to the benefit of both himself and his creditors. Allowing Chapter 13 cases to be dismissed solely based upon pre-petition conduct would be a significant shift in bankruptcy policy.
Tuesday, January 30, 2007
Houston Judges Find Method to Avoid Unnecessary Filing of Means Testing Form in Cases That Have Mostly Business Debt
While means testing is supposed to be self-effectuating, Congress failed to specify a clear mechanism for separating those debtors required to pass through the analysis and those who were exempt. In a new opinion, Judges Marvin Isgur and Wes Steen have developed a test to help debtors navigate the straits between Scylla and Charibidis (complete with a footnote explaining who Scylla and Charibidis were). No. 06-37157, In re David Michael Beacher, (Bankr. S.D. Tex. 1/26/07) and No. 06-35550, In re Michael Antonio Pena (Bankr. S.D. Tex. 1/26/07).
Means testing is one of the hallmarks of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). It was meant to ensure that debtors who could afford to pay their debts did not take the easy way out by filing chapter 7. Means testing only applies to debtors with "primarily consumer debts." This may have been because Congress figured that business debtors would fail in a big way so that they wouldn't be able to repay their debts or it might have been intended to promote entrepreneurship or it just may have been a consequence of the fact that BAPCPA was championed by the consumer credit lobby. Whatever the reason, means testing applies to individuals with primarily consumer debts but not other individuals.
Means testing is enforced through a regime which requires debtors to file a statement of current income and expenditures, which in the case of an individual debtor with primarily consumer debts must include a calculation to determine whether the presumption of abuse arises. See 11 U.S.C. Sec. 521(a)(1) (requiring filing of statement of income and expense unless the court orders otherwise) and 11 U.S.C. Sec. 707(b)(2)(C) (requiring additional calculation if primarily consumer debts are involved). If a debtor fails to file the information required by Sec. 521 within 45 days, then the case is subject to mandatory dismissal. 11 U.S.C. Sec. 521(i)(1).
Form 22A contains a detailed analysis of income and expenditures under the means test. However, judges have disagreed on whether it must be filed by all chapter 7 debtors or just those with consumer debts. Compare In re Moates, 338 B.R. 716 (Bankr. N.D. 2006)(only consumer debtors need file the form) with In re Copeland, 2006 Bankr. LEXIS 2200 (Bankr. S.D. Tex. 2006)(all debtors must file).
Judges Isgur and Steen disagreed with their Southern District colleague and ruled that requiring all debtors to file the form was neither "reasonable or acceptable." They cited Lord Coke for the maxim that "The law requires no one to do vain or useless things." 5 Coke 21.
With that out of the way, the judges had to decide what to do if a debtor failed to file the form. If the debtor was required to file the form but did not do so, then mandatory dismissal was the penalty. On the other hand, if the debtor was not required to file the form, they could hardly complain about its absence. The two cases consolidated in their opinion illustrate two different ways to approach the problem. In the first case, the debtor filed a motion to be excused from filing Form 22A on the ground that it was not required. In the second case, the court issued a show cause order as to why the case should not be dismissed for failure to file the form. When the debtor did not respond, the case was dismissed, leading to a motion to reconsider. In both cases, someone, whether the debtor or the court, had to take a proactive step to tee up the issue.
Further, the consequences of guessing wrong were serious, since they would result in automatic dismissal. In the Beacher case, the debtors contended that 58% of their debts resulted from their failed business. However, what if it turned out that only 49% fell in the business category? If the decision was made 46 days into the case, they would be dismissed.
To solve this problem and avoid "vain and useless expenditure of resources," the judges have developed a new form for requesting waiver of the requirement to file Form 22A. Based on the certification of the debtor and counsel that debts are not primarily consumer, the court will issue a provisional order excusing the form. If no party objects to the order within 90 days, it will become final and compliance will be excused. According to an email from the Southern District, Judges Bohm, Isgur, Schmidt and Steen plan to use the form.
It is good to see judges who care about making the system work. This is a case where Congress drafted an extensive statutory scheme but failed to address an important detail as to its practical application. There may have been a simpler answer however. Form 1, the Voluntary Petition, requires debtors to indicate whether their debts are primarily business or consumer. The form is signed by the debtor under penalty of perjury and is also signed by counsel. As a result, it contains basically the same information as the new form. When a debtor checks the business box it should presumptively excuse the debtor from filing Form B22A unless a party objects. Of course, there is no rule which says this. As a result, there is no time frame for objecting. Therefore, checking the petition box does not eliminate the 45 day dismissal problem. This distinction may be the factor which commends the new Southern District procedure.
Note: All of this discussion pertains to chapter 7 debtors only. While the means test obviously does not apply to chapter 11 or chapter 13 debtors, they are still required to complete an Official Form of income and expense which can be used to determine amounts payable under a plan. Fed.R.Bankr. Pro. 1007(b)(5)requires chapter 11 debtors to file the appropriate Official Form setting forth their current monthly income. Rule 1007(b)(6) requires chapter 13 debtors to file the Official Form reflecting their monthly income, and if their income exceeds the median, they must also file a calculation of disposable income as set out in Sec. 1325(b)(3).
Means testing is one of the hallmarks of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). It was meant to ensure that debtors who could afford to pay their debts did not take the easy way out by filing chapter 7. Means testing only applies to debtors with "primarily consumer debts." This may have been because Congress figured that business debtors would fail in a big way so that they wouldn't be able to repay their debts or it might have been intended to promote entrepreneurship or it just may have been a consequence of the fact that BAPCPA was championed by the consumer credit lobby. Whatever the reason, means testing applies to individuals with primarily consumer debts but not other individuals.
Means testing is enforced through a regime which requires debtors to file a statement of current income and expenditures, which in the case of an individual debtor with primarily consumer debts must include a calculation to determine whether the presumption of abuse arises. See 11 U.S.C. Sec. 521(a)(1) (requiring filing of statement of income and expense unless the court orders otherwise) and 11 U.S.C. Sec. 707(b)(2)(C) (requiring additional calculation if primarily consumer debts are involved). If a debtor fails to file the information required by Sec. 521 within 45 days, then the case is subject to mandatory dismissal. 11 U.S.C. Sec. 521(i)(1).
Form 22A contains a detailed analysis of income and expenditures under the means test. However, judges have disagreed on whether it must be filed by all chapter 7 debtors or just those with consumer debts. Compare In re Moates, 338 B.R. 716 (Bankr. N.D. 2006)(only consumer debtors need file the form) with In re Copeland, 2006 Bankr. LEXIS 2200 (Bankr. S.D. Tex. 2006)(all debtors must file).
Judges Isgur and Steen disagreed with their Southern District colleague and ruled that requiring all debtors to file the form was neither "reasonable or acceptable." They cited Lord Coke for the maxim that "The law requires no one to do vain or useless things." 5 Coke 21.
With that out of the way, the judges had to decide what to do if a debtor failed to file the form. If the debtor was required to file the form but did not do so, then mandatory dismissal was the penalty. On the other hand, if the debtor was not required to file the form, they could hardly complain about its absence. The two cases consolidated in their opinion illustrate two different ways to approach the problem. In the first case, the debtor filed a motion to be excused from filing Form 22A on the ground that it was not required. In the second case, the court issued a show cause order as to why the case should not be dismissed for failure to file the form. When the debtor did not respond, the case was dismissed, leading to a motion to reconsider. In both cases, someone, whether the debtor or the court, had to take a proactive step to tee up the issue.
Further, the consequences of guessing wrong were serious, since they would result in automatic dismissal. In the Beacher case, the debtors contended that 58% of their debts resulted from their failed business. However, what if it turned out that only 49% fell in the business category? If the decision was made 46 days into the case, they would be dismissed.
To solve this problem and avoid "vain and useless expenditure of resources," the judges have developed a new form for requesting waiver of the requirement to file Form 22A. Based on the certification of the debtor and counsel that debts are not primarily consumer, the court will issue a provisional order excusing the form. If no party objects to the order within 90 days, it will become final and compliance will be excused. According to an email from the Southern District, Judges Bohm, Isgur, Schmidt and Steen plan to use the form.
It is good to see judges who care about making the system work. This is a case where Congress drafted an extensive statutory scheme but failed to address an important detail as to its practical application. There may have been a simpler answer however. Form 1, the Voluntary Petition, requires debtors to indicate whether their debts are primarily business or consumer. The form is signed by the debtor under penalty of perjury and is also signed by counsel. As a result, it contains basically the same information as the new form. When a debtor checks the business box it should presumptively excuse the debtor from filing Form B22A unless a party objects. Of course, there is no rule which says this. As a result, there is no time frame for objecting. Therefore, checking the petition box does not eliminate the 45 day dismissal problem. This distinction may be the factor which commends the new Southern District procedure.
Note: All of this discussion pertains to chapter 7 debtors only. While the means test obviously does not apply to chapter 11 or chapter 13 debtors, they are still required to complete an Official Form of income and expense which can be used to determine amounts payable under a plan. Fed.R.Bankr. Pro. 1007(b)(5)requires chapter 11 debtors to file the appropriate Official Form setting forth their current monthly income. Rule 1007(b)(6) requires chapter 13 debtors to file the Official Form reflecting their monthly income, and if their income exceeds the median, they must also file a calculation of disposable income as set out in Sec. 1325(b)(3).
Wednesday, January 10, 2007
Judge Rejects Defense of The Computer Made Me Do It
A volume creditors' practice is facing sanctions after the court rejected its explanation that faulty computer coding caused it to file erroneous pleadings. The opinion illustrates the tension between the requirements of Rule 9011 and the need to rely on automation in a volume practice. While the final sanctions to be awarded have not yet been decided, the court in this case was clearly exasperated.
The Plan and the Original Objection
A debtor filed chapter 13 and included a debt with respect to a property he was leasing to his brother. The debtor's schedules plainly stated that the property was NOT the debtor's principal residence. The debtor's counsel also claimed to have informed the lender's counsel of this fact prior to bankruptcy.
The debtor proposed a plan which sought to pay the lender the value of its collateral plus interest through the plan. The payments to be made to the lender under the plan exceeded the amount of the rents being received by the debtor. The creditor filed a proof of claim in which it adopted the debtor's valuation of the property.
The lender's attorney filed an objection to confirmation which the court characterized as "grossly erroneous, and to anyone familiar with bankruptcy law, the objection is clearly legal nonsense." Among other things, the objection claimed that:
* The debtor's attorney, rather than the debtor had executed the note;
* That the plan did not pay the arrearages in full (despite the fact that the plan proposed a cram-down rather than a cure of arrearages);
* That the plan impermissibly modified a loan on a principal residence;
* That the lender's administrative claim was deferred over 36 months (despite the fact that the lender did not have an administrative claim); and
* That the plan impermissibly proposed to pay interest on the lender's non-dischargeable unsecured claim (despite the fact that the lender did not have a non-dischargeable claim).
The Debtor responded and pointed out the errors in the objection.
The First Hearing
At the first hearing on confirmation on October 3, local counsel for the lender argued that the plan impermissibly modified a loan on a principal residence. When the debtor responded that the property was not the debtor's principal residence, "local counsel replied that he had been instructed by (the lender's counsel) to ask for a continuance if Debtor made that contention."
This choice of tactics was not good. As the court later found, the objection relating to the principal residence violated Rule 9011 because the lender had no evidence that the debtor's statements were wrong. However, it got worse.
"As clear as that violation as, it is even more egregious that Countrywide continued to advocate that position in open court on October 3, notwithstanding Debtor's written response on September 28. Countrywide obviously had considered Debtor's response, knew that the argument had no validity, and was prepared to abandon the argument by asking for a continuance to implement 'Plan B,' which apparently had not yet been devised. . . . (T)he court believes that the request for a continuance was not made in good faith but was intended simply for delay."
Of course, the Court had not made these findings yet on October 3. However, the court did warn the lender's counsel that it should scrutinize its position in light of Rule 9011.
The Lender Withdraws Its Objection But "Discovers" A New One
After the hearing, Debtor's counsel sent the lender's counsel a letter demanding that the lender cure the violation of Rule 9011. In response, the lender filed a withdrawal of its objection. Unfortunately, this pleading violated Rule 9011 as well. The withdrawal stated that the lender was withdrawing its objection because the Debtor had filed an amended plan which proposed to cure the arrearage. Of course, this was just plain wrong. The Debtor had not filed an amended plan and was still seeking to cram-down the value on the rental property.
To further complicate matters, just four business days prior to the re-scheduled hearing, the lender filed a new objection which asserted that it just "discovered" that it held an absolute assignment of rents and that because the rents belonged to Countrywide, the Debtor could not use them in the plan. The absolute assignment of rents theory used to be a standard weapon used by lenders in single asset real estate cases during the 1980s and caused a lot of controversy at that time. However, the theory had major practical difficulties (such as how the rents could be conveyed to the lender without reducing the debt) and has not been seriously advocated for many years.
The First Opinion
At the continued hearing on November 14, lender's counsel abandoned all of its original objections and argued the absolute assignment of rents. Debtor's counsel objected that she had been sand-bagged. This was a legitimate complaint because the local rules required any objections to be filed five business days before confirmation. As a result, the court continued the hearing once again. However, at this point, the court's displeasure took written form. On November 28, the Court wrote the first of three written opinions in the case. Case No. 06-60121, In re James Patrick Allen (Bankr. S.D. Tex. 11/28/06)(Order for Memoranda and for Rule 7016 Conference And Order for Hearing on Sanctions Under Rule 9011). In this opinion, the court required the parties to brief the absolute assignment of rents issue and to advise the court as to the witnesses and exhibits they planned to introduce. The court also stated that it appeared that the lender's counsel had violated Rule 9011. The court required both local counsel and lender's primary counsel to attend the hearing.
The Second Opinion
After the pre-trial conference on the absolute assignment of rents issue, the court concluded that there were not any disputed issues of fact. The court wrote its second opinion which concluded that the assignment of rents was intended for purposes of security rather than as an absolute assignment. No. 06-60121, In re James Patrick Allen (Bankr. S.D. Tex. 12/20/06)(Memorandum Opinion Findings of Fact and Conclusions of Law Concerning Order Denying Motion for Turnover & Accounting And Concerning Confirmation of Chapter 13 Plan). As a result, the court confirmed the plan. The court reserved the issue of sanctions for a subsequent opinion.
The Third Opinion
After all of this prologue, the court finally reached the issue of sanctions in a hearing on December 13. No. 06-60121, In re James Patrick Allen (Bankr. S.D. Tex. 1/9/07)(Memorandum Opinion Regarding Sanction of Creditor's Attorneys). Prior to this hearing, the Court was aware of what had happened. The important factual issue was why it happened, and whether this would serve to mitigate or explain away the erroneous pleadings. The testimony received on December 13th provided a window into the internal workings of a volume practice.
The initial attorney who handled the file testified that she recognized that the property was not the debtor's homestead. Based on this determination, none of the pleadings raising homestead-related issues should have been filed. Despite this conclusion, a clerical person apparently coded the file as a homestead case. Under the law firm's computer system, certain codes are entered which are then used to generate pleadings. In this case, a clerical employee apparently entered the wrong codes which then generated the wrong pleadings. Thus, garbage in, garbage out. The Court concluded that no meaningful review was given to the computer generated pleadings.
"There was no testimony that anyone at (lender's counsel) reviews the computer-generated pleadings (with the level of care required by FRBP 9011) before they are filed. It was the Court's sense of the testimony that either there is no review, or else the review is so superficial that it is meaningless."
The firm's response to the Court's initial warning about sanctionable conduct was also dictated by the computer system. When local counsel contacted the initial lawyer about the Court's concerns, she testified that she "could not believe the document that was filed under [her] password." However, because the file was coded as a homestead case, the instruction to withdraw the objection generated a pleading geared to a homestead case. The frightening thing is that the computer generated a pleading which might have been appropriate in a particular type of homestead case. However, the pleading would not be appropriate in all circumstances. Thus, even without the erroneous coding, the pleading could well have been wrong.
The Inconclusive Result
The Court found that the lender's principal law firm should be sanctioned for its conduct in the case. However, the Court did not enter a sanction at this time. The Court noted with frustration that he had previously reprimanded the firm and had ordered it to address quality control issues. Two other judges in the Southern District had published opinions about the firm's conduct, including one case where the firm was required to pay $65,000. The Court noted that sanctions under Rule 9011(c)(2) should be sufficient to deter further repetition of the conduct. The Court went on to state:
"Although the Court has concluded that there is sanctionable conduct, after two warnings and a $65,000 monetary sanction, the Court is at a loss to determine the appropriate sanction in this case. If the prior warnings and sanction have not worked, what will?"
The Court ordered the managing attorney of the firm's Houston office to appear at a hearing to be held and to "report to the Court what sanctions would deter further repetitions of this conduct."
This Order places the firm in an unusual position. It is being asked to recommend its own punishment. If the firm suggests too light of a sanction, it may invite severe penalties for failure to appreciate the gravity of its actions. But what is sufficient?
While the Court may well consider monetary sanctions, and will likely award attorney's fees to debtor's counsel, the Court appears to be looking for more of a structural solution. The problem here appears to be a law firm subservient to its computer system. In an atmosphere where codes entered by clerical employees can generate nonsensical pleadings, it is difficult to comply with the responsibilities of a professional. In this case, even the attempt to withdraw an erroneous pleading generated another factually defective document. Perhaps Judge Steen, like another judge before him, will sanction the computer. However, it seems more likely that he will order the humans to take control of the computer. Failing that, he may require that all future pleadings be written with a quill pen and bear the cursive penmanship of the attorney submitting the pleading.
Post-script: Local counsel, who had the unenviable task of presenting the flawed pleadings to the court, escaped sanctions. Although Local Rule 11.2 required local counsel to be fully informed and prepared, the court noted that this rule had not been strictly enforced in the past. Based on the hope that local counsel had "a much greater appreciation of his responsibilities to the Court," the Court declined to assess sanctions against him.
The Plan and the Original Objection
A debtor filed chapter 13 and included a debt with respect to a property he was leasing to his brother. The debtor's schedules plainly stated that the property was NOT the debtor's principal residence. The debtor's counsel also claimed to have informed the lender's counsel of this fact prior to bankruptcy.
The debtor proposed a plan which sought to pay the lender the value of its collateral plus interest through the plan. The payments to be made to the lender under the plan exceeded the amount of the rents being received by the debtor. The creditor filed a proof of claim in which it adopted the debtor's valuation of the property.
The lender's attorney filed an objection to confirmation which the court characterized as "grossly erroneous, and to anyone familiar with bankruptcy law, the objection is clearly legal nonsense." Among other things, the objection claimed that:
* The debtor's attorney, rather than the debtor had executed the note;
* That the plan did not pay the arrearages in full (despite the fact that the plan proposed a cram-down rather than a cure of arrearages);
* That the plan impermissibly modified a loan on a principal residence;
* That the lender's administrative claim was deferred over 36 months (despite the fact that the lender did not have an administrative claim); and
* That the plan impermissibly proposed to pay interest on the lender's non-dischargeable unsecured claim (despite the fact that the lender did not have a non-dischargeable claim).
The Debtor responded and pointed out the errors in the objection.
The First Hearing
At the first hearing on confirmation on October 3, local counsel for the lender argued that the plan impermissibly modified a loan on a principal residence. When the debtor responded that the property was not the debtor's principal residence, "local counsel replied that he had been instructed by (the lender's counsel) to ask for a continuance if Debtor made that contention."
This choice of tactics was not good. As the court later found, the objection relating to the principal residence violated Rule 9011 because the lender had no evidence that the debtor's statements were wrong. However, it got worse.
"As clear as that violation as, it is even more egregious that Countrywide continued to advocate that position in open court on October 3, notwithstanding Debtor's written response on September 28. Countrywide obviously had considered Debtor's response, knew that the argument had no validity, and was prepared to abandon the argument by asking for a continuance to implement 'Plan B,' which apparently had not yet been devised. . . . (T)he court believes that the request for a continuance was not made in good faith but was intended simply for delay."
Of course, the Court had not made these findings yet on October 3. However, the court did warn the lender's counsel that it should scrutinize its position in light of Rule 9011.
The Lender Withdraws Its Objection But "Discovers" A New One
After the hearing, Debtor's counsel sent the lender's counsel a letter demanding that the lender cure the violation of Rule 9011. In response, the lender filed a withdrawal of its objection. Unfortunately, this pleading violated Rule 9011 as well. The withdrawal stated that the lender was withdrawing its objection because the Debtor had filed an amended plan which proposed to cure the arrearage. Of course, this was just plain wrong. The Debtor had not filed an amended plan and was still seeking to cram-down the value on the rental property.
To further complicate matters, just four business days prior to the re-scheduled hearing, the lender filed a new objection which asserted that it just "discovered" that it held an absolute assignment of rents and that because the rents belonged to Countrywide, the Debtor could not use them in the plan. The absolute assignment of rents theory used to be a standard weapon used by lenders in single asset real estate cases during the 1980s and caused a lot of controversy at that time. However, the theory had major practical difficulties (such as how the rents could be conveyed to the lender without reducing the debt) and has not been seriously advocated for many years.
The First Opinion
At the continued hearing on November 14, lender's counsel abandoned all of its original objections and argued the absolute assignment of rents. Debtor's counsel objected that she had been sand-bagged. This was a legitimate complaint because the local rules required any objections to be filed five business days before confirmation. As a result, the court continued the hearing once again. However, at this point, the court's displeasure took written form. On November 28, the Court wrote the first of three written opinions in the case. Case No. 06-60121, In re James Patrick Allen (Bankr. S.D. Tex. 11/28/06)(Order for Memoranda and for Rule 7016 Conference And Order for Hearing on Sanctions Under Rule 9011). In this opinion, the court required the parties to brief the absolute assignment of rents issue and to advise the court as to the witnesses and exhibits they planned to introduce. The court also stated that it appeared that the lender's counsel had violated Rule 9011. The court required both local counsel and lender's primary counsel to attend the hearing.
The Second Opinion
After the pre-trial conference on the absolute assignment of rents issue, the court concluded that there were not any disputed issues of fact. The court wrote its second opinion which concluded that the assignment of rents was intended for purposes of security rather than as an absolute assignment. No. 06-60121, In re James Patrick Allen (Bankr. S.D. Tex. 12/20/06)(Memorandum Opinion Findings of Fact and Conclusions of Law Concerning Order Denying Motion for Turnover & Accounting And Concerning Confirmation of Chapter 13 Plan). As a result, the court confirmed the plan. The court reserved the issue of sanctions for a subsequent opinion.
The Third Opinion
After all of this prologue, the court finally reached the issue of sanctions in a hearing on December 13. No. 06-60121, In re James Patrick Allen (Bankr. S.D. Tex. 1/9/07)(Memorandum Opinion Regarding Sanction of Creditor's Attorneys). Prior to this hearing, the Court was aware of what had happened. The important factual issue was why it happened, and whether this would serve to mitigate or explain away the erroneous pleadings. The testimony received on December 13th provided a window into the internal workings of a volume practice.
The initial attorney who handled the file testified that she recognized that the property was not the debtor's homestead. Based on this determination, none of the pleadings raising homestead-related issues should have been filed. Despite this conclusion, a clerical person apparently coded the file as a homestead case. Under the law firm's computer system, certain codes are entered which are then used to generate pleadings. In this case, a clerical employee apparently entered the wrong codes which then generated the wrong pleadings. Thus, garbage in, garbage out. The Court concluded that no meaningful review was given to the computer generated pleadings.
"There was no testimony that anyone at (lender's counsel) reviews the computer-generated pleadings (with the level of care required by FRBP 9011) before they are filed. It was the Court's sense of the testimony that either there is no review, or else the review is so superficial that it is meaningless."
The firm's response to the Court's initial warning about sanctionable conduct was also dictated by the computer system. When local counsel contacted the initial lawyer about the Court's concerns, she testified that she "could not believe the document that was filed under [her] password." However, because the file was coded as a homestead case, the instruction to withdraw the objection generated a pleading geared to a homestead case. The frightening thing is that the computer generated a pleading which might have been appropriate in a particular type of homestead case. However, the pleading would not be appropriate in all circumstances. Thus, even without the erroneous coding, the pleading could well have been wrong.
The Inconclusive Result
The Court found that the lender's principal law firm should be sanctioned for its conduct in the case. However, the Court did not enter a sanction at this time. The Court noted with frustration that he had previously reprimanded the firm and had ordered it to address quality control issues. Two other judges in the Southern District had published opinions about the firm's conduct, including one case where the firm was required to pay $65,000. The Court noted that sanctions under Rule 9011(c)(2) should be sufficient to deter further repetition of the conduct. The Court went on to state:
"Although the Court has concluded that there is sanctionable conduct, after two warnings and a $65,000 monetary sanction, the Court is at a loss to determine the appropriate sanction in this case. If the prior warnings and sanction have not worked, what will?"
The Court ordered the managing attorney of the firm's Houston office to appear at a hearing to be held and to "report to the Court what sanctions would deter further repetitions of this conduct."
This Order places the firm in an unusual position. It is being asked to recommend its own punishment. If the firm suggests too light of a sanction, it may invite severe penalties for failure to appreciate the gravity of its actions. But what is sufficient?
While the Court may well consider monetary sanctions, and will likely award attorney's fees to debtor's counsel, the Court appears to be looking for more of a structural solution. The problem here appears to be a law firm subservient to its computer system. In an atmosphere where codes entered by clerical employees can generate nonsensical pleadings, it is difficult to comply with the responsibilities of a professional. In this case, even the attempt to withdraw an erroneous pleading generated another factually defective document. Perhaps Judge Steen, like another judge before him, will sanction the computer. However, it seems more likely that he will order the humans to take control of the computer. Failing that, he may require that all future pleadings be written with a quill pen and bear the cursive penmanship of the attorney submitting the pleading.
Post-script: Local counsel, who had the unenviable task of presenting the flawed pleadings to the court, escaped sanctions. Although Local Rule 11.2 required local counsel to be fully informed and prepared, the court noted that this rule had not been strictly enforced in the past. Based on the hope that local counsel had "a much greater appreciation of his responsibilities to the Court," the Court declined to assess sanctions against him.
Tuesday, January 09, 2007
Exemptions and the Mobile Debtor
Most states do not allow their residents to choose federal exemptions. However, a new opinion from Judge Leif Clark points out that BAPCPA may have expanded the reach of federal exemptions for a limited number of mobile debtors. In re Battle, No. 06-50545 (Bankr. W.D. Tex. 12/12/06).
Exemptions were a major concern for Congress when it passed the Bankruptcy Abuse and Consumer Protection Act of 2005 (BAPCPA). Among other things, Congress was worried about wealthy debtors moving to states with generous exemptions, such as Texas and Florida, for the purpose of filing bankruptcy. One provision enacted to limit this practice imposed a residency requirement of 730 days before an individual could claim under a state's exemption laws. If the person had not resided in one state for the entire 730 day period, then exemptions would be determined under the law of the state where the debtor had resided for the greater portion of the 180 days prior to the 730 days. See 11 U.S.C. Sec. 522(b)(3)(A). If the effect of Sec. 522(b)(3)(A) is that no exemption law applies (for example, if the person resided out of the country during the relevant time period), then the person would be allowed to take federal exemptions under 11 U.S.C. Sec. 522(d). The application of Sec. 522(d) as exemption of last resort is of little solace, since it only applies in the case where no exemptions whatsoever would be allowed.
While the legislation may guard against abuse, it also operates as a trap for the unwary. Each year, about 3% of the population changes states. See Allison Stone Wellner, "The Mobility Myth," Reason Magazine (April 2006). If these individuals wind up in bankruptcy court, they may find their property rights defined by the laws of a state they had long left behind and which are unfamiliar to their counsel. This extraterratorial application of exemption laws may lead to strange results. For example, the Texas homestead exemption applies to "all homesteads in this state whenever created." Tex. Prop. Code Sec. 41.002(d). Thus, if a Texas resident moves to Florida (both states with high homestead exemptions), purchases a Florida homestead and files bankruptcy 729 days later, then the debtor would arguably not be able to claim a homestead exemption under either law. Sec. 522(b)(3)(A) would mandate application of Texas law. However, the Texas law appears to apply only to homesteads within the state of Texas. Thus, even though both states allowed comparable homestead exemptions, a move for a legitimate reason, such as to take a new job, may lead to loss of the exemption.
The federal exemption option under Sec. 522(d) offers limited protection to some debtors. It allows each debtor to exempt $18,450 of equity in a home and includes a wild card provision as well. One problem is that when Congress created the federal exemption scheme, it also allowed states to opt out. See 11 U.S.C. Sec. 522(b)(2). Thirty-six states prohibit their residents from claiming federal exemptions.
In the case of In re Battle, No. 06-50454 (Bankr. W.D. Tex. 12/12/06), Judge Clark considered whether a former Floridian filing bankruptcy in Texas could claim federal exemptions. Because the debtor had lived in Texas for less than 730 days and had lived in Florida during the 180 days prior to the 730 days, the parties agreed that Florida law would apply. Florida is an opt out state. As a result, the Trustee argued that federal exemptions were not available under Florida law. However, Judge Clark noted that the relevant Florida statute provided that "residents of this state shall not be entitled to the federal exemptions." On the date of filing bankruptcy, the Debtor was not a Florida resident. Although the choice of law was determined by where the Debtor resided during the 180 days prior to 730 days, the facts of the exemption were determined as of the petition date. Because the Debtor was not a resident of Florida on the petition date, the opt-out provision did not apply and the Debtor was able to use the federal exemptions.
This is a case of two restrictive statutes canceling each other out. Both Sec. 522(b)(3)(A) and Sec. 522(b)(2)'s opt-out language restrict debtors' exemption choices. However, it appears that an unintended consequence of Sec. 522(b)(3)(A) is to allow most debtors whose exemption choices are governed by the law of another state to choose federal exemptions regardless of whether they could have chosen federal exemptions in either the original state or the new state. Thus, if a debtor moves from one opt-out state to another opt-out state and files bankruptcy less than 730 days later, the result may be to make federal exemptions available where they would not otherwise have been. If State A's exemption laws prohibit its residents from choosing federal exemptions, but the debtor is no longer a resident of State A, State A's prohibition does not apply. If State B's exemption laws prohibit its residents from choosing federal exemptions, but exemptions are determined under State A's law, then State B's prohibition is inapplicable. Thus, the result is to frustrate the policies of both states and make the federal exemption available. This would be little consolation to a debtor with a million dollar homestead who moves between high exemption states. However, it was enough to protect the Debtor in Battle.
Exemptions were a major concern for Congress when it passed the Bankruptcy Abuse and Consumer Protection Act of 2005 (BAPCPA). Among other things, Congress was worried about wealthy debtors moving to states with generous exemptions, such as Texas and Florida, for the purpose of filing bankruptcy. One provision enacted to limit this practice imposed a residency requirement of 730 days before an individual could claim under a state's exemption laws. If the person had not resided in one state for the entire 730 day period, then exemptions would be determined under the law of the state where the debtor had resided for the greater portion of the 180 days prior to the 730 days. See 11 U.S.C. Sec. 522(b)(3)(A). If the effect of Sec. 522(b)(3)(A) is that no exemption law applies (for example, if the person resided out of the country during the relevant time period), then the person would be allowed to take federal exemptions under 11 U.S.C. Sec. 522(d). The application of Sec. 522(d) as exemption of last resort is of little solace, since it only applies in the case where no exemptions whatsoever would be allowed.
While the legislation may guard against abuse, it also operates as a trap for the unwary. Each year, about 3% of the population changes states. See Allison Stone Wellner, "The Mobility Myth," Reason Magazine (April 2006). If these individuals wind up in bankruptcy court, they may find their property rights defined by the laws of a state they had long left behind and which are unfamiliar to their counsel. This extraterratorial application of exemption laws may lead to strange results. For example, the Texas homestead exemption applies to "all homesteads in this state whenever created." Tex. Prop. Code Sec. 41.002(d). Thus, if a Texas resident moves to Florida (both states with high homestead exemptions), purchases a Florida homestead and files bankruptcy 729 days later, then the debtor would arguably not be able to claim a homestead exemption under either law. Sec. 522(b)(3)(A) would mandate application of Texas law. However, the Texas law appears to apply only to homesteads within the state of Texas. Thus, even though both states allowed comparable homestead exemptions, a move for a legitimate reason, such as to take a new job, may lead to loss of the exemption.
The federal exemption option under Sec. 522(d) offers limited protection to some debtors. It allows each debtor to exempt $18,450 of equity in a home and includes a wild card provision as well. One problem is that when Congress created the federal exemption scheme, it also allowed states to opt out. See 11 U.S.C. Sec. 522(b)(2). Thirty-six states prohibit their residents from claiming federal exemptions.
In the case of In re Battle, No. 06-50454 (Bankr. W.D. Tex. 12/12/06), Judge Clark considered whether a former Floridian filing bankruptcy in Texas could claim federal exemptions. Because the debtor had lived in Texas for less than 730 days and had lived in Florida during the 180 days prior to the 730 days, the parties agreed that Florida law would apply. Florida is an opt out state. As a result, the Trustee argued that federal exemptions were not available under Florida law. However, Judge Clark noted that the relevant Florida statute provided that "residents of this state shall not be entitled to the federal exemptions." On the date of filing bankruptcy, the Debtor was not a Florida resident. Although the choice of law was determined by where the Debtor resided during the 180 days prior to 730 days, the facts of the exemption were determined as of the petition date. Because the Debtor was not a resident of Florida on the petition date, the opt-out provision did not apply and the Debtor was able to use the federal exemptions.
This is a case of two restrictive statutes canceling each other out. Both Sec. 522(b)(3)(A) and Sec. 522(b)(2)'s opt-out language restrict debtors' exemption choices. However, it appears that an unintended consequence of Sec. 522(b)(3)(A) is to allow most debtors whose exemption choices are governed by the law of another state to choose federal exemptions regardless of whether they could have chosen federal exemptions in either the original state or the new state. Thus, if a debtor moves from one opt-out state to another opt-out state and files bankruptcy less than 730 days later, the result may be to make federal exemptions available where they would not otherwise have been. If State A's exemption laws prohibit its residents from choosing federal exemptions, but the debtor is no longer a resident of State A, State A's prohibition does not apply. If State B's exemption laws prohibit its residents from choosing federal exemptions, but exemptions are determined under State A's law, then State B's prohibition is inapplicable. Thus, the result is to frustrate the policies of both states and make the federal exemption available. This would be little consolation to a debtor with a million dollar homestead who moves between high exemption states. However, it was enough to protect the Debtor in Battle.
Wednesday, November 22, 2006
Judge Kelly Finds 401k Loans Deductible Under Means Test
Judge Larry Kelly has recently held that 401k loans may be deducted in performing the chapter 7 means test. In re Otero, 06-30691 (Bankr. W.D. Tex. 11/2/06). BAPCPA expressly designates 401k loans as allowable expenses in chapter 13 cases. 11 U.S.C. Sec. 1322(f). However, there is not a similar provision with respect to the chapter 7 means test. Judge Kelly's ruling differs from a recent decision on this issue out of the Northern District. In re Barraza, 346 B.R. 724 (Bankr. N.D. Tex. 2006).
BAPCPA generally gives favorable treatment to retirement plans. Retirement plans loans have an exception from the automatic stay under Sec. 362(b)(19). Retirement plans are exempt up to $1 million under the federal exemptions pursuant to Sec. 522(d)(12). Retirement plan loans are non dischargeable under Sec. 523(a)(18). Finally, amounts withheld from the debtor's wages to be contributed to retirement plans are not property of the estate under Sec. 541(b)(7). However, while chapter 13 expressly allowed the deduction from disposable income, the chapter 7 means test under Sec. 707(b) was silent.
When this issue was argued to Judge Russell Nelms, the parties apparently framed the issue as to whether the payments could be deducted as "other necessary expenses." Judge Nelms found that they could not, but asked "why would Congress presume under section 707(b)(2)(A) that this amount of money could be used to pay unsecured creditors, and then deny unsecured creditors access to that money in chapter 13?"
However, Judge Kelly was asked to decide whether 401k loan payments could be deducted from the means test income as secured debts. While the U.S. Trustee argued that these "loans" were really just advances against the debtor's entitlement to receive retirement plan assets later, Judge Kelly concluded that they met the statutory definitions of secured debts.
Judge Kelly stated:
"The parties do not dispute that funds were advanced to the Debtors, that there exists documentation giving the plan administrator a 'lien claim' against the funds in the Debtors' 401K accounts, and that such accounts represent property of the Debtors. Each loan is therefore certainly a 'claim against property of the debtor' and so also a 'claim against the debtor,' which makes the interest of the plan administrator a 'security interest' against property of these Debtors. This court thus concludes that each loan is a 'secured claim' within the intendment of 11 U.S.C. Sec. 707(b)(2)(A)(iii)."
Judge Kelly's ruling follows an impeccable trail of statutory construction and harmonizes the Code's treatment of retirement plan loans. Not only is Judge Kelly's result right, but it is also the same argument made by this blog at the time that Barraza came out. http://stevesathersbankruptcynews.blogspot.com/2006/08/means-testing-opinions-strictly.html
Update:
The U.S. Trustee appealed Judge Kelly's decision and obtained an opinion from the U.S. District Court reversing it. McVay vs. Otero, 371 B.R. 190 (W.D. Tex. 4/26/07). The District Court looked at the same language as Judge Kelly and concluded that a loan against a 401k plan was NOT a debt, so that it could not be a secured debt deductible under the means test. In making this ruling,the District Court followed the majority position.
The Debtors did not further appeal the District Court ruling. Instead,they converted to Chapter 13 and proposed a plan which allowed them to deduct the 401k payments from disposable income. The Debtor's plan was confirmed on November 19, 2007. Under the confirmed plan, unsecured creditors will receive approximately 3% on their claims.
BAPCPA generally gives favorable treatment to retirement plans. Retirement plans loans have an exception from the automatic stay under Sec. 362(b)(19). Retirement plans are exempt up to $1 million under the federal exemptions pursuant to Sec. 522(d)(12). Retirement plan loans are non dischargeable under Sec. 523(a)(18). Finally, amounts withheld from the debtor's wages to be contributed to retirement plans are not property of the estate under Sec. 541(b)(7). However, while chapter 13 expressly allowed the deduction from disposable income, the chapter 7 means test under Sec. 707(b) was silent.
When this issue was argued to Judge Russell Nelms, the parties apparently framed the issue as to whether the payments could be deducted as "other necessary expenses." Judge Nelms found that they could not, but asked "why would Congress presume under section 707(b)(2)(A) that this amount of money could be used to pay unsecured creditors, and then deny unsecured creditors access to that money in chapter 13?"
However, Judge Kelly was asked to decide whether 401k loan payments could be deducted from the means test income as secured debts. While the U.S. Trustee argued that these "loans" were really just advances against the debtor's entitlement to receive retirement plan assets later, Judge Kelly concluded that they met the statutory definitions of secured debts.
Judge Kelly stated:
"The parties do not dispute that funds were advanced to the Debtors, that there exists documentation giving the plan administrator a 'lien claim' against the funds in the Debtors' 401K accounts, and that such accounts represent property of the Debtors. Each loan is therefore certainly a 'claim against property of the debtor' and so also a 'claim against the debtor,' which makes the interest of the plan administrator a 'security interest' against property of these Debtors. This court thus concludes that each loan is a 'secured claim' within the intendment of 11 U.S.C. Sec. 707(b)(2)(A)(iii)."
Judge Kelly's ruling follows an impeccable trail of statutory construction and harmonizes the Code's treatment of retirement plan loans. Not only is Judge Kelly's result right, but it is also the same argument made by this blog at the time that Barraza came out. http://stevesathersbankruptcynews.blogspot.com/2006/08/means-testing-opinions-strictly.html
Update:
The U.S. Trustee appealed Judge Kelly's decision and obtained an opinion from the U.S. District Court reversing it. McVay vs. Otero, 371 B.R. 190 (W.D. Tex. 4/26/07). The District Court looked at the same language as Judge Kelly and concluded that a loan against a 401k plan was NOT a debt, so that it could not be a secured debt deductible under the means test. In making this ruling,the District Court followed the majority position.
The Debtors did not further appeal the District Court ruling. Instead,they converted to Chapter 13 and proposed a plan which allowed them to deduct the 401k payments from disposable income. The Debtor's plan was confirmed on November 19, 2007. Under the confirmed plan, unsecured creditors will receive approximately 3% on their claims.
First Amendment vs. BAPCPA: Connecticut Court Strikes Down Section 526(a)(4)
Another U.S. District Court has found that Sec. 526(a)(4), which prohibits advising an assisted person to incur debt in contemplation of bankruptcy, violates the First Amendment. In Zelotes v. Martini, No. 3:05vc1591, 2006 U.S. Dist. LEXIS 81385 (D. Ct. 11/7/06), Judge Peter Dorsey of the U.S. District Court for the District of Connecticut found that attorney Zenas Zelotes had standing to challenge the law and that the particular section was facially unconstitutional. Judge Dorsey noted that the law would prohibit attorneys from giving advice to refinance a debt with one at a lower interest rate, to purchase and automobile which would allow the debtor to work as well as other legitimate actions. "By prohibiting lawyers from advising clients to take lawful, prudent actions as well as abusive ones, Sec. 526(a)(4) is abusive and restricts attorney speech behond what is 'narrow and necessary' to further the governmental interest."
Zelotes is the third opinion to find Sec. 526(a)(4) to be unconstitutional. Previously, Olsen v. Gonzales, No. 05-6365-HO, 2006 U.S. Dist. LEXIS 56197 (D. Or. 8/11/06) and Hersh v. United States, 347 B.R. 19 (N.D. Tex. 2006) had reached the same result. Another case pending in Connecticut District Court, Connecticut Bar Association v. United States, has challenged multiple sections of BAPCPA. That case is still pending.
Zelotes is the third opinion to find Sec. 526(a)(4) to be unconstitutional. Previously, Olsen v. Gonzales, No. 05-6365-HO, 2006 U.S. Dist. LEXIS 56197 (D. Or. 8/11/06) and Hersh v. United States, 347 B.R. 19 (N.D. Tex. 2006) had reached the same result. Another case pending in Connecticut District Court, Connecticut Bar Association v. United States, has challenged multiple sections of BAPCPA. That case is still pending.
Tuesday, October 31, 2006
Don't Mess With Judge Bohm
This column has devoted several articles to lawyers behaving badly in Houston. The Houston judges have been very proactive in writing about unprofessional conduct lately. Before beginning, two important caveats are important. First, these cases generally deal with the bottom 1% of the bar and are not representative of the bar in general. Second, these cases are presently coming out of Houston, but they could happen anywhere. The latest installment of Lawyers Behaving Badly involves an attorney-debtor who filed cases in bad faith, ignored court orders, failed to appear, evaded the U.S. Marshals and could not count.
A Brief Trip to Bankruptcy Court
In In re David Ortiz, No. 05-39982 (Bankr. S.D. Tex. 10/13/06), the attorney debtor filed an initial chapter 7 petition in January 2005 to avoid being evicted from his law office. The case was assigned to Judge Isgur. The Debtor received only a short delay since the stay was lifted early on. Once the eviction was allowed to go forward, he lost interest in his case. The case was dismissed for failure to attend the 341 meeting on May 31, 2005. Judge Isgur dismissed the case with prejudice to refiling for 180 days. Unfortunately, because the Debtor failed to update his address (most likely the one that he had been evicted from), he claimed that he never received the notice.
Return to Bankruptcy Court
Less than one month later, on June 29, 2005, the Debtor filed his second case, which was assigned to Judge Bohm. This case was filed for the same reason as the first case. In the space of six months, the Debtor had managed to find another landlord, fall behind on the rent and receive eviction papers.
Things Start to Get Bad—The First Sanctions Order
The U.S. Trustee promptly moved for sanctions. The Debtor appeared and pleaded ignorance of the prior order. The patient Judge Bohm agreed to abate the U.S. Trustee’s motion long enough to allow the Debtor to return to Judge Isgur and seek a modification of the prior order. When the parties returned to Court, Judge Bohm found that the Debtor had not sought to modify Judge Isgur’s order. He also determined that the Debtor had failed to file accurate schedules and did not have a good reason for failing to appear at the 341 meeting in the first case. At that point, Judge Bohm ordered the Debtor to pay attorney’s fees of $1,875 to each of his landlords and continued the matter to consider whether other sanctions might be appropriate. The Debtor finally retained an attorney at this point. At the continued hearing, Judge Bohm ordered that the Debtor pay $1,000 in sanctions to the Clerk within 60 days and barred him from filing again for a year without prior permission.
Things Get Worse--The Bench Warrant(s)
By the time of the first sanctions order on November 17, 2005, the Debtor had angered a federal bankruptcy judge. However, his problems could have been solved by paying $4,750. It would have been a really good idea to comply with this order through whatever means possible. The Debtor didn’t get the message. Some four months later, the U.S. Trustee filed a Certificate of Non-Compliance indicating that the Clerk had not been paid. Judge Bohm scheduled yet another hearing, which was continued to May 10, 2006. Neither the Debtor nor his attorney appeared at this hearing. The Debtor also failed to accept service from the U.S. Trustee’s process server after agreeing to do so. Judge Bohm issued a bench warrant that day.
In response to the bench warrant, an attorney who said she was acting merely as an intermediary contacted the U.S. Marshal and promised to inform the Debtor about the bench warrant. She gave the Marshal a non-working number for the Debtor. When the Debtor could not be located at his home or office, Judge Bohm issued a bench warrant for the intermediary attorney. This bench warrant met with more success and the “intermediary” appeared and testified that the Debtor was aware that there was a bench warrant out for him, but wanted to meet with his attorney first. Judge Bohm ordered the intermediary to check in with the U.S. Marshal twice a day until the Debtor was apprehended.
Judge Bohm Tries to Get the Debtor’s Attention—The Second Sanctions Order
On May 16, 2006, Judge Bohm, who had no doubt progressed from furious to livid, issued a second sanctions order which required the Debtor to pay $500 per day for each day that he failed to surrender and to pay $250 per day for each day that he failed to pay the $1,000 sanction to the clerk. The Court ordered the Debtor’s attorney to appear two days later to report whether he had informed the Debtor of the second sanctions order.
Melt-Down—The Third Sanctions Order
On May 18, 2006, the Debtor appeared with a new attorney (a respected bankruptcy attorney) and paid the $1,000 owing to the Clerk. The Debtor claimed that while he was aware of the May 10 hearing, that his attorney was scheduled to be out of the country and assured him that he would get the hearing re-set. The attorney did not do this. However, when the Debtor contacted the attorney’s office to see if any arrangements had been made, he was told that they were not aware of any, but that that the attorney would not have left town without having done something. The Debtor also testified that when he learned of the bench warrant, he checked into a hotel to avoid being found.
Judge Bohm was not amused. However, the order he entered was remarkably restrained. He ordered the Debtor to:
1. Write a letter apologizing to the U.S. Marshals for not turning himself in immediately;
2. Contact the Texas Lawyers Assistance Program to see if he would benefit from counseling;
3. Take 10 hours of bankruptcy continuing legal education (including three hours of ethics) if he ever planned to appear in the Southern District again;
4. Find other counsel for a client he was currently representing in a chapter 7 case; and
5. Either pay $750.00 or write “I will respect the judicial system, and such respect includes obeying all court orders” 750 times.
Judge Bohm gave the Debtor five days to comply.
When the Debtor returned five days later, he only tendered 700 sentences instead of 750, he had failed to pay the prior sanction to his landlords and he had failed to find alternate counsel for his client (whose case was subsequently dismissed by Judge Brown). However, he did complete his CLE.
The Judge gave the Debtor one more opportunity to comply and at the next hearing, he presented cashier’s checks to pay his landlords’ attorney’s fees and tendered the remaining 50 sentences. As a final sanction, the Court wrote a lengthy opinion chronicling the pattern of abuse which had led to his orders.
What Were They Thinking?
Attorneys make mistakes. Sometimes the difference between a good attorney and a disgraced attorney is the ability to engage in damage control. The attorney(s) here did not learn that lesson.
Mr. Ortiz’s motivations in filing bankruptcy to avoid eviction were not pure. Filing a second bankruptcy in violation of a court order that he arguably did not know about was bad but not fatal. At this stage, the Debtor/Attorney had a problem, but the court offered a way out (returning to Judge Isgur to modify the prior order of dismissal). This was a serious mistake.
When the Debtor missed his first opportunity to extricate himself, he could have begged or borrowed the money to pay the initial sanctions and limped away, humbled but not crushed. However, at the point that he failed to appear in court and then evaded the U.S. Marshal, he risked serious jail time. The fact that the ultimate consequences were so light may have been because the Debtor finally retained a competent bankruptcy attorney or perhaps because the court was happy just to have gotten his attention. However, it is clear that things could have been worse—much worse.
The Debtor’s first attorney and the “intermediary” attorney do not come off very well either. The opinion does not explain why the first attorney went off to Jordan without obtaining a continuance of the May 10 hearing. However, the attorney had to know that he was dealing with an extremely volatile situation. His absence caused a bench warrant to be issued for his client. The attorney who appeared only as an intermediary does not fare very well either. She was in contact with the Debtor on a regular basis, but somehow managed to provide the U.S. Marshal with a non-working number to contact him. The court found her testimony to be less than forthcoming.
When all was said and done, three attorneys found themselves named in an opinion which did not reflect well upon them. This opinion should be made required reading in legal ethics courses.
A Brief Trip to Bankruptcy Court
In In re David Ortiz, No. 05-39982 (Bankr. S.D. Tex. 10/13/06), the attorney debtor filed an initial chapter 7 petition in January 2005 to avoid being evicted from his law office. The case was assigned to Judge Isgur. The Debtor received only a short delay since the stay was lifted early on. Once the eviction was allowed to go forward, he lost interest in his case. The case was dismissed for failure to attend the 341 meeting on May 31, 2005. Judge Isgur dismissed the case with prejudice to refiling for 180 days. Unfortunately, because the Debtor failed to update his address (most likely the one that he had been evicted from), he claimed that he never received the notice.
Return to Bankruptcy Court
Less than one month later, on June 29, 2005, the Debtor filed his second case, which was assigned to Judge Bohm. This case was filed for the same reason as the first case. In the space of six months, the Debtor had managed to find another landlord, fall behind on the rent and receive eviction papers.
Things Start to Get Bad—The First Sanctions Order
The U.S. Trustee promptly moved for sanctions. The Debtor appeared and pleaded ignorance of the prior order. The patient Judge Bohm agreed to abate the U.S. Trustee’s motion long enough to allow the Debtor to return to Judge Isgur and seek a modification of the prior order. When the parties returned to Court, Judge Bohm found that the Debtor had not sought to modify Judge Isgur’s order. He also determined that the Debtor had failed to file accurate schedules and did not have a good reason for failing to appear at the 341 meeting in the first case. At that point, Judge Bohm ordered the Debtor to pay attorney’s fees of $1,875 to each of his landlords and continued the matter to consider whether other sanctions might be appropriate. The Debtor finally retained an attorney at this point. At the continued hearing, Judge Bohm ordered that the Debtor pay $1,000 in sanctions to the Clerk within 60 days and barred him from filing again for a year without prior permission.
Things Get Worse--The Bench Warrant(s)
By the time of the first sanctions order on November 17, 2005, the Debtor had angered a federal bankruptcy judge. However, his problems could have been solved by paying $4,750. It would have been a really good idea to comply with this order through whatever means possible. The Debtor didn’t get the message. Some four months later, the U.S. Trustee filed a Certificate of Non-Compliance indicating that the Clerk had not been paid. Judge Bohm scheduled yet another hearing, which was continued to May 10, 2006. Neither the Debtor nor his attorney appeared at this hearing. The Debtor also failed to accept service from the U.S. Trustee’s process server after agreeing to do so. Judge Bohm issued a bench warrant that day.
In response to the bench warrant, an attorney who said she was acting merely as an intermediary contacted the U.S. Marshal and promised to inform the Debtor about the bench warrant. She gave the Marshal a non-working number for the Debtor. When the Debtor could not be located at his home or office, Judge Bohm issued a bench warrant for the intermediary attorney. This bench warrant met with more success and the “intermediary” appeared and testified that the Debtor was aware that there was a bench warrant out for him, but wanted to meet with his attorney first. Judge Bohm ordered the intermediary to check in with the U.S. Marshal twice a day until the Debtor was apprehended.
Judge Bohm Tries to Get the Debtor’s Attention—The Second Sanctions Order
On May 16, 2006, Judge Bohm, who had no doubt progressed from furious to livid, issued a second sanctions order which required the Debtor to pay $500 per day for each day that he failed to surrender and to pay $250 per day for each day that he failed to pay the $1,000 sanction to the clerk. The Court ordered the Debtor’s attorney to appear two days later to report whether he had informed the Debtor of the second sanctions order.
Melt-Down—The Third Sanctions Order
On May 18, 2006, the Debtor appeared with a new attorney (a respected bankruptcy attorney) and paid the $1,000 owing to the Clerk. The Debtor claimed that while he was aware of the May 10 hearing, that his attorney was scheduled to be out of the country and assured him that he would get the hearing re-set. The attorney did not do this. However, when the Debtor contacted the attorney’s office to see if any arrangements had been made, he was told that they were not aware of any, but that that the attorney would not have left town without having done something. The Debtor also testified that when he learned of the bench warrant, he checked into a hotel to avoid being found.
Judge Bohm was not amused. However, the order he entered was remarkably restrained. He ordered the Debtor to:
1. Write a letter apologizing to the U.S. Marshals for not turning himself in immediately;
2. Contact the Texas Lawyers Assistance Program to see if he would benefit from counseling;
3. Take 10 hours of bankruptcy continuing legal education (including three hours of ethics) if he ever planned to appear in the Southern District again;
4. Find other counsel for a client he was currently representing in a chapter 7 case; and
5. Either pay $750.00 or write “I will respect the judicial system, and such respect includes obeying all court orders” 750 times.
Judge Bohm gave the Debtor five days to comply.
When the Debtor returned five days later, he only tendered 700 sentences instead of 750, he had failed to pay the prior sanction to his landlords and he had failed to find alternate counsel for his client (whose case was subsequently dismissed by Judge Brown). However, he did complete his CLE.
The Judge gave the Debtor one more opportunity to comply and at the next hearing, he presented cashier’s checks to pay his landlords’ attorney’s fees and tendered the remaining 50 sentences. As a final sanction, the Court wrote a lengthy opinion chronicling the pattern of abuse which had led to his orders.
What Were They Thinking?
Attorneys make mistakes. Sometimes the difference between a good attorney and a disgraced attorney is the ability to engage in damage control. The attorney(s) here did not learn that lesson.
Mr. Ortiz’s motivations in filing bankruptcy to avoid eviction were not pure. Filing a second bankruptcy in violation of a court order that he arguably did not know about was bad but not fatal. At this stage, the Debtor/Attorney had a problem, but the court offered a way out (returning to Judge Isgur to modify the prior order of dismissal). This was a serious mistake.
When the Debtor missed his first opportunity to extricate himself, he could have begged or borrowed the money to pay the initial sanctions and limped away, humbled but not crushed. However, at the point that he failed to appear in court and then evaded the U.S. Marshal, he risked serious jail time. The fact that the ultimate consequences were so light may have been because the Debtor finally retained a competent bankruptcy attorney or perhaps because the court was happy just to have gotten his attention. However, it is clear that things could have been worse—much worse.
The Debtor’s first attorney and the “intermediary” attorney do not come off very well either. The opinion does not explain why the first attorney went off to Jordan without obtaining a continuance of the May 10 hearing. However, the attorney had to know that he was dealing with an extremely volatile situation. His absence caused a bench warrant to be issued for his client. The attorney who appeared only as an intermediary does not fare very well either. She was in contact with the Debtor on a regular basis, but somehow managed to provide the U.S. Marshal with a non-working number to contact him. The court found her testimony to be less than forthcoming.
When all was said and done, three attorneys found themselves named in an opinion which did not reflect well upon them. This opinion should be made required reading in legal ethics courses.
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