Trustee Avoids Judicial Estoppel Finding As Fifth Circuit Comes Full Circle

Good things come in threes. Think of the first Star Wars trilogy or Lord of the Rings. Now the Fifth Circuit has completed a trilogy of cases on judicial estoppel which brings its exposition of the doctrine full circle. Kane v. National Union Fire Insurance Company, No. 07-30611 (5th Cir. 7/14/08).

Judicial estoppel “is a common law doctrine that prevents a party from assuming inconsistent positions in litigation.” In re Superior Crewboats, Inc., 374 F.3d 330 (5th Cir. 2004). The elements of judicial estoppel are: (1) the party is judicially estopped only if its position is clearly inconsistent with the previous one; (2) the court must have accepted the previous position; and (3) the non-disclosure must not have been inadvertent. In bankruptcy, the doctrine is frequently applied to prevent parties from pursuing undisclosed claims. The doctrine enforces the debtor’s duty to make full disclosure of all assets on his schedules.

The first of the recent Fifth Circuit cases was In re Coastal Plains, Inc., 179 F.3d 197 (5th Cir. 1999). In that case, the Debtor’s CEO formed a company which acquired the assets of the debtor corporation. The insider purchaser then filed suit on a claim which had not been disclosed in the schedules. The purchaser recovered $3.6 million on the undisclosed claim. The Fifth Circuit reversed on appeal, finding that accepting the argument that the claims were inadvertently left off the schedules “would encourage bankruptcy debtors to conceal claims, write off debts, and then sue on undisclosed claims and possibly recover windfalls.” In re Coastal Plains at 213.

Next came In re Superior Crewboats, 374 F. 330 (5th Cir. 2004). In that case, it was the debtor who was estopped. In that case, one of the debtors was injured prior to bankruptcy. During their chapter 13 case, they filed suit on a claim which was not listed in their schedules. After their case was converted to chapter 7, the debtors told the trustee about their claim, but represented that it was barred by limitations. As a result, the trustee abandoned the claim which the debtors continued to pursue. When the trustee learned about the case, he attempted to substitute in. However, the court granted summary judgment for the defendant.

The trend of ruling in favor of defendants continued with the lower court opinion in Kane. In Kane, the debtor filed a personal injury suit prior to bankruptcy. However, he did not list it on his schedules. Once the debtor received his discharge, the defendant moved for summary judgment based on judicial estoppel. The debtors then tried to do the right thing by asking that their bankruptcy case be re-opened so that the trustee could administer the undisclosed lawsuit. The case was reopened and the trustee asked to be substituted as real party in interest. Relying upon Superior Crewboats, the District Court granted the defendants’ motion for summary judgment and denied the trustee’s request to substitute in as real party in interest.

While Kane looked a lot like Superior Crewboats, the Fifth Circuit found an important distinction. The Court stated:

There, because the trustee had abandoned the claim, he was not the real party in interest and was not entitled to be substituted as such. Rather, following the trustee’s abandonment, the interest in the claim had reverted to the debtors, who stood to collect a windfall from the asset at the expense of the creditors. In the case before us, the Kanes’ personal injury claim became an asset of their bankruptcy estate when they filed their Chapter 7 petition. The Trustee became the real party in interest in the Kanes’ lawsuit at that point and never abandoned his interest therein.

Kane at 8.

The Fifth Circuit noted that the present case did not present any equitable concerns. Indeed, the creditors would be harmed if judicial estoppel was applied to preclude the trustee from pursuing the claims. The court quoted from a great Seventh Circuit opinion which made the obvious point:

[The debtor’s] nondisclosure in bankruptcy harmed his creditors by hiding assets from them. Using this same nondisclosure to wipe out [the debtor’s claim against the defendant] would complete the job by denying creditors even the right to seek some share of the recovery. Yet the creditors have not contradicted themselves in court. They were not aware of what [the debtor] was doing behind their backs. Creditors gypped by [the debtor’s] maneuver are hurt a second time by the district judge’s decision. Judicial estoppel is an equitable doctrine and using it to land another blow on the victims of bankruptcy fraud is not an equitable application.

Kane at 10, quoting Biesek v. Soo Line R.R. Co., 440 F.3d 410, 413 (7th Cir. 2006).

Thus, the Fifth Circuit reversed the summary judgment based on judicial estoppel and remanded to consider whether the trustee should be permitted to substitute as real party in interest (an issue which had not been considered by the district court).

In any good trilogy, things appear darkest after the second part. Here, the Superior Crewboats decision appeared to foreclose even a suit by the trustee. This was much like saying that the creditors had to be punished to protect the integrity of the system which was intended to protect the creditors, or to put it another way, it was necessary to destroy the village in order to save it.

Kane corrects this misimpression by pointing out that judicial estoppel only applies against the party who took the inconsistent position, namely the debtor; it does not apply against the trustee as the representative of the innocent creditors. Kane has an added bonus in that it encourages debtors to correct their mistakes. If the debtor omits a cause of action, but later repents, the trustee is not prejudiced. The debtor protects himself by mitigating the effects of his previous non-disclosure. The debtor also stands to benefit directly if the litigation proceeds are used to pay non-dischargeable claims or if there estate produces a surplus.

Thanks to St. Clair Newbern for the pointer on this case.

Tchaikovsky's Overture: How an Unremarkable Case Took on a Life of Its Own

Peter Tchaikovsky's 1812 Overture ends with a cannonade. Some commentators have viewed a recent opinion from Bankruptcy Judge Leslie Tchaikovsky as a cannon shot aimed at the irresponsible practices of the home mortgage industry. However, what is most remarkable about National City Mortgage vs. Hill, No. 07-4106 (Bankr. N.D. Cal. 5/28/08) is how unremarkable the opinion is.

The Opinion

In the Hill case, the debtors purchased a home for $220,000 twenty years ago. By the time that they filed bankruptcy, they had incurred debt of $683,000 against the house, including a second lien debt to National City Mortgage for $250,000. However, the debtors' combined income never exceeded $65,000.

When the debtors first applied for a loan with National City Mortgage in April 2006, they stated that their combined income was $145,716 on an annual basis. Six months later, they asked the bank to increase their Home Equity Line of Credit from $200,000 to $250,000. This time they stated their income as $190,800 on an annual basis. The bank either did not notice or did not care that the debtors were asserting that their income had increased by $45,000 per year in the span of just six months.

After the debtors filed for chapter 7 bankruptcy in April 2007, the first lienholder foreclosed and the second lien to National City Mortgage was wiped out. National City Mortgage brought a dischargeability action based on submitting a false financial statement under 11 U.S.C. Sec. 523(a)(2)(B). The court had little trouble finding that the first five elements of the claim were established. The debtors had made knowingly made a false financial statement with intent to deceive the lender. However, the court found that the element of reasonable reliance was missing.

Section 523(a)(2)(B) is unusual in that the statutory language expressly requires that reliance on a false financial statement be reasonable. This contrasts with Section 523(a)(2)(A) which states that debts based upon fraud are non-dischargeable but does not spell out the standard for reliance. The Supreme Court has said that reliance must be "justifiable" under Sec. 523(a)(2)(A), which is a lesser standard than "reasonable." Field v. Mans, 516 U.S. 59 (1995)("While the Court of Appeals followed a rule requiring reasonable reliance on the statement, we hold the standard to be the less demanding one of justifiable reliance, and accordingly vacate and remand."). Thus, Congress required a higher level of reliance on written statements of financial condition.

Judge Tchaikovsky set out the standad for reasonable reliance as follows:

Whether the creditor reasonably relied on the materially false statement under Sec. 523(a)(2)(B) is measured objectively by the degree of care exercised by a reasonably cautious person in the same transaction under similar circumstances. (citation omitted). Absent other factors, a creditor's reliance on a statement of financial condition is reasonable if it followed it normal business practices. (citation omitted). Other factors that may affect whether the creditor's reliance on its own standard lending practices is reasonable include the standards of the creditor's industry in evaluating creditworthiness, and the existence of any "red flags" that would alert the reasonably prudent lender of the possibility that the information was inaccurate. (citation omitted).

Memorandum of Decision at 8.

This was what is known as a stated income loan. According to the creditor's own guidelines, it did not require verification of income. However, it did require that an independent contractor verify that the amount stated was reasonable and that for a self-employed person that the borrower provide a copy of the borrower's business license, a copy of a bank statement showing a balance equal to 1/10 of the stated annual income or a letter from a CPA verifying the existence and ownership of the business. The Court found that the lender did not follow its own guidelines. There was no evidence that a third party contractor had verified that it was reasonable for an auto parts manager in the San Francisco Bay area (the husband) to earn $98,112 on an annual basis. While the wife submitted a letter on a CPA's letterhead with regard to her sole proprietorship, the person who signed the letter was not the CPA. Thus, the bank failed to follow its own guidelines. The Court also found that the bank ignored obvious red flags. In April 2006, the debtors claimed that Mr.Hill's income was $98,112 and that Mrs.Hill's income was $47,604. However, in October 2006, the debtors claimed that Mr. Hill's income was $67,200 (a 33% drop) and that Mrs. Hill's income was $123,600 (a 300% increase). Reasonable minds would have wondered about such a dramatic fluctuation in income, but the bank apparently did not.

In denying the complaint, the court concluded:

Based on the foregoing, the Court concludes that either the Bank did not rely on the Debtors representations concerning their income or that its relaiance was not reasonable based on an objective standard. In fact, the minimal verification required by an 'income stated' loan, as established by the Guidelines, suggestes that this type of loan is essentially an 'asset-based' loan. In other words, the Court surmises that the Bank made the loan principally in reliance on the value of the collateral: i.e., the House. If so, the Bank obtained the appraisal upon which it principally relied in making the loan. Subsequent events strongly suggest that the appraisal was inflated. However, under these circumstances, the Debtors cannot be blamed for the Bank's loss, and the Bank's claim should be discharged.

Memorandum of Decision at 13.

The Response

While the opinion was rather unremarkable, one line in it drew a lot of attention. Near the beginning of the opinion, the Court stated, "This adversary proceeding is a poster child for some of hte practices that have led to the current crisis in the housing market." Memorandum of Decision at 2. According to one blogger who wrote the day after the opinion was released, "This is a big deal, and will no doubt strike real fear in the hearts of stated-income lenders everwhere." BK Judge Rules Stated Income HELOC Debt Dischargeable, http://calculatedrisk.blogspot.com/2008/05/bk-judge-rules-stated-income-heloc-debt.html. This comment was picked up on and repeated by dozens of bloggers. The Wall Street Journal ran a story with the headine "Are borrowers free to lie?" Amir Efrati, "Are Borowers Free to Lie?," Wall Street Journal, May 31, 2008, p. B2. An article on MSN Money on June 30, 2008 amplified the story, claiming that, "In a little-noticed decision, U.S. Bankruptcy Judge Leslie J. Tchaikovsky let a California couple off the hook for debt they owed their home-equity lender because the incomes they had listed on their applications were obvious "red flags" that the lender had ignored." Liz Pulliam Webster, "Lenders create a bankruptcy monster," http://articles.moneycentral.msn.com/Banking/BankruptcyGuide/
LendersCreateABankruptcyMonster.aspx?page=1.

By this point, the focus on the legal definition of reasonable reliance had been lost. From the comments being circulated, it appeared that a crazy bankruptcy judge had declared war on the stated-income lenders, was countenancing lying by debtors and was letting borrowers off the hook for their misdeeds. One email which I received from a colleague asked me if I had heard about a case “in which the good judge held that despite the mendacity of the debtors, Mr. and Mrs. Hill (In Re Hill), National City Bank could not enforce, post petition, a home equity type of loan against the debtors post discharge.” He asked “Is this a case that you are aware of?” However, the debtors were not let off the hook. They lost their home of 20 years. What they did get was a discharge, something that debtors are entitled to if their creditors do not object or do not prove an exception to discharge.

We have been through this before. During the 1990s and early years of the 2000s, credit card lenders made a concerted effort to object to dischargeability in cases where debtors irresponsibly ran up their credit card debt. Many of these decisions focused on reliance or the lack thereof. E.g., In re Mercer, 246 F.3d 391 (5th Cir. 2001)(no reliance where creditor sent debtor pre-approved credit card);In re Eashai, 87 F.3d 1082 (9th Cir. 1996)(reliance justifiable where no red flags appeared).

In one noteworthy case, the court stated:

There is no reliance in this case. There is not even a scintilla of reliance in this case. . . .

The Plaintiff's extension of credit to the Defendant in this case was a result of their own negligent lending practices and the industry's negligent use of a faulty FICO score system which has been engineered to create the greatest amount of credit for the greatest number of working people in this country with artificially low monthly repayment requirements so that credit card companies can make the greatest amount of interest and profits possible. Losses such as this are simply a cost of doing business in such a greedy manner.

In re Akins, 235 B.R. 866, 874 (Bankr. W.D. Tex. 1999).

As long as lenders continue to make high risk loans, it is inevitable that some borrowers will default and file bankruptcy. If the loss results from the lender's own negligence, the debt will be dischargeable. This is nothing remarkable.

In Memory of Gray Byron Jolink, 1946-2008

The Central Texas bankruptcy community lost a valued friend and colleague when Gray Byron Jolink passed away unexpectedly on June 23, 2008. Gray graduated from the University of Texas Law School in 1974 and was a solo practitioner in Austin. Much of his practice involved representing the debtor in small chapter 11 cases.

Gray is survived by his mother Bette; wife Kathy; children Luke, Radkey, Georgia, Tatum and Willa; daughter-in-law Christine; brother, Dirk; sister-in-law Carol; mother-in-law Bea Cromack; grandchildren, Mason and Miles; eight nieces and nephews; and numerous other relatives and friends.

Gray’s obituary did a good job of summarizing his life. It stated:

“He was many things during his full life: pilot, photographer, attorney, birder, coach and nature lover. But the titles of which he was most proud were husband, father, grandfather, son, uncle, brother, cousin and friend.”

“He spent the last thirty years practicing bankruptcy law in Austin. His passion for the law lay in his desire to help others, and he saw his bankruptcy practice as a means to help those who struggled financially to get back on their feet.”

After Gray’s death, his colleagues shared memories of his life.

I first met Gray in the late 1980s at a hearing on a motion for relief from the automatic stay. I managed to show up after the court had already called my case and ruled without me. I located Gray in the back of the courtroom and asked him if he would object to a motion for reconsideration. He went up to the podium with me and asked the judge to let me go forward. Afterward he told me, “One of these days someone may need a favor from you. Be sure to remember when the time comes.” For a young associate, it meant a lot that a more experienced lawyer went out of his way to be nice.

Ronnie Hornberger of San Antonio said:

“Gray was one of the good guys; he was knowledgeable, gracious, easy to work with and you could always count on a hand shake deal to be honored. He truly will be missed.”

Joe Martinec recalled:

“Gray called me just about every Friday to ask ‘what are you seeing?’, at which time we would discuss the state of the Austin bankruptcy market and the crazy, outrageous or comical things the ‘young pups’ were doing. Gray was someone whose call I was always happy to take because it was almost invariably upbeat and informative. He was a great fan of history, he knew all about my distant relative being defenestrated in Prague, and he was an avid birder. I hate that I did not call him last week to tell him I had just seen a nesting pair of black-bellied whistling ducks on my brother’s stock tank. He would have told me their range, mating habits and maybe their call. I always envied Gray’s ability to get an adverse ruling or criticism without over-reacting. Most of the time, he would just chuckle and say, ‘You may be right. I’ll think about that.’ I could learn from that. He will be especially missed by those of us who are his contemporaries (a dwindling number).”

Steve Ravel said:

“I tried the first contested bankruptcy matter of my career against Gray before Judge Elliott in 1983. He was unfailingly gracious that time and every time since. When my twins were born only about 3 years after his, he went out of his way to share tips and wisdom. He coined the phrase, ‘Twins, twice as much work and four times as much fun.’”

Gray’s funeral was held at the Episcopal Church of the Good Shepherd on June 27, 2008. The church was packed to capacity as friends,family, members of his church, clients, lawyers and court staff gathered to remember him. Bankruptcy Judge Frank Monroe gave one of the eulogies. He said:

“I’m not sure that I ever met a man that enjoyed life more fully or exuded more joy in his life than Gray Jolink. Gray was a man who drew others to himself. He had a magnetic and upbeat personality. You knew instinctively that he was a person you could trust—with anything. In many ways he lived his life with the heart of a child—every new discovery was viewed with great delight and excitement.

“The last time I talked with Gray was after a Court hearing one day last week. He wanted to tell me about his experience of seeing the people who ‘danced’ on the side of the federal courthouse and the federal building. He had gone to the performance with Kathy and was obviously greatly impressed by the performance. The excitement in his eyes as he told me of his experience reminded me of a young child seeing some new wonder for the first time—not fully understanding how it could have been done but fully appreciating what he had seen.

“Gray was the consummate gentleman attorney. He was always prepared, always well mannered, polite and respectful of his fellow attorneys, the parties, the witnesses, the Court and the Court’s staff. He was unfailingly honest and forthright and always looked for a solution that would be fair to both sides. He was also an excellent litigator and cross-examiner of adverse witnesses. He was exceptionally bright, and he was an absolute joy to have in one’s courtroom.

“Gray viewed the practice of law as a profession—a way to help people—and not just a business to be run for profit, and he always conducted himself in that mode—always the gentleman.”

Judge Monroe was kind enough to type up the complete eulogy and provide me with a copy. I would be happy to send copies to anyone who asks.

Donations can be made to the Gray Jolink Memorial Fund, P.O. Box 5516, Austin, TX 78763 or to the Travis Audubon Society.

Fifth Circuit Clarifies Post-Confirmation Jurisdiction

The Fifth Circuit has written a new opinion in which it holds that once "related to" jurisdiction attaches, confirmation of the plan will not divest that jurisdiction. The opinion reconciles an apparent conflict with its holding in Craig's Stores that post-confirmation jurisdiction is limited to enforcing the plan. Newby v. Enron Corporation, No. 07-20051 (5th Cir. 7/10/08).

In the Newby case, nine actions against Enron-related parties were removed to federal court based upon "related-to" jurisdiction. Seven cases were removed prior to confirmation of Enron's plan and two were removed between plan confirmation and the plan's effective date. The cases were consolidated in U.S. District Court where they were dismissed with prejudice. The plaintiffs appealed the dismissal on the basis that the U.S. District Court lacked jurisdiction subsequent to plan confirmation.

The Fifth Circuit noted an apparent conflict in its opinions.

"We previously have stated that 'Section 1334 does not expressly limit bankruptcy jurisdiction upon plan confirmation.' (citation omitted). Other Circuits agree, holding that 'if ‘related to’ jurisdiction actually existed at the time of . . . removal” subsequent events '[can]not divest the district court of that subject matter jurisdiction.” (citation omitted). But at the same time, this Court has stated that '[a]fter a debtor’s reorganization plan has been confirmed, the debtor’s estate, and thus bankruptcy jurisdiction, ceases to exist, other than for matters pertaining to the implementation or execution of the plan.' (citations omitted). Although these statements may seem contradictory, they are easily reconciled."

Slip Opinion, at 14-15.

The Fifth Circuit clarified its holding in Craig's Stores as one relating to claims brought post-confirmation. Thus, if bankruptcy jurisdiction attaches to a claim prior to confirmation, the court retains jurisdiction over that claim post-confirmation.

"(Plaintiffs)cannot point to a single case in which we have held that plan confirmation divests a District Court of bankruptcy jurisdiction over preconfirmation claims based on pre-confirmation activities that properly had been removed pursuant to 'related to' jurisdiction. We likewise find none. Accordingly, we hold that the District Court had bankruptcy jurisdiction over the Fleming plaintiffs’ claims at the time it issued its decision dismissing them with prejudice."

Slip Opinion at 16.

5th Circuit Rejects Equitable Subordination Claim With Deepening Insolvency Aspect; Insiders Not Subordinated for Stoking the Fires of a Sinking Ship

The Fifth Circuit has ruled that insiders who “grabbed for as much as they could get” were not subject to equitable subordination where the bankruptcy court did not find sufficient harm resulting from their conduct. The court rejected a theory of damages which it equated to deepening insolvency. Matter of S.I. Restructuring, Inc., 2008 U.S. App. LEXIS 13140 (5th Cir. 6/20/08).

Background

S.I. Restructuring involved the Schlotzsky’s sandwich chain. At the time, John and Jeffrey Wooley were officers, directors and the largest shareholders of the company. In April 2003, the Wooleys made a secured loan to the company for $1 million. The company and the Wooleys were each represented by separate counsel, the transaction was approved by the company’s audit committee and board of directors and the loan was reported in the company’s SEC filings.

The company’s finances continued to deteriorate and in October 2003, it sought financing from International Bank of Commerce. IBC declined to make a loan to Schlotzsky’s, but agreed to loan the money to the Wooleys for them to loan to the company. The board of directors was given just three days notice of the meeting to approve the loan, but were provided with copies of the proposed loan documents along with emails from the company’s assistant general counsel.

In mid-2004, the Wooleys were removed as officers and directors and the company for chapter 11 shortly thereafter. The unsecured creditors committee brought a complaint for equitable subordination against the Wooleys. The bankruptcy court found that John and Jeffrey Wooley, as fiduciaries, engaged in inequitable conduct in relation to the November transaction and that their conduct conferred an unfair advantage upon them. Specifically, the court found that the Wooleys breached their fiduciary duties by: (i) presenting the loan proposal to the board as a fait accompli; (ii) by securing the loan with the “crown jewel” of the Debtor’s assets; and (iii) by securing their contingent liability as guarantors. As a result, the bankruptcy court subordinated the secured claims to the level of the unsecured creditors.

Fifth Circuit Ruling

The Fifth Circuit reversed and rendered. The Fifth Circuit characterized equitable subordination as an “extraordinary remedy” and recited the following test from In re Mobile Steel Corp., 563 F.2d 692 (5th Cir. 1977): “(1) the claimant must have engaged in inequitable conduct; (2) the misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant; and (3) equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Code.” The Court also noted an additional requirement that “a claim should be subordinated only to the extent necessary to offset the harm which the debtor or its creditors have suffered as a result of the inequitable conduct.”

Applying this test to the April 2003 transaction, the appellate court found that the bankruptcy court had not made any findings of inequitable conduct or unfair advantage. As a result, it was necessary to reverse the subordination of this debt.

When examining the November 2003 transaction, the Fifth Circuit assumed without deciding that the record supported the findings of inequitable conduct and unfair advantage. The court went on to state, “However, the bankruptcy court made no finding of harm, and the record does not support a finding that either the debtor or the unsecured creditors were harmed by the November transaction.”

The Plan Administrator argued that the securing of the loan harmed the Debtor by diminishing the pool of assets available to unsecured creditors. On a certain level, the Plan Administrator was correct. Creditors would have been better off if the Wooleys had made unsecured loans to the company. However, the Fifth Circuit did not penalize the Wooleys for protecting their own interest. Instead, the court noted that the bankruptcy court had expressly found that the debtor needed the money and that the money had been used to pay unsecured claims. The Court stated:

“Because the loan proceeds were used to pay current unsecured creditors, unsecured creditors as a class, were not harmed when the Wooleys obtained security for for the November loan. The general unsecured creditors who were paid from the proceeds of the November loan may have benefitted to the detriment of another group of unsecured creditors, but this does not mean that unsecured creditors were harmed when the Wooleys obtained security for their loan.”

The Fifth Circuit also rejected the argument that the Wooleys harmed the company by loaning it additional funds which allowed it to continue operating until its condition worsened. Although the Appellee denied that it was relying upon deepening insolvency, the court found that this was exactly what was being alleged and rejected the theory. The Court stated that, “Deepening insolvency has been defined as prolonging an insolvent corporation’s life through bad debt, causing the dissipation of corporate assets.” The Court went on to state that:

“A deepening insolvency theory of damages has been criticized and rejected by many courts. We agree with the Third Circuit Court of Appeals, which recently concluded that deepening insolvency is not a valid theory of damages. The court recognized that deepening insolvency as a measure of harm depends on how the company uses the proceeds of the loan in question and ‘looks at the issue through hindsight bias.’”

As a result, the Fifth Circuit reversed and rendered.

What About Herby’s Foods?

S.I Restructuring has some factual similarities to Matter of Herby’s Foods, 2 F.3d 128 (5th Cir. 1993), an earlier decision which upheld equitable subordination. How then to reconcile the two cases?

In Herby’s Foods, the parent company purchased the debtor less than two years before it failed. Part of the consideration was payment of a debt to another entity. In return for this payment, the parent company took a lien against the debtor’s assets. Another related entity extended a secured line of credit to the company. Another insider made unsecured advances to the company. The secured claims were not perfected until shortly before bankruptcy. During the time between the acquisition and the bankruptcy filing, unsecured claims grew from about $900,000 to $4,600,000. The unsecured creditors’ committee sought to avoid the liens as preferential, to recharacterize the loans as equity and to subordinate the insider debts to the level of equity. The bankruptcy court granted all of the relief requested. On appeal, the Fifth Circuit affirmed, finding that the requisites for equitable subordination had been established, but did not reach the issue of recharacterization.

The Fifth Circuit found that a combination of undercapitalization, failure to disclose the existence of unfiled liens and advancing funds as loans rather than capital constituted inequitable conduct. The Fifth Circuit found that unsecured creditors were harmed by the fact that the amount of unsecured debt owed to third parties increased dramatically.

“The bankruptcy court found that the Insiders’ conduct harmed Herby’s outside creditors by significantly increasing their trade credit exposure and by reducing their ultimate dividend in the liquidation. Most importantly, the court found that the Insiders had secured an unfair advantage by structuring their cash contributions to Herby’s as loans, rather than as equity capital. If the Insiders were allowed to retain their ranking as unsecured creditors, they would have gained an advantage in the priority scheme by encouraging outside creditors to increase their credit to Herby’s. Their efforts were successful; those trade creditors substantially increased their credit to Herby’s during the period in question.”

Herby’s at 134.

The Court in Herby’s accepted the “deepening insolvency” model of damages which was expressly rejected in S.I. Restructuring. However, they did not call it deepening insolvency, a term which was not in vogue in 1993. Instead, the court analyzed the case as one involving deception and trickery. The bad Insiders (referred to with a capital I in the opinion) tricked the trade creditors into advancing more credit by advancing debt rather than infusing equity, by failing to timely record their liens and by failing to adequately record the loans on the company’s books, thus giving the appearance that the company was adequately capitalized. This caused the unsecured creditors to extend trade credit. The court did not cite any evidence that creditors had relied on the company’s books. It simply found that an increase in trade debt was enough to prove harm. However, the court in S.I. Restructuring expressly rejected an argument that an increase in trade debt standing alone was evidence of harm.

Scott Ritcheson (see Acknowledgement below) suggests that Herby’s Foods is best understood as a recharacterization case which was decided based upon equitable subordination. Section 510(b) allows the court to recharacterize a debt as equity without regard to inequitable conduct, while Section 510(c) is based upon principles of equitable subordination which courts have interpreted to require proof of inequitable conduct. In the Herby’s case, the evidence of inadequate capitalization, failure to record loans on the books and failure to treat the insider loans as debts would be evidence to support a finding of recharacterization (which was one of the grounds found by the bankruptcy court but not addressed by the court of appeals). On the other hand, in S.I. Restructuring, the company was publicly traded and the transactions were approved by an audit committee of outside directors and the full board and were reported as loans to the SEC. This greater level of formality may be the factor which reconciles the two apparently contradictory opinions.

Acknowledgement

My analysis in this article was strongly influenced by an excellent paper presented by Scott Ritcheson to the Annual Meeting of the Bankruptcy Section of the State Bar of Texas on June 26, 2008 entitled “Issues and Trends in Equitable Subordination.” Anyone litigating an equitable subordination issue would benefit significantly from reading Scott’s scholarly, comprehensive article. Scott can be reached at scottr@rllawfirm.net.

On Judicial Selection

On my non-bankruptcy blog, I have written an article about the different approaches that the two presidential candidates take toward appointing judicial nominees. If you are interested in reading more, you can go to:

http://satherthoughts.blogspot.com/2008/06/presidential-campaign-reveals-different.html

Northern District of Texas Releases En Banc Opinion on Early Completion of Chapter 13 Plan

The six judges of the Bankruptcy Court for the Northern District of Texas have released an opinion on when a debtor can pay off a chapter 13 plan prior to its scheduled completion date under BAPCPA. In re Howard L. McCarthy, Jr., No. 06-40127-DML-13 (Bankr. N.D. Tex. 6/11/08). The judges ruled that absent modification of the plan to increase the payments or bad faith by the debtor, that the court must enter a discharge once payments are completed.

In the McCarthy case, the Debtor had above median income and was required to file a 60 month plan. The Court confirmed a plan providing for payments of $49,260. This payment would pay about 60% of the unsecured claims. The Debtor had to pay more than the amount of his disposable income in order to satisfy the chapter 7 liquidation test. After six months, the Debtor sold his non-exempt real estate pursuant to court order and paid the proceeds to the Trustee. The Debtor continued to make his regular monthly payments. After 21 months, he had paid $49,260 into the plan and the Trustee filed a notice of completion of payments. The Debtor then filed a motion for entry of discharge, which the Trustee opposed.

The Court found that the case did not turn on the definition of "applicable commitment period" under Section 1325(b). Instead, the Court found that the result was dictated by Sec. 1328(a).

The Court stated:

"Much of the focus of the Parties and the Amici in their briefs and at oral argument was on the question of whether the 'applicable commitment period' provided for in section 1325(b) of the Code, in Debtor's case 60 months, serves as a temporal requirement for the duration of a chapter 13 case or is simply a multiplier to be used to determine a minimum amount a debtor's plan must provide for unsecured creditors. A number of courts have struggled with this question arriving at diverse conclusions. . . . In the case at bar, however, we are not required to reach or decide that issue. Rather, the Motion poses the easier question of whether Debtor is entitled to a discharge under section 1328(a) of the Code.

* * *

"We must apply section 1328(a) in accordance with its plain meaning. . . .

"Section 1328(a)'s meaning is, in fact, plan and unambiguous. If the debtor has completed all payments under the plan, 'the Court shall grant the debtor a discharge. . . . ' (citation omitted). The use of the word 'shall' in section 1328(a) means that granting the relief is mandatory if the preconditions specified in the section are met."

Memorandum Opinion, pp. 4-5.

Having arrived at its conclusion in just five pages, the Court devoted the remainder of its opinion to replying to the Trustee's argument that deceptive debtors could use this language to slide a payment under the Trustee's door in the dead of night in order to avoid disclosing changed circumstances which would justify a modification.

The Court had two responses to this argument. First, the Court pointed out that the Marrama decision meant that "a debtor's fraudulent conduct may be addressed to prevent as well as undo a result achieved through the ordinary operation of the Code . . . " However, the Court noted that "this case is not one where money was slipped under the Trustee's door in aid of a scheme to avoid a potential plan modification." Instead, the Debtor had done exactly what was contemplated under the plan. The Debtor's Plan required the Debtor to pay a sum exceeding his monthly payments. As a result, it was clear that the Plan contemplated sale of assets. Additionally, at the time of the sale of the Debtor's property, it was clear that this pre-payment would result in the plan being paid off early. However, the Trustee did not seek to modify the plan.

Finally, the Court noted that the better procedure would be to formally request a modification of the plan to pay it off early. "The safe procedure for prepayment by a debtor under a plan is to seek approval of a plan modification under section 1329(a). If that is done, the Trustee, creditors and the court will have confidence that the prepayment is undertaken in good faith and not in anticipation of a windfall or other change in the debtor's circumstances that might otherwise bring about proposal of a Trustee's or unsecured creidtir's modification to the debtor's plan." Memorandum Opinion, p. 9.

Thus, the lesson of McCarthy is that a discharge must be granted once the payments are completed, even under BAPCPA. However, that right is balanced by the ability of the Trustee to seek a modification or to oppose discharge based upon fraud.

Sources for Free Legal Research on Texas Bankruptcy Cases

It used to be that to keep up with the latest case law, it was necessary to review the advance sheets or keep up with the latest legal journals. Of course, this required expensive subscriptions and ran weeks or months behind the release date of the opinions. Today there are many sources of free legal research released in real time.

There are three main ways to gain access to up to the minute case updates free of charge. The first is through listserves which provide case updates as they are released. The second is court websites which contain links to recent opinions. Finally, opinions can be searched through PACER.

PACER (or Public Access to Court Electronic Records) is primarily known for containing electronic docket sheets and court documents, which can be accessed for a fee of 8 cents per page. However, a relatively new addition to PACER allows free searches for written opinions. To search for opinions under PACER, go to the PACER site for a district, look for “Reports” and then click on “Written Opinions.” The opinions can be searched by date and by division. It is also possible to search for an opinion by name. A search for the Southern District of Texas Bankruptcy Court revealed that there were sixteen opinions released from May 1 to June 7, 2008. PACER is the most comprehensive source for new bankruptcy court opinions. However, the written opinions feature only goes back to April 2005 and is not searchable by keyword. As a result, it requires some patience.


Here are the best sources for opinions relevant to Texas Bankruptcy lawyers.

Supreme Court

The best source for Supreme Court updates is the Cornell Law School Supreme Court listserve. By subscribing to this free service, readers receive updates as to cases which have been granted cert and opinions released. The updates are released in real time so that it is a very good way to stay up to date on developments in the Supreme Court. The nice thing about this listserve is that it contains both summaries of the opinions and links to read the opinions themselves. This makes it easy to scan through the day’s opinions to decide which ones merit further reading.

To subscribe to this listserve, go to: http://ruckus.law.cornell.edu/mailman/listinfo/liibulletin

Fifth Circuit

The Fifth Circuit has an opinions page located at http://www.ca5.uscourts.gov/opinions.aspx. The initial page lists opinions released that day. There is also an option to do a keyword search for opinions going back to 1992.

The other nice feature of the Fifth Circuit opinions page is that they offer an opinions subscription which provides an email twice a day listing the opinions released that day and attaching copies of the published opinions. Opinions can be received in either WordPerfect or PDF format. The downside to this service is that the opinions do not come with a summary so that it is necessary to either read every opinion to figure out which ones relate to bankruptcy (which are a very small percentage) or just try to guess based on the name of the case.

District Courts

Both the U.S. District Courts for the Southern and Western Districts of Texas participate in a site sponsored by the Southern District of New York called Courtweb. The site can be accessed at: http://www.nysd.uscourts.gov/courtweb/public.htm. The opinions can be searched by keyword. Curiously, a search for the term “bankruptcy” turned up only eight opinions from the Southern District, but found 121 decisions from the Western District.

Bankruptcy Courts

Each of the four bankruptcy courts in Texas has a website. However, each district has a different approach to posting its opinions.

Northern District of Texas: www.txnb.uscourts.gov

The Northern District of Texas offers several options for opinion searching. It has a comprehensive list of opinions which can be sorted by judge, by date, by case name or by case number. One nice feature of this page is that it includes retired judges as well as current judges. While the opinions can be sorted by date released, the page does not list those dates. Thus, it is necessary to open up the opinions to find out just how recent they are. One unique feature contained on the Northern District page is that it includes an email subscription service which allows the reader to receive updates whenever new opinions are released.

Southern District of Texas: www.txs.uscourts.gov

The Southern District judges previously released opinions intended for publication on the Courtweb site and selected unpublished opinions on the Court’s website. Unfortunately, no new Southern District opinions have been added to Courtweb since July 18, 2007. As a result, PACER is currently the only way to find current Southern District Bankruptcy opinions.

Eastern District of Texas: www.txeb.uscourts.gov

The Eastern District recently unveiled a new and improved website. It includes an opinions page for its two judges. The page breaks down opinions by subject matter, date and whether they are published or unpublished. Unfortunately the page for Judge Parker is still under construction. However, litigants appearing before Judge Rhoades can browse through 76 of her opinions on topics ranging from admissions to zip codes.

Western District of Texas: www.txwb.uscourts.gov

The Western District of Texas site contains two unique features. First, the front page of its opinions section lists the ten most recent opinions by date. This makes it easy to keep up with what is current in the Western District. The page also includes a key word search. A search for the term “means test” pulled up 43 hits. The opinions only date back to April 21, 2005. However, that is still a considerable body of cases.

The courts are constantly updating their websites. As a result, it is helpful to check frequently to see what is new. I will update this article from time to time to try to keep up with new developments.

New Opinion Illustrates the Dangers of Going to Trial

Trials are unpredictable things. That's why most cases settle. A recent opinion from Austin Bankruptcy Judge Frank Monroe illustrates how a case can go astray. In MARTNKIM Dining, LLC vs. Chaney, Adv. No. 07-1082 (Bankr. W.D. Tex. 5/29/08), the defendants won the case but in the process exposed themselves to new and potentially greater legal problems.

The adversary proceeding involved a suit over sale of a restaurant. The debtor claimed that the sellers had committed fraud, including providing false financial statements. This required the court to examine the sellers'/defendants' unique accounting practices. According to the court, the sellers received 2/3 of their revenues from cash sales. These funds were deposited into the owners' personal bank account rather than the corporate account. They then "loaned" these funds back to the corporation as needed. At the end of the year, the sellers would add up the cash register tapes and report these items as income to the company's CPA. While the full amount of revenues were reported to the IRS on the company's form 1120, the cash receipts were not included on the company's sales tax return. The Court stated:

"There can be only one rational explanation for this procedure. The Chaneys did not want to, and did not, pay the sales taxes on the cash sales to the State of Texas. This is, most likely, a considerable sum of money."

Memorarndum Opinion, p. 7. The Court later estimated the amount of diverted sales taxes at approximately $100,000.

The Court also noted that the sellers paid some of their employees in cash and reported their income on form 1099 instead of paying payroll tax as required by law.

Ultimately, the Court found that the sellers/defendants had not defrauded the debtor/purchaser. The Court found that the financial statements provided were not inaccurate with regard to revenues and had not been relied upon for the expense side. As a result, the Court entered a take-nothing judgment for the defendants. However, the Court's written opinion shone an unwelcome light on the defendants' accounting practices prior to the sale. Thus, it can be said that both the plaintiff and the defendants lost.

Debt Buyers Win Respect in New Opinion

Debt buyers are not the most popular people these days. However, their role as economic scavengers was acknowledged in a recent opinion from Judge Leif Clark of San Antonio. In re Salvador Santana, No. 07-30027 (Bankr. W.D. Tex. 5/21/08).

In Santana, Portfolio Recovery Associates, LLC filed a Notice of Transfer of Claim with respect to a claim that they had acquired from Capital One in the amount of $604.19. The Debtor objected on the basis that "a third party purchasing the instrument at a very reduced cost and having [the] Bankruptcy Court enforce payment is not in the best interest of the debtor."

While the Debtor's objection was no doubt accurate (that is, that is not in the best interest of the debtor to recognize the transferred claim), this was not a valid objection.

Judge Clark recognized that a purchaser of claims was entitled to enforce the full amount of the claim regardless of what it paid. While the creditor might receive a windfall, it was also assuming the risk of default by the debtor. As a result, the benefit should accrue to the debt buyer and not the debtor.

Judge Clark wrote:

"The holder of a claim is permitted to sell the claim for less than the face amount of the claim, and the transferee is entitled to enforce the claim for its face value, even though the transferee bought the claim at a discount. In other words, the debtor is not entitled to the benefit of the discount. This is so because the discount represents the transferee's assumption of risk of payment at less than the face amount of the debt. The transferor 'cashed out' its risk of nonpayment by agreeing to accept less than face value from the transferee, but again the debtors are not entitled to the benefit of that de facto writedown. Insofar as the debtor is concerned the original debt is till owed to whomever is the current rightful owner of the obligation. the transferee 'bought' the obligation, and is now the rightful owner entitled to enforce the debt at its face value. Because this is a chapter 13 case, it is almost certain that the debt will not be paid at its face value. . . . Thus, the transferee has factored in these risks when it set the price to be paid for the claim that it purchased. To realize the benefit of its bargain, however, it needs to be able to enforce the full amount of the claim purchased. And so the law allows."

Only in bankruptcy court would a claim for $604.19 merit such a thoughtful opinion!

Bankruptcy Court Limits Texas Homestead Under 1,215 Day Rule

The Bankruptcy Court for the Western District of Texas was recently faced with several issues relating to the homestead limitations under 11 U.S.C. Sec. 522(o) and (p). In re Fehmel, No. 07-60831 (Bankr. W.D. Tex. 5/22/08)(Frank R. Monroe, B.J.). Judge Monroe's opinion decides what it means to acquire an "interest" in property within 1,215 days, as well as interpreting the rollover and fraud provisions of the exemption statute.

The Issues

The Debtors owned a homestead which was purchased more than 1,215 days before bankruptcy. Within the 1,215 day period, they purchased a new homestead prior to selling the old one. They made the downpayment on the new homestead by drawing down on a corporate line of credit. Subsequently, they sold their old home and paid the proceeds into the corporate bank account. They made substantial improvements to the new homestead property, renovating the main house and adding a barn, a workshop and a guest house. At the time that they purchased the new homestead, the Debtor's company was doing well. However, subsequent reverses put the company out of business and caused the Debtors to file bankruptcy. At the time that they filed bankruptcy, the new homestead was worth almost double what they had paid for it.

Union State Bank, which had obtained a judgment on a guarantee of corporate debt, objected to the homestead exemption on the basis that the Debtors had acquired the homestead within 1,215 days before bankruptcy and should be limited to $125,000, that the downpayment from the corporate line of credit should be deducted from the allowed exemption based on fraud and that the debtors were not entitled to credit for reinvestment from the prior homestead.

The Debtors responded that they were allowed $125,000 in equity per debtor, that they had used the funds from sale of the prior homestead to improve the new property and that any additional equity was the result of passive appreciation which should not be counted toward the homestead cap. The Debtors also argued that their use of the corporate line of credit was not fraudulent and that the bank had tacitly consented to this personal use of the funds.

The Court's Ruling

The Court released its opinion on May 22, 2008, finding that the Debtors' exemption was limited to a total of $273,750 in equity. Judge Monroe noted that while the parties had relied on the amount of $125,000 contained in the original version of BAPCPA, that the cap had been adjusted to $136,875 in April 2007. The Court found that the cap should be applied on a per debtor basis. Section 522(m) states that the limitations contained in Sec. 522 are to be applied per debtor in a joint case. As a result, the homestead cap was doubled in a joint case.

The Court rejected arguments to enhance or diminish the homestead exemption based on passive appreciation, rollover from a prior residence or fraud.

The Debtor relied on a line of cases which held that passive appreciation should be added to the amount of the homestead cap. These cases hold that "any amount of interest" as used in the statute refers to the equity acquired by the debtor such that passive appreciation should not cause the debtor to exceed the limitation.

Courts are split on what the phrase "any amount of interest" means. One line of cases holds that "any amount of interest" refers to acquiring legal title to the property, while a competing line holds that it refers to obtaining equity in the property. The cases following the equity approach exclude passive appreciation in value from the amount of interest subject to the homestead cap while the cases applying the title approach look solely at when the debtor acquired title.

The Bankruptcy Court chose to follow the title theory. Judge Monroe stated:

"The title theory allows a court to focus on when the debtor acquired its interest in the property as opposed to the potential myriad of points in time which equity increased in value. It also avoids the incongruous result where property is acquired outside of the 1,215 day period but the exemption is limited based on equity accumulated during this period."

Memorandum Opinion at 18.

The Court also found support from the reasoning of a recent Fifth Circuit opinion. In Matter of Rogers, 513 F.3d 212 (5th Cir. 2008). In Rogers, the Fifth Circuit declined to choose between the title and equity theories. However, it held that interest referred to "vested economic interests." As a result, in that particular case, the fact that a property owned by the debtor more than 1,215 days before bankruptcy became the debtor's homestead within the 1,215 day period did not trigger the homestead cap because the debtor did not acquire any additional vested economic interest when the property's status changed. The Bankruptcy Court relied on this analysis to state, "Title, unlike a designation of homestead, is clearly a vested economic interest. When a debtor acquires title, he acquires a vested economic interest in the property." Memorandum Opinion at 19.

The Court rejected arguments for either supplementing the homestead exemption based on rollover from a prior homestead or reducing the amount of the exemption based on fraud.

The Court found that it was the Debtor's burden of proof to show that monies from a prior residence had been invested into the new property. Here, the Debtors had deposited the funds from sale of the initial residence into a company account where they were co-mingled with corporate funds. While the Debtors claimed that these funds had been used to make improvements on the property, they failed to trace any specific funds from the corporate account into the homestead. As a result, they failed to meet their burden of proof.

However, the Court also found that the creditor failed to meet its burden of proof with respect to fraud under Sec. 522(o). The Court found that three out of four elements were present, in that the debtors had disposed of property within ten years prior to the bankruptcy, that the funds were non-exempt and that the funds were used to enhance the value of the homestead. However, the Court found that the bank failed to show that the debtor had disposed of the non-exempt property with intent to hinder, delay or defraud.

The Court noted that the term "intent to hinder, delay or defraud" is not defined in the Bankruptcy Code. The Court chose to use the badges of fraud analysis from the Uniform Fraudulent Transfer Act. While the Court analyzed 13 separate factors, the most telling ones were that the Debtors had acted openly in using the corporate line of credit and that they had not been insolvent at the time that the downpayment had been made. As a result, the Court found that fraudulent intent was absent.

The Court's opinion also contains a discussion of the Texas tools of the trade exemption. The Court sustained the objection on the basis that the Debtor did not have a trade or profession at the time that he filed bankruptcy and that the tools were not actually used in a trade or profession.

Disclaimer: I represented Union State Bank in this case.

Obscure Provision Protects Local Taxing Authorities

Three years after the adoption of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, there are still opportunities to find something new in the statute. Under both the Bankruptcy Act and under the Code prior to BAPCPA, it was possible for a debtor to ask a court to redetermine the appraised values used to compute ad valorem taxes so long as the values had not been previously contested.

As the Fifth Circuit explained:

"Debtors financially involved are not always vigilant in the exercise of their rights to challenge tax claims or secure abatements; their mangaments may be inept, incompetent, uninterested, or dishonest; indeed, they may be under pressure to accept overassessements which may aid in maintaining their credit standard or commercial rating.

"The [Act], by authorizing redetermination in those instances where the tax claim was never appealed, serves to protect creditors of the bankrupt from the bankrupt's lack of diligence or interest."

City of Amarillo v. Eakens, 399 F.2d 541, 544 (5th Cir. 1968). Allowing redetermination of property tax values turned the appraisal system on its head. Under the laws of many states, including Texas, property tax values must be protested in a timely manner or they become final. Tax rates are then set based on the final valuations. Section 505 allowed a debtor to come in after the appraisal rolls had been finalized and taxes set and complain that the valuations were not correct. Needless to say, taxing authorities did not like this. Among other difficulties, the opportunity for redetermination was open-ended, allowing debtors to go back indefinitely in time so long as the values had not previously been protested.

Redetermination of tax values was a controversial issue under the Bankruptcy Code. Some courts abstained from redetermining property tax values, In re New Haven Projects Ltd. Liability Co., 225 F.3d 383 (2nd Cir. 2000), while others allowed it, In re Hospitality Ventures/La Vista, 314 B.R. 843 (Bankr. N.D. Ga. 2004); In re Fairchild Aircraft Corp., 124 B.R. 488 (Bankr. W.D. Tex. 1991). The cases declining to exercise jurisdiction relied on language in the legislative history to the code stating that abstention was appropriate "where uniformity of assessment is of significant importance." S. Rep. No. 989, 95th Cong., 2d Sess. 11 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5853.

As a debtor's lawyer, I have not hesitated to use this provision to object to ad valorem tax claims which seemed excessive based on the valuation determined in the Bankruptcy Court. However, on a recent claims objection, I came across Section 505(a)(2)(C) (in fairness, I came across it when the Court asked me how it affected my objection). Section 505(a)(2)(C) states that the court may not redetermine:

"the amount or legality of any amount arising in connection with an ad valorem tax on real or personal property of the estate, if the applicable period for contesting or redetermining that amount under any law (other than bankruptcy law) has expired."

This subsection eliminates the ability to retroactively challenge valuations going back many years. Instead, only valuations which could have been challenged on the petition date may be redetermined in the Bankruptcy Court. However, if the time to challenge has not expired on the petition date, Section 108(a) would appear to give the debtor two years in which to file the motion (providing that where nonbankruptcy law establishes a deadline which has not expired on the petition date, that the trustee may commence the action within the longer of the original period or two years).

This amendment also seems to quiet the controversy over redetermination is proper. By limiting redetermination to situations where the protest period has not expired on the petition date, Congress appears to have implicitly endorsed it in that one case.

To date, there are not any published decisions under this subsection. One pre-BAPCPA case noted that the result would have been different under the new law. In re Delafield 246 Corp., 368 B.R. 285 (Bankr. S.D. N.Y. 2007). However, I was not able to find any cases applying the new statute. Thus, it appear that this subsection remains shrouded in obscurity.

Plan Proposed by Environmental Advocate Save Our Springs Alliance Denied Based Upon Lack of Feasibility

Another chapter has unfolded in Austin’s development wars with the denial of the plan of reorganization proposed by the Save Our Springs Alliance. In re Save Our Springs (S.O.S.) Alliance, Inc., No. 07-10642 (Bankr. W.D. Tex. 4/11/08). While the case was a defeat for the debtor, it provides a wealth of useful case law for chapter 11 lawyers. It also provides a detailed examination of issues unique to a non-profit corporation attempting to reorganize. The issues discussed here could easily apply to a church or a cooperative as well.

Background

SOS is a “citizen action group whose primary purpose is to advance community awareness of water pollution and to protect water sources such as Barton Creek, the watershed in the surrounding community, and the Edwards Aquifer, which is the primary or only water supply in central and south Texas.” Memorandum Opinion, p. 4. One method that SOS used to advance its goals was to pursue litigation against developers.

Three of those lawsuits ended badly for SOS with the nonprofit being ordered to pay hundreds of thousands of dollars in attorney’s fees. This posed a quandary for the debtor. The corporation depended upon its contributions for its funding. However, environmentally minded donors were unlikely to make contributions for the purpose of paying attorney’s fees to developers. As a result, contributions either dried up or came with strings attached which prohibited their use to pay the judgments.

In addition to the judgment creditors, SOS owed $175,000 to Kirk Mitchell, one of its founders and largest donors. Mr. Mitchell had guaranteed a bank loan to SOS and was forced to pay off the debt when his guaranty was called. This left Mr. Mitchell holding a claim secured by all of the debtor’s assets.

SOS filed chapter 11 to try to work out of this dilemma. It proposed a plan which offered to raise $60,000 in contributions to pay its unsecured creditors. Those creditors were divided into three classes despite the fact that they would each receive a pro rata share of the same pot. Class 4 contained the claim of Sweetwater Austin Properties, LLC, the largest judgment creditor. Class 5 consisted of two other judgment creditors whose judgments were not yet final. Class 6 consisted of its other unsecured creditors, including the deficiency claim of Kirk Mitchell. Classes 4 and 5 voted to reject the plan, while Class 6 voted to accept. The debtor negotiated settlements with the two judgment creditors in class 5 which resulted in their votes changing to accept the plan.

This left the debtor in a confirmation battle with its largest creditor. The pleadings framed issues of which party was acting in good faith. The debtor accused Sweetwater of casting its ballot in bad faith for the ulterior motive of putting the environmental group out of business, while Sweetwater accused the debtor of gerrymandering its classes to engineer acceptance by a class and offering an infeasible yet inadequate payment to creditors.

The Court conducted the confirmation hearing over five days and then took the case under advisement. The Court’s 68-page ruling addressed the following issues (plus several others):

1. Whether SOS as a small business debtor had met its burden to extend the 45 day period to confirm a plan;
2. Whether the ballot of Sweetwater should designated as having been cast in bad faith;
3. Whether the debtor improperly gerrymandered its unsecured classes;
4. Whether the plan met the chapter 7 liquidation test;
5. Whether the plan was feasible;
6. Whether the plan satisfied the absolute priority rule; and
7. Whether the plan was proposed in good faith.

Timely Confirmation

Section 1121(e)(3) posed a difficult problem for the court. The Code requires a small business chapter 11 debtor to confirm its plan within 45 days after being filed. The confirmation hearing began on the last day of the period. The debtor filed a motion to extend the 45 day period which was heard on the first day of trial. Sweetwater argued that the debtor had failed to meet its burden to show that it was more likely than not that the debtor would confirm a plan within a reasonable time. With only one day of testimony received, it was objectively impossible to tell whether the plan was likely to be confirmed.

This raised a conundrum. If taken literally, a debtor could never obtain an extension to confirm a plan unless the confirmation hearing had already proceeded to the point where it was clear that the debtor was going to win. As a result, the more complex the case, the less likely it was that the debtor could meet its burden to gain an extension of time to complete the confirmation hearing. As the court pointed out:

“(U)nless a debtor is able to file and obtain a hearing on its motion to extend time well in advance of the end of the 45-day period, no purpose would be served by hearing the motion to extend time separately from the confirmation hearing. That is because the evidence that would allow the court to make the factual findings required by §1121(e)(3) is virtually the same as that which would be offered at the confirmation hearing. Thus, in most instances the debtor will have to act so that the confirmation hearing itself can be scheduled, conducted and concluded, and an order entered, within 45 days of the date the plan is filed. In many if not most cases this presents virtually insurmountable obstacles, particularly when the plan is amended after filing.”

Memorandum Opinion, at 30-31.

The Court found that the strict deadlines imposed by BAPCPA were unworkable. In their place, the court substituted a requirement that the debtor act promptly to bring its case and to trial and to request an extension of time.

“The Court finds BAPCPA’s small business confirmation deadlines provisions—the onerous showing required under §1121(e)(3) to get an extension, combined with the accelerated timeline for making that showing under §§1121(e)(3) and 1129(e)—are simply unworkable under the facts of this case. The Court is therefore reluctant to impose on the Debtor the full consequences of a failure to meet §1121(e)’s deadline, inasmuch as that failure was due to the impossibility of the Court’s receiving and considering the evidence in time to make the findings required to rule on the requested extension of that deadline.”

Memorandum Opinion at 34. As a result, the Court extended the deadline through the ruling on confirmation. However, because the Court denied confirmation of Debtor’s plan, it declined to grant the Debtor any further extension.

Motion to Designate Ballot

The opinion also considered whether the creditor’s ballot was cast in bad faith. Section 1126(e) allows the Court to disregard a ballot “whose acceptance or rejection . . . was not in good faith.” Although this provision is infrequently used, it will allow a ballot to be disregarded when the creditor acts with an unacceptable ulterior motive. The Debtor contended that Sweetwater opposed the plan for the ulterior purpose of putting SOS out of business and avoiding litigation over future developments. Sweetwater, on the other hand, contended that it merely sought to obtain the best recovery for its claim.

The Court found that it was not bad faith for a creditor to act according to its economic self-interest. Moreover, the creditor was entitled to be the sole judge of what was in its economic self-interest. As a result, the Debtor could not successfully argue that the creditor must be acting in bad faith because it would not receive a better bargain if the Debtor’s plan was denied.

The Court quoted from a leading opinion which stated:

“Too, what debtors think represents a ‘good deal’ may not look so rosy from a creditor’s point of view, and the voting process is expressly designed to give creditors the opportunity to express how the plan looks to them. The fact that a creditor may not know what is good for it, therefore, can again, of itself, not be grounds for disqualifying that creditor’s vote.”

Memorandum Opinion, page 39, quoting In re The Landing Associates, Ltd., 157 B.R. 791, 807 (Bankr. W.D. Tex. 1993).

Additionally, the Court found that the creditor was acting in its economic self-interest where it sought to prevent confirmation of the plan for the purpose of undercutting the Debtor’s ability to litigate the allowance of the creditor’s claim. This motivation also related to the creditor’s economic self-interest.

Ultimately, the Court found that it was just as likely that the creditor was acting in a defensive posture (that is, to prevent the debtor from imposing an unfavorable result on it) rather than offensively (that is, to take out a rival in the development wars).

Classification

The classification scheme in this case was reminiscent of the one from In re Greystone III Joint Venture, 995 F.2d 1274 (5th Cir. 1991). In Greystone, the Debtor proposed two classes of unsecured claims based on their separate legal status and motivation to vote on the plan. However, the plan provided the same treatment to both. The Fifth Circuit rejected this argument, finding that there was a presumption that all similar claims be classified together and that “thou shalt not classify similar claims differently in order to gerrymander an affirmative vote on a reorganization plan.” The Fifth Circuit found that separate classification could be warranted based on legitimate business reasons, but that legitimate business reasons were not present when the debtor proposed to give the two classes exactly the same treatment.

In this case, the Court found that the plan as originally proposed contained gerrymandering between classes 4, 5 and 6. However, once the Debtor settled with the creditors in Class 5, those claims were no longer similar in nature to the claims in classes 4 and 6. There were good business reasons for separately classifying the claims in class 5 because the treatment of those claims included additional provisions relating to the settlement. “A creditor’s ongoing involvement in litigation with the debtor has been held to be . . . a non-creditor interest, justifying separate classification of the claim.” Memorandum Opinion, at 47. Thus, although the plan as originally proposed involved unacceptable gerrymandering, and although the plan continued to gerrymander the separate classification of classes 4 (Sweetwater) and 6 (general unsecured creditors), separate classification of class 5 was not only permissible but required. This meant that the debtor succeeded in obtaining one accepting class of claims despite the gerrymandering finding.

Chapter 7 Liquidation Test

While Sweetwater argued that the debtor did not meet the best interests of creditors test, this was not a particularly difficult burden to meet. In this case, the Debtor was a non-profit corporation dependent on contributions for its operations. The Debtor convincingly testified that its meager assets, consisting of a conservation easement, some office furniture and computers, its name and its mailing list, were worth much less than the secured debt against them. As a result, any payment to unsecured creditors exceeded what they would receive in a chapter 7 liquidation. Like the union in In re General Teamsters, Warehousemen and Helpers Union Local 890 (9th Cir. 2001), the right to collect future contributions was not an asset which could be liquidated in a chapter 7 case.

Feasibilty

Feasibilty proved to be the Achilles Heel of this plan. The Debtor proposed to raise a fund of $60,000 to pay its unsecured creditors. The Court found that to satisfy the feasibility standard “a reasonable prospect of success must be shown” and that most courts require “specific, concrete evidence to support feasibility.” Memorandum Opinion, page 53.

The Plan allowed the Debtor 60 days to raise the $60,000 payment to be made to unsecured creditors. However, as of confirmation, the Debtor only had commitments for $12,500. The Court found that under this record, feasibility was lacking.

“The evidence was clear that the Debtor had not raised the $60,000 as of the confirmation hearing. The fact that SOS built into its Plan a delay in its obligation to obtain those funds does not relieve it of its burden to show that it will be able to perform under the Plan. True, under the terms of para. 7.3, it would not be in default the moment an order confirming the plan were entered but would have time to obtain more contributions to fund the Creditor Settlement Fund. However, it offered no evidence at the hearing to show that it could meet that obligation—no commitments, no evidence of relevant past performance, nothing. On the contrary, Kirk Mitchell testified that as of the date of the hearing he had expressly not agreed to contribute any amount to be used to fund the Creditor Settlement Fund.”

Memorandum Opinion at 53.

The Debtor argued that because the plan provided that failure to raise the necessary funds would be an event of default which would return the parties to the status quo that feasibility was a non issue. The Court found that, “Such a provision, rather than curing the Debtor’s failure to show the Plan is feasible, merely highlights that failure.” Memorandum Opinion at 57.
Thus, because the Debtor’s contributors would not commit to fund the Plan in advance, the Plan was defeated.

Absolute Priority Rule

While the absolute priority rule is a major focus of most chapter 11 cases involving cram-down, it was of little consequence to SOS. The absolute priority rule requires that junior classes not receive or retain any interest unless senior classes are paid in full. In the typical case, equity must be cancelled unless unsecured claims are paid in full. However, a non-profit corporation does not have equity holders. The members of a non-profit corporation may direct its affairs, but do not own an interest in the corporation. The laws of most states provide that upon dissolution, the assets of a non-profit corporation must be transferred to another non-profit entity.

In this case, Sweetwater made the novel argument that claims of insiders should be subordinated and not receive any distribution unless its claim was paid in full. Thus, the creditor argued that insider claims should be treated as de facto equity. The Court dismissed this argument, stating that “Several courts have expressed the opinion that the claim of an insider or equity holder may not be treated unequally unless the insider or equity holder used superior knowledge concerning the debtor’s affairs in an unfair manner or equitable subordination principles otherwise apply.” Memorandum Opinion at 61.

Good Faith

Good faith is shown where the plan is “proposed with the legitimate and honest purpose to reorganize and has a reasonable hope of success.” In re Sun Country Development, Inc., 764 F.2d 406, 408 (5th Cir. 1985). The Court found that, “”While the question is a close one precisely because of the Plan’s impermissible classification scheme and the small size of the payments proposed, the Court nevertheless finds that its provisions for Sweetewater’s claim . . . does not amount to bad faith.” Memorandum Opinion at 64.

One issue considered by the Court was whether the Debtor had played fast and loose with its donations for the purpose of evading creditors. Once the Debtor had judgments rendered against it, contributors began making “restricted” gifts which could not be used to pay the judgments. However, these restricted funds were commingled with the Debtor’s other assets. On the eve of bankruptcy, the Debtor transferred $31,156.21 into an Education & Outreach Fund. Based upon a tracing analysis, the Court found that at least half of these funds were unrestricted funds and that a portion of the restricted funds had been spent on other purposes. The Court found that the portion of these funds constituting “restricted” funds were not property of the estate despite the fact that they had been commingled. The Court also found that these facts did not establish bad faith.

“The Court finds, however, that the Debtor’s apparent unauthorized use of restricted funds should not override the express intent of the donors, and should therefore not destroy the overall character of the funds as restricted. The evidence on the issue was limited to the Debtor’s inability to explain the accounting that indicates its use of some of the funds was not authorized. The Court finds, however, that there was insufficient evidence to establish any sort of complicity between the Debtor and the donors, and or malfeasance or bad faith on the part of the Debtor. Confirmation of this Debtor’s Plan has presented a number of unusual and even unique issues, including what a Debtor in SOS’s position can and must offer creditors when its source of income is donors who have the right to choose whether or not to fund a plan. Based on all the evidence presented and the totality of the circumstances of this case, the Court finds and concludes that there was no credible evidence that the Plan was proposed with bad intent or malfeasance, or in contravention of any applicable law.”

Memorandum Opinion at 67-68.

Where Does This Leave the Parties?

At the end of the day, the Debtor’s Plan was not confirmed. The Debtor is past its 300 day window to propose a plan and past its 45-day window to confirm the previously filed plan. On the other hand, the Debtor’s assets remain encumbered by a lien held by a friendly party which greatly exceeds their value. Donors cannot be forced to contribute funds to pay the claim of Sweetwater. As a result, it appears that the decision leaves the parties in a stalemate.

Disclaimer: The law firm that I work for was a small unsecured creditor in this case. We voted to accept the plan.

Fifth Circuit Clarifies Requirements of Rule 9011

The Fifth Circuit has written a new opinion requiring strict compliance with Rule 9011 prior to awarding sanctions. The Cadle Company v. Pratt, No. 07-10457 (4/8/08). Specifically, the Fifth Circuit held that prior to seeking sanctions under Rule 9011, the movant must serve a copy of the actual motion on the respondent 21 days prior to filing it and that a mere letter threatening sanctions was inadequate.

In Pratt, the Cadle Company objected to a debtor's discharge. The debtor failed to disclose his right to receive payments under his mother's will, but testified persuasively that he owed more in loans received from his mother than the distribution he would have received from her estate. Subsequently, the Cadle Company learned that the debtor had received loans from his mother's estate after her death. It is not clear from the opinion why this fact was significant. Perhaps Cadle viewed the estate loans as disguised distributions or perhaps they contradicted the testimony that loans were made during the mother's lifetime. At any rate, the Cadle Company blamed the debtor's lawyer for the non-disclosure of this fact.

Prior to filing a motion for sanctions, the Cadle Company sent not one but two letters to the debtor's lawyer alleging a Rule 9011 violation. However, when the motion came up for hearing, the Bankruptcy Court denied it because: (a) the Cadle Company had not served its proposed motion on the debtor's lawyer 21 days before filing it; and (b) the debtor's lawyer did not do anything sanctionable. The Bankruptcy Court then went on to award sanctions against the Cadle Company for bringing a frivolous motion for sanctions.

On appeal, the District Court affirmed the denial of the Cadle sanctions motion, but remanded the award of sanctions against Cadle for further consideration. Cadle appealed to the Fifth Circuit.

The Fifth Circuit affirmed the denial of the Cadle sanctions motion. It held that an informal notice did not meet the requirements of Rule 9011. In pertinent part Rule 9011 provides:

"The motion for sanctions may not be filed with or presented to the court unless, within 21 days after service of the motion (or such other period as the court may prescribe), the challenged paper, claim, defense, contention, allegation, or denial is not withdrawn or appropriately corrected, except that this limitation shall not apply if the conduct alleged is the filing of a petition in violation of subdivision (b)."

While the rule is not a model of drafting clarity, the Fifth Circuit sided with the Fourth, Eighth, Ninth and Tenth Circuits and rejected an opinion from the Seventh Circuit to hold that Rule 9011 requires that the party to be sanctioned be served with the actual motion 21 days before it is filed.

The practical difficulty lies in reconciling the language "may not be filed with or presented to the court" with "after service of the motion." On the one hand "service of the motion" is typically understood to refer to service of a motion which has been filed with the court. On the other hand, the preceeding language, says that the motion may not be filed until 21 days after it has been served. The Fifth Circuit reconciles this conflict (without expressly addressing it) by holding that the motion must be served before filing (and presumably then served again after filing).

The ruling of the Court of Appeals smooths over a difficultly worded rule. It adopts a policy position that sanctions should be an exceptional remedy and not just an added bonus for a victorious party. By requiring pre-filing "service" of the proposed motion, it requires the aggrieved party to stop and methodically lay out why the pleading is sanctionable rather than merely firing off a letter in anger or an excess of testosterone.

In addition to its main focus, the opinion contains an interesting discussion of finality for purposes of appeal. In this case, the District Court reversed and remanded. Only final orders may be appealed from the District Court to the Fifth Circuit. In this case, the Fifth Circuit held that the portion of the District Court opinion which affirmed the denial of sanctions to the Cadle Company was final and could be appealed, while the portion which remanded the sanctions against the Cadle Company was interlocutory and could not be appealed. The fact that a single order could be partially appealable and partially non-appealable provides a trap for the unwary. Here, appellate practice is like voting in Chicago or South Texas: appeal early and often.

Minority Position on Surrendering Vehicles Subject to Hanging Paragraph Gains Support; Automobile Lenders Allowed Deficiency Claims

Some of the architects of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) have said that they would not change a word of this complex legislation. However, some of those words have left judges scratching their heads. One of the more troublesome provisions has been the so-called “hanging paragraph” of 11 U.S.C. Sec. 1325(a). Immediately following Sec. 1325(a)(9), it provides that the valuation provisions of Sec. 506(a) do not apply to a loan for purchase of a vehicle for personal use incurred within 910 days prior to bankruptcy.

In one context, the hanging paragraph is clear. If a debtor intends to retain a 910-day vehicle, he must pay the full amount owed regardless of its value. However, does the same logic apply in reverse? If the debtor elects to surrender the vehicle, must the lender give credit for the full amount of the debt regardless of the value?

The symmetry of an anti-valuation provision which applied in both directions (that is, retaining or surrendering) appealed to several courts. In fact, it became known as the majority position. Examples of this position include In re Payne, 347 B.R. 278 (Bankr. S.D. Ohio 2006); In re Turkowitch, 355 B.R. 120 (Bankr. E.D. Wis. 2006); In re Gentry, 2006 WL 3392947 (Bankr. E.D. Tenn. 11/22/06); In re Quick, 360 B.R. 722 (Bankr N.D. Okla. 2007).

However, several recent appellate decisions may have shifted the weight of authority. Four cases from the Sixth, Seventh and Eighth Circuits have all held that surrender of a 910-day vehicle does not prevent the creditor from filing an unsecured deficiency claim. In re Long, 2008 U.S. App. LEXIS 4549 (6th Cir. 3/4/08); AmeriCredit Financial Services, Inc. vs. Moore, 2008 U.S. App. LEXIS 2497 (8th Cir. 2/5/08); Capital One Auto Finance vs. Osborn, 515 F.3d 817 (8th Cir. 2008); Matter of Wright, 492 F.3d 829 (7th Cir. 2007). These cases take a broader look at the application of Sec. 502 and 506 to determine that a deficiency claim is not barred. Basically, they hold that Sec. 506(a) only applies to determination of a claim secured by property of the estate. Once the secured property is surrendered, the estate no longer has an interest in property to be valued. From that point, the issue shifts to Sec. 502, which determines allowance of claims. Because Sec. 502 does not contain any provision requiring disallowance of a 910-day deficiency claim, the claim should be allowed.

Within Texas, this shift in position should not affect a major change. Several Texas courts were already following the “minority” position adopted by the recent appellate opinions. In re Aguerro, No. 07-12195 (Bankr. W.D. Tex. 3/30/08)(Gargotta, B.J.); In re Newberry, 2007 Bankr. LEXIS 1589 (Bankr. W.D. Tex. 2007)(McGuire, B.J.); In re Gay, 375 B.R. 343 (Bankr. E.D. Tex. 2007)(Parker, B.J.).

In most cases, allowing or disallowing a deficiency claim will not have a major effect on the debtor, since the typical chapter 13 plan pays unsecured creditors mere pennies on the dollar. However, in some instances it could make a lot of difference. In re Esparza, No. 06-31040 (Bankr.W.D. Tex. 5/9/07) was just such a case. In Esparza, the debtors financed two vehicles with GECU. One vehicle was purchased within 910 days and the other was not. The debtors elected to surrender the 910 day vehicle, which resulted in a deficiency. Because the two loans were cross-collateralized, the deficiency from the surrendered vehicle attached to the retained vehicle. Because the balance owed on the retained vehicle was small enough, the value of this vehicle was sufficient to secured both the remaining value on the vehicle financed and the deficiency on the surrendered vehicle. If the one vehicle could have been surrendered in full satisfaction of the debt, the amount to be paid on the retained vehicle would have been much less. Thus, because the hanging paragraph did not mandate full satisfaction of the debt, the debtors had to pay an extra $11,809.84 as a secured claim. The only way to have avoided this result would have been to retain both vehicles (in which case the 910-day vehicle would have been required to be paid in full) or to surrender both vehicles in which case the deficiency, if any, would have been a mere unsecured claim).

Note: The original version of this article erroneously referred to In re Dominquez, No. 06-31167 (Bankr. W.D. Tex. 5/11/07) instead of In re Esparza, No. 06-31040 (Bankr. W.D. Tex. 5/9/07). The article has been corrected and now refers to the appropriate case.

Fifth Circuit Releases Interest-ing Opinion on Chapter 13 Interest Rates

The Fifth Circuit has released a new opinion on interest rates in chapter 13 cases. Drive Financial Services, L.P. v. Jordan, 2008 U.S. App. LEXIS 5334 (5th Cir. 3/12/2008). While the opinion does not contain any earth-shattering conclusions, it provides an excellent starting point for a practitioner wanting to learn treatment of secured claims in chapter 13.

The Facts

Debtor financed a pickup truck with Drive Financial. The contract interest rate was 17.95%. When the Debtor filed chapter 13, he proposed to lower the rate to 6%. At the confirmation hearing, the parties stipulated that the rate would be 7.5% under the Supreme Court's Till v. SCS Credit Corp., 541 U.S. 465 (2004) decision or 17.95% under the Fifth Circuit's Green Tree Fin. Servicing Corp. v. Smithwick, 121 F.3d 211 (5th Cir. 1997). Under Till, the interest rate is to be determined based on the prime rate plus a risk premium, while Smithwick applied a rebuttable presumption that the contract rate should apply. The Bankruptcy Court applied Till and used the lower rate. The parties received permission to take a direct appeal to the Fifth Circuit.

The Hanging Paragraph Does Not Apply

The Fifth Circuit first dispelled the notion that the hanging paragraph of Sec. 1325(a)(*) applies to calculation of interest on a chapter 13 secured debt. Drive Financial argued that because Till dealt with the interest rate on a lienstripped claim, that it had no application to a post-BAPCPA claim on a vehicle claim protected from lienstripping under the hanging paragraph. The Fifth Circuit found that the fact that the claim had been subject to lienstripping did not play any part in the Supreme Court's decision to apply a prime + interest rate calculation and thus concluded that BAPCPA had not overruled the Till decision.

This raises an important point. Loans secured by a principal residence are protected from modification in both chapter 11 and chapter 13. On the other hand, loans incurred for purchase money on a vehicle within 910 days are protected from lienstripping (that is, having the secured claim reduced to the value of the collateral), but are still subject to having their interest rates modified. Thus, home mortgages receive greater protection than recent car loans.

The Till Plurality Is the Law; Smithwick Is Not

Next, the Fifth Circuit explored how to apply a plurality opinion from the Supreme Court. In Till, a plurality of four justices adopted a prime rate + approach, while Justice Thomas concurred in the judgment but found that a risk premium was not mandated. Where no single rationale is approved by a majority, the lower courts are required to follow the position of the justices who concurred in the judgment on the narrowest grounds. Drive Financial argued that because Justice Thomas did not concur in any part of the plurality opinion that Till was not binding. However, the Fifth Circuit noted that the fifth vote cast by Justice Thomas found that a prime + interest rate would always be sufficient to protect the secured creditor because the statute only required a risk free rate of return. Thus, there were five votes for the position that a prime + rate would adequately protect the interest of the secured creditor, and thus, that the lower courts must follow this result.

The Fifth Circuit also pointed out that, even if the reasons for adopting Till were murky, that the facts were the same as the present case. As a result, stare decisis required that the Fifth Circuit follow Till and not its own prior precedent.

As a result, the Fifth Circuit found that the prime rate + approach to calculating the interest rate in chapter 13 remains the law.

Sanctioned Lawyer Wins Reprieve From District Court; Court Clarifies Standards for Non-9011 Sanctions

This blog previously reported on In re Cochener, 360 B.R. 542 (Bankr. S.D. Tex. 2007), a case in which an attorney was sanctioned under 11 U.S.C. Sec. 105 and 28 U.S.C. Sec. 1927 based on events which had occurred years earlier. See "Brief Representation Comes Back to Haunt Attorney." (May 7, 2007). Now, a U.S. District Court has reversed most of the sanctions award and the case is on its way to the Fifth Circuit. Barry v. Sommers, No. H-07-0629 (S.D. Tex. 12/28/07).

What Happened in the Bankruptcy Court

The underlying case involved a debtor who had made questionable transfers prior to bankruptcy. When the trustee began asking difficult questions at the 341 meeting, the first attorney realized that he was in over his head and referred the case to a board certified attorney. The second attorney realized that the debtor was not helping herself by being in bankruptcy and tried to get the case dismissed. While the motion to dismiss was pending, the attorney advised the debtor not to attend a re-scheduled 341 meeting or to produce documents which the prior counsel had agreed to hand over. When the trustee sought to conduct a Rule 2004 examination, the second attorney argued against producing documents going back four years on the basis that 11 U.S.C. Sec. 548 only allowed the trustee to recover transfers made within one year prior to bankruptcy. The debtor failed to appear for the examination, after which the second attorney sought permission to withdraw. The second attorney was given permission to withdraw, but the court reserved the power to issue sanctions.

Over four years later, the trustee brought a motion for sanctions under Rule 9011 and 11 U.S.C. Sec. 105. Because the trustee had never given the safe harbor notice under Rule 9011, the court concluded that this relief was not viable. However, after hearing four days of testimony, the court granted relief under both Sec. 105 and 28 U.S.C. Sec. 1927 based upon the following actions:

(1) The attorney concocted a reason for the debtor not to attend the continued 341 meeting and then advised the debtor not to appear;
(2) The attorney did not attend the continued meeting of creditors;
(3) The attorney filed a motion to dismiss which included "blatantly false factual and legal allegations;"
(4) The attorney wrote a letter to the trustee which misstated the law regarding the appropriate lookback period for a fraudulent transfer case;
(5) The attorney instructed the debtor not to produce the documents requested at the initial meeting of creditors.

Based on these actions, the court awarded sanctions of $25,121.89 based upon disgorgement of the retainer paid to the attorney and payment of the trustee's attorney's fees incurred in resisting the motion to dismiss and prosecuting the motion for sanctions.

Reversal on Appeal

On appeal, the District Court reversed all of the sanctions, except for the disgorgement order. However, to get there, it had to work through several preliminary issues first.

The District Court refused to apply laches based on the delayed prosecution of the sanctions motion. While the four year delay in bringing the sanctions motion represented a long period of time, it was not prejudicial because the attorney had been placed on notice of the claim at the time of his withdrawal and because no evidence had become stale in the meantime.

The District Court also rejected the argument that the Bankruptcy Court lacked authority to issue sanctions under 11 U.S.C. Sec. 105. The Court noted the recent Supreme Court opinion in Marrama v. Citizens Bank of Massachusetts, 127 S.Ct. 1105 (2007)in which the court stated that section 105(a) provides Bankruptcy Courts broad authority to "take any action that is necessary or appropriate to prevent an abuse of process." The Court concluded that Sec. 105(a) gave bankruptcy courts the inherent power to sanction bad faith conduct that was applicable to Article III Courts under Chambers v. NASCO, Inc., 501 U.S. 32 (1991).

However, before sanctions could be awarded under the Court's inherent powers under Sec. 105(a), the court had to find bad-faith conduct. Bad faith conduct was equated with either an attempt to abuse the judicial process or an affirmative misrepresentation. After an exhaustive analysis, the District Court upheld the Bankruptcy Court's finding that the attorney had engaged in bad faith conduct when he told the debtor not to appear or produce documents at the continued 341 meeting. However, the District Court reversed the other findings as being clearly erroneous.

Having concluded that only one act was sanctionable, the District Court turned to the proper sanction to be applied. The Court noted that "Inherent powers may be exercised only if essential to preserve the authority of the court, and the sanction imposed must employ the least possible power adequate to the purpose to be achieved." Memorandum Opinion and Order, p. 81. The Court found that disgorgement of the retainer was appropriate under this standard. "Attorneys who instruct their clients to violate duties imposed by the Bankruptcy Code have not provided effective assistance of counsel and have not earned a fee." Memorandum, p. 83.

The District Court reversed the award of attorney's fees to the trustee. Because the Court found that filing the motion to dismiss was not sanctionable, it found that the Trustee could not recover his fees incurred in opposing the motion to dismiss. The District Court denied the attorney's fees incurred in prosecuting the motion for sanctions on the basis that the debtor's attorney (who had already withdrawn at this point) did not commit any sanctionable conduct during the time that the trustee was pursuing the motion for sanctions. As a result, an award of attorney's fees in connection with the motion for sanctions was not necessary to deter sanctionable conduct.

The District Court also found that the Bankruptcy Court abused its discretion in imposing sanctions under 28 U.S.C. Sec. 1927. The Court found that there were three elements to an award of sanctions of Sec. 1927: (1) the attorney must engaged in "unreasonable and vexatious" conduct; (2) the "unreasonable and vexatious" conduct must be conduct that "multiplies the proceedings;" and (3) the dollar amount of the sanction must bear a financial nexus to the excess proceedings, i.e., the sanction may not exceed the "costs, expenses and attorneys' fees reasonably incurred because of such conduct." The Court found that the motion to dismiss did not merit sanctions under Sec. 1927 because it could not be plausibly argued that it was filed in bad faith. Although the District Court found that the attorney could be sanctioned under Sec. 105 for advising the debtor not to attend the creditors' meeting, this conduct did not merit sanctions under Sec. 1927 for the reason that it did not multiply the proceedings.

The Final Analysis

In the final analysis, it appears that while Rule 9011, Sec. 105(a) and Sec. 1927 serve similar purposes, they each have slightly different focuses. Rule 9011 applies to pleadings and papers only. It applies where motions are filed for an improper purpose or are legally or factually frivolous. However, the mere filing of a frivolous or odorous pleading is not enough. It is the refusal to withdraw a sanctionable pleading after fair warning which triggers the penalty. This means that a victorious party cannot go back after the fact and decide that his opponent's position was friviolous. Sec. 105(a) and Sec. 1927, on the other hand, apply to any conduct and allow for an after the fact examination. As a result, these sections require a higher standard before sanctions can be awarded. In order to violate the Court inherent power under Sec. 105(a), counsel must make an affirmative misrepresentation or try to abuse the judicial process, either of which will add up to the requisite finding of bad faith. Sec. 1927 invokes the three-party test discussed above, which must include a finding that court proceedings were multiplied.

In this case, advising a client not to obey her duties under the Code was sanctionable, while filing a questionable motion to dismiss and taking a questionable position on a discovery matter (which was later abandoned) were not.

The Trustee has appealed this case to the Fifth Circuit, so that we may hear from this case again.

Kudos to the District Court

As a final note, U.S. District Judge Sim Lake deserves high praise for the diligence and speed with which he handled this bankruptcy appeal. He produced his thoughtful, 93-page opinion just ten months after the notice of appeal was filed and seven months after the last brief was filed. The Court did the parties and the bar a service with the prompt manner in which this case was handled.

Update:

On October 23, 2008, the Fifth Circuit reversed the opinion of the District Court and affirmed the opinion of the Bankruptcy Court. Matter of Cochener, No. 08-20048, 2008 WL 4681579 (5th Cir. 2008).