Texas Bankruptcy Courts Split Over Application of Schwab v. Reilly

The Supreme Court's decision in Schwab v. Reilly, 130 S.Ct. 2652 (2010) last term provoked a lot of concern about the finality of exemptions. Under Taylor v. Freeland & Kronz, 503 U.S. 638 (1992), a trustee's failure to timely object to an exemption, even a frivolous one, meant that the asset left the estate. However, in Schwab v. Reilly, the Supreme Court held that an exemption of a specific dollar amount in value of property exempted only the value claimed but not the asset itself, allowing a trustee to sell the asset if the value ultimately exceeded the amount of the debtor's exemption.

I have written about Schwab v. Reilly and its consequences here and here.

Now Texas Bankruptcy Judges are struggling with whether Schwab permits, or even dictates, that a debtor may claim 100% of fair market value, forcing the trustee to object within 30 days. Judge Michael Lynn and Judge Craig Gargotta have held that claiming 100% of FMV is permissible, In re Moore, 442 B.R. 865 (Bankr. N.D. Tex. 2010), In re Dominguez-Ortega, No. 10-61416 (Bankr. W.D. Tex. 5/17/11), while Judge Robert Jones has ruled the opposite way, In re Salazar, 2011 Bankr. LEXIS 1117 (Bankr. N.D. Tex. 2011).

Because Judge Gargotta's opinion is the latest word, I will start with his ruling in this post. The transcript is not yet available online. I will be happy to provide a copy to anyone who requests it.

The Permissible Approach

In the Dominguez-Ortega case, the court was faced with objections filed by the chapter 7 and chapter 13 trustees in six cases in which the debtors claimed 100% of FMV. Relying upon the Moore decision and scholarly articles from the American Bankruptcy Institute, Judge Gargotta denied the objections. He stated:

As everyone knows, in Schwab v. Reilly, the Supreme Court unequivocally says at least two things--it may say other things in addition to that.

One, that one hundred percent of fair market value on Schedule C is permissible and correct.

And second, that the trustee may not be bound by the 30 day objection period under Federal Rule of Bankruptcy Procedure 4003(b).

Transcript, pp. 6-7. He went on to adopt the reasoning of Judge Lynn of the Northern District. He stated:

(T)he judges in the (Fort Worth) division had the following observations.

First of all, fair market value of one hundred percent is the correct methodology. It puts the trustee on notice to object within 30 days. Then there can be an evidentiary hearing . . . regarding whether or not that's a fair objection.

For purposes of the proceedings here in Waco, I agree with that. I think that's exactly what the Supreme Court requires.

Second as to the discussion that we had on the record day about whether or not debtors may use a numeric amount for the interest they claim as an aid, they are free to do that, but they are not required to do that. And I will leave it up to them as to whether or not they want to do that.

Transcript, pp. 8-9.

Judge Gargotta acknowledged that his ruling would result in more work for the trustees and the court, but stated that his mandate was to follow the Supreme Court.

Now, what is the consequence to the Court? Well, the consequence to the Court is, in those situations where the trustee thinks that . . . when (the debtors) use the designation of one hundred percent of fair market value, that it may exceed the amount of the interest in an asset, the trustee is going to have to object, and I'll have to conduct a hearing on it and we'll . . . figure out how that plays out.

I recognize that, ultimately, it may increase the litigation in this Court. But, by the same token, I'm of the opinion, and I think it's unequivocally clear that what debtors are doing in that consequence is precisely what the Supreme Court ordered, and I'm not going to alter their methodology in terms of claiming it.

I apologize to both Mr. Hendren and Mr. Studensky if it increases their workload. That is not my intent. Rather, I am complying with what the Supreme Court commands.

Transcript, p. 10.

The Impermissible Approach

Writing in Salazar, Judge Robert Jones agreed that if a debtor claimed 100% of fair market value and no party objected, that "the debtor effectively reclaims the property." 2011 Bankr. LEXIS 1117 at *15. However, he disagreed with Judge Lynn about what to do if there was a timely objection. His conclusion was that an objection to 100% of fair market value was a facially valid objection and that the debtor would be required to amend his exemption to state a specific dollar amount.

He explained his reasoning as follows:

The Court will set forth its reasons for the approach it adopts. First, the Court fails to see the necessity of a hearing under the circumstances as presented. The debtors' exemption claims are limited to an interest in the property. The value of the property itself is relevant only to the extent that there is sufficient value to support the amount of the exemptible interest. If, as suggested by the Supreme Court, the debtor is trying to exempt the property in-kind rather than an interest in property, such goal may still be thwarted if, for example, the property subsequently appreciates in value. This is the very issue confronted by the Ninth Circuit in In re Gebhart, 621 F.3d 1206 (9th Cir. 2010). There the debtors made an exemption claim to the equity in their house, which amount was well within the amount they were allowed under § 522(d)(1). The trustee did not object; like the trustee in Schwab, the trustee in Gebhart had no reason to object. During the pendency of the bankruptcy case, the house appreciated in value. Two years later, after the debtors had defaulted on their mortgage payments and the mortgage company moved for stay relief, the trustee sought approval to sell the house to recover the value of the house that then well exceeded the exemption claim. The Ninth Circuit, consistent with Schwab, emphasized that the debtors' allowable exemptions did not permit the exemption of the house itself, but rather the specific dollar amount of their interest in the house.

2011 Bankr. LEXIS 1117 at *17-18. The Court went on to state

The Supreme Court in Schwab predicted such claims would likely draw objections. Claiming "100% of FMV" is the debtors' way of stating that they wish to keep the asset in-kind. While this is their desire, the Court must construe that such claim has the legal effect of claiming an interest in the property up to an amount that is determined by the fair market value of the property in-kind. Accordingly, if the trustee wishes to preserve for the estate any excess value--value over the amount of the statutory limit that may exist either at the time the exemption is claimed, as was the case in Schwab, or any excess value that may exist as a result of an anticipated appreciation in the property, as happened in Gebhart--the trustee must object to the exemption claim itself. That is precisely what has been done here. The trustees' objections are facially valid. The objections do not otherwise contest the exemption claims. The Court certainly concedes that, given the items against which the exemptions were made and the claimed values of the items in-kind, it is highly unlikely that any of the items would ever achieve a value that would exceed the statutory limit for the exemption. Regardless, the Court recognizes the trustees' right to preserve this eventuality for the estates.

2011 Bankr. LEXIS 1117 at *25-26.

Reconciling the Cases

Moore, Salazar and Dominguez-Ortega all agree that if a debtor claims 100% of fair market value and no party objects, that the debtor gets to keep the property. However, where they split is in allocating the burden of proof. Under Fed.R.Bankr. P. 4003(c), the objecting party has the burden of proof on an objection to exemptions. Moore and Dominguez-Ortega require the trustee to meet the burden of proof with evidence. On the other hand, Salazar holds that the objection should be sustained as a matter of law and that the debtor has the burden of proof to state what the value of the property is. Even then, the debtor has no security. If the value of the property increases beyond the exempt amount, the trustee may sell it out from underneath the debtor.

I have mixed feelings about these opinions. Moore and Dominguez-Ortega bring order to the force by restoring the status quo under Taylor v. Freeland & Kronz. On the other hand, Salazar is more faithful to the Supreme Court's reasoning that an exemption attaches to a dollar amount rather than the thing itself. However, that is a horrible result. It allows trustees to sleep on their rights and leave estates open in the hope that an asset may appreciate. As a practical matter, it is much better to require the trustee to put up or shut up in an evidentiary hearing. This will ensure that the trustee only objects when there is a genuine basis for doing so and gives all parties certainty in dealing with assets claimed as exempt.

Post-Script

I typically do not blog about oral rulings. I chose to do so in this case because it was a very definitive ruling from one of my local judges. However, I do want to acknowledge that all of the Texas bankruptcy judges that I appear in front of put a lot of thought and hard work into their oral rulings. In most cases, the oral rulings are equivalent in force to a written opinion, just delivered in a more informal manner. In this case, it was refreshing to hear the directness of the Court’s comments.

Finally, I apologize to Judge Robert Nelms. In his ruling, Judge Gargotta referred to rulings by Judge Michael Lynn and Judge Robert Nelms. I could only find Judge Lynn's opinion. When Judge Gargotta refers to the Fort Worth judges, he is referring to both Judge Lynn and Judge Nelms.

Central California Judges Give Lesson in Constitutional Law, Find that Legally Married Same Sex Couple Can File a Joint Petition

A decision by twenty Central California Bankruptcy Judges is likely to generate more heat than light[i] with its ruling that the Defense of Marriage Act is unconstitutional when applied to prevent a legally married same sex couple from filing a joint bankruptcy petition under 11 U.S.C. §302. In re Balas, No. 2:11-bk-17831 TD (Bankr. C.D. Cal. 6/13/11). You can find the opinion here. (PACER registration required).

A Gay Couple Walks Into a Courtroom

G. Balas and C. Morales were legally married in California. After experiencing numerous periods of illness, hospitalization and extended periods of unemployment, they filed for chapter 13 bankruptcy to attempt to restructure and repay their debts. Had they been named Jean and Carlos, there would have been no question that the legally married couple could file a joint petition. However, their names were actually Gene and Carlos, both males, married during a brief period when same sex marriage was legal in California.[ii] The U.S. Trustee filed a Motion to Dismiss unless they consented to severing their cases.

However, the debtors were up to the challenge. They were represented by well-respected California bankruptcy attorney Peter Lively. They were also represented by pro bono special counsel Robert Pfister with Ken Klee’s firm, Klee, Tuchin, Bogdanoff & Stern, LLP, who brought some star power to the case.

Joint Administration and DOMA

The general rule in bankruptcy is one debtor one case.[iii] However, under 11 U.S.C. §302(a), a single petition may be filed by “an individual that may be a debtor under such chapter and such individual’s spouse.” In 1996, the Defense of Marriage Act (DOMA) dictated that under federal law, the word spouse “refers only to a person of the opposite sex who is a husband or wife.” 1 U.S.C. §7. Reading the two statutory sections together, a joint petition could only be filed by a man and a woman who were husband and wife.[iv]

Filing a joint petition offers several advantages. For one thing, the couple pays one filing fee instead of two. In a chapter 13 case, that means a savings of $274. It also means paying one attorney’s fee instead of two. Filing a joint petition avoids difficult community property issues posed by separate filings. Under 11 U.S.C. §541(a)(2)(A), the bankruptcy estate of a debtor includes all community property under the sole, equal or joint management and control of the debtor.” That means that the first to file includes all joint community property. Additionally, a joint filing may influence the ability to confirm a chapter 13 plan. Assume two individuals, one with positive disposable income and one with negative disposable income. Together, they could confirm a plan based on their combined disposable income. Separately, one could not confirm a plan and the other would have to pay more. These are not huge differences, but they could be important in specific cases.

Prior to 2011, joint cases which did not involve a legally married man and a woman did not fare well. Courts had denied joint petition status to a man and his corporation,[v] In re Jephunneh Lawrence & Assoc. Chartered, 63 B.R. 318 (Bankr. D.C. 1986), a co-habiting but unmarried heterosexual couple, In re Malone, 50 B.R. 2 (Bankr. E. D. Mich. 1985), an unmarried same sex couple, In re Favre, 186 B.R. 769 (Bankr. N.D. Ga. 1995) and a same sex couple married in Canada, In re Kandu, 315 B.R. 123 (Bankr. W.D. Wash. 2004).

However, in 2011, two other courts held that legally married same sex couples could file joint petitions notwithstanding DOMA. In re Ziviello-Howell, No. 11-22706 (Bankr. E.D. Cal. 5/31/11); In re Somers, 2011 WL 1709839 (Bankr. S.D. N.Y. 5/4/11).

The Ninth Circuit and Constitutional Law

The Bankruptcy Court considered DOMA in the context of the equal protection clause of the Fifth Amendment and prior Ninth Circuit precedent. Under Equal Protection analysis, a distinction based on sexual orientation must survive heightened scrutiny, a standard greater than rational relationship. Under heightened scrutiny, a statute must be justified based on the reasons stated when it was passed rather than post hoc reasoning.

The Ninth Circuit had previously held that the military’s “Don’t Ask, Don’t Tell” policy violated the Constitution. Witt v. Department of Air Force, 527 F.3d 806 (9^th Cir. 2008). This ruling gave the bankruptcy court considerable support for its ruling.

The Bankruptcy Court’s Ruling

Given the court and the context, there was little suspense as to how the issue would be decided. The Court began its opinion with the following statement:

This case is about equality, regardless of gender or sexual orientation, for two people who filed for protection under Title 11 of the United States Code (Bankruptcy Code). Like many struggling families during these difficult economic times, Gene Balas and Carlos Morales (Debtors), filed a joint chapter 13 petition on February 24, 2011. Although the Debtors were legally married to each other in California on August 20, 2008, and remain married today, the United States Trustee (sometimes referred to simply as “trustee”) moved to dismiss this case pursuant to Bankruptcy Code § 1307(c) (Motion to Dismiss), asserting that the Debtors are ineligible to file a joint petition based on Bankruptcy Code § 302(a) because the Debtors are two males. The issue presented to this court is whether the Debtors, who are legally married and were living in California at the time of the filing of their joint petition, are eligible to file a “joint petition” as defined by § 302(a). As the Debtors state, “[T]he only issue in this Bankruptcy Case is whether some legally married couples are entitled to fewer rights than other legally married couples, based solely on a factor (the gender and/or sexual orientation of the parties in the union) that finds no support in the Bankruptcy Code or Rules and should be a constitutional irrelevancy.” Debtors’ Opp. 5:24–28. In this court’s judgment, no legally married couple should be entitled to fewer bankruptcy rights than any other legally married couple.

Opinion, p. 1-2.

The Bankruptcy Court did not have any difficulty finding that, in the specific context, DOMA would not survive rational relationship analysis, let alone heightened scrutiny.

The Court advanced the following analysis of the reasons advanced to support DOMA in Congress as applied to the specific case:

*Encouraging responsible procreating and child bearing. The couple did not have children and their ability to file a joint bankruptcy would not affect children in other relationships.

*Defending or nurturing the institution of traditional heterosexual marriage. Since the debtors were already married, allowing them to proceed with a joint bankruptcy would not affect anyone else’s marriage.

*Defending traditional notions of morality. The joint bankruptcy filing “is in no sense discernible to the Court to be a validly challengeable to morality, traditional, or otherwise, under the Fifth Amendment”.

*Preserving scant resources. “No governmental resources are implicated by the Debtors’ bankruptcy case different from the resources brought to bear routinely in thousands upon thousands of joint bankruptcy cases filed over the years[vi]”.

Opinion, pp. 12-13.

The Bottom Line

While the Balas case has attracted a lot of publicity, it is unlikely to have a lot of practical effect. First, it is limited to couples who are legally married. The Court did not allow unmarried same sex couples to file joint petitions. Therefore, the case is not a step toward requiring same sex marriage. Second, it is not clear whether courts outside of the Ninth Circuit would reach the same conclusion. The Ninth Circuit is the most liberal circuit. A more difficult test would be if a couple married in California were to move to Texas and file a joint petition. Third, allowing a joint bankruptcy petition, while desirable in some cases, is not a huge victory. What it means in this specific case is that two guys will have a little easier time proposing a plan to pay their creditors.

The case does have two interesting sidelights to it. First, it is unusual for bankruptcy courts to deal with the constitutionality of federal statutes. The Debtors’ counsel apparently provided a lot of very helpful briefing as shown by the many references to the Debtors’ Response in Opposition throughout the opinion. This shows that good briefing and research can be invaluable when the court is faced with a novel question. Second, it is unusual that twenty judges out of twenty-four in the district signed off on the opinion. This was Bankruptcy Judge Thomas Donovan’s case. There was no explanation given for why the other nineteen judges joined in. Sometimes, the judges of a district will sit en banc when considering an important issue. However, that does not appear to be what happened in this case. It seems to be highly unprecedented for other judges to sign on to a colleague’s decision on an ad hoc basis. Perhaps some of the judicial readers of this blog can shed some light on the issue.

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[i] The phrase originates from Hamlet, Act I, Scene 3 where Polonius gives his daughter Ophelia the following advice:

When the blood burns, how prodigal the soul

Lends the tongue vows. These blazes, daughter,

Giving more light than heat, extinct in both

Even in their promise as it is a-making,

You must not take for fire.

In judicial parlance, the phrase has come to refer to an argument with more passion than persuasiveness. See Sather, “Shakespeare for Lawyers: More Heat Than Light,” Am. Bankr. Inst. J. (March 1998). I am using the phrase in this context to refer to a decision which generates more controversy than practical effect.

[ii] According to the Opinion, there were 18,000 same sex marriages in California before the law was overturned by Proposition 8.

[iii] Not to be confused with the Texas Rangers maxim “one riot, one Ranger.” If you are confused over whether the phrase refers to the baseball team or the legendary law enforcement organization, you are not from Texas.

[iv] Theoretically, the man could be the wife and the woman could be the husband and still pass scrutiny under DOMA.

[v] While the man’s wife could have claimed that he was married to his job, this argument apparently was not raised.

[vi] This is actually not correct, since the clerk’s office is foregoing a filing fee of $274. However, if it is assumed that the filing fee is an accurate reflection of the cost of administering a case, then it would be a break even proposition.

Court Rules That Regulatory Actions Can Violate the Stay, Especially When You Say You Are Trying to Collect a Debt

An opinion from San Antonio Bankruptcy Judge Leif Clark examines when a claim against a non-debtor can violate the automatic stay. The short answer is: when the creditor says he is doing it to collect from the debtor. The long answer requires an examination of the interplay between 11 U.S.C. Sec. 362(a)(1) and 362(b)(4). In re Reyes, No. 10-52366-C (Bankr. W.D. Tex. 4/20/11). You can read the opinion here.

What Happened

The Reyes case arises from a real estate transaction gone bad. Josie Jones sued real estate broker Liza Reyes in state court and recovered a judgment. The Court succinctly described what happened next:

After the verdict was rendered, Jones and her lawyer, Robert Wilson, met with the debtor in a conference room at the courthouse. There, the debtor informed Wilson that they intended to file for bankruptcy. In response, Wilson, in the hearing of not only the debtor but also members of the debtorʼs family, told the debtor that he would “run them out of business by filing a complaint with the TREC (Texas Real Estate Commission) and close them down to get the money.” After the debtor filed for bankruptcy, Wilson, true to his word, filed a complaint in September 2010, on behalf of his client, with the TREC. The complaint took a number of months to prepare, and Wilson billed his client for the service. The TRECʼs procedures do not require a pre-investigation as a prerequisite to instituting such a complaint. Instead, the filing of the complaint itself necessitates an investigation by the Commission. If such an investigation results in a determination of wrongdoing on the part of the agent, and if a finding of damages is made, then the the TREC may make a monetary award to the complaining witness, and may subsequently seek reimbursement from the agent in the amount of the award. Wilson is well aware of these rules and procedures, this being one of his areas of practice.

Opinion, pp. 1-2.

The Debtors filed a Motion for Contempt against Jones and her attorney for violating the automatic stay by filing the Complaint with TREC. The Bankruptcy Court agreed with the Debtors and ruled that the stay had been violated.

The Automatic Stay By the Numbers

Among other things, the automatic stay prohibits:

(1) the commencement or continuation . . . of a judicial, administrative, or other action or proceeding against the debtor that was or could have been commenced before the commencement of the case under this title, or to recover a claim against the debtor that arose before the commencement of the case;

* * *

(6) any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case under this title.

It is clear that the respondents commenced an administrative proceeding that could have been commenced before the commencement of the case and that the claim against the Debtor arose before the commencement of the case. More difficult is the question of whether it was a proceeding to recover a claim against the debtor.

The Court answered this question in the affirmative, but only after an extensive discussion of whey the exception to the automatic stay of Sec. 362(b)(4) did not apply. Sec. 362(b)(4) allows

the commencement or continuation of an action or proceeding by a governmental unit . . . to enforce such governmental unit's police and regulatory power . . .

Notably, Sec. 362(b)(4) does not allow a private party to commence an action to enforce a governmental unit's police and regulatory power. Additionally, the Court found it significant that the TREC was required to act on the complaint.

Here, by contrast, the filing of a complaint that stated the requisite grounds for an investigation commences such an investigation, without any independent discretion on the part of the Commission. The TREC had no independent choice in the matter once that complaint was filed. The institution of an action that necessarily required further prosecution was not the mere discharge of a public duty, . . . .

Opinion, p. 8.

Further, the Court found that Ms. Jones, who lives in California, was unlikely to be motivated by a desire to protect Texas residents from unethical real estate brokers, and was more likely to be motivated by collection of money.

The Court ultimately found that the respondents were using the TREC as a vehicle to recover a claim against the debtor. Judge Clark stated:

The filing of this complaint is more correctly viewed as Wilsonʼs following up on his threats -- and his hope to recover his judgment from the debtor indirectly, by way of the TREC. Viewed that way, Jonesʼ initiation of this complaint, carefully crafted by Wilson, is better understood as the commencement or continuation of a proceeding against the debtor to collect on a prepetition debt, in violation of section 362(a)(1).

Opinion, p. 9.

What Does It All Mean?

Does collection of a judgment "from the debtor indirectly" violate the automatic stay? It is black letter law that the automatic stay does not protect non-debtors. Thus, absent the Sec. 1301 co-debtor stay, a creditor is free to proceed against a guarantor or other co-obligor after the debtor has filed bankruptcy. This raises the question of how the TREC is different from any other party who might be jointly or contingently liable on a debt of the debtor.

The Court stated that "(t)he TREC . . . does have the authority to compel payment from the debtors" but did not fully explain that statement. Under Texas law, a person who recovers a judgment against a license or certificate holder for a prohibited practice, may apply for payment from the Texas Real Estate Recovery Trust Account. Tex. Occ. Code Sec. 1101.612. The TREC may revoke a license "if the commission makes a payment from the real estate recovery trust account to satisfy all or part of a judgment against the license or registration holder " and that "a person is not eligible for a license or certificate until the person has repaid in full the amount paid from the account for the person, plus interest at the legal rate." Tex. Occ. Code Sec. 1101.655(a) and (c).

Thus, the Court is correct that the TREC could coerce repayment of amounts paid from the real estate recovery trust account by revoking the debtor's license until the amount was repaid. However, it is unclear that they could do so while the Debtor was in bankruptcy. Sec. 362(b)(4) allows a governmental unit to enforce a judgment "other than a money judgment." Thus, it seems likely that the TREC could not revoke the debtor's license for failure to repay the real estate recovery trust account. Further, Sec. 525(a) states that a governmental unit may not revoke a license based on failure to pay "a debt that is dischargeable in the case under this title."

Sec. 525(a) may provide the glue that holds the court's opinion together. The TREC may revoke a license for failure to pay a nondischargeable debt. The Texas Occupations Code provides that in order to recover from the real estate recovery fund "the person shall verify to the commission that the person has made a good faith effort to protect the judgment from being discharged in bankruptcy."

In this case, the respondents had filed a complaint to determine dischargeability but had not yet proceeded to trial. Had the respondents first obtained a nondischargeable judgment and then filed a complaint with TREC, there would have been no violation. The automatic stay terminates upon entry of the discharge and the discharge does not apply to nondischargeable debts. Here, the respondents jumped the gun. Rather than waiting until they had a nondischargeable judgment, they acted immediately to take actions which would have threatened the debtor's livelihood by threatening her license.

It was a matter of timing rather than a matter of absolute prohibition. It was also really foolish for the lawyer to tell the debtor in the hearing of multiple witnesses that he would "run them out of business by filing a complaint with the TREC and close them down to get the money."

Implications for Hot Check Cases

It is an open secret in Texas that County Attorneys' offices act as a collection agency for merchants who received dishonored checks. It is also quite clear that the automatic stay does not apply to "the commencement or continuation of a criminal action or proceeding against the debtor." 11 U.S.C. Sec. 362(b)(1). Therefore, it is clear that the County Attorney does not violate the automatic stay by filing hot check charges.

However, under the logic of Reyes, it is intriguing to ask whether the merchant who initiates hot check charges as a debt collection device could be held liable for violating the stay. The difference between subsections (b)(1) and (b)(4) may provide the answer. Sec. 362(b)(4) is limited to actions by governmental actions, while 362(b)(1) is not. Thus, if hot check charges are criminal actions, a private party may initiate hot check charges without violating the stay. They only way around that would be to say that hot check charges are not legitimate criminal actions at all, but are really debt collection actions in substance. Unfortunately, telling a state what it can and cannot criminalize probably runs afoul of the Constitution.