Supreme Court Sets Defalcation Bar at Gross Recklessness under Section 523(a)(4)

In the only bankruptcy case pending before it this term, a unanimous Supreme Court has ruled that the archaic term "defalcation" used in 11 U.S.C. Sec. 523(a)(4) requires 

knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior

complained of.    Bullock v. BankChampaign, No. 11-1518 (5/13/13), Slip Op., p.1, which can be found here.  While the case represents a setback for the creditor in the specific case, the judicial hairsplitting engaged in by the Court ensures that trial courts will continue to struggle with the meaning of "defalcation."

What Happened

In 1978, a father established a trust for the benefit of his five children and named his son Randy as trustee.    The trust allowed the trustee to borrow money against the asset of the trust, which was an insurance policy.    On three occasions, Randy borrowed against the policy to make loans to himself and his mother.   The first loan was made at the father's request.   All of the loans were repaid with interest.

Was the family pleased with Randy's investing?   No.   They sued him to recover his profits made on the investments.   Although they alleged that their brother "does not appear to have had a malicious motive in borrowing funds from the trust" he "was clearly involved in self-dealing."    The state court agreed and ordered Randy to repay the trust for "the benefits he received from his breaches" (along with costs and attorney's fees).     

When Randy could not pay, he filed bankruptcy.   The replacement trustee for the trust brought suit to except the debt from discharge under 11 U.S.C. Sec. 523(a)(4).   Section 523(a)(4) denies discharge for debts arising from fraud or defalcation in a fiduciary capacity, larceny and embezzlement.  The Bankruptcy Court granted summary judgment that the debt was nondischargeable based on defalcation in a fiduciary capacity.   The District Court affirmed.   The Court of Appeals affirmed as well, finding that "the conduct can be characterized as objectively reckless."    670 F.3d at 1166.

The beleaguered Randy asked the Supreme Court to consider whether "defalcation" applied "in the absence of any specific finding of ill intent or evidence of an ultimate loss of trust principal."    The Supreme Court agreed to hear the intent issue, but did not consider whether there could be defalcation in the absence of a loss of principal.   

What the Court Ruled

The Supreme Court reversed and remanded the decision of the Eleventh Circuit.   The Court held, as stated above, that defalcation required either a knowing breach of fiduciary duty or "gross recklessness" with regard to the conduct.    The Court did not get there by reading the dictionary.   After consulting an 1867 Law Dictionary, as well as more contemporary sources, the Court concluded that there was not a clear answer.   To illustrate the muddled state of the definition, the Court contrasted opinions from Augustus Hand and Learned Hand reaching differing conclusions as to whether mere negligence could constitute defalcation.   In one of my favorite passages from the opinion, the court noted that

A more modern treatise on trusts ends its discussion of the subject with a question mark.

Slip Op. at 5.   Great Scott!   If treatises are using question marks and Learned Hand disagrees with Augustus Hand, this must be a very muddled doctrine indeed!

 Instead of looking to definitions, the Court dusted off its maxims of statutory interpretation.   Using noscitur a sociis (which means "it is known from its associates"), the Court looked at the string of nondischargeable actions contained within section 523(a)(4):   fraud in a fiduciary capacity, defalcation in a fiduciary capacity and embezzlement.     Back in 1878, the Court had concluded that fraud, being associated with embezzlement, must mean "positive fraud . . . involving moral turpitude or intentional wrong, as does embezzlement."     This led Justice Breyer to declaim that "the statutory term 'defalcation' should be treated similarly."   Slip Op. at 6.    

Taking this analysis further, the court engaged in a stair-stepped equivalency analysis.   If the conduct "does not involve bad faith, moral turpitude, or other immoral conduct, the term requires an intentional wrong."   Id.  If conduct is not actually intentional, it must be its equivalent.  

We include as intentional not only conduct that the fiduciary knows is improper but also reckless conduct of the kind that the criminal law often treats as the equivalent. Thus, we include reckless  conduct of the kind set forth in the Model Penal Code. Where actual knowledge of wrongdoing is lacking, we consider conduct as equivalent if the fiduciary “consciously disregards” (or is willfully blind to) “a substantial and unjustifiable risk” that his conduct will turn out to violate a fiduciary duty.

Id.   In this context, I think that the willfully blind test would be met by a trustee who responded to an email from a Nigerian prince or who "invested" the trust funds by depositing them in his own bank account.   

Nevertheless, although defalcation thus understood was morally similar to fraud, embezzlement and larceny, it was not identical.   Embezzlement requires conversion while larceny involves taking and carrying away someone else's property.   Fraud requires a false statement or omission.    Thus, defalcation

can encompass a breach of fiduciary obligation that involves neither conversion, nor taking and carrying away another's property nor falsity.

Slip Op. at 8.  Finally, in a rather tepid endorsement of its own position, the Court noted that it had to find that the term meant something and that none of the parties had come up with a better idea.   To show that I am not making this up, I will quote Justice Breyer, who stated:

(I)t is important to have a uniform interpretation of federal law, the choices are limited, and neither the parties nor the Government has presented us with strong considerations favoring a different interpretation. In addition to those we have already discussed, the Government has pointed to the fact that in 1970 Congress rewrote the statute, eliminating the word “misappropriation” and placing the term “defalcation” (previously in a different exemption provision) alongside its present three neighbors. See Brief for United States as Amicus Curiae 16–17. The Government believes that these changes support reading “defalcation” without a scienter requirement.  But one might argue, with equal plausibility, that the changes reflect a decision to make certain that courts would read in similar ways “defalcation,” “fraud,” “embezzlement,” and “larceny.”

Id.

Having decided what the term meant, the Court vacated the Eleventh Circuit decision and sent it back to them to "permit the court to determine whether further proceedings are needed and, if so, to apply the heightened standard that we have set forth."   Id.

Thus, the Court completed its term paper on the meaning of defalcation.   But what does it mean to the bankruptcy community and to the parties in this case? 

Why The Ruling Is Good

As a matter of statutory interpretation, the Court should be commended for not simply picking a dictionary that it liked and pronouncing that the answer was clear.   Having consulted at least nine references (and two of the Brothers Hand, both the Learned one and the one who was merely Augustus) the Court realized that the various formulations were hopelessly inconsistent and they said so.   In my attempts to rely on the dictionary as legal authority, I have frequently had to concede that my preferred meaning was one of several contained within the same dictionary.    The process of judging requires more than simply opening a dictionary and pointing to a definition; it requires a thought process.   That is precisely what the court did in this case.

Next, the court required a finding of scienter.   There are five types of conduct that must be proven to be nondischargeable:   fraud under subsections (a)(2) or (a)(4), defalcation in a fiduciary capacity, embezzlement and larceny under subsection (a)(4) and willful and malicious injury under subsection  (a)(6).    Prior to this opinion, the Supreme Court had excluded "implied fraud or fraud in law" from the definition of nondischargeable fraud, Neal v. Clark, 95 U.S. 704 (1878), and had rejected negligence as the basis for willful and malicious injury, Kawaahau v. Geiger, 523 U.S. 57 (1998).   With the current ruling, the Court has raised the bar for all of the (a)(2),(4) and (6) exceptions to something much more than negligence.

To illustrate the danger of negligence based defalcation, consider the classic film, It's A Wonderful Life. When George Bailey sends Uncle Billy to the bank to make the deposit (that subsequently turns up missing causing George to contemplate suicide), there are many reasons he could be criticized as negligent:  Uncle Billy was a forgetful old man, who may have had a drinking problem and the funds were not kept in a locked and secure deposit bag.   But was it grossly reckless, that is, to say, the equivalent of an intentional breach of fiduciary duty? I don't think so.   Had this decision come out in 1946, George might not have jumped off the bridge (and a classic American film might not have been made).  

The opinion is also good because it distinguishes between creditors who deserve to be protected by having to prove a lower standard and those who should be required to establish a higher level of proof.

It is also consistent with a set of statutory exceptions that Congress normally confines to circumstances where strong, special policy considerations, such as the presence of fault, argue for preserving the debt, thereby benefiting, for example, a typically more honest creditor. See, e.g., 11 U.S.C. §§523(a)(2)(A), (a)(2)(B), (a)(6), (a)(9) (fault). See also, e.g., §§523(a)(1), (a)(7), (a)(14), (a)(14A) (taxes);§523(a)(8) (educational loans); §523(a)(15) (spousal and child support). In the absence of fault, it is difficult to find strong policy reasons favoring a broader exception here, at least in respect to those whom a scienter requirement will most likely help, namely nonprofessional trustees, perhaps administering small family trusts potentially immersed in intrafamily arguments that are difficult to evaluate in terms of comparative fault.

Slip Op. at 8.   The Court demonstrates wisdom in recognizing that family disputes can frequently turn into take no prisoners brawls where parties make ever more outrageous accusations against each other and hire ever more expensive lawyers to resolve conflicts that are more psychological than financial.   Even in a straight business dispute, it is not unusual for a party to spend many times more than the amount in dispute in attorney's fees to avenge a real or imagined wrong.   

It is not hard to imagine a wrongdoer who seeks to cover up his own large malfeasance by complaining loudly about his fellow partner's negligible misfeasance.   This is all a long-winded way of saying that requiring proof of bad intent may be a potent antidote to allowing trial by emotion and innuendo.  While it may be a lot to ask, it is at least possible that if the courts do not allow claims based on technical and insubstantial faults to prevail that at least some wrongdoers in plaintiffs' clothing may lose interest and turn elsewhere for their amusement.

Why the Ruling Is Frustrating

The Court's ruling is frustrating because it does so little to answer the dischargeability question in specific cases or even in this specific case.  In this case, the Bankruptcy Court granted summary judgment and was affirmed by the District Court and the Court of Appeals.  The Supreme Court reversed so that means that the Debtor wins, right?  Not necessarily.   Does it mean that the Debtor gets a trial?  Not even that much is certain.   Instead, the Supreme Court reversed the lower court's summary judgment with instructions to 

determine whether further proceedings are needed and, if so, to apply the heightened standard that we have set forth.

Slip Op. at 9.  What does it mean that the Court of Appeals should "determine whether further proceedings are needed"?    I read this cryptic reference to tell the Eleventh Circuit that it could remand the case to the Bankruptcy Court for a trial or it could solemnly consider the Supreme Court's "heightened standard" and reach the same result.   Given that the Plaintiffs below never alleged bad intent, it seems a given that the case should be remanded for trial or even rendered in favor of the Debtor.   However, the Supreme Court has ordered what may be a reversal in name only.  

Further, what is even more frustrating is that the Court offers very little guidance to the Eleventh Circuit in how to apply what it described as a "heightened" standard.   In its opinion, the Eleventh Circuit identified three levels of defalcation:   the Fourth, Eighth and Ninth Circuits allowed defalcation based upon mere negligence; the Fifth, Sixth and Seventh Circuits required a showing of recklessness; and the First and Second Circuits demanded extreme recklessness.   The Eleventh Circuit adopted the middle standard, that of recklessness.    The Supreme Court, on the other hand, adopted "gross recklessness" as the standard.  In its opinion, the Supreme Court hinted that it was siding with the First and Second Circuits. The high court noted that "at least some Circuits have interpreted the statute similarly for many years without administrative, or other practical difficulties" and then cited to decisions from the First and Second Circuits.   Thus, "gross recklessness" and "extreme recklessness" appear to be synonymous terms.

Rating Recklessness

So, how should courts distinguish between what is merely objectively reckless and that which is grossly or extremely recklessness?   One possibility would be to have the guy from Fast Times At Ridgemont High listen to the evidence.  If, at the conclusion of the case, he says, "dude, that's extreme," then the debtor loses.   That's probably not what Justice Breyer had in mind.   While the distinction between objective, extreme and gross negligence may seem like angels dancing on the head of a pin, a comparison  between the reasoning of the Eleventh Circuit and the Supreme Court's Kawaauhua opinion may be helpful.

In the Eleventh Circuit's opinion, the fact that the Debtor knew that he was engaged in self-dealing was enough to constitute "objective recklessness."   The Court wrote:

Applying the recklessness standard for defalcation to the facts of the instant case, this Court concludes that the bankruptcy court was correct in determining that Bullock committed a defalcation by making the three loans while he was the trustee of his father's trust. Because Bullock was the trustee  of the trust, he certainly should have known that he was engaging in self-dealing, given that he knowingly benefitted from the loans. Thus, his conduct can be characterized as objectively reckless, and as such, it rises to the level of a defalcation under § 523(a)(4). Accordingly, the bankruptcy court's order must be affirmed on the issue of whether the Illinois judgment debt was non-dischargeable under § 523(a)(4) as a debt arising from a defalcation while Bullock was acting in a fiduciary capacity.

 670 F.3d at 1166.   Thus, if the Debtor intended the act which violated the fiduciary duty, then he was objectively reckless.   However, in Kawaauhua, the Supreme Court rejected the argument that the Debtor need only have intended the act that caused the injury and instead held that the Debtor must have intended the injury.   While the standards of defalcation in a fiduciary duty and willful and malicious injury are different, the common denominator is an intent to cause the harm rather than the act that results in the harm. This equates to the language in Justice Breyer's opinion that the Debtor must have intended to breach a fiduciary duty or would have known he was breaching his fiduciary duty but for his willful blindness. 

To illustrate:

Under the Eleventh Circuit's approach, if the Debtor intended to drive his car at 70 mph in a 55 mph zone, he would be objectively reckless even if he had not seen a speed limit sign.

On the other hand, under Justice Breyer's approach, the Debtor would be grossly reckless if he saw the 55 mph sign but did not know how fast he was going because he had spray painted over the speedometer.   

The Take Away

At a minimum, we know that defalcation precedents from the Fourth, Fifth, Sixth, Seventh, Eighth, Ninth and Eleventh Circuits should be re-examined in light of the Bullock case.   The Debtor's best case will be to show that he did not know that he was breaching a fiduciary duty, while the creditor's case will be that the Debtor either actually knew he was violating a fiduciary duty or would have known had he kept his eyes open.  

Wife's Homestead Claim Remains in Limbo With No Answer From Fifth Circuit

The plight of the non-filing spouse who stands to lose an interest in the homestead is a trap that is easy to overlook.   Under 11 U.S.C. Sec. 541(a)(2), when one spouse files bankruptcy, all joint management community property enters the bankruptcy estate.    This means that if the filing spouse elects not to claim the homestead as exempt in favor of selecting other property or is subject to a cap, the non-filing spouse may lose her interest in the property without having any say in the matter.     

I have previously written about the Odes Ho Kim case here.   In the Kim case, an involuntary petition was filed against Mr. Kim.    The creditors then sought to impose a cap upon his homestead exemption.  Mrs. Kim intervened asserting that she had an independent interest in the homestead.   The Bankruptcy Court and the District Court ruled that Mr. Kim was subject to a cap on the homestead exemption and that Mrs. Kim had no separate interest in the property.    If both spouses had filed, they would have been entitled to two times the amount of the cap.   However, with Mrs. Kim sitting outside of bankruptcy, her interest in the homestead was completely divested by the bankruptcy filing.

Up until this point, the result of the case illustrated an unfair result for the non-filing spouse, but one which was based on an arguable reading of the code.    However, things got interesting after the case was appealed to the Fifth Circuit.    On September 10, 2010, Pronske & Patel and Andrews & Kurth appealed the District Court ruling on behalf of the Kims.    The case was argued to Judges Higginbotham, Owens and Haynes on July 8, 2011.   Now, almost two years have passed since oral argument without a ruling.   According to the Bar Association for the Fifth Circuit, the case is the oldest bankruptcy case still under advisement and is the second oldest case of any kind under advisement.    

While speculation about the reason for the long gestation of the opinion is not worth much, I will engage in some anyway.   Both Judges Owens and Haynes sat on Texas state benches before being named to the Fifth Circuit.   (Indeed, Judge Owens was on the Texas Supreme Court).   Texas has a long tradition of protecting homestead rights.   Additionally, according to a recent book on the history of the Texas Supreme Court (Haley,The Texas Supreme Court: A Narrative History 1836-1986, University of Texas Press 2013),  Texas also was also the first state to recognize property rights for married women.    It may be that the judges are struggling with how to reconcile these strong Texas state law protections with the Bankruptcy law applicable here.   It will be interesting to see how the case is finally resolved.

Meet Judge Tony Davis

From 1989 to 2007, Judges Larry Kelly and Frank Monroe occupied the bankruptcy bench in Austin, providing a period of judicial continuity rivaled only by their colleagues in San Antonio (Judges Leif Clark and Ronald King served at the same time from 1988 to 2012).   Effective today on April 1, the Austin bar will be welcoming its third new judge in six years as Judge Craig Gargotta moves to San Antonio and Judge Tony Davis takes the bench.   Here is an introduction to the newest jurist to oversee Austin insolvency proceedings.

Judge Tony Davis spent his time as a student and a young practitioner in three very different locales.    He received a B.A. in economics and mathematics from the University of Minnesota at Morris in 1980, was awarded a J.D. from the University of Virginia School of Law in 1983 and then was admitted to the Oklahoma bar.   He spent his early years as an associate with Conner & Winters in Tulsa before making his move to Baker Botts, LLP.    Immediately prior to taking the bench, Judge Davis was a partner in the Houston office of Baker Botts.  

 One of the most challenging cases that he worked on was the Asarco case, which involved nearly $6.5 billion (with a B) in environmental claims.    According to the Judge on that case:

Debtors' counsel, lead  by Tony Davis with Baker Botts, initiated and ultimately set in place a procedure for pre-trial, discovery, mediation and trial schedule for the estimation of the environmental claims that would have resulted in Court orders or settlements in months instead of years even if all such claims had to be estimated to a final judgment. This incredible process required Debtors' counsel to prepare for multiple-tracked sites teams of environmental and bankruptcy lawyers toward mediation, trial or settlement of each site, yet coordinated such that overlapping legal issues, overlapping facts and experts, could be efficiently implemented.

In re ASARCO, LLC, 2011 Bankr. LEXIS 2880 at *26-27 (Bankr. S. D. Tex. 2011).

Some of his other noteworthy cases include representing Ralph S. Janvey, the court appointed receiver in the Stanford International Bank, Ltd. case and representing the Russian Federation in the short-lived bankruptcy of Yukos Oil Company.  (The Yukos case involved a Russian company which moved its offices to the home of its CFO in Houston and paid a retainer to Fulbright & Jaworski to qualify for bankruptcy in the United States.   The case was dismissed after about three months).    Thus, he has experience chasing fraudsters and oligarchs and cleaning up the financial fallout from environmental claims.   

Bill Stutts, who worked with Judge Davis at Baker Botts, described his former colleague as “measured and thoughtful,” stating:

He started practice in bankruptcy in Oklahoma during the oil-patch bankruptcies of the 1980's.   He is known to be measured and thoughtful, and rarely (if ever) rash.  Responsibility and an expectation that others will be responsible can be hallmarks of his approach to the practice.  He is pretty well organized (I don't want to over-sell his work habits too soon), having even found some time during practice to write published law review articles.  I believe that he really and honestly views his upcoming service on the bench to be just that-- service. 

Mr. Stutts also characterized Judge Davis as a voracious learner and said that by the time he handles his first chapter 13 hearing, he will have studied until he knows as much as or more than anyone else in the room.

In a 2009 interview, Judge Davis stated that the Bankruptcy Code had already seen “excessive reform.”   He said:

If anything, bankruptcy law has seen excessive reform. The Bankruptcy Code, as originally enacted in 1978, has been and continues to be such a remarkably flexible and efficient way to conduct a financial restructuring under court supervision that it is the envy of the commercial world.  

Since it was enacted, however, a number of special interest groups have succeeded in carving out special interest legislation to address or protect unique issues that apply to specific industries. These numerous amendments have somewhat increased the complexity of the Bankruptcy Code but, fortunately, have not materially impaired the Bankruptcy Code’s overall effectiveness.

Law 360, Q & A with Baker Botts’ Tony Davis, which can be found here.

            When asked what advice he would give a young lawyer, he said:

Seek and take on responsibility — responsibility for understanding the facts and issues involved in the case, responsibility for advising clients, and responsibility for preparing for and conducting in-court hearings and out-of-court negotiations. Accepting and discharging responsibility is the surest way to develop the professional growth you need to be an accomplished and successful lawyer.

This is good advice for lawyers of any age.   

A Warning Against Do It Yourself Legal Forms

A debtor avoided losing her home in a recent case illustrating the perils of do it yourself legal forms.    Lowe v. Vazquez, No. SA-12-CV-00399-DAE (W.D. Tex. 3/28/13).    

The Debtor paid $10 to download a living trust form while she was living in Nevada.   When she moved to Texas, she conveyed her homestead to the trust.   Her stated reason for setting up the trust was:

 The one and only reason I created the Living Trust after my divorce was to be sure my son could have access to any assets I owned at the time I die and to avoid probate, so I named my son as Successor Trustee. Probate proceedings in Nevada are lengthy and costly and I only wanted to make things easier for him when I die.

When she filed bankruptcy in Texas, the trustee objected to her exemption on the basis that title to the home was vested in the trust.   The Bankruptcy Court denied the objection.    In re Vazquez, 2012 Bankr. LEXIS 642 (Bankr. W.D. Tex. 2012).    

On appeal, the Court found that notwithstanding some confusing language in the pre-printed form, that the Debtor was the sole beneficiary of the trust.   As the sole trustee and sole beneficiary, a valid trust had not formed as of the petition date and the property remained vested in the Debtor.

U.S. District Judge David Ezra had some insightful words for individuals who might want to save money by creating their own legal documents.

This case is a poster child for the proposition that one should not rely on prepaid legal forms with boilerplate language for important legal matters. Had Debtor passed away, it is clear to the Court that the document would not have accomplished what she hoped; indeed, all of the tax consequences she hoped to avoid would have been visited upon her son. It is also clear that a properly drafted trust prepared by a competent lawyer would have accomplished the goal she sought in the first instance.

Opinion, p. 8, n. 2.

I cannot say it any better than Judge Ezra.    If you own a Texas homestead, do not EVER convey it to a trust.   You may place your homestead exemption at risk for no good reason.    The Debtor in this case did not lose her homestead.   However, she had to defend an objection to exemption and an appeal at her own expense.
 

Disclosure:   My firm represented Karen Vazquez in the appeal.    

Fifth Circuit Issues Two Decisions Easing Path for Chapter 11 Debtors

Within the span of a few days, Judge Patrick Higginbotham of the Fifth Circuit released two decisions which will ease the way for chapter 11 debtors to confirm their plans.   In the first decision, the Court definitively put a stake through the heart of the artificial impairment doctrine, while in the second, the Court held that the Till prime + formula, while not mandatory, was becoming the "default" rule for calculating interest in chapter 11 plans.    The cases are Matter of Village at Camp Bowie I, LP, No. 12-10271 (5th Cir. 2/26/13), which can be found here, and Matter of Texas Grand Prairie Hotel Realty, LLC, No. 11-11109 (5th Cir. 3/1/13), which can be found here.

Village at Camp Bowie and Artificial Impairment

Village at Camp Bowie involved an oversecured creditor whose claim overshadowed those of other creditors.    Western Real Estate Equities held a debt of $32.1 miliion secured by property valued by the court at $34 million.    The Debtor owed $59,398 to thirty-eight (38) trade creditors.    Under the plan, the Debtor's equity holders and related parties were to infuse $1.5 million in new equity.   As a result, the Debtor had sufficient funds to simply pay off the trade creditors and leave their claims unimpaired.   This would have allowed Western to veto the plan since there would not have been another class available to accept the plan.

Western objected that the Debtor's plan had not been proposed in good faith and that the plan hadn't really been accepted by an impaired class since the impairment was "artificial."     The Bankruptcy Court confirmed the Plan over Western's objections.

The Court noted that the Eighth Circuit requires that impairment be driven by economic need, while the Ninth Circuit did not distinguish between "discretionary and artificially driven impairment."    The Court also noted that it had previously rejected the concept of artificial impairment in Matter of Sun Country, Ltd., 764 F.2d 406 (5th Cir. 1986), but that because the court concluded that the impairment in that case was economically motivated "we deprived our analysis of precedential force."    On the other hand, the court had expressed concern over potential artificial impairment in Matter of Sandy Ridge Development Corp., 881 F.2d 1346 (5th Cir. 1989).  (Parenthetically, it is interesting to note that these cases involved two individuals who went on to achieve prominence on the Texas bench.   Leif Clark was the Debtor's lawyer in Sun Country, while Wesley Steen was the bankruptcy judge for Sandy Ridge during the period in which he was a judge in Louisiana).      

Judge Higginbotham found that artificial impairment was inconsistent with the statutory language of the Code, writing:

Today, we expressly reject Windsor [the Eighth Circuit decision] and join the Ninth Circuit in holding that § 1129(a)(10) does not distinguish between discretionary and economically driven impairment. As the Windsor court itself acknowledged, § 1124 provides that “any alteration of a creditor’s rights, no matter how minor, constitutes ‘impairment.’” By shoehorning a motive inquiry and materiality requirement into § 1129(a)(10), Windsor warps the text of the Code, requiring a court to “deem” a claim unimpaired for purposes of § 1129(a)(10) even though it plainly qualifies as impaired under § 1124.   Windsor’s motive inquiry is also inconsistent with § 1123(b)(1), which provides that a plan proponent “may impair or leave unimpaired any class of claims,” and does not contain any indication that impairment must be driven by economic motives.

The Windsor court justified its strained reading of §§ 1129(a)(10) and 1124 on the ground that “Congress enacted section 1129(a)(10) . . . to provide some indicia of support [for a cramdown plan] by affected creditors,” reasoning that interpreting § 1124 literally would vitiate this congressional purpose.   But the Bankruptcy Code must be read literally, and congressional intent is relevant only when the statutory language is ambiguous.   Moreover, even if we were inclined to consider congressional intent in divining the meaning of §§ 1129(a)(10) and 1124, the scant legislative history on § 1129(a)(10) provides virtually no insight as to the provision’s intended role, and the Congress that passed § 1124 considered and rejected precisely the sort of materiality requirement that Windsor has imposed by judicial fiat.

The Windsor court also reasoned that condoning artificial impairment would “reduce [§ 1129](a)(10) to a nullity.”   But this logic sets the cart before the horse, resting on the unsupported assumption that Congress intended § 1129(a)(10) to implicitly mandate a materiality requirement and motive inquiry.   Moreover, it ignores the determinative role § 1129(a)(10) plays in the typical single-asset bankruptcy, in which the debtor has negative equity and the secured creditor receives a deficiency claim that allows it to control the vote of the unsecured class.   In such circumstances, secured creditors routinely invoke § 1129(a)(10) to block a cramdown, aided rather than impeded by the Code’s broad definition of impairment.

Opinion, pp. 8-10.

While the passage quoted above is rather long, I have quoted it in its entirety because I find its statutory analysis to be spot-on.  There is no need to make things more complicated by delving into the meaning of a provision when the words used are clear.   Congress set the bar for determining impairment quite low.  Thus, when Congress required acceptance by an impaired class, it similarly set an easily met standard.  (Note: when Judge Higginbotham speaks of judicial fiat, I can't help but think of a small Italian car filled with black-robed judges).

The Court also rejected the argument that Matter of Greystone III Joint Venture, 995 F.2d 1274 (5th Cir. 1991) embodied a "broad, extrastatutory policy against 'voting manipulation.'"   He stated:

Greystone does not stand for the proposition that a court can ride roughshod over affirmative language in the Bankruptcy Code to enforce some Platonic ideal of a fair voting process.    

Opinion, p. 11.    While it is comforting to see Greystone limited to its actual holding, you also have to admire a judge who can work "Platonic ideal" into a bankruptcy opinion.   (According to Wikipedia, Platonic idealism refers to universals or abstract objects.  Thus, a Platonic ideal of voting would mean voting according to abstract, universal principles.)

Nevertheless, the Court did point out that good faith was still a relevant inquiry.

We emphasize, however, that our decision today does not circumscribe the factors bankruptcy courts may consider in evaluating a plan proponent’s good faith. In particular, though we reject the concept of artificial impairment as developed in Windsor, we do not suggest that a debtor’s methods for achieving literal compliance with § 1129(a)(10) enjoy a free pass from scrutiny under § 1129(a)(3). It bears mentioning that Western here concedes that the trade creditors are independent third parties who extended pre-petition credit to the Village in the ordinary course of business. An inference of bad faith might be stronger where a debtor creates an impaired accepting class out of whole cloth by incurring a debt with a related party, particularly if there is evidence that the lending transaction is a sham.  Ultimately, the § 1129(a)(3) inquiry is factspecific, fully empowering the bankruptcy courts to deal with chicanery. We will continue to accord deference to their determinations.

Opinion, pp. 12-13.

Texas Grand Prairie and Cram-Down Interest Rates

In the second case, the Court affirmed a bankruptcy court ruling which confirmed a chapter 11 plan which using a 5% cram-down rate of interest under the Till decision.   In Grand Prairie, the parties agreed that the Till decision provided the appropriate method for calculating a chapter 11 cram-down interest rate.   The Debtor's expert, faithfully following the Till approach, concluded that prime + a risk factor of 1.75% was appropriate, so that the indicated interest rate was 5.0%.   Even though the lender stipulated that Till was the correct approach, its expert did not follow its methodology.  Instead, he opined that the proper rate was 8.8% by "taking the weighted average of the interest rates the market would charge for a multi-tiered exit financing package" and then adjusting for risk factors.  The Court adopted the 5.0% rate which had the effect of costing the lender $1,485,000 in interest per year based on the appraised value of $39,080,000.

On appeal, Wells Fargo sought to exclude the Debtor's expert testimony on the basis that his "purely subjective approach to interest-rate setting" violated the Supreme Court's call for an "objective inquiry" in Till.   The Court wisely observed that:

Here, Wells Fargo does not challenge Robichaux’s factual findings, calculations, or financial projections, but rather argues that Robichaux’s analysis as a whole rested on a flawed understanding of Till. As we read it, Wells Fargo’s Daubert motion is indistinguishable from its argument on the merits. It follows that the bankruptcy judge reasonably deferred Wells Fargo’s Daubert argument to the confirmation hearing instead of deciding it before the hearing.  We pursue the same path and proceed to the merits.

Opinion, p. 7. 

Next, the Court addressed the proper legal standard for calculating an interest rate under section 1129(b).   The court ultimately concluded that the Till decision was not binding on the court because:

•  Till was a plurality opinion; and

• Till expressly left open the issue of interest rates in chapter 11 in footnote 14.

As a result, the Court found that its prior decision in In re T-H New Orleans Partnership, 116 F.3d 790 (5th Cir. 1997) remained binding.   T-H New Orleans held that the Court would not "establish a particular formula for determining an appropriate cramdown interest rate," but would review the Bankruptcy Court's decision for "clear error."   Having concluded that the Till formula was not mandatory, the Court nevertheless found that it was becoming the majority approach.

In spite of Justice Scalia’s warning, the vast majority of bankruptcy courts have taken the Till plurality’s invitation to apply the prime-plus formula under Chapter 11. While courts often acknowledge that Till’s Footnote 14 appears to endorse a “market rate” approach under Chapter 11 if an “efficient market” for a loan substantially identical to the cramdown loan exists, courts almost invariably conclude that such markets are absent.   Among the courts that follow Till’s formula method in the Chapter 11 context, “risk adjustment” calculations have generally hewed to the plurality’s suggested range of 1% to 3%.   Within that range, courts typically select a rate on the basis of a holistic assessment of the risk of the debtor’s default on its restructured obligations, evaluating factors including the quality of the debtor’s management, the commitment of the debtor’s owners, the health and future prospects of the debtor’s business, the quality of the lender’s collateral, and the feasibility and duration of the plan.

 Opinion, pp. 14-15.

 
Under the Fifth Circuit's deferential clear error analysis, a bankruptcy court which followed the majority approach could not be faulted, even if the court could have found another approach more persuasive.   

The Court found that the Debtor's expert properly followed the Till approach.  

We agree with the bankruptcy court that Robichaux’s § 1129(b) cramdown rate determination rests on an uncontroversial application of the Till plurality’s formula method. As the plurality instructed, Robichaux engaged in a holistic evaluation of the Debtors, concluding that the quality of the bankruptcy estate was sterling, that the Debtors’ revenues were exceeding projections, that Wells Fargo’s collateral — primarily real estate — was liquid and stable or appreciating in value, and that the reorganization plan would be tight but feasible. On the basis of these findings — which were all independently verified by Ferrell — Robichaux assessed a risk adjustment of 1.75% over prime. This risk adjustment falls squarely within the range of adjustments other bankruptcy courts have assessed in similar circumstances.

Opinion, p. 18.

Finally, the Court rejected Wells Fargo's argument that the path taken by the Debtor's expert produces "absurd results."

Wells Fargo complains that Robichaux’s analysis produces “absurd results,” pointing to the undisputed fact that on the date of plan confirmation, the market was charging rates in excess of 5% on smaller, over-collateralized loans to comparable hotel owners. While Wells Fargo is undoubtedly correct that no willing lender would have extended credit on the terms it was forced to accept under the § 1129(b) cramdown plan, this “absurd result” is the natural consequence of the prime-plus method, which sacrifices market realities in favor of simple and feasible bankruptcy reorganizations.   Stated differently, while it may be “impossible to view” Robichaux’s 1.75% risk adjustment as “anything other than a smallish number picked out of a hat,” the Till plurality’s formula approach — not Justice Scalia’s dissent — has become the default rule in Chapter 11 bankruptcies.  (emphasis added).

Opinion, p. 19.    Thus, the Court is not required to apply Till, but if it does, it is not error to pick a "smallish number" out of a hat.

Final Thoughts

These two opinions, while both affirming confirmation of chapter 11 plans, take very different approaches to judging.    Village at Camp Bowie is very much a straightforward application of statutory analysis.    While I thought that Sun Country's statement that:

Congress made the cram down available to debtors; use of it to carry out a reorganization cannot be bad faith.

effectively killed the doctrine of artificial impairment, it is nonetheless heartening to see a judge put the final nail in the coffin.     Just as I noted in my prior post about Spillman Development Group, this is a case of a judge rejecting magical thinking.   In this case, the magical thinking was that Greystone III Joint Venture can be cited in talismanic fashion for the proposition that the secured creditor automatically gets a veto.

Texas Grand Prairie is a much more subversive opinion.   While ostensibly following T-H New Orleans' no formula approach, the court gave the green light to bankruptcy courts to follow the Till plurality's prime + approach, referring to it as the majority approach and the default rule.   On the other hand, the Court left bankruptcy courts free to reject Till as well.   If anything, this decision gives broad discretion to the factfinder, something that has been noticeably lacking since the adoption of BAPCPA. 

Finally, Texas Grand Prairie may spell the death of expert interest rate testimony in chapter 11 cases.   If the Debtor's expert can pull a "smallish number" out of a hat, why can't the Debtor's attorney do so without the intervention of an expert witness?   The irony of Wells Fargo's Daubert argument is that it probably was right, but not for the reason that Wells Fargo thought.   The logical extension of Till is that the fact-finder does not require "scientific, technical or other specialized knowledge . . . to understand the evidence or determine a fact in issue" as required by Fed.R.Evid. 702 so that neither side should have been allowed to tender an expert witness.   This case will probably not preclude courts from considering experts pontificating on interest rates, but it frees up the court to take it or trash it.


Post-script:   While Judge Higginbotham may not receive as much recognition as a scholar of bankruptcy law as some of his colleagues, it is worth noting that he has now authored about 50 bankruptcy opinions, which is more than some bankruptcy judges.   In addition to the opinions discussed in this post, some of his other influential opinions include Wells Fargo Bank, N.A. v. Stewart, 647 F.3d 553 (5th Cir. 2011); Milligan v. Trautman, 496 F.3d 366 (5th Cir. 2007); Supreme Beef Processors, Inc. v. USDA, 275 F.3d 432 (5th Cir. 2001); Krafsur v. Scurlock Petroleum Corp., 171 F.3d 249 (5th Cir. 1999); Miller v. J.D. Abrams, Inc., 156 F.3d 598 (5th Cir. 1998); In re Clay, 35 F.3d 190 (5th Cir. 1994); and In re Howard, 972 F.2d 639 (5th Cir. 1992).   In my view, this is sufficient to earn him a place among the leading bankruptcy lights on the court.