Bankruptcy Bulletin - June 2015

QUARTERLY UPDATE

BANKRUPTCY SEMINAR REGISTRATION COMING SOON!

The 2015 NAAG/NAGTRI/SABA Bankruptcy for the Governmental Practitioner Seminar is coming up soon. We will be gathering in Seattle from October 4-7 at the Crowne Plaza Hotel. Online registration will open by June 30 on the NAAG website. An announcement with more details along with a draft agenda is being sent in a separate document. We hope to see you all there!

SUPREME COURT CASES[1]

Baker Botts L.L.P. v. Asarco LLC, 14-103, 2015 U.S. LEXIS ____ (6/15/15).

Holding: Debtor’s attorneys may not be compensated for costs of defending fee applications.

The attorneys in this case performed excellent services and obtained a huge, fraudulent transfer verdict that allowed all creditors in the case to be paid in full. Unfortunately, by the time they submitted their final fee applications, the debtor was now controlled by its former parent – which was the entity against which the fraudulent transfer verdict was entered. That parent engaged in a strenuous attack against the fees, all of which challenges were eventually denied. The attorneys sought to have their costs in defending their fees also be compensated, but the Supreme Court (6-3, Breyer, Ginsburg, and Kagan dissenting) held that there was no basis in Section 330 to depart from the “American Rule” which leaves each litigant to bear its own attorneys fees. The Code provides for the debtor to pay for actual services rendered but litigating over whether it must pay additional amounts cannot be seen as a service to it. Moreover, Section 330 explicitly deals with fees for preparing the applications but not for defending them. While in this case, the result adversely affected a clearly meritorious fee applicant, the opposite ruling, the Court held, could allow even an unsuccessful applicant for additional fees to demand compensation.

Bank of America, N.A. v. Caulkett, 13-1421, 14-163, 2015 U.S. LEXIS 3579 (6/1/15).

Holding: Debtors may not “strip off” wholly unsecured liens in Chapter 7; there is no reasonable basis to distinguish “strip down” from “strip off” in applying Dewsnup v. Timm, 502 U.S. 410 (1992), which the Court was not asked to reexamine.

Section 506(a) of the Code provides that an “allowed claim” is a “secured claim” to the extent that asset value exists to support the security interest and is an unsecured claim if the asset value is insufficient. Section 506(d) provides that “to the extent that a lien secures a claim that is not an “allowed secured claim,” the lien is void. One way of reading those two provisions would allow the partial “strip down” of a lien to the existing value of the property on the petition date. Thus, if a property was originally valued at $500,000 and a $400,000 mortgage was issued, the lender has a fully secured claim under Section 506(a) that would be protected under Section 506(d). If the property value declined, though, so it is now worth only $300,000, the lender would have a secured claim for $300,000, the lien would be “stripped down” to that value, and any remaining amount left on the mortgage would be an unsecured claim that could be discharged.

The net result would be that the Chapter debtor would retain any increase in the value of the property after the petition date, without any requirement to make any further payments on the loan as would be the case if the debtor had filed in Chapter 13. That Chapter explicitly bars “modification” of first mortgage loans on primary residences which the Supreme Court had held means that the liens cannot be removed by the Plan. Under this reading, at least for that category of loans, the debtor would be better off by filing in Chapter 7, despite providing less to his creditors. For that reason, to avoid giving the debtor a windfall by allowing a strategic bankruptcy filing when property values are temporarily depressed, and to avoid making a major change from prior law without clear direction from Congress, the ourt in an earlier case, Dewsnup v. Timm, 502 U.S. 410 (1992), the Court adopted a different reading of the interaction of the two sections. It concluded that, “if a claim has been ‘allowed’ pursuant to §502 of the Code and is secured by a lien with recourse to the underlying collateral, it does not come within the scope of §506(d).” Thus, the function of “§506(d) was to “void[] a lien whenever a claim secured by the lien has not been allowed,” not to serve as a basis for strip down. Thus, in construing the meaning of the combined term “allowed secured claim,” the Court focused on the issue of “allowance,” not on the question of the extent of the “security” underlying that claim.

There has been much criticism of that approach but Congress has made two major rewrites of the Code since then, in 1994 and 2005, without touching that provision. And, certainly, for all of the policy considerations asserted by those favoring a more debtor-friendly view, there are other, also compelling considerations against allowing an overly easy strip down of a lien. The issue in this case dealt with the next issue – if Dewsnup does not allow a strip down of an undersecured lien, does it allow a “strip off” of a wholly unsecured second lien. This is a more difficult question – if one looks at the provisions in Chapter 13, it turns out that the language in that chapter does allow courts to make that distinction – a partially secured lien may not be modified, but if a lien is wholly unsecured, it may be stripped off. So, would the same distinction apply in Chapter 11?

Most courts tended to read Dewsnup as a broad bar on any such changes, but the Eleventh Circuit took a different approach. When the issue came up, it looked to its pre-Dewsnup case law which had allowed a strip off, found that Dewsnup did not literally cover the situation and held that it was bound to follow existing Circuit precedent in that situation. Accordingly, it held, “strip down” was allowed.

The Court granted certiorari on that issue and unanimously reversed. While the result was clear, the approach to that result was unusual. The opinion by Justice Thomas recites in a cursory and somewhat unpersuasive fashion the underlying analysis in Dewsnup but goes out of its way to emphasize the criticism of Dewsnup, to the point of including a pointed footnote noting those contrary analyses. Justices Kennedy, Breyer, and Sotomayor, though, equally pointedly, refused to join that footnote. The opinion states, though, that in Dewsnup the Court “adopted a construction of the term ‘secured claim’ in §506(d) that forecloses the argument that Section §506(a) dictates how the lien is treated in §506(d). It then held that “Dewsnup’s construction of ‘secured claim’ resolves the question presented here.

The apparently crucial factor was that the petitioners, as a tactical matter, had decided not to ask the Court to overrule Dewsnup, but only to distinguish it. The Court rejected their arguments for limiting Dewsnup and concluded that, if Dewsnup remained good law, there was no basis for the artificial limitation the petitioners argued for. The resulting opinion is distinctly odd – it reads as if there was real sentiment for overruling Dewsnup but the Court did not take that step because the petitioners hadn’t asked for it – yet, amicus briefs had certainly made the argument and the Court has not necessarily been shy about reaching out to decide an issue if it truly felt reversal was warranted. Another party might be encouraged from the language to try to bring the issue back to the court and make the direct request but, if the Court did not take his opportunity and in the absence of any basis for a new circuit split, it’s difficult to see how such a case would arrive at the Court. What seems more likely is that the majority of the Court did not want to overrule Dewsnup, but were willing to give Justice Thomas his head in writing the opinion in order to allow for a unanimous decision.

Wellness Int’l Network, Ltd. v. Sharif, 13-935, 2015 U.S. LEXIS 3203 (5/26/15).

Holding: Consent is a valid basis for allowing bankruptcy courts – like magistrate judges – to decide issues that are otherwise reserved for adjudication only by district judges appointed under Article III of the Constitution, so long as there is an adequate supervisory role maintained for the district courts. Moreover, such consent need not be manifested by an express written or oral statement but may be demonstrated impliedly.

In the 1978 Bankruptcy Code, in reaction to issues arising under the prior law, which limited bankruptcy courts to hearing only certain aspects of the case, Congress expanded the role of bankruptcy judges by granting them most of the “powers of a court of equity, law, and admiralty.” It did so, even though it refused to make Article III judges so they did not have the same degree of judicial independence derived from a lifetime appointment. In Northern Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982), the Court held that Congress had given those judges too much power by allowing them to resolve “certain claims for which litigants are constitutionally entitled to an Article III adjudication.” Congress responded by amending the bankruptcy laws in 1984 so that a bankruptcy court could decide “core proceedings” (matters as to which litigants would not be entitled to an Article III adjudication) but could only issue reports and recommendations on “non-core proceedings” for de novo review by the district court.

In the 1984 amendments (28 U.S.C. § 157), Congress established a non-exclusive list of 16 “core” proceedings, including any “counter claim by the debtor” to any claim filed by a creditor – even if there was no other relationship between those two causes of action. In Stern v. Marshall, 131 S. Ct. 2594 (2011), the Court held that Congress had still given the bankruptcy judges too much power by not requiring a closer nexus between the creditor’s claim and the debtor’s counterclaim. Such unrelated counterclaims had to be treated as akin to “related to” claims that could not be finally adjudicated by the bankruptcy court. In this follow-up case, the issue was whether such claims could, nonetheless, be finally adjudicated by the bankruptcy court if the parties consented thereto.

It would hardly seem this was a difficult issue in that bankruptcy courts have, since 1978, been allowed to decide non-core, “related to” issues with the consent of the parties. Similarly, outside of bankruptcy, Article I Magistrate Judges have been given broad powers to decide issues with the parties’ consent. Nevertheless, this question caused serious concerns for a number of courts, based on language in some prior opinions that noted that the Article III powers issue was a Separation of Powers question that could not be resolved simply by the parties’ consent. As a result, least two circuits, including the Seventh Circuit here, had held that consent was not enough and these “Stern claims” could never be decided by a bankruptcy judge.

The Court rejected that view though, on a 6-3 vote in an opinion by Justice Sotomayor, holding that “Article III is not violated when the parties knowingly and voluntarily consent to adjudication by a bankruptcy judge.” The Court did not decide whether the issue here was a “Stern claim” that only an Article III court may resolve. Instead, it went to the ultimate issue, and concluded that, even for such claim, the bankruptcy court could proceed with consent.

The Court stated that its “precedents make clear that litigants may validly consent to adjudication by bankruptcy courts” noting that “non-Article III referees, masters, or arbitrators” had been used since “the early years of the Republic.” It then explained that Commodity Futures Trading Comm’n v. Schor, 478 U.S. 833 (1986), which raised the “structural issue” concern, did not dictate a contrary result since there was “at most a ‘de minimis’ infringement on the prerogative of the federal courts” by use of an agency adjudicatory process. Similarly, the Court had held in Peretz v. United States, 501 U.S. 923 (1991) that a federal magistrate judge may preside over jury selection if the defendant consents—because the process takes place under the district court’s control. Thus, “allowing Article I adjudicators to decide claims submitted to them by consent does not offend the separation of powers so long as Article III courts retain supervisory authority over the process.” Keeping in mind that separation-of-powers issues “must be decided . . . ‘with an eye to the practical effect,’” the Court found “that allowing bankruptcy litigants to waive the right to Article III adjudication of Stern claims does not usurp the constitutional prerogative of Article III courts.”

Finally, the Court held that a party can implicitly consent to adjudication by a bankruptcy court, relying on Roell v. Withrow, 538 U.S. 580 (2003), where it had held that a party can consent to proceedings before a magistrate judge based on “actions rather than words.” The Court ruled that “the key inquiry is whether ‘the litigant or counsel was made aware of the need for consent and the right to refuse it, and still voluntarily appeared to try the case’ before the non-Article III judge.” Justice Alito filed a short opinion concurring in part and concurring in the judgment. He stated that the “Court faithfully applies [Schor]” and “[w]hatever one thinks of Schor, it is still the law of this Court, and the parties do not ask us to revisit it.” He would not have decided, however, “whether consent may be implied.”

Chief Justice Roberts, Scalia, and Thomas dissented. Chief Justice Robert’s opinion first argued that it would have been wiser to decide the case on the narrow ground that the issue was not a Stern claim at all. He and Justice Scalia then argued that the majority gave too little weight to the structural concerns and that consent could not cure those issues. He distinguished magistrate judges saying that they merely issue reports and recommendations that are reviewed de novo by Article III judges (which is not actually correct); and distinguished arbitration as “a matter of contract.” Justice Thomas issued his own lengthy ruminating dissent indicating that a number of additional questions needed to be considered by the Court before any answer should be given.

Perhaps most interesting is that the final result of these cases is to establish very much the same division of decisional authority that existed prior to 1978, with the difference being that bankruptcy courts could not hear those cases at all then, whereas now, they hear them but only issue non-binding results, which is a far less disruptive process.

Harris v. Viegelahn, 14-400, 135 S.Ct. 1829 (5/18/15).

Holding: Payments made by a Chapter 13 debtor to his case trustee that have not yet been distributed to the creditors must be returned by the trustee to the debtor upon conversion of the case, not paid out to creditors that would have otherwise received them.

The Court unanimously held that a debtor who files bankruptcy under Chapter 13 but then exercises his right to convert to Chapter 7 is entitled to the return of any postpetition wages not yet distributed by the Chapter 13 trustee. A Chapter 13 trustee is responsible for collecting a portion of the debtor’s postpetition wages and distributing them to creditors according to the plan. Petitioner Charles Harris confirmed a plan that provided for the trustee to make payments on his home mortgage arrears. However, after Harris fell behind on making his regular mortgage payments, the lender was allowed to foreclose. Thereafter, Harris continued to make his plan payments but the Chapter 13 trustee stopped making payments to the mortgage lender. The payments simply accumulated with the Chapter 13 trustee for over a year until Harris chose to convert his case to Chapter 7. It was only at that point that the trustee (apparently without seeking further authority from the court) paid some of that amount to Harris’ counsel, paid her own fees, and distributed the rest to other secured and unsecured creditors in the case.

Harris asked the bankruptcy court to order the trustee to reimburse him for those funds on the basis that she lacked authority to dispose of them once the case was converted to Chapter 7. While the bankruptcy and district courts sided with Harris, the Fifth Circuit reversed, holding that the trustee was obligated to distribute the funds. The Supreme Court reversed the Fifth Circuit. The Court relied heavily on §348 of the Bankruptcy Code, which provides that, except for bad-faith conversions, a debtor’s postpetition earnings and acquisitions do not become part of the Chapter 7 estate when a case is converted from Chapter 13. Instead, the Chapter 7 estate consists only “of the property of the estate, as of the date of the [initial Chapter 13] petition, that remains in the possession of or is under the control of the debtor on the date of conversion.” Thus, this section bars postpetition earnings from becoming part of the pool of assets to be transferred in the converted case (although they are property of the estate in Chapter 13).

While this does not precisely answer the question of what happens with those funds if they are not transferred to the Chapter 7 estate, the Court concluded that allowing the “Chapter 13 trustee to distribute the very same earnings to the very same creditors is incompatible with the statutory design.” Although the statute is not specific, “the most sensible reading of what Congress did provide” is that “accumulated wages go to the debtor,” “particularly when the trustee proposes to distribute funds post-conversion after her services have been terminated. That distribution of funds is not part of the trustee’s obligation to “wind-up” the affairs of the Chapter 13 estate following conversion because it is not among the authorized “wind-up” tasks.

The Court next found that the Fifth Circuit’s concern about debtors receiving a “windfall” was unfounded because any accumulated postpetition earnings would have been kept by a debtor who filed under Chapter 7 in the first place. Finally, the Court acknowledged the “fortuity” that a debtor’s chance of having funds returned depends on the frequency with which a trustee distributes those funds. But the Court saw this situation as simply a product of the statutory scheme, which shields postpetition wages from creditors in a converted Chapter 7 case, and permits Chapter 13 debtors to convert to Chapter 7 “at any time.”

In the long run, this case will probably not have a large practical effect since the problem can be avoided by trustees being more diligent about making interim distributions and/or modifying the amounts and payees if the party initially receiving funds drops out of the picture. There was no apparent reason why the trustee could not have made the same payments prior to the debtor’s conversion of the case during the year the payments were building up in her account. Indeed, the Code clearly intends that payments go out as expeditiously as possible: Section 1326(a)(1) requires a debtor to start making payments to the trustee even before a plan is confirmed and Section 1326(a)(2) requires that the trustee is to distribute those funds received as soon as practicable after confirmation. Thus, there is little reason for a trustee to have large sums held back at any given time.

Bullard v. Blue Hills Bank, 14-116, 135 S.Ct. 1686 (5/4/15).

Holding: A bankruptcy court’s order denying confirmation of a proposed repayment plan is not a “final” order that can be appealed as of right.

Chapter 13 debtors must propose a payment plan that meets the requirements of Section 1325(a). If the bankruptcy court denies confirmation, the debtor is usually given an opportunity to submit a revised plan. The issue in this case is what is the debtor’s remedy if it disagrees with the bankruptcy court’s assessment as to what the Code requires its plan to contain. The debtor here, for instance, proposed a treatment of the lender’s secured claim on his home that the bankruptcy court held was not allowed under the Code. After his plan was denied confirmation, the debtor appealed to the First Circuit BAP. It refused to allow the appeal as a matter of right because parties can only appeal “final” orders of and the order denying confirmation was not final (since he could propose a new plan). It did agree, though, to accept a discretionary appeal under 28 U.S.C. §158(a)(3) but agreed with the bankruptcy court that his plan violated the Code. The First Circuit then dismissed his further appeal for lack of jurisdiction, holding that an order denying confirmation is not final if the debtor remains free to propose another plan. The Court unanimously affirmed.

While in ordinary litigation a party may only appeal, as a matter of right, final decisions that dispose of the entire case, bankruptcy is somewhat unusual because it involves many separate decisions (on matters such as claims objections, avoidance actions, etc.). However while 28 U.S.C. §158(a) allows appeals of “separate proceedings,” the Court rejected the debtor’s argument that each review of a plan is a “separate “proceeding, finding instead that the entire process of considering plans was the proceeding. Only plan confirmation, or dismissal of the case, “alters the status quo and fixes the rights and obligations of the parties;” denial of a plan leaves the parties’ rights largely intact.

The Court explained that there remain “several mechanisms for interlocutory review” in cases like this one. First, a district court or BAP can grant leave to hear an appeal, 28 U.S.C. §158(a)(3) (as occurred here), and a debtor who loses in district court can seek certification to the court of appeals under 28 U.S.C. §1292(b). In addition, §158(d)(2) allows a bankruptcy court, district court, BAP, or the parties acting jointly to certify a bankruptcy court’s order to the court of appeals, which would then have discretion to hear the matter. Although these interlocutory avenues will not provide relief in every case, they are “useful safety valves.” The Court concluded by stating its “expectation” that lowers courts will certify and accept interlocutory appeals from plan denials “in appropriate cases.”

SELECTED LOWER COURT CASE HOLDINGS:

In the Matter of Ritz (Husky International Electronics, Inc. v. Ritz), 2015 U.S. Appl. LEXIS 8584 (5th Cir. 5/22/15). False representation is required to show Section 523(a)(2) “actual fraud.”

Although Section 523(a)(2) refers to obtaining funds by “false pretenses, a false representation, or actual fraud,” the Circuit Court concluded that “actual fraud” under this section could not be shown unless a false statement/representation were made by the debtor. It rejected the view of McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000), which held that, in light of the fact that the statute explicitly referred to “actual fraud” as well as “false representation,” the use of the former must be meant to include something more – specifically, fraudulent transfers where actual intent to defraud was shown. The Fifth Circuit rejected that view, based largely on the fact that courts (including the Supreme Court) had normally defined “actual fraud” by including a misrepresentation as one of the factors – although those cases rarely if ever looked at the issue here. The Fifth Circuit did hold that it was not necessary to include fraudulent transfer debts in Section 523 because they were separately covered in the objections to discharge language in Section 727 – although one would assume that most debtors would prefer to have a single debt denied discharge than to lose his entire discharge. And, from the creditor’s side, Section 727 is of limited value since the transfer had to have taken place within one year of the petition date, which could exclude many debts that would otherwise be covered by Section 523.

In re Jevic Holding Corp. (Official Committee of Unsecured Creditors v. CIT Group/Business Credit, Inc.), 2015 U.S. App. LEXIS (3rd Cir. 5/21/15). “Structured dismissals” can be allowed.

Section 349 provides that dismissal of a case normally “resets” the parties’ relationships as if the bankruptcy had not occurred, unless “the court orders otherwise.” The Third Circuit held there that, where there were good justifications, a debtor could agree with other parties in the case on a settlement that would benefit some unsecured creditors, while leaving one group (employees with a potential “WARN Act” claim wholly uncompensated. The payments came from settlement agreements with certain defendants who agreed to pay the funds but only if none went to the employees (so they could not use such payments to fund the WARN Act litigation against those defendants). The Third Circuit held that it could first analyze whether the settlement was fair and reasonable (without being bound by the absolute priority rule that only applied to plan confirmation) and then, after approving the settlement and disbursing all of the estate funds, could then allow the case to be dismissed. In the court’s view, since the funds provided by the settlement were above the estate funds (which were fully secured and not available for unsecured creditors), approving its terms was the only way to provide something to some creditors, and, if that left others out entirely, they were no worse off than if no settlement had been taken. The majority viewed this as the “least bad” alternative; a dissent would have denied acceptance of such a settlement with the expectation that the parties would have come to a different deal. This is the first decision to squarely approve this sort of “structured dismissal” as a full substitute for a plan; although stated to be a rare occurrence, this is likely to engender many copycats.

In re Schupbach (Bank of Commerce & Trust Co. v. Schupbach), 2015 U.S. App. LEXIS 8192 (10th Cir. 5/19/15). Plan statement that claim is fully satisfied by transfer of collateral controls.

Where the debtors transferred the lender’s collateral to it in the corporate case with the notation that the transfer more than satisfied the claims, and where the debtors’ referenced that treatment in their individual plan and gave the lender a chance to object and claim a different value for its claim, that plan treatment controlled and mooted the lender’s pending dischargeability complaint.

In re Pajian, 2015 U.S. App. LEXIS 7763 (7th Cir. 5/11/15). Secured creditor must file proof of claim by 90-day deadline in Rule 3002(c).

Although Rule 3002(a) only requires unsecured creditors to file a proof of claim in order to be paid under the plan, Rule 3002(c) does not differentiate between secured and unsecured creditors and sets a 90-day deadline for any proof of claim. To the extent a secured creditor files a proof of claim and seeks to be paid under the plan, it must meet the same 90-day deadline as unsecured claimants. The Court of Appeals noted that that Bankruptcy Rules Committee was proposing that Rule 3002 be changed to clarify that this was the correct reading.

In the Matter of Cantu (Cantu v. Schmidt), 784 F.3d 253 (5th Cir. 2015). When does claim accrue for purposes of becoming “property of the estate.”

Section 105(5) defines a claim very broadly for purposes of determining if the matter is one that can be discharged in the case. Courts often use a test that looks to not only when did the debtor’s culpable conduct occur, but also when did that conduct have any effect on the creditor. That test is used to balance the goal of bringing as many claims as possible into the case to protect the debtor’s “fresh start” with the need for due process for the creditor. No similar balancing is needed with respect to claims asserted by the debtor that will become property of the estate. For those claims, the issue turns on the normal accrual standard, which requires a showing that the estate has been harmed prepetition in order to make a claim for compensation property of the estate. In this case, where debtor’s counsel had been incompetent during the Chapter 11 case, it was appropriate to find the harm had accrued prior to conversion to Chapter 7 and, thus, was property of the Chapter 11 estate. As a result, any payments made by the attorney would be used to satisfy estate creditors, not paid over to the debtors.

In re Jenkins (Jenkins v. Simpson), 784 F.3d 230 (4th Cir. 2015). Ending Section 341 meeting.

While courts had differed over what formalities a trustee had to take to continue or end a Section 341 meeting, the court here held that, where the trustee failed to follow any of the provisions of Rule 2003(e) (as amended in 2011), the meeting concluded when it ended on the date it was held. The trustee stated that he did not intend to conclude it then but he neither stated a date to which the meeting would be adjourned, nor did he later file a statement setting such a date, nor did he ever hold another meeting. Thus, despite his intentions, the Court of Appeals held, the meeting was never effectively continued and the time limit for filing the discharge complaint ran from the date that the meeting ended. The Rule was meant to give relatively clear guidance so the parties did not need to continue litigating the issue as the Trustee argued for here. Thus, while the court did leave room for “substantial compliance,” i.e. promptly filing the written notice without announcing the date at the meeting or vice versa, none of that occurred here.

In the Matter of Woerner (Barron & Newburger v. Texas Skyline, Ltd.), 783 F.3d 266 (5th Cir. 2015) (en banc). Standard for granting attorneys fees.

At long last, the Fifth Circuit has used an en banc decision to retreat from a strikingly harsh approach it had previously taken on awarding attorneys fees. In 1998, the Circuit had held that fees must be analyzed as to whether, viewed in hindsight, the amounts spent had produced an actual “material benefit” to the estate. Thus, the firm was essentially made a guarantor of the success of any litigation it undertook and would be denied compensation if it lost, no matter how logical the case appeared to have been when it was filed. In this case, the court overruled the prior decision and adopted the prospective “reasonably likely to benefit the estate” standard used by other circuits. That standard does not give counsel a free rein, but it does require that the court assess fees based on what counsel could have known at the time they were incurred.

Metrou v. M.A. Mortenson Companuy and Schuff Steel Company, 781 F.3d 357 (7th Cir. 2015).

Trustee who takes on claim omitted by debtor is not limited to recovering only value of creditors’ claims.

A debtor that omits a claim from his schedules prior to receiving a discharge may turn the claim over to the trustee and allow that party to litigate the matter on behalf of the creditors. In bringing such a suit, the trustee is not limited to only the value of the creditors’ claims but may sue for the full value of the debtor’s rights. If, at the end of the case, the debtor is found to have omitted the claim inadvertently, he is entitled to the surplus. If not, the court may choose to return the funds to the defendant – but, at least initially, the trustee will be able to litigate for a suit whose value makes it worthwhile to proceed on a contingency fee basis.

In re Seaside Engineering & Surveying, Inc., (SE Property Holdings, LLC v. Seaside Engineering & Surveying, Inc.), 780 F.3d 1070 (11th Cir. 2015). Third-party releases.

Noting a circuit split on the issue, the Eleventh Circuit concluded that it was acceptable, in appropriate circumstances, for the court to impose a non-consensual release of claims against non-debtor third parties in a confirmed plan. Although the provision at issue appears to be the less controvsial type of provision, often referred to as an “exculpation provision” that protects parties from their actions in connection with the bankruptcy case itself, the court’s reasoning is not so limited and extends broadly to any release granted to a third party including for prepetition claims. The Eleventh Circuit held that, while Section 524(e) precludes the debtor’s discharge from being enough, standing alone, to allow the discharge, that did not bar a bankruptcy court from using its powers under Section 105 to grant a release where warranted. The court endorsed the factors in In re Dow Corning Corp., 280 F.3d 648 (6th Cir. 2002), and gave the usual cautions that such orders should be used “cautiously and infrequently” and only where essential, fair, and equitable. (Notwithstanding those admonitions, the use of exculpation orders, in particular, is well-nigh universal and even general releases are often more the rule than the exception.)

Here, the court held that it was appropriate to release principals of the debtor (who were also its main revenue-producing employees) from their personal guarantees because they would be distracted from working if they were sued and because the contributions of their services (in their normal role as employees) was a contribution of “substantial assets” that supported their release. That latter point is fairly debatable, since the “substantial assets” is usually looked at in the same way as “new value” – i.e., adding something to the case that those parties were not already obligated to provide. Stating that providing the services they would have provided in any event is a contribution of assets tends to make that factor meaningless. On the other hand, the court did note that the dissenting creditors received a promise of payment in full – albeit the payment was at the lower disputed valuation the creditor had challenged and at only a 4.25% interest rate, which might well not represent the risky nature of the venture. Bottom line: the opinion sets a low bar for approving such a release so it will be difficult to defeat one in this Circuit.

Listecki v. Official Committee of Unsecured Creditors, 780 F.3d 731 (7th Cir. 2015). Milwaukee Archdiocese case -- Religious Freedom Restoration Act (“RFRA”) issues.

In a fraudulent transfer action challenging transfers of diocese assets as being made to keep them out of the hands of those suing the Archdiocese for sexual abuse cases, the Court held that RFRA only applies to actions by governmental actions; the Creditors’ Committee is not the government

for these purposes, and, to the extent that these avoidance actions are independently analyzed for whether they violate the Free Exercise clause, the right to bring these actions is a compelling state interest that justifies allowing them to proceed, even if they are viewed as substantially burdening the Archbishop’s exercise of his religious beliefs, noting that the Code provisions apply neutrally and are not designed to single out religious belief. The Court also held that, where the avoidance action dealt with trust funds to maintain Catholic cemeteries, and the district judge had nine close relatives buried in those cemeteries, there was enough appearance of a conflict of interest that the judge likely should have recused himself. (A different judge will hear the case on remand.

In re Fahey (Fahey v. Massachusetts Dept. of Revenue), 779 F.3d 1 (1st Cir. 2015). Do “late-filed tax returns” qualify as “returns” for discharge purposes.

Joining the other two circuits that have decided the issue, the First Circuit agreed with the Tenth and Eleventh Circuit that the language added to Section 523(a) to define a “return” for tax discharge purposes includes timeliness of filing within the “applicable filing requirements” that must be met. Thus, under this rule, if returns are filed late, the taxes owed thereunder will not qualify as dischargeable debts even if the bankruptcy is filed more than two years after the returns are submitted unless the return is filed under Section 6020(a) of the Internal Revenue Code or a similar state provision. The result is fairly harsh, but the majority found that the alternative reading urged by the dissent required too much rewriting of the definition; while harsh, the new reading was not absurd or impossible to apply as written.

In re Dow Corning Corp. (Sutherland v. DCC Litigation Facility, Inc., 778 F.3d 545 (6th Cir. 2005). Choice of law principles in personal injury claims against debtor.

A plaintiff may normally select her own venue to bring her suit and the choice of law provisions of that venue govern. The bankruptcy court may not try personal injury cases against a debtor; rather, the district court for the district in which the case is pending is allowed to decide whether the cases should be tried there or in the district court where the claim arose. However, even if the forum district court decides to transfer such cases and have them heard before it, that transfer should not serve to change the determination of which state’s choice of law provisions apply. This is the same rule that applies when state cases are brought to federal court based on diversity jurisdiction – a transfer of venue does not chance the underlying law in order to prevent forum shopping and leaving the decision on transfer to relate solely to procedural issues of convenience and the interest of justice, not on issues of substantive law that might decide the case.

In re FFS Data, Inc. (Iberiabank v. Geisen), 776 F.3d 1299 (11th Cir. 2015). Third-party releases.

Where a plan clearly spells out the scope of the release, it may impose a binding release on claims against non-debtor parties with respect to causes of action by other third-parties that do not actually involve the debtor or its estate. Thus, for instance, a broadly-worded release of “all claims” against a debtor’s principal by any creditor in the case could release matters wholly unrelated to the bankruptcy case, such as a home mortgage loan the principal had in his individual capacity if it were issued by a lender that was a party in the debtor’s case. This holding means that it is critical to parse release provisions very carefully.

Janvey v. The Golf Channel, Inc., 780 F.3d 641 (5th Cir. 2015). Provision of “value” in context of Ponzi scheme.

The debtor operated a massive classic Ponzi scheme in which investors were promised very high returns that were satisfied solely from payments from later investors. In 2005, the Ponzi operators decided to begin running direct advertisements to bring in new investors. One party running the ads and being paid for them in the ordinary course was the Golf Channel. The court held that, inasmuch as the payments were for efforts that directly supported the Ponzi scheme and that provided no actual benefits to the investors or other creditors, there was no “value” given for the amounts paid, even though there was no question that the services billed for had been provided. The court treated them as equivalent to payments made to a broker to secure new investments into the Ponzi scheme, in that the services provided directly furthered the illegal scheme. As such, it was irrelevant that the services might have been valuable to a legitimate business; “services rendered to encourage investment in such a scheme do not provide value to creditors.” It is not clear whether this stringent reading would extend even to more mundane trade creditors (such as the utility provider) who do not directly induce the doomed investments.

In re Hokulani Square, Inc. (Tamm v. United States Trustee), 776 F.3d 1083 (9th Cir. 2015).Trustee compensation.

The Chapter 7 trustee is not entitled to be paid a commission on amounts that a secured lender “credit bids” in order to obtain its collateral. The trustee is only entitled to payment for “moneys disbursed” and turning property over to a secured creditor based on a credit bid does not entail any disbursement of money. The legislative history makes clear that turning property over to a secured creditor is not intended to be covered by the compensation section.

Chrysler Group LLC v. Fox Hills Motor Sales, Inc., 776 F.3d 411 (6th Cir 2015). Federal preemption of state regulatory law

In the Chrysler and GM bankruptcies, the companies were strongly encouraged by the United States to prune their dealership ranks to make more cost-effective. There was substantial opposition to that effort not only by the affected dealers but also at the state level since such terminations were often being made without regard to state dealer termination laws that were enacted to protect dealers from the arbitrary actions of the manufacturers with which they dealt. A number of bills were proposed in Congress in reaction to those terminations, the one that emerged required an arbitration process and a right for the dealers to be given a new sales agreement with Chrysler or GM. In earlier litigation, the courts upheld these laws and found that they could preempt the state legislation to the extent that it would have given the terminated dealers greater rights. In this case, the court again found that the agreements preempted state law – but from the opposite perspective. Chrysler – and some of the favored dealers that it had retained or added to its network – sought to rely on parts of those laws that allowed existing dealers to preclude the addition of new competitors within a specific radius as a way to bar the reinstated dealers from opening within that specified limit. The court rejected those efforts, finding that the federal law preempted those state laws to the extent that they would interfere with or hamper the effectiveness of the federal arbitration awards.

In re Shelbyville Road Shoppes, LLC (Lawrence v. Kentucky), 775 F.3d 789 (6th Cir. 2015). Turnover rights in “good faith” non-refundable deposit for purchase agreement.

Where the debtor had made a downpayment on a purchase agreement, pursuant to terms that provided that those funds would be forfeited as liquidated damages if the balance was not paid timely, the debtor did not gain any right to those funds by filing bankruptcy or by rejecting the purchase agreement. The funds did not become property of the estate on the filing of the case because there were only two outcomes for the treatment of the funds – they could be applied to payment of the full balance or they would be forfeited. There was no circumstance under which the debtor -- on the petition date (or, thereafter) – had any right to a return of the payments. The rejection of the purchase agreement did not change that situation – nothing in the debtor’s creation of a breach of that agreement by its rejection gave it any greater right to demand back the deposit. While rejection meant the state could not enforce the purchase agreement, it did not change the fact that the deposit had already been paid prepetition and the state was lawfully entitled to retain it. Rejection does not entail any effect on transactions completed prepetition.

Travelers and Co. v. Chubb Indem. Ins., 759 F.3d 206 (2nd Cir. 2014). Scope of discharge order; clarifying injunction.

In 1982, Johns-Manville was the first asbestos manufacturer to file bankruptcy and its case ushered in a whole era of mass tort cases, “future claims,” and “channeling injunctions.” More than thirty years later, the fall-out still continues. In the original case, Manville settled with its primary insurer, Travelers, in order to obtain funds to pay for asbestos personal injury claims and Travelers received a broad release of any liability based on its insurance policies. Unfortunately, the estimates of those claims were vastly understated and claimants began casting about for other possible defendants. A number began to sue Travelers based on “direct action” claims alleging that Travelers knew of the hazards and had an independent duty to warn those exposed. In turn, Travelers sought an order from the bankruptcy court holding that such claims were barred by the original order. In 2004, Travelers agreed to pay in an additional $450 million (well over what is original policies had paid out) in order to obtain an order from the bankruptcy court “clarifying” that the original order had covered the direct action claims. A different insure, Chubb, challenged the entry of that order, claiming it had not received notice of the original order, and that the clarification would preclude it from seeking indemnity from Travelers if Chubb were similarly sued on the direct action claims.

The bankruptcy court entered the order, and was affirmed by the District Court. The Second Circuit concluded that any such clarification could not be entered because it would exceed the allowed scope of an injunction in the case. On appeal, the Supreme Court reversed and held that the settlement language could be viewed as a clarification of the original order and it was immaterial whether that order would have been unconstitutionally broad because it had not been challenged at the time and was no res judicata. (Of course, there was a strong question whether any of the parties had read the original order so broadly then so as to know that they should have challenged it, but the Court brushed aside that argument.) The Court, though, did remand to allow the Second Circuit to consider Chubb’s claims that it did not receive notice and could not have been bound – which was what the Second Circuit did find on remand.

This case deals with, hopefully, the final round in the saga – namely, Travelers’ attempt to back out of paying the $450 million it owed under the settlement, based on its argument that it had not gotten what it bargained for – i.e., a total release and peace and quiet. Instead, it had faced many more years of litigation and had been left subject to suit by Chubb. The bankruptcy court turned Travelers down, the district court reversed, and, on appeal, the Second Circuit reversed again. It held that, in the end, Travelers had been given the order that it asked for. If that order turned out not to be sufficient or to have left it still subject to suit by a party that could not be bound by the original order, as clarified, that was not the problem of the other parties to the settlement. Thus, Travelers was left to make the $450 million payment.

In the Matter of Emergency Room Mobile Services, L.L.C. (Marable, Jr. v. Sam Pack’s Ford Country of Lewisville, Ltd.), 529 B.R. 676 (N.D. Tex. 2015). Standing to assert automatic stay violations; stay exception for criminal proceedings.

The debtor had taken one of its ambulances to Pack’s for repairs prior to the bankruptcy but had been unable to pay the bill when the repairs were done and the ambulance stayed at Pack’s for several months (presumably as security for the unpaid bill). Shortly after the filing, the debtor’s owner, Marable, decided it was “okay to retrieve the vehicle” and after getting it from Pack’s for a test drive took it back the debtor’s facility and refused to either return it to Pack’s or pay the invoice. The next day, Pack filed a complaint against Marable personally for “theft of services” which eventually resulted in his being individually indicted. Marable filed suit in bankruptcy court asserting that Pack’s initiation and participation in the criminal proceedings violated the stay and/or the discharge injunction but the bankruptcy court disagreed and the district court affirmed.

First, an equity owner of a debtor does not have individual standing to assert violations of the interests of the debtor; such claims are property of the estate. And, to the extent that Marable suffered personal injuries, none of those related to any interests he held as a creditor of the debtor; they are were all due to his own individual, non-debtor rights. Second, even if standing were not an issue, the claims were without merit. Participation by a creditor in the initiation and prosecution of criminal charges is protected by the Section 362(b)(1) exception to the stay for such proceedings. Any damages that Marable sustained were incurred as a result of those lawfully-initiated criminal proceedings. As to the allegations of a violation of the discharge, the courts found that that protection applied to the debtor, not Marable who was a non-debtor party. Moreover, the action was not even “related to” the bankruptcy case, since the only activities taken by Pack were directed at Marable as an individual and not as attempts to collect from the debtor. The result of the criminal case could not have any conceivable effect on the debtor. As such, the bankruptcy court would have no power under Section 105 to enjoin action against, and effectively discharge a claim against a non-debtor party. If the criminal charges could have the effect of making Marable pay a debt that was actually owed by the debtor, not by him, that was a defense he was free to raise in state court. It did not create an issue in bankruptcy court. Finally, to the extent that Marable was seeking punitive contempt damages, that constituted a criminal contempt action and the Fifth Circuit had held that bankruptcy courts lacked power to decide such allegations to the extent they occurred outside the presence of the court.

United States v. Fed. Res. Corp., 525 B.R. 759 (D. Id. 2015). Scope of police and regulatory exception for environmental and related claims

The district court has jurisdiction to determine whether a bankruptcy filing by the defendants precluded it from issuing a final judgment in the case before it. On the merits, a clean-up action under CERCLA is excepted from the automatic stay – it meets the pecuniary purpose test because it is intended to protect public health and welfare and not simply to benefit the government, and it meets the public policy test since, again, it is directed at the overall public safety and not merely the interests of discrete individuals. The fact that there is an economic component to the judgment to cover the government’s costs does not change the nature of the decision. The case discusses the scope of the 1998 amendments to the automatic stay. It also found that a fraudulent transfer and veil-piercing action brought under the Federal Debt Collections Procedures Act were also excepted from the stay as part of the overall police and regulatory action and because they were brought against a non-debtor party to bring assets into the estate.

Walters v. Tehrani, 2015 U.S. Dist. LEXIS 51910 (D. N.J. 4/22/15). Police and regulatory exception to stay; attorney discipline complaint

The creditors had engaged in various business deals with an attorney who had allegedly cheated them out of various properties. The filing of an ethics complaint with the state Office of Attorney Ethics and a request for compensation from the Lawyers’ Fund for Client Protection did not violate the stay. The matters were not directly requests for payment; rather they were complaints regarding the attorney’s unethical behavior. The claim against the Fund was not, moreover, one directly against the attorney-debtor in any case. As such, the actions were excepted from the automatic stay.

In re City of Stockton, 526 B.R. 35 (Bankr. E.D. Cal. 2015). Ability of court to authorize rejection of pension contracts with state administrative agency (CALPERS), confirmation of plan without rejecting contract.

Section 903 and 904 of the Code limit the bankruptcy court’s ability to interfere with the "political or governmental functions” of the municipal debtor; such functions, the court held, were limited to “basic matters of the organization and operation of government that are incidents of sovereignty, but do not extend to financial relations between the state and its municipalities.” The court further held that the provisions of Section 545 could preclude any statutory lien held by CALPERS from being effective in the bankruptcy case and that the general bankruptcy clause powers could preempt any provisions in the State Constitution purporting to bar the rejection of contracts between CALPERS and the municipality. This whole lengthy analysis, though, is close to dicta since, in the end, the city did not propose to reject the CALPERS contract (and the plan was close to fully funded in any event); rather it, and the employees, chose to agree to a different set of cost reductions (primarily elimination of retiree health benefit coverage) that resulted in a savings of $550 million for the city. All creditors but one agreed to the overall bargain proposed in the city’s plan, and the court agreed that the city’s proposal took sufficient steps to share the pain of nonpayment among all of the parties and rejected the challenge to confirmation.

Frankfurt v. Friedman (In re Frankfurt), 2015 Bankr. LEXIS 1823 (Bankr. N.D. Ill. 6/1/15). Police and regulatory exception to stay applied to state agency decision on securities law violations, collateral estoppel effects.

The state did not violate the stay by completing action on a securities violation complaint after the petition date, since the police and regulatory exception applied. Based on the broad language in Section 523(a)(19), even a default judgment is given collateral estoppel effect to final orders. To the extent that the judgment found that the debt was one for fraud, deceit, or manipulation in connection with the sale of securities, the bankruptcy court was required to find that the debt was nondischargeable.

In re Wyly, 526 B.R. 194 (Bankr. N. D. Tex. 2015). Seeking disgorgement from “relief defendants” of funds derived from securities violations did not violate stay.

Naming parties in complaint who had allegedly received “ill-gotten gains” from a securities violation scheme did not violate stay. The district court in which the securities action was pending deferred to the stay motion filed by the debtor in bankruptcy court and allowed that court to decide the issue, although the district court did have the authority to make that decision itself as well. Litigating securities law violations falls into the general police and regulatory powers of the state and the exception covers entry of disgorgement orders in such proceedings. Those principles apply even if the debtor is not herself the party guilty of wrongdoing but is merely being sued to force return of funds that were illegally obtained by the primary debtors and turned over to related parties. A disgorgement remedy reverses those defendants’ receipt of funds they were never entitled to and reverses their undue enrichment. Retrieving such funds is as much part of the basic police and regulatory purposes as collecting from the primary defendants.


[1] Thanks are given to Dan Schweitzer and the Center for Supreme Court Advocacy at NAAG for use of their excellent write-ups on these cases as a starting point for these discussions.

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