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March 2, 2016:
9th Cir. Declines to Dismiss Appeal on Equitable Mootness Grounds Despite Substantial Consummation of the Plan

Dear constituency list members of the Insolvency Law Committee, the following is a case update analyzing a recent case of interest:

Summary

In JPMCC 2007–C1 Grasslawn Lodging, LLC v. Transwest Resort Props. Inc. (In re Transwest Resort Props., Inc.), 801 F.3d 1161 (9th Cir. 2015), a divided three-judge panel of the U.S. Court of Appeals for the Ninth Circuit (the “Ninth Circuit”) ruled that a creditor’s appeal of a chapter 11 plan confirmation order should not be dismissed on equitable mootness grounds despite the substantial consummation of the subject plan. In so holding, the Ninth Circuit concluded that the appeal was not equitably moot under circuit precedent because the lender had diligently sought a stay, and the bankruptcy court could fashion an equitable remedy to address the lender’s objections without unfairly impacting third parties or undoing the plan.

To read the full published decision, click here:  http://cdn.ca9.uscourts.gov/datastore/opinions/2015/09/15/12-17176.pdf

Factual Background and Procedural History

Five related entities (collectively, the “Debtors”) acquired two resort hotels in 2007.  Two of the Debtors owned and operated the respective hotels (the “Operating Debtors”).  Two of the Debtors (the “Mezzanine Debtors”), in turn, were each the sole owners of the Operating Debtors.  The fifth Debtor (the “Holding Company Debtor”) was the sole owner of the Mezzanine Debtors.  The acquisition was financed with two loans: first, a $209 million loan from JPMCC 2007-C1 Grasslawn Lodging, LLC (“Lender”) to the Operating Debtors secured by liens on the two hotels (the “Mortgage Loan”); and second, a $21.5 million loan from PIM Ashford Subsidiary I LLC (“PIM”) to the Mezzanine Debtors secured by liens on their ownership interests in the Operating Debtors (the “Mezzanine Loan” and, together with the Mortgage Loan, the “Loans”).

The Debtors filed for bankruptcy in 2010 after defaulting on the Loans. By order of the bankruptcy court, the cases were jointly administered. Lender’s claim arising from the Mortgage Loan was allowed in the amount of $247 million.  PIM  filed two proofs of claim totaling $39 million.

The Debtors’ joint plan of reorganization proposed to dissolve the Mezzanine Debtors and cancel their equity interest in the Operating Debtors, thereby extinguishing the collateral for the Mezzanine Loan. The plan contemplated that a new investor, Southwest Value Partners Fund XV, LP (“SWVP”), would invest no less than $30 million and would become the new sole owner of the Operating Debtors. PIM’s treatment under the plan depended on its vote.  If PIM voted against the plan, PIM would receive no distributions thereunder. If, on the other hand, PIM voted to accept the plan, then PIM would be entitled to receive a small percentage of future surplus cash flow.

Lender elected to have its entire allowed claim treated as a secured claim under section 1111(b)(2) (unless otherwise noted all statutory references refer to sections of title 11 of the United States Code).  While the plan reinstated the Mortgage Loan, the Debtors proposed that the loan be paid in monthly interest-only payments with a balloon payment due in 21 years.  The plan also proposed that the Mortgage Loan be restructured to include a due-on-sale clause, but with an exception that the hotels could be sold or refinanced between years five and fifteen of the loan, without the full amount of the loan coming due. 

The separately classified Mortgage Loan and Mezzanine Loan claims comprised two of the ten classes of claims under the plan.  After the plan was proposed, Lender acquired the Mezzanine Loan from PIM.  Lender then voted both of its claims to reject the plan.

Lender’s Two Objections to the Plan

Lender objected to the plan on two grounds.  First, Lender asserted that the ten-year exception to the restructured Mortgage Loan’s due-on-sale clause negated the benefit of its section 1111(b) election.  Lender argued that by enacting section 1111(b), Congress intended to protect secured creditors against the undervaluation of their collateral.  Thus, Lender concluded, the plan’s ten-year exception to the due-on-sale clause could allow the Debtors to sell Lender’s collateral without satisfying its secured claim, thereby eradicating the protections afforded to Lender by section 1111(b).

Second, Lender contended that the Debtors did not satisfy section 1129(a)(10)’s requirement that “at least one class of claims that is impaired under the plan [must have] accepted the plan” in order for the plan to be confirmed.  Lender observed that in cases involving multiple debtors, courts were split on whether section 1129(a)(10)’s requirement applies per plan or per debtor.  Noting that the Mezzanine Debtors did not have any impaired class of creditors voting to accept the plan, Lender urged the bankruptcy court to adopt its “per debtor” interpretation of section 1129(a)(10), and deny confirmation of the plan.

The plan was confirmed over Lender’s objections pursuant to the “cram down” provisions of section 1129(b). 

The Appellate Proceedings

Lender filed a notice of appeal four days after the bankruptcy court confirmed the plan.  Lender concurrently filed a motion to stay consummation of the plan pending the appeal, arguing that any failure to grant the stay could result in the appeal being rendered moot.  The Debtors and investor SWVP objected to the stay motion, asserting that Lender had not shown how substantial consummation of the plan would moot Lender’s appeal.  The bankruptcy court denied Lender’s motion for stay, finding the risk of irreparable harm arising from possible mootness to be “speculative, at best.” Lender filed an identical motion in the district court, which was also denied.

After considering the appeal, including Lender’s two objections to the plan, the district court ruled that the appeal was equitably moot because, notwithstanding Lender’s diligent attempt at procuring a stay, the plan had been substantially consummated, third parties (including the investor) had relied on confirmation of the plan, and the relief sought by Lender would therefore be inequitable.

Lender appealed the district court’s decision to the Ninth Circuit.  Finding that Lender’s appeal was not equitably moot notwithstanding the substantial consummation of the plan, a divided three-judge panel of the Ninth Circuit ultimately reversed the district court’s decision and remanded the case for further proceedings.

Reasoning

Judge J. Clifford Wallace penned the majority opinion and Judge Michelle T. Friedland concurred. Noting that equitable mootness is a judge-created doctrine by which a court elects not to reach the merits of a bankruptcy appeal, the majority identified four factors for courts to consider when determining whether an appeal is equitably moot:

We will look first at whether a stay was sought, for absent that a party has not fully pursued its rights.  If a stay was sought and not granted, we then will look to whether the substantial consummation of the plan has occurred.  Next, we will look to the effect a remedy may have on third parties not before the court.  Finally, we will look at whether the bankruptcy court can fashion effective and equitable relief without completely knocking the props out from under the plan and thereby creating an uncontrollable situation for the bankruptcy court.

Transwest Resort Properties, supra, 801 F.3d at 1167-68, citing Motor Vehicle Cas. Co. v. Thorpe Insulation Co. (In re Thorpe Insulation Co.), 677 F.3d 869, 881 (9th Cir. 2012).  Observing that each of Lender’s two objections would require a separate form of relief, the majority then applied the equitable mootness analysis separately to each objection.

Factor #1: Diligence in Seeking Stay

The Ninth Circuit first evaluated whether a stay was sought.  Citing Thorpe Insulation and its previous decisions in Rev Op Grp. v. ML Manager LLC (In re Mortgs. Ltd.), 771 F.3d 1211 (9th Cir. 2014) and Rev Op Grp. v. ML Manager LLC (In re Mortgs. Ltd.), 771 F.3d 623 (9th Cir. 2014), the majority stressed that courts must be cautious in applying equitable mootness when a party diligently sought a stay—warning that applying the doctrine in such situations could transform the doctrine to one of “inequitable mootness”. The majority then concluded that Lender’s diligence in filing its appeal and seeking a stay strongly militated in favor of appellate review of Lender’s objections.

Factor #2: Substantial Consummation of the Plan

The Ninth Circuit next turned to the question of substantial consummation.  The majority noted that the term “substantial consummation” has been defined in section 1101(2) as:

(A) transfer of all or substantially all of the property proposed by the plan to be transferred;

(B) assumption by the debtor or by the successor to the debtor under the plan of the business or of the management of all or substantially all of the property dealt with by the plan; and

(C) commencement of distribution under the plan.

The majority concluded that the plan was, in fact, substantially consummated because: (i) SWVP had assumed control over the Debtors, (ii) reorganized them by extinguishing the Mezzanine Debtors’ equity interests in the Operating Debtors, and (iii) funded accounts necessary to make disbursements under the plan. The majority, however, expressly rejected the notion that substantial consummation creates a presumption that the appeal is moot—noting that the law of the Ninth Circuit has never included such a presumption.

Factor #3: Impact on Innocent Third Parties

The Ninth Circuit then addressed the penultimate factor—the interests of third parties.  Once again citing to Thorpe Insulation, the majority articulated the third prong of the equitable mootness test as “whether it is possible to [alter the plan] in a way that does not affect third party interests to such an extent that the change is inequitable.” The majority clarified that a third party’s reliance on the plan’s consummation is not sufficient to meet this test. Instead, the majority acknowledged that an appeal might be equitably moot if the specific relief sought bears “unduly” on innocent third parties.

Analyzing Lender’s first objection, the majority concluded that the relief requested by Lender—i.e., exclusion of the five to fifteen year exception in the restructured Mortgage Loan’s due-on-sale clause—affects only the division of any appreciation in value of the hotels between the Lender and the Reorganized Debtors (or SWVP, their owner).  In determining that this relief would not “unduly” bear on the investor, the majority noted that SWVP was hardly an “innocent” third party. Instead, the majority reasoned, SWVP had participated in the bankruptcy case by, inter alia, attending the hearings on plan confirmation, negotiating the final form of the confirmation order, and objecting to the stay relief requested by Lender.  Thus, the majority opined, SWVP was not the type of innocent third party that the third prong of its equitable mootness test was crafted to protect.

In considering Lender’s second objection, the majority noted that Lender proposed two forms of alternate relief if it prevailed on its appeal of the bankruptcy court’s interpretation of section 1129(a)(10)—namely, either (i) compensating Lender for the extinguishment of its collateral for the Mezzanine Loans; or (ii) reinstating its liens on the ownership interest in the Reorganized Debtors.  The majority found that the Reorganized Debtors had failed to show how either of Lender’s proposed forms of relief would affect innocent (as opposed to interested) third parties, given that the two forms of relief would alter only the relationship between Lender and the Reorganized Debtors.

Factor #4: Equitable Relief Without Undoing the Plan    

Lastly, the Ninth Circuit considered the potential fall-out from the reversal or modification of the plan confirmation order.  The majority identified the fourth, and “most important,” prong in its equitable mootness test as whether the bankruptcy court could fashion equitable relief without undoing the plan should Lender prevail on the merits of its appeal.  Again relying on Thorpe Insulation, the majority concluded that an appeal is not moot where there are any forms of even partial relief that could be provided without unravelling the plan.

The majority declined to consider the merits of Lender’s first objection, focusing instead on whether the bankruptcy court could provide any equitable relief to Lender on appeal, even if that relief was incomplete.  The majority did, however, articulate two forms of potential partial relief available to Lender if it prevailed on its first objection on appeal: (i) the court could reduce the length of the due-on-sale exception; and (ii) if the sale took place in the exception window, then Lender could receive some percentage of the difference between the balance of the loan and its present value.  In reaching this conclusion, the majority rejected Reorganized Debtors’ argument that such relief would be inequitable, noting that the objecting parties had failed to articulate how such relief would undo the plan.

Examining Lender’s second objection, the majority noted that Lender, as the sole creditor of the Mezzanine Debtors, voted against the plan—which would violate section 1129(a)(10)’s requirement for confirmation if Lender prevailed on this objection on appeal.  The majority observed, however, that if the Mezzanine Loan had been paid in full, that class would have been deemed to have voted for the plan.  Thus, the majority concluded, making that payment (with interest) now could at least offer a partial remedy, and one that would not necessarily undo the plan.

Judge Smith’s Dissent

In his dissenting opinion, Circuit Judge Milan D. Smith, Jr. criticized the majority’s application of the Ninth Circuit’s equitable mootness test on several bases. Citing to the Third Circuit’s In re Continental Airlines decision, 91 F.3d 553 (3d Cir. 1996), Judge Smith first opined that substantial consummation should be the “foremost consideration” in assessing equitable mootness, writing:

[A]s the majority acknowledges, many of our sister circuits have held that substantial consummation creates a presumption of equitable mootness. While we have not recognized such a presumption, nothing in our precedents suggests that we should not accord significant weight to substantial consummation in determining whether an equitable and effective remedy is available.

Id. at 1173 (citations omitted and emphasis in original).

Next, reasoning that “the majority’s decision discourages potential investors from relying on the finality of bankruptcy court confirmation orders,” Judge Smith pointed out that third parties’ reliance on bankruptcy confirmation orders is critical to facilitating workable reorganizations.  Indeed, Judge Smith strongly disagreed with the majority’s conclusion that the equitable mootness doctrine was not designed to protect the interests of a third-party investor like SWVP. The dissent emphasized that there is no indication that SWVP had any connection with the bankruptcy cases until the Debtors approached it to fund the reorganization plan the Debtors had already crafted. Also, observing that SWVP funded the plan approximately three years ago, Judge Smith noted that the majority’s application of the equitable mootness test encourages investors to delay funding post-confirmation improvements until any appeal of the confirmation order is completed.  Noting that such a delay is likely to have a detrimental impact on both creditors and debtors, the dissent concluded that protecting the interests of those who acquire assets in reliance on a confirmed plan increases the price an estate can realize for those assets—thereby benefiting the estate and its creditors.

Finally, Judge Smith disagreed with the majority’s conclusion that the bankruptcy court could fashion truly equitable relief without disrupting the plan. In contrast to the majority, the dissent examined each of Lender’s two objections on the merits, and concluded that through its appeal, Lender requested relief more favorable than the prepetition terms of its loans. Specifically, Judge Smith observed that the Mortgage Loan did not contain a due-on-sale provision in the first place. The dissent also noted that the collateral securing repayment of the Mezzanine Loan was worthless, as it consisted of the Mezzanine Debtors’ ownership interest in the “deeply insolvent” Operating Debtors.  To the extent Lender’s Mezzanine Loan had value due to its ability to veto the plan, the dissent concluded that the availability of such relief did not justify wholly upsetting the plan. 

Author's Commentary

This opinion provides substantial guidance to those considering, or opposing, an appeal of a plan confirmation order. First, as confirmed by the majority, a creditor’s failure to seek a stay of the plan’s consummation pending appeal is a significant consideration of whether an appeal might be deemed as equitably moot.  While it is not certain that an appeal will be rendered moot if the appellant fails to seek a stay, Transwest Resort Properties confirms that an appellant should strongly consider seeking such a stay so as not to run afoul of the first factor in the Ninth Circuit’s equitable mootness test. 

Importantly, the Transwest Resort Properties decision also affirms that under the law of the Ninth Circuit a plan’s substantial consummation does not create a presumption of equitable mootness. Thus, even where the plan has been substantially consummated (whether or not a stay was sought), a court may consider an appeal of the confirmation order on its merits if an equitable remedy could be fashioned without unwinding the plan, and that remedy does not unduly impact “innocent” third parties.  It is also noteworthy that the majority, as well as the Thorpe Insulation court, recognizes the “great discretion” bankruptcy courts have in devising such a remedy.  See Thorpe Insulation, 677 F.3d at 883.

The majority confirms that where a creditor is appealing confirmation of a plan but only seeks money, it is generally not impossible to provide a remedy. See also Platinum Capital, Inc. v. Sylmar Plaza, L.P. (In re Sylmar Plaza, L.P.), 314 F.3d 1070, 1074 (9th Cir. 2002) (“Even if the plan has been substantially consummated, because Platinum’s claim is only for monetary damages against solvent debtors, this is not a case in which it would be impossible to fashion effective relief.”).  Whether that remedy is equitable, and whether and to what extent that remedy might detrimentally impact third parties, however, depends on the structure of the plan, the timing for its implementation, and the bankruptcy court’s creativity in devising relief that addresses the appellant’s colorable objections without unravelling the plan.

Still, more definitive guidance on the scope and applicability of the equitable mootness doctrine may be forthcoming. On January 11, 2016, Aurelius Capital Management, LP (“Aurelius”) filed its petition for a writ of certiorari in the Supreme Court of the United States.  Aurelius’ petition arises from the Third Circuit Court of Appeals’ decision affirming the dismissal of Aurelius’ appeal of the plan confirmation order entered in the Tribune Media Company chapter 11 proceedings over its objections. See In re Tribune Media Co., 799 F.3d 272 (3d Cir. 2015). Noting that the Supreme Court has never reviewed the judge-made equitable mootness doctrine, Aurelius argues that the Supreme Court’s review “is urgently needed to bring uniformity (and some measure of restraint)” to the interpretation and application of this doctrine.  (Petition, p. 2.)  Unless and until the Supreme Court grants Aurelius’ petition for certiorari, however, the Ninth Circuit’s ruling and reasoning in Transwest Resort Properties decision should guide the actions of those considering an appeal of a plan confirmation order in this circuit.

These materials were written by Monique Jewett-Brewster of Hopkins & Carley, APLC in San Jose, California (mjb@hopkinscarley.com).  Ms. Jewett-Brewster is a past Co-Chair of the Insolvency Law Committee, and a current member of the Business Law Section’s Executive Committee.  Editorial contributions were provided by ILC member Michael T. Delaney of Baker & Hostetler, LLP in Los Angeles. 

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee

Co-Chair
Leib Lerner
Alston & Bird LLP
Leib.Lerner@alston.com

Co-Chair
Corey Weber
Brutzkus Gubner Rozansky Seror Weber LLP
cweber@brutzkusgubner.com

Co-Vice Chair
Asa S. Hami
SulmeyerKupetz, A Professional Corporation
ahami@sulmeyerlaw.com

Co-Vice Chair
Reno Fernandez
Macdonald Fernandez LLP
Reno@MacFern.com

February 9, 2016:  Ninth Circuit Holds That the Absolute Priority Rule Still Applies in Individual Chapter 11 Cases

Summary

In Zachary v. California Bank & Trust, ___ F.3d ___ , 2016 WL 360519 (9th Cir. Jan. 28, 2016) (“Zachary”), the U.S. Court of Appeals for the Ninth Circuit (the “Ninth Circuit”) held that the absolute priority rule, codified in section 1129(b)(2)(B)(ii) of the Bankruptcy Code, continued to apply to individual chapter 11 cases following the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act (“BAPCPA”).  In so holding, the Ninth Circuit overruled the decision of the U.S. Bankruptcy Appellate Panel for the Ninth Circuit (the “BAP”) in In re Friedman, 466 B.R. 471 (9th Cir. BAP 2012) (“Friedman”), and adopted the “narrow view” of the individual debtor exception to the absolute priority rule.

To read the full opinion, click here: http://cdn.ca9.uscourts.gov/datastore/opinions/2016/01/28/13-16402.pdf

Facts

In September 2011, David K. Zachary and Annmarie S. Snorky (the “Debtors”) filed a joint voluntary petition for relief under chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Eastern District of California (the “Bankruptcy Court”)—thereby commencing the subject bankruptcy case.

Thereafter, the Debtors proposed several chapter 11 plans of reorganization.  By and through the operative plan (the “Plan”), the Debtors proposed paying creditors over a term of years and, thereafter, retain their interests in certain rental property and an engineering practice.  Of particular relevance here, the Debtors proposed paying California Bank & Trust (“CBT”) the sum of $5,000 over five years with 3% interest on account of the nearly $2,000,000 unsecured claim asserted by CBT.  Thus, CBT’s claim was impaired under the Plan.  CBT objected to the Plan.  In sum, CBT argued that the Plan violated the absolute priority rule by allowing the Debtors (equity interest holders) to retain their interests in the rental property and engineering practice without paying CBT (a senior unsecured creditor) in full.  In response, the Debtors sought to confirm  the Plan over CBT’s objection (i.e., “cram down” the Plan), relying on Friedman to argue that the absolute priority rule does not apply in individual chapter 11 cases following the enactment of BAPCPA.

The Bankruptcy Court disagreed with the Debtors and the holding in Friedman, and sustained CBT’s objection to the Plan.  The Debtors timely appealed.  The Debtors also moved to certify the appeal for direct review by the Ninth Circuit, which motion the Bankruptcy Court granted.

Reasoning

The question presented on appeal has been much debated since 2005: Does the absolute priority rule continue to apply in individual chapter 11 reorganizations after the amendments to the Bankruptcy Code enacted as part of BAPCPA?  In sum, the Ninth Circuit held that the rule continues to apply in individual chapter 11 bankruptcy cases.  In reaching this conclusion, the Ninth Circuit first reviewed the origins of the absolute priority rule and the applicable amendments enacted through BAPCPA. 

As recounted in Zachary, the absolute priority rule (as it is colloquially known) is a long-standing principle in bankruptcy law tracing its roots to the early twentieth-century railroad bankruptcies.  In sum, the absolute priority rule “provides that a dissenting class of unsecured creditors must be provided for in full before any junior class can receive or retain any property under a reorganization plan.”  Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 202 (1988).  Since its inception, the absolute priority rule has migrated in and out of applicable bankruptcy codes and statutes.  The modern manifestation of the absolute priority rule is codified as section 1129(b)(2)(B)(ii) of the Bankruptcy Code.

Prior to the enactment of BAPCPA, the absolute priority rule provided as follows: “[T]he condition that a plan be fair and equitable with respect to a class [of creditors] includes the following requirements: … (B) With respect to a class of unsecured claims— … (ii) the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest any property.”  11 U.S.C. § 1129(b)(2)(B)(ii) (1994).  Thus, as the Ninth Circuit remarked, “under the pre-BAPCPA Bankruptcy Code, it was clear that ‘every unsecured creditor must be paid in full before the debtor can retain “any property” under a plan.’”  Zachary, at *2, quoting Ice House Am., LLC v. Cardin, 751 F.3d 734, 737 (6th Cir. 2014) (“Ice House”). 

The enactment of BAPCPA, however, created an exception to this immutable rule in the context of individual chapter 11 bankruptcy cases.  “Three provisions of the post-BAPCPA Bankruptcy Code intertwine to implement the absolute priority rule”—namely, sections 541, 1115, and 1129(b)(2)(B)(ii).  Zachary, at *3.  Section 541 defines “an estate in bankruptcy as ‘comprised of all’ the property enumerated in that section, ‘wherever located and by whomever held,’ including ‘all legal or equitable interests of the debtor in property as of the commencement of the case.’”  Id. (emphasis in original), quoting 11 U.S.C. § 541(a).

Section 1115, a provision added to the Bankruptcy Code by BAPCPA, includes after-acquired property within the gamut of estate property in the context of individual chapter 11 bankruptcy cases.  More precisely, section 1115 provides as follows:

In a case in which the debtor is an individual, property of the estate includes, in addition to the property specified in section 541—

(1) all property of the kind specified in section 541 that the debtor acquires after the commencement of the case but before the case is closed, dismissed or converted to a case under chapter 7, 12, or 13, whichever occurs first; and

(2) earnings from services performed by the debtor after the commencement of the case but before the case is closed, dismissed, or converted to a case under chapter 7, 12, or 13, whichever occurs first.

11 U.S.C. § 1115(a) (emphasis added); see Zachary, at *3.

The final provision governing the post-BAPCPA application of the absolute priority rule is section 1129(b)(2)(B)(ii), which was amended by BAPCPA to include the italicized language below:

[T]he condition that a plan be fair and equitable with respect to a class [of creditors] includes the following requirements:

. . ..

(B) With respect to a class of unsecured claims—
. . ..
(ii) the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest any property, except that in a case in which the debtor is an individual, the debtor may retain property included in the estate under section 1115, subject to the requirements of subsection (a)(14) of this section.

11 U.S.C. § 1129(b)(2)(B)(ii) (emphasis added); see Zachary, at *3.

As the Ninth Circuit noted, “[t]he new clauses in subsection (B)(ii) plainly create an exception to the absolute priority rule that applies only to a chapter 11 ‘case in which the debtor is an individual.’”  Zachary, at *3.  The BAPCPA amendments, however, failed to address the scope of the exception “[o]r, put another way, what property … an individual chapter 11 debtor [may] retain ‘without running afoul of the absolute priority rule.” Id., quoting Friedman, 466 B.R. at 487 (Jury, Bankr. J., dissenting).

Due to the absence of guidance regarding the scope of the exception established by BAPCPA, “[t]wo conflicting positions have emerged: the ‘broad view’ and the ‘narrow view.’” Zachary, at *4.  Under the broad view, which the BAP adopted in Friedman, “an individual debtor is entitled to retain most prepetition and postpetition property and nonetheless cram down a plan over an unsecured creditor’s objection.”  Id., citing Friedman, 466 B.R. at 482, In re Anderson, No. 11-61845-11, 2012 WL 3133895, at *7 n.6 (Bankr. D. Mont. August 1, 2012), In re Shat, 424 B.R. 854, 868 (Bankr. D. Nev. 2010), and In re Roedemeier, 374 B.R. 264, 276 (Bankr. Kan. 2007).  Under the narrow view, on the other hand, “an individual debtor may not cram down a plan that would permit the debtor to retain prepetition property that is not excluded from the estate by [section] 541, but may cram down a plan that permits the debtor to retain only postpetition property.”  Zachary, at *4.

Like many others, the split in authority regarding the scope of the exception to the absolute priority rule relates to a question of statutory interpretation.  As succinctly stated by the Ninth Circuit, the key to the scope of the exception “is determining what the word ‘included’ means in the phrase of [section] 1129(b)(2)(B)(ii) stating that ‘the debtor may retain property included in the estate under section 1115.’”  Id.

Courts employing the “broad view” hold that, for purposes of the absolute priority rule, section 1115 acts as a conduit of sorts through which all property is included in the estate of an individual chapter 11 debtor; thus, in the opinion of these courts, “included” in section 1129(b)(2)(B)(ii) refers to both prepetition property defined by section 541 as well as postpetition (after-acquired) property incorporated into the bankruptcy estate under section 1115.  As explained by the majority in Friedman:

“Included” is not a word of limitation. To limit the scope of estate property in [sections] 1129 and 1115 would require the statute to read “included, except for the property set out in Section 541” (in the case of [section] 1129(b)(2)(B)(ii)), and “in addition to, but not inclusive of the property described in Section 541” (in the case of [section] 1115).

Friedman, 466 B.R. at 482 (footnote omitted).

Courts employing the “narrow view,” on the other hand, view estate property in individual chapter 11 cases as consisting of two tranches.  The first tranche consists of prepetition property, which becomes property of the estate on the petition date by operation of section 541.  The second tranche consists of postpetition property, which becomes property of the estate upon acquisition by the debtor by operation of section 1115.  Under this view, only postpetition property—i.e., property “included in the estate under section 1115”—is exempt from the absolute priority rule.  11 U.S.C. § 1129(b)(2)(B)(ii).  The linguistic nuance of this interpretation is explained by the U.S. Court of Appeals for the Sixth Circuit (the “Sixth Circuit”) in Ice House:

The critical language in [section] 1129(b)(2)(B)(ii) is that “the debtor may retain property included in the estate under section 1115.”  And the key word within that language is “included.”  “Include” is a transitive verb, which means it “shows action, either upon someone or something.”  The action described by “include” is either “to take in as a part, an element, or a member” (first definition) or “to contain as a subsidiary or subordinate element” (second definition).  The first definition (“to take in”) describes genuine action—grabbing something and making [it] a part of a larger whole—whereas the second definition (“to contain”) lends itself, more dryly, to a description of things that are already there—“the duties of a fiduciary include….”  The first definition is plainly the better fit in [section] 1129(b)(2)(B)(ii): converted into the active voice, [section] 1129(b)(2)(B)(ii) refers to property that [section] 1115 includes in the estate, which naturally reads as “property that [section] 1115 takes into the estate,” rather than as “property that [section] 1115 contains in the estate.”  Thus—employing this definition and converted into the active voice—[section] 1129(b)(2)(B)(ii) provides that “the debtor may retain property that [section] 1115 takes into the estate.”

Ice House, 751 F.3d at 738-39 (internal citations omitted).  Applying this linguistic analysis to the scope of the absolute priority rule under BAPCPA, the Ninth Circuit stated: “Under this reading, ‘what [section] 1115 takes into the estate is property “that the debtor acquires after the commencement of the case,”’ and it is only ‘that property’ that ‘“the debtor may retain” when his unsecured creditors are not fully paid.’” Zachary, at *5 (emphasis in original), quoting Ice House, 751 F.3d at 739 (quoting 11 U.S.C. §§ 1115(a), 1129(b)(2)(B)(ii)) (internal punctuation omitted).

Based on its review of the potential interpretations of “included” in section 1129(b)(2)(B)(ii), the Ninth Circuit in Zachary agreed with the Sixth Circuit—finding that reading sections 1115 and 1129(b)(2)(B)(ii) “as defining a new class of property that is exempt from the absolute priority rule nicely harmonizes the new provisions.”  Zachary, at *5.

After adopting the plain language interpretation underlying the “narrow view,” the Ninth Circuit addressed the policy concerns and Congressional intent arguments leading several courts to follow the “broad view.”  Those courts generally contend that Congress enacted BAPCPA to bring individual chapter 11 cases in line with chapter 13 reorganizations, which are not subject to the absolute priority rule (or an analogous rule), and that imposing the absolute priority rule on individual chapter 11 debtors is onerous.

With respect to the former, the Ninth Circuit found the contention unpersuasive.  The Ninth Circuit opined that if Congress desired to align individual chapter 11 cases with chapter 13 cases by eliminating the absolute priority rule, Congress had the authority to expressly repeal the absolute priority rule (as it did in 1952) or to make the rule inapplicable to individuals; however, Congress did neither in BAPCPA.  Zachary, at *5-6.  The Ninth Circuit further opined that if Congress wanted to provide more individual debtors that ability to reorganize free of the absolute priority rule, Congress could have simply raised the debt limits in section 109, which would have allowed more individual debtors to file under chapter 13.  Zachary, at *6.  Once again, however, Congress did not raise the debt limits for chapter 13 debtors.  Id.  As Congress did not expressly act to alter the applicability of the absolute priority rule to individual chapter 11 debtors (except with respect to after-acquired property), the Ninth Circuit declined to do so in its stead.  Id

Lastly, the Ninth Circuit addressed the burden of the absolute priority rule on individual chapter 11 debtors.  Although sympathetic to the burden placed on individual chapter 11 debtors, the Ninth Circuit disregarded the purported equitable concerns—stating, “[o]ur task is not to balance the equities … but to interpret the Bankruptcy Code.”  Id. (“We acknowledge that retaining the absolute priority rule in chapter 11 cases works a ‘double whammy’ on a debtor because, under the BAPCPA amendments to [section] 1129(a)(15), [a debtor] ‘must dedicate at least five years’ of disposable income to the payment of unsecured creditors, and—unlike a debtor in Chapter 13—is also subject to the absolute-priority rule (and thus cannot retain any pre-petition property) if [the debtor] does not pay those creditors in full.”).

Ultimately, the plain language interpretation prevailed, and the Ninth Circuit in Zachary affirmed the Bankruptcy Court order sustaining CBT’s objection to the Plan.

Author's Commentary

Bankruptcy practitioners in the Ninth Circuit have long awaited a decision resolving the dispute regarding the scope of the individual debtor exception to the absolute priority rule under BAPCPA.  While the Friedman decision provided some guidance, due to questions regarding the precedential effect of BAP decisions, bankruptcy court decisions remained unpredictable—rendering it difficult, if not impossible, for attorneys to provide reliable advice to their clients on this issue.  Absent Supreme Court or en banc review, the Zachary opinion provides a reliable basis for practitioners to advise clients and formulate plans in individual chapter 11 cases, which remain prevalent in many parts of the Ninth Circuit.

The question, however, that will likely remain due to equitable concerns is whether the interpretation adopted by the Ninth Circuit is correct.  While alternative interpretations are conceivable, a plain reading of the statutory language lends itself to the conclusion that property “included” in the estate by section 1115 means just that—property added to the bankruptcy estate by section 1115, not all estate property. 

Beyond the plain language, the Zachary interpretation also recognizes the interrelated nature of the amendments instituted by BAPCPA.  More precisely, pursuant section 1115, property acquired by individual chapter 11 debtors is now included in the definition of estate property—thereby expanding the scope of the estate.  Thus, it is logical to conclude that the additional protections afforded by the amendments to section 1129(b)(2)(B)(ii) (an amendment that specifically references section 1115) was intended to provide additional protection for this new class of estate property, not all estate property.

Similarly, the Zachary interpretation also maintains the status quo or balance found in pre-BAPCPA absolute priority rule jurisprudence.  Pre-BAPCPA, the absolute priority rule applied to all estate property; however, at the time, estate property did not include after-acquired assets in individual chapter 11 bankruptcy cases.  BAPCPA, however, altered this paradigm—adding property acquired by the debtor postpetition to the estate pursuant to section 1115.  Thus, to read the amendment to section 1129(b)(2)(B)(ii) as applying solely to estate property acquired postpetition maintains the same balance struck prior to BAPCPA (at least with respect to the absolute priority rule) between the rights of debtors and creditors.  While not a canon of statutory interpretation, the logical relationship between these interrelated provisions certainly lends some credence to the Ninth Circuit’s interpretation.

While the Zachary opinion addresses an essential question regarding the post-BAPCPA absolute priority rule, several questions still remain, including whether the reference in section 1129(b)(2)(B)(ii) to section 1129(a)(14) was the result of a scrivener’s error (as has been suggested (see Zachary, at *5 n. 4)), and, if it was, how courts will address this error absent Congressional amendment to address the same, and how the decision will affect individual bankruptcies in the Ninth Circuit—i.e., will more individuals be forced to file under chapter 7 because they cannot obtain a better result in chapter 11 due to the applicability of the absolute priority rule (and increased administrative expenses) and they have too much debt to file under chapter 13?

Notwithstanding any pending debates, open questions, or potential implications, the Zachary opinion is a significant ruling for Ninth Circuit practitioners—one likely to impact the way attorneys advise their clients and formulate chapter 11 plans in individual cases and that may reshape the bankruptcy landscape in the Ninth Circuit for years to come.

These materials were written by Insolvency Law Committee member Michael T. Delaney of Baker & Hostetler LLP in Los Angeles, California (mdelaney@bakerlaw.com).  Editorial contributions were provided by Insolvency Law Committee member and Publications Subcommittee Chair Peter J. Gurfein of Landau, Gottfried & Berger LLP in Los Angeles, California. 

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee

Co-Chair
Leib Lerner
Alston & Bird LLP
Leib.Lerner@alston.com

Co-Chair
Corey Weber
Brutzkus Gubner Rozansky Seror Weber LLP
cweber@brutzkusgubner.com

Co-Vice Chair
Asa S. Hami
SulmeyerKupetz, A Professional Corporation
ahami@sulmeyerlaw.com

Co-Vice Chair
Reno Fernandez
Macdonald Fernandez LLP
Reno@MacFern.com

2015

December 30, 2015: The Northern District of California Concludes the Ninth Circuit’s Sherwood Partners Decision Remains Binding

Summary

In Windmill Health Products, LLC v. Sensa Products (Assignment for the Benefit of Creditors), LLC, 2015 U.S. Dist. LEXIS 145685 (N.D. Cal., Oct. 27, 2015), the U.S. District Court for the Northern District of California held that the Ninth Circuit’s prior ruling that bankruptcy law pre-empted California’s statute permitting an assignee for the benefit of creditors to avoid a preference governed, even though subsequent state court decisions rejected that view. To read the full unpublished decision, click here.

Facts

Windmill Health Products, LLC (“Windmill”) sued Sensa Products, LLC (“Sensa”) in California state court. The parties’ ensuing settlement obligated Sensa to make a series of $200,000 payments to Windmill. After making two of the payments, Sensa made a general assignment for the benefit of creditors (an “ABC”) under California law. The assignee then demanded that Windmill return the $400,000 as avoidable preferences under California Code of Civil Procedure section 1800(b). Windmill filed for declaratory relief in the district court, asking for a declaration that federal bankruptcy law and its preference provisions in Bankruptcy Code section 547 pre-empted section 1800(b) per Sherwood Partners, Inc. v. Lycos, Inc., 394 F.3d 1198, cert. denied, 546 U.S. 917 (2005) and that it therefore was not liable to the assignee for the return of the $400,000. The parties made cross summary judgment motions. The district court granted Windmill’s motion and denied Sensa’s motion.

Reasoning

The district court held that it was bound by the Ninth Circuit’s decision in Sherwood. As the district court explained, Sherwood concluded that the Bankruptcy Code pre-empted section 1800(b) because it alters the incentives for commencing a bankruptcy proceeding and the scheme for equitable distribution to creditors it entails. Why file a bankruptcy with its attendant complexities just to recover preferences when they can be recovered via an ABC? Moreover, creditors in a subsequent bankruptcy proceeding would be denied the benefits of recovery of preferences under section 547 if an assignee for the benefit of creditors had already avoided those transactions.

The district court rejected Sensa’s argument that two post-Sherwood California Courts of Appeal cases rejecting Sherwood were binding on the district court. While federal courts should look to state courts for the rule of decision on state law issues, federal law governs the question of whether federal law pre-empts state law, which was the issue before the district court in Windmill. Therefore, the district court concluded that the Ninth Circuit’s decision in Sherwood was binding, and federal law pre-empts section 1800(b).

Author's Commentary

The author believes that the decision in Windmill is correct given the controlling authority of Sherwood. But the logic of that decision remains debatable. Why does Sherwood conclude that Bankruptcy Code section 547 pre-empts state preference law, but Bankruptcy Code section 548 does not pre-empt state fraudulent conveyance law? It can be argued that Congress indicated an intent not to pre-empt unsecured creditors’ rights by, for example, effectively incorporating state fraudulent conveyance law via Bankruptcy Code section 544(b).

However, one could also contend that state fraudulent conveyance law interferes with the incentives to employ the remedial scheme of the Bankruptcy Code every bit as much as section 1800(b). Moreover, the Bankruptcy Code enables recovery of fraudulent conveyances for the benefit of all creditors, not just a particular creditor as is the case under state law. Further, there no clear reason why Congress’ attitude toward state preference law as interfering with bankruptcy should be any different than its attitude towards state fraudulent conveyance law. Indeed, cases that have criticized Sherwood argue that, taken to its logical conclusion, the reasoning of Sherwood could be used to attack state ABC law altogether, since ABCs are themselves a form of relief designed to deliver equitable distribution to creditors of distressed companies, just as is the Bankruptcy Code.

These materials were written by Adam Lewis of Morrison & Foerster LLP in San Francisco, California (alewis@mofo.com). Editorial contributions were provided by Leib M. Lerner of Alston & Bird, LLP in Los Angeles, California.

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee

Co-Chair
Leib Lerner
Alston & Bird LLP
Leib.Lerner@alston.com

Co-Chair
Corey Weber
Ezra Brutzkus Gubner LLP
cweber@ebg-law.com

Co-Vice Chair
Asa S. Hami
SulmeyerKupetz, A Professional Corporation
ahami@sulmeyerlaw.com

Co-Vice Chair
Reno Fernandez
Macdonald Fernandez LLP
Reno@MacFern.com

October 29, 2015: Overruling Prior Precedent, the U.S. Court of Appeals for the Ninth Circuit Confirms Award of Attorney’s Fees for Prosecution of Suit Seeking Damages for Violation of the Automatic Stay

Summary

In America’s Servicing Co. v. Schwartz-Tallard (In re Schwartz-Tallard), ___ F.3d ___, 2015 WL 5946342 (9th Cir. Oct. 14, 2015), the U.S. Court of Appeals for the Ninth Circuit (the “Ninth Circuit”), en banc, held that section 362(k) of the Bankruptcy Code authorizes an award of attorneys’ fees reasonably incurred in a debtor’s prosecution of a suit for damages to provide redress for a violation of the automatic stay.  In so holding, the Ninth Circuit overruled its prior decision in Sternberg v. Johnston, 595 F.3d 937 (9th Cir. 2010), which limited the costs recoverable under section 362(k) to those incurred to end the stay violation itself.  To read the court’s opinion, click here:  http://1.usa.gov/1PV8DXc

Facts

The debtor, Irene Schwartz-Tallard (the “Debtor”), took out a mortgage on her home in Henderson, Nevada.  After filing a Chapter 13 bankruptcy petition, she continued to make monthly mortgage payments to America’s Servicing Company (“ASC”), the loan servicer.

Post-petition, ASC wrongfully foreclosed on the Debtor’s home.  ASC purchased the home at the foreclosure sale and promptly served the Debtor with an eviction notice.

In response, the Debtor filed a motion in the U.S. Bankruptcy Court for the District of Nevada (the “Bankruptcy Court”) seeking relief under section 362(k) of the Bankruptcy Code—namely, an order requiring ASC to reconvey title to the home and awarding actual and punitive damages and attorney’s fees and costs.  Finding that ASC willfully violated the automatic stay, the Bankruptcy Court ordered ASC to reconvey title to the Debtor and pay the Debtor $40,000 in economic and emotional distress damages, $20,000 in punitive damages, and $20,000 in attorneys’ fees.

ASC reconveyed title to the property and appealed the order to the U.S. District Court for the District of Nevada (the “District Court”).  On appeal, ASC did not challenge the reconveyance; rather, ASC challenged the award of damages.  Ultimately, the District Court affirmed the Bankruptcy Court’s order.  ASC did not challenge the damages award further.

After succeeding on appeal, the Debtor filed a second motion seeking relief under section 362(k) of the Bankruptcy Code.  More precisely, the Debtor sought an order awarding additional attorneys’ fees and costs associated with the appeal.  The Bankruptcy Court denied the motion—holding that since the stay violation ended upon reconveyance of title, which occurred shortly after entry of the initial stay violation order, the fees and costs incurred thereafter in the course of the appeal could not be awarded under Sternberg.

The Debtor appealed the decision to the U.S. Bankruptcy Appellate Panel of the Ninth Circuit (the “BAP”), which reversed the Bankruptcy Court.  Schwartz-Tallard v. America’s Servicing Co. (In re Schwartz-Tallard), 473 B.R. 340 (B.A.P. 9th Cir. 2012).  The BAP distinguished Sternberg because, on appeal to the District Court, ASC continued to challenge the Bankruptcy Court’s determination that the automatic stay had been violated in the first place.  Therefore, the BAP concluded, Sternberg did not preclude the Bankruptcy Court from awarding the Debtor attorneys’ fees incurred when defending the Bankruptcy Court’s enforcement of the stay and her stay-enforcement damage award; such fees constituted actual damages recoverable under section 362(k)(1).  ASC appealed the reversal to the Ninth Circuit. 

A divided three-judge panel of the Ninth Circuit affirmed, distinguishing the case from Sternberg.  Judge Wallace dissented because, in his view, the stay violation ended once the property was reconveyed and therefore, under Sternberg, attorneys’ fees incurred after that point could not be awarded.  The Ninth Circuit then vacated the three-judge panel’s decision and agreed to rehear the appeal en banc.

Reasoning

A majority of the Ninth Circuit’s en banc panel declined to directly evaluate the BAP’s conclusion that Sternberg did not preclude the Bankruptcy Court’s award; rather, the majority decided to take a more drastic step—namely, to “jettison Sternberg’s erroneous interpretation of § 362(k) altogether.”  Schwartz-Tallard at p. 6.

The majority observed that Sternberg draws a line in the sand—holding that only those fees and costs incurred before the stay violation ceased or was cured constituted “actual damages” resulting from the stay violation.  Although the majority acknowledged that section 362(k) uses atypical language in deviating from the American rule, the majority criticized the Sternberg interpretation on the grounds that it created two classes of litigation expenses.  As the majority opined:

We see nothing in the statute that suggests Congress intended to cleave litigation-related fees into two categories, one recoverable by the debtor, the other not.  The statute says “including costs and attorneys’ fees,” with no limitation on the remedy for which the fees were incurred.  To uphold Sternberg’s interpretation of § 362(k), we would have to read into the statute limiting language—something like, “including costs and attorneys’ fees incurred to end the stay violation”—that is simply not present.

Schwartz-Tallard, supra, at p. 8 (emphasis in original).  The majority bolstered its interpretation by opining that allowing a debtor to recoup all related fees and costs carried out the purpose and underlying Congressional intent of the statute, and concluding that the new Schwartz-Tallard interpretation of section 362(k) will avoid litigation relating to the bifurcation of costs under the Sternberg interpretation.  Id. at pp. 9-12.

Judge Bea and O’Scannlain concurred with the majority’s judgment but criticized the majority for looking beyond the plain language of the statute, under which, in their opinion, the Debtor was entitled to recover her attorneys’ fees.  Judge Ikuta, on the other hand, dissented and criticized the majority’s interpretation of section 362(k), which, in Judge Ikuta’s opinion, expanded the fee-shifting aspects of section 362(k) without clear Congressional intent.  Judge Ikuta also criticized the majority’s reasoning—opining that the increased availability of attorneys’ fees and costs may increase litigation by serving as an extra incentive to bring an action under section 362(k).

Author's Commentary

Schwartz-Tallard’s interpretation of section 362(k) represents a significant shift in Ninth Circuit jurisprudence—one that brings the Ninth Circuit in line with many of its sister circuits.  If applied judiciously, the new interpretation of section 362(k) may limit litigation and provide additional protection for debtors by disincentivizing actions that may violate the automatic stay.  The interpretation, however, may just as easily be exploited by unscrupulous debtors seeking leverage over, or nuisance settlements from, creditors that innocently violated the automatic stay—a result that would arguably pervert the purpose of bankruptcy and create an imbalance in the debtor/creditor relationship.  Ultimately, only time will tell whether the majority or Judge Ikuta will be proven right.

These materials were prepared by Michael T. Delaney (mdelaney@bakerlaw.com), an associate in the Los Angeles office of Baker & Hostetler LLP and member of the Insolvency Law Committee, with editorial contributions from John N. Tedford, IV, of Danning, Gill, Diamond & Kollitz, LLP, in Los Angeles.  The opinions expressed herein are those of the author alone and do not reflect the opinions or positions of Baker & Hostetler LLP or its attorneys.

Thank you for your continued support of the Committee.

Best regards,
Insolvency Law Committee

Co-Chair
Leib Lerner
Alston & Bird LLP
Leib.Lerner@alston.com

Co-Chair
Corey Weber
Ezra Brutzkus Gubner LLP
cweber@ebg-law.com

Co-Vice Chair
Asa S. Hami
SulmeyerKupetz, A Professional Corporation
ahami@sulmeyerlaw.com

Co-Vice Chair
Reno Fernandez
Macdonald Fernandez LLP
Reno@MacFern.com

2014

Leib Lerner’s e-Bulletin re the upcoming Supreme Court decisions in Executive Benefits Ins. Agency v. Arkison and Law v. Siegel.  E-Bulletin published on 1/3/14. 

KEYWORDS: Stern, Marshall, Bellingham, core, final, judgment, jurisdiction, fraudulent, transfer, creditor, non-creditor, 157 (as to Bellingham case); surcharge, lien, exemption, homestead, misconduct, fraud, 105 (as to Law v. Siegel case).

Dear constituency list members of the Insolvency Law Committee, the following is a case update on two cases of interest that will be heard by the United States Supreme Court:

Summary

This January, the United States Supreme Court will hear oral arguments on two bankruptcy cases originating out of the Ninth Circuit Court of Appeals:  Law v. Siegel, No. 12-5196 and Executive Benefits Ins. Agency v. Arkison, No. 12-1200. 

The cases present distinct questions.  In Law, the question is whether—pursuant either to its authority under 11 U.S.C. § 105(a) or to its inherent power to sanction misconduct—a bankruptcy court may impose an equitable surcharge on a debtor’s residential property, protected by the homestead exemption, in order to compensate the estate for litigation costs that it incurred as a result of the debtor’s bad-faith litigation conduct.  In Executive Benefits Ins. Agency, the questions are: (i) whether, in light of Stern v. Marshall, 131 S. Ct. 2594 (2011), bankruptcy courts have the constitutional authority to enter a final judgment in a fraudulent conveyance action against a non-creditor, (ii) whether parties may consent to final judgment by a bankruptcy court, and whether litigation conduct reflecting an implied consent to the entry of final judgment by a bankruptcy judge may waive the right to have certain fraudulent-conveyance claims adjudicated only by an Article III court, and (iii) whether a bankruptcy judge has the statutory authority to issue proposed findings of fact and conclusions of law, subject to a district court’s de novo review, regarding a fraudulent-conveyance claim filed by the estate against a non-creditor

Factual and Procedural Background: Law v. Siegel (In re Law)

Stephen Law filed a chapter 7 petition and claimed a $75,000 homestead exemption, pursuant to 11 U.S.C. § 522 and California law, with respect to a residence in Hacienda Heights, California.  He further scheduled two voluntary liens on the residence, one of which was a second deed of trust supported by a purported $168,000 personal loan from a woman named Lili Lin.  The chapter 7 trustee, Alfred Siegel, instituted an adversary proceeding to avoid the Lin lien as a fraudulent transfer, and obtained a default judgment avoiding the lien.  The default judgment was vacated after a Lili Lin of China filed a motion to set aside the judgment through her attorney.  After the judgment was vacated, a Lili Lin of Artesia, California, responded and executed a stipulation for judgment purporting to resolve the adversary proceeding.  In the stipulated judgment, Lili Lin of Artesia acknowledged (1) that she had never made a loan to the debtor and (2) that that the debtor had attempted to involve her in a sham foreclosure of the disputed deed of trust.

The trustee filed a motion to surcharge Debtor’s homestead exemption, to cover the trustee’s litigation costs and expenses, and moved to sell the Property.  The trustee argued that the surcharge was warranted due to the debtor’s "exceptional circumstances of misconduct" by "willfully and knowingly attempt[ing] to defraud his creditors by removing equity from the property."  The bankruptcy court granted the motion, ruling that the debtor’s litigiousness had been a direct cause of the trustee’s increased fees and expenses, and that an equitable surcharge was authorized by 11 U.S.C. § 105(a).  On appeal, the surcharge motion was reversed by the Bankruptcy Appellate Panel and the reversal was affirmed by the Ninth Circuit, on the grounds that a surcharge could not be used to punish the debtor. 

When presented with the trustee's renewed motion to surcharge the debtor's homestead exemption, the bankruptcy court found the surcharge was appropriate to compensate for the debtor's misconduct and prevent fraud caused by misconduct.  The debtor appealed this decision to the Ninth Circuit Bankruptcy Appellate Panel, which this time affirmed the bankruptcy court’s imposition of a surcharge.  The Ninth Circuit Court of Appeals affirmed.  The Supreme Court granted certiorari.  Briefing is complete, and oral argument is scheduled for January 13, 2014. 

Authors' Commentary

The dispute boils down to whether or not the specific provisions of section 522 prevent the bankruptcy court from using its general equitable powers under section 105 to surcharge a debtor’s exemption.  Amicus briefs in support of the debtor have been filed by the National Association of Consumer Bankruptcy Attorneys and by various law scholars.  The National Association of Bankruptcy Trustees, the National Association of Chapter Thirteen Trustees and the United States filed briefs in support of the trustee.  The Supreme Court’s decision can be expected to resolve the split between the first and ninth circuits and the tenth circuit.  Compare Malley v. Agin, 693 F.3d 28, 30 (1st Cir. 2012) and Latman v. Burdette, 366 F.3d 774, 785 & n.8 (9th Cir. 2004) (permitting surcharge), with In Re Scrivner, 535 F.3d 1258 (10th Cir.2008) (not permitting surcharge).

Factual and Procedural Background: Executive Benefits Ins. Agency v. Arkison (In re Bellingham Ins. Agency, Inc.)

Debtor Bellingham Insurance Agency, Inc.’s chapter 7 trustee initiated an adversary proceeding against a non-creditor, Executive Benefits Insurance Agency ("EBIA"), seeking to, among other things, avoid and recover an allegedly fraudulent conveyance to EBIA, under section 548 of the Bankruptcy Code.

The bankruptcy court ultimately granted summary judgment in favor of the trustee (finding the transfers to be fraudulent) and entered a final judgment in favor of the trustee for $373,291.28.  EBIA appealed to the district court, which affirmed the summary judgment.  EBIA then appealed to the Ninth Circuit Court of Appeals.

In a motion to dismiss submitted prior to oral argument, EBIA objected for the first time to the bankruptcy judge's entry of final judgment on the trustee's fraudulent conveyance claims—relying on the landmark Supreme Court case Stern v. Marshall—and claiming the bankruptcy court did not have the constitutional authority to enter final judgment on the fraudulent conveyance claims.  The Ninth Circuit held that, following Stern v. Marshall, while the bankruptcy court had the statutory authority to hear and determine a fraudulent conveyance claim against a non-creditor, the bankruptcy court lacked the constitutional authority to enter final judgment.  The next issue analyzed by the Ninth Circuit is whether bankruptcy courts may still enter proposed findings of fact and conclusions of law pursuant to 28 U.S.C. § 157(c)(1) given that fraudulent conveyance claims are “core” claims based on 28 U.S.C. § 157(b)(2)(H), but notwithstanding 28 U.S.C. § 157(b)(1), bankruptcy courts lack the constitutional authority to enter final judgment against non-creditors.  The Ninth Circuit held that bankruptcy courts may still enter proposed findings of fact and conclusions of law, reasoning that fraudulent conveyance claims remain in the "core," and that only the power to enter a final judgment against non-creditors is abrogated.  The Ninth Circuit ultimately decided against EBIA, holding that parties may waivetheir right to an Article III court, and that EBIA waived its right because it failed to timely object to the bankruptcy court's exercise of jurisdiction over the fraudulent conveyance claim.

The Supreme Court granted EBIA’s petition for certiorari.  Briefing is complete and oral argument is scheduled for January 14, 2014.

Authors' Commentary

The Supreme Court’s upcoming decision is expected to resolve a circuit split regarding whether the right to an Article III tribunal, identified by Stern, is waivable by litigant consent.  See Waldman v. Stone, 698 F.3d 910 (6th Cir. 2012) and Wellness Int’l Network Ltd. v. Sharif, __ F.3d __, No. 12-1349, 2013 WL 4441926, at *17-18 (7th Cir. Aug. 21, 2013) (holding the right is not subject to waiver).  Previous E-Bulletins have discussed the merits of both positions.  Compare Dan Schechter, Bankruptcy E-Bulletin (Dec. 10, 2012) (arguing that the issue is one of subject matter jurisdiction, which cannot be waived by the parties), with Adam Lewis, Bankruptcy E-Bulletin (Jan. 9, 2013) (arguing the contrary).  The Supreme Court's decision is hotly anticipated, because a determination that consent cannot cure the constitutional issues identified by Stern could shift numerous cases from bankruptcy courts to district courts.  The Supreme Court will also have the opportunity to resolve the split, between Bellingham and Wellness, regarding whether a bankruptcy court has statutory authority under section 157 to issue proposed findings of fact and conclusions of law in core matters to a federal district court. 

For more information on both of the cases discussed above, the American Bar Association has a helpful website with links to the merit briefs by the parties and amici curie, available at http://www.americanbar.org/publications/preview_home/alphabetical.htm.

These materials were prepared by Leib M. Lerner, a partner at Alston & Bird LLP in Los Angeles, California (leib.lerner@alston.com) and John Spears, an associate at Alston & Bird LLP in New York, New York (john.spears@alston.com).  Mr. Lerner is a member of the Insolvency Law Committee.  Editorial contributions were provided by Insolvency Law Committee member Ori Katz (OKatz@sheppardmullin.com) of Sheppard Mullin in San Francisco, California.

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee

Adam Lewis’ e-Bulletin re the Supreme Court’s decision in Executive Benefits Ins. Agency v. Arkison.  E-Bulletin published on 6/12/14.  (Note: correction issued on 6/13/14 with correct link to the case). 

KEYWORDS: Stern, Marshall, Bellingham, core, final, judgment, jurisdiction, fraudulent, transfer, creditor, non-creditor, consent, implied, 157, “de novo”, gap.

Dear constituency list members of the Insolvency Law Committee, the following is a case update analyzing a recent case of interest:

Summary

On June 9, 2014, in Executive Benefits Ins. Agency v. Arkison, the United States Supreme Court ruled that, pursuant to 28 U.S.C. § 157(c)(1), a bankruptcy court may make proposed findings of fact and conclusions of law in a Stern “core” proceeding subject to de novo review by an Article III court.    To read the full decision, click here: http://www.supremecourt.gov/opinions/13pdf/13-339_886a.pdf

Facts

The Palavedas owned two companies that began to suffer financial distress.  The Palavedas formed a new company, Executive Benefits Ins. Agency (“EBIA”), to which they transferred assets of the other companies.  The other companies later filed chapter 7 cases. 

The chapter 7 trustee brought an action against EBIA in the bankruptcy court seeking, among other things, to recover the asset transfers as fraudulent conveyances.  After some inconclusive maneuvering between the parties over whether the claims should remain in the bankruptcy court or be transferred to the district court for a jury trial, the trustee moved for summary judgment.  The bankruptcy court granted the motion.  EBIA appealed to the district court, which reviewed the decision de novo.  The district court affirmed. 

EBIA appeal to the Ninth Circuit Court of Appeals.  After EBIA filed its opening brief, the Supreme Court decided Stern v. Marshall, 564 U.S. ___, 131 S. Ct. 2594 (2011).  Stern held that bankruptcy judges cannot enter a final judgment in certain matters statutorily-designated as “core [1] ” under 28 U.S.C. §§ 157(b)(1) and (2) because they are not Article III judges.  In light of Stern's holding, EBIA moved to dismiss the appeal on grounds that the bankruptcy court lacked subject matter jurisdiction over the underlying proceeding and, in turn, the Ninth Circuit lacked jurisdiction over the appeal.  The trustee contended that EBIA had consented to the bankruptcy court’s jurisdiction to enter a final judgment in non-core matters as permitted by 28 U.S.C. § 157(c)(2), which provides that the district court may refer a proceeding related to a case under the Bankruptcy Code to a bankruptcy judge with the consent of the parties. 

The Ninth Circuit affirmed.  Agreeing with the trustee, the Ninth Circuit held that consent could be, and was, implied (and need not be express).  It also found that the district court's de novo review was consistent with 28 U.S.C. § 157(c)(1), which permits a district court to refer any cases or proceedings under the Bankruptcy Code to bankruptcy judges for the district.  The Supreme Court granted EBIA’s petition for certiorari

The Supreme Court affirmed the Ninth Circuit’s decision on the grounds that the proceedings in the bankruptcy and district court effectively comported with section 157(c)(1)’s authority for the bankruptcy court to make proposed findings of fact and conclusions of law, subject to the district court’s de novo review.  The Supreme Court, therefore, found no need to decide whether section 157(c)(2) is itself constitutional and, if so, whether consent may be implied (or must be express). 

Reasoning

The Supreme Court assumed that the subject claims were “Stern" claims -- claims denominated as “core” under section 157(b) that, under Stern, could not be finally decided by the bankruptcy court absent consent of the parties under section 157(c)(2).  But the Supreme Court concluded that, although the procedure under section 157(c)(1) for a bankruptcy court’s issuing proposed findings and conclusions for the district court's de novo review in non-core matters is not expressly authorized for Stern “core” matters, the procedure nevertheless is applicable in such instances. 

The severability provisions accompanying the passage of section 157 mean that matters not governed by the “core” provisions of section 157(b) are, in effect, non-core and, thus, subject to section 157(c)(1).  In essence, the Supreme Court can be seen as re-writing “core” in section 157(b) to mean “subject to a final adjudication by the bankruptcy court under Stern and its provenance.”  Anything that does not meet that “test” becomes “non-core” under section 157(c).  The ruling observes that nothing suggests that Congress intended to create the so-called “Stern gap” that would have left certain kinds of claims subject to neither section 157(b) or section 157(c), without a jurisdictional home in bankruptcy jurisprudence (except perhaps at the district court level under 28 U.S.C. § 1334(a), which vests all bankruptcy jurisdiction in the district courts in the first instance).

The Supreme Court then found that EBIA received the appropriate de novo review when the district court applied the standard applicable to review of grants of summary judgment.  As a result, the Supreme Court determined there was no need to decide whether, under section 157(c)(2), EBIA consented to the bankruptcy court’s jurisdiction to decide the matter. 

Author’s Comment

Accepting that Stern made massive inroads on the jurisdiction of bankruptcy courts over important matters and imposed a system of dual de novo assessment of certain cases (first, by the bankruptcy court making proposed findings and conclusions, and second, by the district court reviewing those proposed findings and conclusions), Executive Benefits at least ameliorates the challenging impositions of Stern.  More particularly, this opinion leaves a large class of cases important to bankruptcy court proceedings – essentially, “related-to” cases – available for treatment at the bankruptcy court level in the first instance (except in the cases requiring jury trials by an Article III court), even if it does so by essentially re-writing the definitions of “core” and “non-core” through its severability analysis.  It seems the fundamental jurisdictional issues created by the Supreme Court’s jurisprudence culminating in Stern are now here to stay unless Congress converts bankruptcy judgeships to Article III positions, as – in the author’s opinion – it should. 

No doubt district courts will be relieved that they do not have to try such cases from scratch given their massive dockets and the wide-open scope of what de novo review requires under section 157(c)(1).  That said, it would have been beneficial if the Supreme Court had decided the consent issues.  Although unnecessary, it certainly could have decided that issue as an alternative rationale as the facts and law below position them well for an intelligent decision.  In any event, the effect of the Supreme Court’s decision in regard to the consent issue is to presently leave the Ninth Circuit’s Bellingham decision on consent the law of the circuit. 

These materials were prepared by ILC member Adam A. Lewis (alewis@mofo.com) of Morrison & Foerster LLP, San Francisco, California.  Editorial contributions were provided by ILC member Asa S. Hami of SulmeyerKupetz, a professional corporation.

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee


[1]Core proceedings are proceedings or issues that are entirely related to a bankruptcy case and are exclusively granted to a bankruptcy court.  See 28 U.S.C. § 157(b)(2).  Non-core proceedings are those that do not arise under bankruptcy law, even if some of the issues in the case relate to the bankruptcy.  Back

Robbin Itkin’s e-Bulletin re Law v. Siegel.  E-Bulletin published on 5/1/14.

KEYWORDS: surcharge, lien, exemption, homestead, misconduct, fraud, 105.

Dear constituency list members of the Insolvency Law Committee, the following is a case update on a recent decision of interest:

Summary

The Supreme Court of the United States held that a bankruptcy court exceeded the limits of its authority by imposing a surcharge on a debtor’s homestead exemption to pay for a chapter 7 trustee’s litigation fees and costs incurred in avoiding a fraudulent lien against estate property created by the debtor.  In a unanimous opinion written by Justice Scalia, the Court held that a bankruptcy court cannot exercise its authority under 11 U.S.C. § 105(a) or its inherent equitable powers in contravention to a specific statutory provision, in this case 11 U.S.C. § 522.  Law v. Siegel, Chapter 7 Trustee, __ U.S. __, 134 S.Ct. 1188, 2014 WL 813702 (March 4, 2014).  To read the decision, click here: http://www.supremecourt.gov/opinions/13pdf/12-5196_8mjp.pdf.

Factual Background

Debtor Stephen Law (“Debtor”) filed for chapter 7 bankruptcy relief in 2004.  On his schedules of assets and liabilities filed with the bankruptcy court, the Debtor listed his personal residence located in Hacienda Heights, California (the “Property”), stated the value of the Property to be $363,348, and claimed a homestead exemption in the Property of $75,000 under section 704.730(a)(1) of California Code of Civil Procedure.  The Debtor further listed two creditors holding claims secured by deeds of trust against the Property.  The first deed of trust was held by Washington Mutual Bank and secured a note in the amount of $147,156.52.  The second deed of trust, securing a note in the amount of $156,929.04, named “Lin’s Mortgage & Associates” (“Lin”), as beneficiary, and reflected a debt owed to someone named “Lili Lin” (the “Lin Deed of Trust”). Because the two stated liens against the Property exceeded the nonexempt value of the Property, it appeared that there was no value in the Property that would be available to pay the estate’s creditors.

Alfred H. Siegel, the duly-appointed chapter 7 trustee (the “Trustee”), commenced an adversary proceeding to challenge the validity of the lien purportedly held by Lin.  During the course of the litigation, two different individuals appeared claiming to be Lili Lin.  The first Lili Lin, of Artesia, California, claimed to be a former acquaintance of the Debtor and described the Debtor’s numerous attempts to involve her in sham transactions involving the Property and Lin Deed of Trust.  Ms. Lin of Artesia denied ever loaning money to the Debtor and quickly entered into a stipulated judgment with the Trustee in which she disclaimed any interest in the Property.  At some point, however, a second Lili Lin, who supposedly lived in China and spoke no English, appeared in the matter and claimed to be the true beneficiary under the Lin Deed of Trust.  This second Ms. Lin engaged in extensive and costly litigation with the Trustee, including several appeals, over the avoidance of the Lin Deed of Trust and subsequent sale of the Property.

After five years of litigation, the bankruptcy court concluded that no person named Lili Lin made a loan to the Debtor and that the alleged loan was a fiction created by the Debtor to preserve the Debtor’s equity in the Property beyond his homestead exemption.  The bankruptcy court was unpersuaded that Lili Lin of China signed or approved any of the declarations or pleadings filed in her name, finding it more likely that the Debtor himself drafted, signed and filed such papers.  The bankruptcy court further found that the Debtor submitted false evidence purporting to show that Lili Lin of China, and not Lili Lin of Artesia, was the beneficiary under the Lin Deed of Trust. 

In the end, the Trustee had incurred over $500,000 in fees and costs in litigating the dispute and overcoming the Debtor’s fraudulent misrepresentations.  Based on the Debtor’s misconduct, the Trustee moved to “surcharge” the entire $75,000 homestead exemption to defray the Trustee’s attorney’s fees.  The bankruptcy court granted the Trustee’s motion.  The Ninth Circuit Bankruptcy Appellate Panel affirmed the bankruptcy court’s decision.  Citing Latman v. Burdette, 366 F.3d 774 (9th Cir. 2004), the BAP recognized a bankruptcy court’s power to equitably surcharge a debtor’s statutory exemption in exceptional circumstances, including where the debtor engages in inequitable or fraudulent conduct.  The Ninth Circuit Court of Appeals also affirmed, holding that the surcharge was proper because it was “calculated to compensate the estate for the actual monetary costs imposed by the debtor’s misconduct, and was warranted to protect the integrity of the bankruptcy process.”  The Debtor appealed.

Holding and Analysis

The Supreme Court found that the bankruptcy court exceeded the limits of its authority by surcharging the Debtor’s homestead exemption and ultimately reversed and remanded the Ninth Circuit’s decision.

The Court’s opinion began by recognizing the bankruptcy court’s statutory authority under Bankruptcy Code section 105(a) to issue any order, process, or judgment necessary to carry out the provisions of the Bankruptcy Code, along with the bankruptcy court’s inherent power to sanction parties engaging in abusive litigation conduct.  The Court, however, held that the bankruptcy court may not exercise either its statutory power under section 105(a) or its inherent equitable powers in contravention to any specific statutory provisions.  In this case, the Court found that the bankruptcy court’s surcharge of the Debtor’s homestead exemption contravened Bankruptcy Code section 522, which: (1) allowed the Debtor to claim a California homestead exemption (sub-section 522(b)(3)(A)) and (2) provided that such exemption could not be liable for the payment of any administrative expenses of the estate (section 522(k)).

The Court was not persuaded by the Trustee’s argument that section 522 merely establishes the procedure for a debtor to claim an exemption in property, and does not require the bankruptcy court to allow such exemption regardless of the circumstances.  This argument was supported by the United States, which filed an amicus brief asserting that section 522 “neither gives debtors an absolute right to retain exempt property nor limits a court’s authority to impose an equitable surcharge on such property.”  The Court read these arguments as equating a bankruptcy court’s right to surcharge an exemption with the bankruptcy court’s right to deny or limit the Debtor’s homestead exemption under section 522.  In this case, the Court held that such arguments fail for two reasons. 

First, the Court held that the Trustee did not timely object to the Debtor’s claimed homestead exemption, and, therefore, the exemption became final prior to the imposition of the surcharge.  The Court noted that it previously held that a trustee’s failure to object timely to a claimed exemption prevents him from later challenging the exemption, citing Taylor v. Freeland & Kronz, 503 U.S. 638, 643-644 (1992).

Second, the Court reasoned that, even if the bankruptcy court could reconsider the Debtor’s ability to claim the exemption, section 522 does not give the bankruptcy court discretion to grant or withhold exemptions based on any factors the bankruptcy court deems appropriate.  The statute specifies the criteria that will allow the debtor to claim an exemption, and it is the debtor’s discretion whether to elect to take the exemption.  If the debtor chooses to do so, the Court reasoned, a bankruptcy court may not refuse to honor such exemption without a valid statutory basis.  The Court explained that section 522 sets forth a number of specific exceptions and limitations to exemptions, some of which relate to a debtor’s misconduct, and stated that section 522’s “meticulous…enumeration of exemptions and exceptions to those exemptions confirms that courts are not authorized to create additional exceptions.”  While the Court acknowledged that there may be circumstances where state law may be applied to disallow a state-created exemption based on the debtor’s misconduct, the Court held that “federal law provides no authority for bankruptcy courts to deny an exemption on a ground not specified in the Code.” (emphasis in original).

The Court concluded by recognizing that its ruling will leave the Trustee with a great financial burden as a result of the Debtor’s egregious misconduct, and may also result in inequitable outcomes in future cases as well.  Ultimately, however, the Court determined that Congress already balanced the interests of debtors and creditors in section 522, and the courts cannot alter the statute’s balance.  The Court also reassured the bankruptcy courts that this decision does not strip or otherwise alter the bankruptcy court’s authority to impose other authorized means of discipline on a dishonest debtor, such as sanctions, a denial of discharge, and, in cases of fraudulent conduct in a bankruptcy case, criminal prosecution.

Author’s Commentary

Although the bankruptcy court in this case admirably tried to achieve an equitable result and to lessen the substantial financial burden to be borne by the Trustee as a result of outrageous and egregious conduct on the part of the Debtor, all in the best interests of the creditors, the Supreme Court’s decision appropriately requires that any actions taken by the bankruptcy court be consistent with specific provisions of the Bankruptcy Code.  To the extent any trustees have relied on Ninth Circuit law allowing for surcharging of a debtor’s exemption in certain circumstances, this decision may impact the strategic considerations of litigating contested property disputes because the trustees would not be able to reach any property subject to a debtor’s exemption.  In this particular case, the fees incurred by the Trustee in fighting over the Debtor’s exemption exceeded the value of the Property—so certainly Trustees need to keep this decision in mind when commencing litigation and in evaluating the costs and benefits of extensive litigation. 

These materials were written by Robbin Itkin and Monsi Morales of Steptoe & Johnson LLP, in Los Angeles, California (ritkin@steptoe.com and mmorales@steptoe.com), with editorial contributions were provided by ILC member Haeji Hong in San Diego, California.  Ms. Itkin is a member of the Insolvency Law Committee. 

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee

Diana Herman’s e-Bulletin re Clark v. Rameker.  E-Bulletin published on 7/30/14. 

KEYWORDS: IRA, retirement, exempt, exemption, inherited, 522.

Dear constituency list members of the Insolvency Law Committee, the following is a recent case update:   

Summary

On June 12, 2014, in Clark v. Rameker, the United States Supreme Court unanimously held that funds held in inherited IRAs are not “retirement funds” within the meaning of 11 U.S.C. §522(b)(3)(C) and are therefore not exempt property.  To read the full decision, click here:  http://www.supremecourt.gov/opinions/13pdf/13-299_6k4c.pdf

Facts

In 2001, Heidi Heffron-Clark inherited an individual retirement account (“IRA”) worth roughly $450,000 from her mother’s estate.  Heffron-Clark and her husband (“Debtors”) filed for bankruptcy in October 2010 and sought to exclude the $300,000 in funds remaining in the IRA as exempt under 11 U.S.C. §522(b)(3)(C).  The Chapter 7 trustee and unsecured creditors objected to the claimed exemption on the ground that the funds in the inherited IRA were not “retirement funds” within the meaning of the statute. 

The bankruptcy court disallowed the Debtors’ claimed exemption and held that the inherited retirement funds must be held for the current owner’s retirement in order to qualify as an exempt retirement fund under 11 U.S.C. §522(b)(3)(C).  The district court reversed and held that the exemption covers any account containing funds originally accumulated for retirement purposes.  The U.S. Court of Appeals for the Seventh Circuit (“Seventh Circuit”) reversed the district court and disallowed the exemption, holding that the rules for inherited IRAs, unlike the rules for non-inherited IRAs, require the owner to withdraw the funds in the account (either within five years of the original owner's death or through minimum annual distributions), so inherited IRAs "represent an opportunity for current consumption, not a fund of retirement savings." 

Ruling

The Supreme Court affirmed the Seventh Circuit's decision, holding that the funds in an inherited IRA are not set aside for the debtor's retirement and thus are not "retirement funds" under the exemption in 11 U.S.C. § 522(b)(3)(C).  The Court examined three legal characteristics of inherited IRAs in determining whether the funds are objectively set aside for the purpose of retirement.  First, unlike traditional IRAs, the holder of an inherited IRA is prohibited from investing additional money in the account.  Second, the holder of an inherited IRAs is required to take minimum annual distributions every year, no matter how many years they are from retirement. Finally, unlike traditional IRAs, the holder of an inherited IRA may withdraw the entire balance of the account at any time and for any reason without penalty.

Based on these three legal characteristics, the Court held that inherited IRAs cannot be treated as an exempt “retirement fund” under Section 522.  The Court reasoned that if an individual were to be “allowed to exempt any inherited IRA from her bankruptcy estate, nothing about the inherited IRA’s legal characteristics would prevent (or even discourage) the individual from using the entire balance of the account on a vacation home or sports car immediately after her bankruptcy proceedings are complete.”  The Court held that this would frustrate the balance between ensuring creditor recoveries while protecting the debtor’s essential needs during their retirement years and enabling a “fresh start.” 

Author's Commentary

While the Supreme Court’s opinion dealt with an IRA inherited by a child from a parent, the Court noted that IRAs inherited by spouses may be treated differently.  In particular, the Court noted the distinction between an IRA inherited from a parent and an IRA inherited from a spouse.  Unlike an IRA inherited from a parent, when the heir to an inherited IRA is the owner’s spouse, the spouse “may ‘roll over’ the IRA funds into his or her own IRA, or he or she may keep the IRA as an inherited IRA” subject to the applicable rules. 

These materials were written by ILC member Diana Herman (dherman@mckennalong.com), of counsel at McKenna Long Aldridge LLP, in San Francisco, California, with editorial contributions from ILC member Michael J. Gomez of Lang, Richert & Patch, P.C., in Fresno, California. 

Adam Lewis’ e-Bulletin re Heller Ehrman LLP v. Davis, Wright, Tremaine, LLP.  E-Bulletin published on 6/19/14. 

KEYWORDS: Heller, UPA, RUPA, partnership, Jewel, waiver, fee, fraudulent, conveyance, transfer, “quantum meruit”, duty, unfinished, business.

Dear constituency list members of the Insolvency Law Committee, the following is a case update analyzing a recent case of interest:

Summary

On June 11, 2014, in Heller Ehrman LLP v. Davis, Wright, Tremaine, LLP, the United States District Court for the Northern District of California ruled that the trustee of the bankruptcy estate of the defunct law firm Heller Ehrman LLP (“Heller”) could not recover fees earned by other law firms on Heller matters that former Heller shareholders took with them to those new firms after Heller’s dissolution.  [Heller Ehrman LLP v. Davis, Wright, Tremaine, LLP, 2014 WL 2609743 (N.D. Cal. June 11, 2014)]. 

Facts

Heller was a large international law firm.  In 2008, its lender declared it in default.  Heller’s shareholders voted to dissolve the firm and advised its clients that it could no longer provide services on their open matters.  Jewel v. Boxer, 156 Cal. App.3d 171 (1984), held that under the Uniform Partnership Act the partners of a dissolved law partnership had to account to each other (that is, to the partnership) for income from post-dissolution work with their new firms on former partnership matters.  The Heller dissolution resolution contained a “Jewel waiver” waiving Heller’s right to recover fees earned by firms employing former Heller shareholders who took Heller matters to those new firms post-dissolution.

Proceeding in the Bankruptcy Court, the Heller trustee sued several law firms to which former Heller shareholders took existing hourly fee matters after the dissolution, seeking recovery of profits earned from former Heller clients.  The trustee alleged that the Jewel waiver was avoidable as a constructive fraudulent conveyance made by Heller while it was insolvent without any consideration in return, leaving him free to sue the new firms under Jewel.  The parties made cross motions for summary judgment.  The Bankruptcy Court granted the trustee’s motion as either a final judgment or, if it lacked jurisdiction to enter a final judgment, as proposed findings and conclusions subject to de novo review by the District Court pursuant to 28 U.S.C. § 157(c)(1).  The defendant firms appealed. 

Relying on Executive Benefits Ins. Agency v. Arkison, decided by the Supreme Court just two days before, the District Court treated the matter as being subject to de novo review under 28 U.S.C. § 157(c)(1).  With the fundamental facts undisputed by the two sides, the District Court granted summary judgment for the defendant firms, rather than the trustee. 

Reasoning

The District Court’s fundamental rationale was that a law firm does not have a property interest in prospective work, even on existing matters.  Such matters are owned, instead, by the client.  A client has an absolute right to terminate a firm, with the firm’s only remedy a quantum meruit claim for the reasonable value of services rendered to date.  There was, therefore, nothing for which the successor firms had to account to the Heller estate.[1]  The District Court further noted that equity and policy considerations further supported its decision.  To require successor firms to pay to a firm’s estate revenues generated from matters brought with them by the estate’s former partners would burden not only the employability of the former partners, but the ability of the clients to avoid having to hire counsel who would have to learn a case from scratch (and having to charge the client for doing so). 

The District Court then added a cascade of lesser reasons for its decision.  For example, it noted that, as the trustee admitted, Jewel, which only applies in the event of a dissolution, would not apply to partners who left thriving firms (though they might be liable for a breach of duty to the partnership under certain circumstances).  Similarly, if a firm simply took business from a distressed or collapsed firm without taking any of its partners, the latter would have no claim against the former.  The implication of these two points by the District Court was why should it make any difference that a dissolution has occurred?  Also of concern was that the Jewel rule would encourage partners to ditch firms at the first sign of trouble so that they could be out the door in time to avoid the Jewel consequences of a collapse, something that such an exodus might precipitate unwittingly.  Finally, the District Court opined that it doubted that the California Supreme Court would stand by Jewel and that, in any event, Jewel differed from Heller factually in a number of important ways.[2] 

Author’s Comment

The author believes that the Heller decision is correct on both the property interest and policy rationales, and welcome.  In particular, the Jewel doctrine’s burden on the transition of lawyers and clients to new firms was a heavy one.  Moreover, since the Revised Uniform Partnership Act, which was passed after the Jewel decision, expressly permits waiver of a partnership’s Jewel rights, Heller is not cutting off otherwise ineluctable sources of recovery for creditors of defunct firms.[3]  Of course, this is just a District Court decision in the Northern District of California, as yet unpublished.  Moreover, it may be appealed to the Ninth Circuit.  Nevertheless, it may immediately be persuasive authority in New York and elsewhere where courts are wrestling with the same issues, sometimes complicated by differing underlying state partnership law. 

These materials were prepared by ILC member Adam A. Lewis (alewis@mofo.com) of Morrison & Foerster LLP, San Francisco, California.  Editorial contributions were provided by ILC member Doris A. Kaelin of Berliner Cohen, in San Jose, California.

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee

[1] The District Court therefore skipped over the fraudulent conveyance issues entirely. Back

[2] It is not at all clear that these differences matter; the District Court’s reliance on them may give rise to claims that the decision is limited to its facts. Back

[3] The problem in Heller was that the shareholders waited until the last moment to adopt the Jewel waiver (included as part of the firm’s dissolution plan), thereby setting up the fraudulent conveyance claim that the trustee asserted to set aside the waiver so that he could sue on the Jewel rights.  Of course, on the other hand, partners who are getting together or who are joining an apparently healthy partnership may be reluctant to include a Jewel waiver in their partnerships.  Hence, Heller may yet be important in future situations. Back

Rob Harris’ e-Bulletin re Wu v. Markosian.  E-Bulletin published on 8/5/14. 

KEYWORDS: dismiss, abuse, income, convert, reconvert, re-convert, conversion, bonus, earnings, services, 1115, 541, 348, property, post-petition, BAPCPA.

Dear constituency list members of the Insolvency Law Committee,

The following is a case update analyzing a recent decision of interest:

Summary

The United States Bankruptcy Appellate Panel of the Ninth Circuit (the “BAP”) has affirmed a bankruptcy court’s ruling that individual debtor’s chapter 11 post-petition earnings which are property of the estate under § 1115 revert to him or her upon a subsequent conversion to chapter 7.  Wu v. Markosian (In re Markosian) – 9th Cir. BAP (3/12/14).  Click HERE http://cdn.ca9.uscourts.gov/datastore/bap/2014/03/12/Markosian-13-1339.pdf to read this decision.

Facts

On February 7, 2009, debtors and appellees Ara and Anait Markosian filed a chapter 7 bankruptcy petition.  The United States Trustee moved to dismiss their case for abuse based on high income and their ability to pay their creditors.  In response, the Markosians converted their case to chapter 11 on February 11, 2010.  The Markosians could not, however, confirm a plan due to a decrease in income owing to Mrs. Markosian’s loss of her job.  Thus, on March 7, 2012, the Markosians reconverted their case to chapter 7.  In the following month, Mr. Markosian received a $102,498.421 bonus from his employer for personal services provided during the period that the case was under chapter 11.

The Markosians turned over the bonus to the Chapter 7 trustee and filed a motion to address whether the bonus was property of their chapter 11 estate, partially exempt property of the chapter 7 bankruptcy estate or property excluded from the chapter 7 estate.  The Trustee opposed.  

The bankruptcy court, adopting the reasoning of In re Evans, 464 B.R. 429, 438-41 (Bankr. D. Col. 2011), entered an order granting the Markosians’ motion, finding that the bonus constituted earnings from personal services within the meaning of Bankruptcy Code §1115(a)(2), but the bonus ceased to be property of the estate upon conversion to chapter 7.  The Trustee timely appealed to the Bankruptcy Appellate Panel (“BAP”).

Reasoning

The issue on appeal was whether an individual debtor’s chapter 11 post-petition earnings, which are property of the estate under § 1115, revert to him or her upon a subsequent conversion to chapter 7.  The issue was a matter of first impression in the Ninth Circuit.

In affirming the bankruptcy court’s order compelling the Trustee to return the bonus, the BAP initially focused on the distinction between estate and debtors’ property delineated by Bankruptcy Code §§ 541(a)(6) and (7).  The BAP noted that “[u]nder § 541(a)(6), “earnings from services performed by individual debtors after the commencement of the case are the debtor’s property which are excluded from property of the estate.” 

The BAP observed next that Bankruptcy Code §1115, added by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, makes an individual chapter 11 debtor’s post-petition earnings property of the estate.  The bankruptcy court found that the bonus received by Mr. Markosian post-conversion was property of the Markosians’ chapter 11 estate under § 1115(a)(2).  The BAP disagreed, though that finding was not appealed, stating that § 1115 does not apply upon conversion from chapter 11 to chapter 7. 

The BAP focused instead upon Bankruptcy Code § 348, which governs the effect of a conversion.  The BAP agreed with the bankruptcy court that § 348(f)(1)(A) excludes a debtor’s post-petition earnings from property of a chapter 7 estate upon conversion from chapter 13 but that there is no parallel provision for chapter 11 debtors.  As a consequence, the BAP held that it had to look more broadly to § 348(a) – a section that applies to all cases under Title 11.  The BAP stated that “[w]here a case is converted from Chapter 11 to Chapter 7, property of the estate is determined by the filing date of the Chapter 11 petition, and not by the conversion date” citing Magallanes v. Williams (In re Magallanes), 96 B.R. 253, 255 (9th Cir. BAP 1988). 

The BAP then simply applied the earnings exception of section 541 to a case that, for analytical purposes, it treated as having been commenced on the date of conversion: “[a]s of the petition date, § 541(a)(6) excludes from the chapter 7 estate earnings from services performed by individual debtors after the commencement of the case.  Therefore, by operation of § 348(a), personal service income that came into Debtors’ chapter 11 estate is recharacterized as property of the debtor under § 541(a)(6) when the case is converted to chapter 7.  Accordingly, upon conversion, the bonus reverted to Debtors.”  The BAP spends the balance of its opinion explaining away contrary views espoused by other courts that have come to different conclusions.

The BAP provides sound policy reasons to explain why it elected not to stretch to fill a statutory void that Congress left in amending § 348 in 1994 to add subsection (f)(1)(A): “[i]n the end, there is no reason to treat chapter 11 debtors differently than chapter 13 debtors in this context.  As the Evans court pointed out, at the time Congress enacted § 348(f), it ‘clearly conveyed its purpose to avoid penalizing debtors who first attempt a repayment plan . . . [t]here is no policy reason as to ‘why the creditors should not be put back in precisely the same position as they would have been had the debtor never sought to repay his debts . . . .’ 464 B.R. at 441.”

Author’s Comment

The failure by Congress to enact a provision parallel to § 348(f)(1)(A) for chapter 11 debtors so that all debtors’ post-petition earnings from property of a chapter 7 estate upon conversion are treated identically is disappointing.  Courts often abandon plain language statutory interpretation to try to make sense of BAPCPA, more often than not at the expense of a blameless debtor.  Here, the BAP’s refusal to attempt “to divine Congressional intent from congressional silence” and create a rule that works differently for Chapter 11 and Chapter 13 debtors in identical circumstances generated an equitable and consistent outcome.  Until Congress decides to address the void in section 348, In re Markosian will serve as well-reasoned authority to assist practitioners in dispensing appropriate advice to individual Chapter 11 clients with ongoing income from employment who must convert their cases to Chapter 7.

These materials were written by Robert G. Harris (rob@bindermalter.com), a partner in the Silicon Valley firm Binder & Malter, LLP.  Mr. Harris is an advisor to the Insolvency Law Committee and a member of the State Bar Business Law Section Executive Committee.  Editorial contributions were provided by ILC member, Everett Green (Everett.L.Green@usdoj.gov). 

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee

Asa Hami’s e-Bulletin re Tracht Gut.  E-Bulletin published on 2/10/14. 

KEYWORDS: tax, fraudulent, conveyance, transfer, property, record, recordation, post-petition, automatic, stay, 12(b)(6), dismiss, 541, 362, ministerial, sale, leave, amend.

Dear constituency list members of the Insolvency Law Committee, the following is a recent case update:

Summary

The Bankruptcy Appellate Panel of the Ninth Circuit affirmed the bankruptcy court’s dismissal, with prejudice, of a debtor’s fraudulent transfer action seeking to avoid the sale of tax-defaulted real property because: (i) the complaint failed to allege sufficient facts, (ii) the debtor unduly delayed in seeking to amend the complaint, and (iii) amendment of the complaint was futile, since a properly conducted sale of tax-defaulted real property establishes reasonably equivalent value as a matter of law.  Tracht Gut, LLC v. County of Los Angeles (In re Tracht Gut, LLC), 12-20308 (MT); CC-13-1229-PaTaD (B.A.P. 9th Cir. Jan. 3, 2014).  To read the full decision, click here:  http://cdn.ca9.uscourts.gov/datastore/bap/2014/01/03/TrachtGut-13-1229.pdf

Facts and the Bankruptcy Court’s Decision

In April of 2012, Tracht Gut, LLC (“Debtor”) purchased two parcels of real property, both located in Los Angeles County.  Both properties were tax-defaulted pursuant to California tax law and subject to the Los Angeles County Tax Collector’s (the “County") power to sell three years after default.  The County conducted a tax sale of the properties in October of 2012.  The tax sale was regularly conducted in accordance with all applicable statutory requirements.  Debtor subsequently filed a petition under chapter 11 in November of 2012.  Although the tax sale occurred pre-petition, tax deeds transferring title of the properties were not recorded until after Debtor had filed bankruptcy.

In December of 2012, Debtor commenced an adversary proceeding against the County, seeking to avoid the tax sales as fraudulent transfers, asserting the post-petition recordation of the tax deeds violated the automatic stay, and other ancillary claims.  The bankruptcy court granted the County’s motion to dismiss under Fed. R. Civ. P. 12(b)(6) and denied Debtor leave to amend the complaint. 

The court noted that Debtor’s complaint was clearly filed as a “placeholder” and was “unbelievably bad.”  The court did not to grant leave to amend for several reasons.

First, granting leave to amend would be futile because Debtor could never plead any facts to support its fraudulent transfer claim; since the tax sale occurred prior to the bankruptcy filing, the properties were never property of the estate under 11 U.S.C. § 541.  Second, post-petition recording of the tax deeds could not violate the automatic stay in 11 U.S.C. § 362 because it was “solely a ministerial action.”  Third, Debtor could never allege that a duly conducted tax sale of the subject properties could be the basis of an action under 11 U.S.C. §§ 548 and 549. 

The court later denied Debtor’s motion for reconsideration to amend the complaint, in large part because Debtor waited too long to attempt amendment. 

The Bankruptcy Appellate Panel’s Holding and Analysis

The Bankruptcy Appellate Panel of the Ninth Circuit (the “BAP”) affirmed.   

Addressing Debtor’s claims, the BAP held the court’s dismissal of the complaint was proper because “even liberally read, Debtor’s complaint presented no factual matter to support its prayer for relief.”  The BAP agreed with the bankruptcy court’s rationale, holding that the two properties never became property of the estate under 11 U.S.C. § 541, and further that the recording of the tax deeds post-petition would not have violated the automatic stay, since that type of ministerial act is not enjoined by the stay. 

The BAP affirmed the court’s denial of leave to amend, holding that the court's two bases for denying leave to amend--undue delay and futility--were adequate to sustain the decision.  The BAP held Debtor’s right to amend the complaint as a matter of course had expired 21 days after service of the County’s 12(b)(6) motion, and Debtor was culpable for its failure to exercise diligence in seeking to amend the complaint.  The BAP further held that any amendment to Debtor’s fraudulent transfer claim would be futile because a duly conducted tax sale of tax-defaulted real property under California law conclusively establishes an exchange of “reasonably equivalent value,” and Debtor did not assert any irregularities or actual fraud in connection with the tax sale.

Author’s Comment

This decision is a valuable reminder that a complaint must contain more than mere recitations of the statutory elements of a claim.  If a deficient complaint is initially filed as a placeholder, it should be amended as soon as possible—and certainly within the statutory period for amendment as a matter of right. 

These materials were written by Asa S. Hami, an attorney at SulmeyerKupetz APC in Los Angeles, California (ahami@sulmeyerlaw.com).  Mr. Hami is a member of the Insolvency Law Committee.  Editorial contributions were provided by ILC member Ori Katz, a partner at Sheppard Mullin in San Francisco, California.

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee

Jonathan Dabbieri’s e-Bulletin re Jones v. United States Trustee.  E-Bulletin published on 1/21/14.

KEYWORDS: discharge, revoke, disclose, 727, 341, undervalue, value, omit, omission, schedules, inadvertent, advice, fraud.

Dear constituency list members of the Insolvency Law Committee, the following is a case update on a recent decision of interest:

Summary

The United States Court of Appeals for the Ninth Circuit held that fraud which would have justified the bankruptcy court denying a discharge under 11 U.S.C. §727(a)(4)(A) will support an action to revoke a discharge under 11 U.S.C. §727(d)(1).  Jones v. U.S. Trustee, Eugene, ___ F.3d ___, 2013 WL 6224330 (9th Cir. 2013 Dec. 2, 2013 Dkt. no. 12-35665) (“Jones”).  To read the opinion, click here:
 http://cdn.ca9.uscourts.gov/datastore/opinions/2013/12/02/12-35665.pdf.

Facts

In his initially filed bankruptcy schedules and in his testimony at the meeting of creditors under 11 U.S.C. §341(a), Jerry Jones (debtor) omitted a number of assets and undervalued other assets, largely valuing them at zero.  The debtor received his discharge in due course.  Within a year of the date the discharge was granted, the United States Trustee discovered the debtor had omitted and undervalued assets in his bankruptcy schedules, and brought an adversary action to revoke the discharge.  After two days of hearings, the bankruptcy court ruled that the debtor’s omissions and undervaluations violated 11 U.S.C. §727(a)(4) and revoked the discharge.  On appeal, the Ninth Circuit affirmed.

Reasoning

Before the bankruptcy court the debtor argued that his omissions and undervaluations had been inadvertent or on advice of counsel, and that several were corrected through schedule amendments.  The bankruptcy court rejected these defenses, found the omissions and undervaluations had been made knowingly and fraudulently, and determined they constituted a violation of 11 U.S.C. §727(a)(4), justifying revocation of the discharge pursuant to 11 U.S.C. §727(d)(1).

On appeal, the debtor argued that it was error to revoke a discharge under 11 U.S.C. §727(d)(1) based on a violation of 11 U.S.C. §727(a)(4).  Quoting Nielsen v. White (In re Nielsen), 383 F.3d 922, 925 (9th Cir. 2004) that to revoke a discharge due to the debtor’s fraud it had to be shown that “but for the fraud, the discharge would not have been granted” the debtor argued that some fraud other than his fraudulent schedules had to be proven, and it had to be proven that but for the additional fraud, the discharge would not have been granted.  The debtor argued that since he would have received his discharge even without the fraud, that is, he would have received a discharge had he filed accurate schedules, it could not be said he would not have obtained a discharge  “but for” his fraud.  The debtor further argued, citing Nielsen, 383 F.3d at 925-26, that to revoke the discharge it had to be proven the outcome of the case would have been different had the fraud not occurred.  According to the debtor, the alleged fraud did not affect the outcome of his case.  The chapter 7 trustee investigated all the assets on the debtor’s schedules and was liquidating them for the benefit of creditors.  As a result, the debtor believed that creditors would get paid and there was no harm caused by his actions.

The Ninth Circuit rejected these arguments.  The Ninth Circuit cited two Ninth Circuit Bankruptcy Appellate Panel cases, In re Gilliam, 2012 WL 1191854 (9th Cir. BAP 2012, Dkt. no. 11-1248) and In re Wahl, 2009 WL 7751412 (9th Cir. BAP 2009, Dkt. no. 08-1218), and a district court case, In re Guadarrama, 284 B.R. 463 (C.D. Cal. 2002), all holding that pre-discharge fraud which would have justified denial of a discharge had it been discovered prior to the grant of a discharge, will justify revocation of the discharge when it is discovered post-discharge.  Jones at *2.  As for the requirement in Nielsen that “but-for” the fraud the discharge would not have been granted, the Ninth Circuit stated this is “properly read as establishing the rule that the fraud must be material, i.e., must have been sufficient to cause the discharge to be refused if it were known at the time of discharge.”  Here, the Ninth Circuit concluded that had the fraud been discovered prior to issuance of the discharge, the debtor could have been denied a discharge, satisfying the suggestion in Nielsen that the fraud must have affected the outcome of the bankruptcy.

Author's Comment

There were two strands to the debtor’s argument, neither of which was accepted by the Ninth Circuit.  First, by noting that he would have received a discharge had he properly disclosed the assets, the debtor argued that his fraud did not procure the discharge; he would have received the discharge had he properly disclosed and valued the assets.  The Ninth Circuit rejected interpreting the “but-for” language of Nielsen as a requirement that the fraud must have directly procured the discharge, instead interpreting it as a materiality requirement, that the fraud must have been sufficient to justify denying a discharge had it been known at the time of the discharge.  Jones at *2.  The Ninth Circuit implicitly adopted the holding of Guadarrama and the other cited cases that the fraud need only have occurred “in the procurement” of the discharge.  It is not required to be the direct cause of the debtor obtaining a discharge.

The second strand of the debtor’s argument was that since the debtor was not questioned about the omissions and undervaluations on his schedules. He therefore did not engage in a second fraud to conceal the first to procure a discharge. The Ninth Circuit rejected a requirement there be two frauds, the second consisting of concealing the first.  Only the initial fraud need be shown.

Although not addressed by the Ninth Circuit, the debtor also argued that because 11 U.S.C. §727(d)(3) explicitly makes a violation of 11 U.S.C. §727(a)(6) a ground for revocation of a discharge, it is error to revoke a discharge under 11 U.S.C. §727(d) by reason of a violation of any other subsection of 11 U.S.C. §727(a).  The debtor argued that by explicitly making a violation of 11 U.S.C. §727(a)(6) a ground for discharge under 11 U.S.C. §727(d)(1), Congress implicitly rejected making the violation of any other subsection of 11 U.S.C. §727(a) a basis for revocation of the discharge. If any violation of 11 U.S.C. §727(a) justified revocation under 11 U.S.C. §727(d)(1), the debtor argued, there was no need for 11 U.S.C. §727(d)(3), rendering the subsection superfluous.  Presumably, however, because 11 U.S.C. §727(d)(1) requires a showing of fraud, only those violations of 11 U.S.C. §727(a) which implicate fraud, e.g., 11 U.S.C. §727(a)(2), would be the basis for an action to revoke a discharge under 11 U.S.C. §727(d)(1).  Section §727(a) is not wholly incorporated into 11 U.S.C. §727(d).

The case establishes that a debtor who has committed pre-discharge fraud is not safe once the discharge is obtained.  The debtor remains exposed to possible revocation proceedings under 11 U.S.C. §727(d)(1) for one year from the date of discharge.  11 U.S.C. §727(e)(1).

Interestingly, the opinion did not address the debtor’s materiality argument.  The debtor did not dispute that he listed many of his assets as having no value.  However, according to the debtor, the bankruptcy court never made a finding as to the specific value of his assets.  Because the bankruptcy court did not determine the value of his assets, the bankruptcy court could not find that the debtor’s undervaluation was material, i.e. sufficient to cause the discharge to be refused if it were known at the time of the discharge. 

Finally, the opinion did not address the debtor’s argument that even if the debtor undervalued his assets, the chapter 7 trustee investigated each asset and determined that he could liquidate them.  Because the chapter 7 trustee was liquidating the assets, the debtor’s non-disclosure or undervaluation had no impact on the case.  Perhaps the Ninth Circuit did not want to lessen the debtor’s burden to be truthful regarding the information reported in the schedules.

These materials were prepared by Jonathan Dabbieri of Sullivan, Hill, Lewin, Rez & Engel.  Editorial contributions were provided by Everett L. Green, United States Department of Justice, Office of the United States Trustee.

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee

Adam Lewis’ e-Bulletin re Fisker Automotive Holdings.  E-Bulletin published on 2/26/14.

KEYWORDS: sale, auction, free, clear, liens, 363, cause, secured, creditor, credit, bid, buy, purchase, claim, chill.

Dear constituency list members of the Insolvency Law Committee, the following is a case update analyzing a recent case of interest:

Summary

In connection with the proposed sale of substantially all of the debtors’ assets free and clear of liens under Bankruptcy Code Section 363(k), the bankruptcy court for the District of Delaware found “cause” within the meaning of Section 363(k) to limit the senior secured creditor’s right to credit bid its secured claim to the discounted amount the secured creditor paid the claim’s original holder of the secured claim to buy the claim.  The case is In re Fisker Automotive Holdings, Inc., 2014 WL 210593 (Bankr. D. Del. Jan. 17, 2014). 

Facts

Fisker Automotive and its subsidiaries (the “Debtors”), embarked on development of two premium models of hybrid plug-in electric vehicles.  To fund the development, the Debtors arranged lines of credit with Federal Financing Bank (“FFB”) through the Department of Energy (the “DOE”).  The loans were secured by various assets of the Debtors, though it appears that the security did not include some assets and there was a dispute as to whether it extended to some other assets.  A variety of factors led to failure of the business.  In the meantime, Hybrid Tech Holdings, LLC (“Hybrid”) purchased the DOE’s $168 million loan for $25 million.  The Debtors and Hybrid then negotiated a sale of substantially all of the Debtors’ assets to Hybrid for consideration that included a $75 million credit bid.  The bankruptcy court did not describe the other consideration.  The Debtors then filed chapter 11 for the purpose of effectuating the Hybrid sale, with a liquidating plan to follow.

The Debtors filed a simple sale motion, believing that no one else would make a bid higher or more attractive than Hybrid’s bid.  The Creditor’s Committee (the “Committee”), however, filed a motion asking the bankruptcy court to set up an auction with bidding procedures.  In the meantime, Wanxiang America Corp. (“Wanxiang”) made an offer to the Debtors that “was extremely attractive both economically and in its significant non-economic terms.”  Again, the bankruptcy court did not detail the Wanxiang offer. 

The Debtors and Committee then agreed that if Hybrid’s right to credit bid was denied altogether for “cause” under Section 363(k), or appropriately limited, it was likely that there would be a lively auction that would produce better results for the estate than the Hybrid offer.  Without any such limitations, neither Wangxiang nor any other party was likely to participate in an auction. 

At the hearing on the bidding procedures and sale motions, the bankruptcy court capped Hybrid’s right to credit bid at the $25 million it paid for the DOE’s secured claim.

Reasoning

The bankruptcy court adopted two rationales for its decision.  First, it held that not only would Hybrid’s right to credit bid the entire claim chill bidding, but the Debtors/Committee stipulation indicated that there would be no bidding at all.  Second, the bankruptcy court pointed to the dispute over just what collateral Hybrid held and, therefore, just what its secured claim really was.  The bankruptcy court also noted that neither the Debtors nor Hybrid explained what the rush was to push through a sale to Hybrid because the Debtors had already shuttered their operations.  The bankruptcy court did not explain why it selected the claim purchase price as the cap, but the decision may be tied to how much Hybrid (as contrasted with the original lender, the DOE) put at risk. 

Author’s Comment

The decision represents a mixed bag of policy considerations.  On the one hand, it is a fair argument that a secured creditor’s right to credit bid always will stifle bidding, if not kill it altogether, particularly if the gap between the value of the collateral and the gross amount of the claim (which is the figure up to which the secured creditor may credit bid) is large.  But that argument, in essence, eats up the Section 363(k) exception since it will virtually always apply.  Section 363(k)’s preservation of the right to credit bid would be meaningless.  The bankruptcy court’s distinction between chilling and killing bidding altogether is an empty one, in the author’s opinion.  Moreover, most secured creditors are not necessarily determined to credit bid their entire gross claim; they want money, not property.  Thus, they will stop bidding when any third party’s cash bid approaches the value they attribute to the collateral.  It can be argued that the bankruptcy court’s decision transformed Section 363(k)’s “cause” exception into what amounts to a “best interests of creditors” test. 

On the other hand, in many situations the attempt to prevent or limit credit bidding protects  against the shifting of value from the secured creditor to a bidder if the secured creditor lacks cash to bid  That shifting frequently benefits an insider who is part of the stalking horse bid (see, e.g., River Road Hotel Partners, LLC v. Amalgamated Bank, 651 F.3d 642, 651 n.6 (7th Cir. 2011), aff’d sub nom. RadLAX Gateway Hotel, LLC v. Amalgamated Bank, ___ U.S. ___, 132 S. Ct. 2065 (2012)).  That is not necessarily the case when the secured creditor purchases the secured claim at a discount from the original secured creditor.  Moreover, since in Fisker it was clear that Hybrid wanted the assets themselves, not just cash like most secured creditors, it is more likely that it would have credit bid well beyond the value of the collateral. 

RadLAX was decided in the context of whether a debtor may propose a plan that includes sale of the secured creditor’s collateral free and clear while denying the right of the creditor to credit bid under Section 363(k) despite Section 1129(b)(2)(A)(ii) (requiring application of Section 363(k) in a plan sale free and clear of liens), on the theory that such a plan is permissible instead under Section 1129(b)(2)(A)(iii) (provision of the “indubitable equivalent”).  There, the Supreme Court decided such a plan was impermissible based upon its view of the plain meaning of Section 1129(b)(2)(A)(ii).  The predictable fallout from RadLAX can be seen in Fisker:  more action on the “cause” exception of Section 363(k) whether in connection with a plan or just a straight sale, an exception that has been little used before.  

The confusion over what collateral Hybrid really held is a concern that has previously invoked the “cause” exception of Section 363(k), but only to require that the secured creditor provide a form of protection for the payment of other secured creditors who might have priority on some of the asset, rather than limiting credit bidding altogether (that is, the bankruptcy court tailored a remedy to suit the situation) while still protecting the secured creditor’s right to credit bid.  See In re Diebart Bancroft, 1993 U.S. Dist. LEXIS 836 at *15 (E.D. La. Jan. 25, 1993); see also In re Daufuskie Island Props., LLC, 441 B.R. 60 (Bankr. D.S.C. 2010) (cited by Fisker court) (creditor whose lien and claim were subject to dispute and equitable subordination proceeding either would be prohibited from bidding or would have to pay senior mortgages). 

The bottom line is that Fisker probably is only the first in a wave of cases newly exploring the limits of “cause” under Section 363(k). 

These materials were written by Adam Lewis of Morrison Foerster, in San Francisco, California (alewis@mofo.com).  Editorial contributions were provided by ILC member Haeji Hong in San Diego, California.  Mr. Lewis is a member of the Insolvency Law Committee. 

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee

Mark Bradshaw’s e-Bulletin re Shapiro v. Henson.  E-Bulletin published on 3/26/14. 

KEYWORDS: turnover, 542, possession, custody, control, honor, honored, value, property.

Dear constituency list members of the Insolvency Law Committee, the following is a case update analyzing a recent case of interest:

Summary

In Shapiro v. Henson (9th Cir. January 9, 2014), in a published decision, the United States Court of Appeals for the Ninth Circuit reversed the district court’s ruling affirming the bankruptcy court’s denial of a trustee’s motion for turnover pursuant to 11 U.S.C. § 542(a).  The Ninth Circuit held that a trustee may seek recovery from entities having “possession, custody, or control” of the property sought, whether the property was in the entity’s possession, custody, or control at the time the motion was filed or at any other point during the pendency of the bankruptcy case.  Click here http://cdn.ca9.uscourts.gov/datastore/opinions/2014/01/09/11‑16019.pdf to read this published decision.

Facts

In a case of first impression in the Ninth Circuit, the Ninth Circuit addressed whether a trustee’s turnover power is solely restricted to recovering bankruptcy estate property, or its value, from entities having possession, custody, or control of such property at the time the motion for turnover is filed or whether a trustee may seek turnover from an entity that had possession, custody, or control of the subject property at any time during the bankruptcy case. 

The facts of the case are as follows.  Barbara Henson filed a Chapter 7 bankruptcy petition.  On the petition date, Henson had a checking account with $6,955.19.  Henson had written several checks drawn on this account before bankruptcy which the bank honored after the petition date.  Brian Shapiro (the bankruptcy trustee) sent Henson a letter demanding turnover of the funds that had been in her bank account.  Henson denied being in possession of the funds.  Shapiro then filed a motion for turnover under 11 U.S.C. § 542(a) against Henson to recover $6,155.19 of her petition‑date account balance (i.e., the full amount on the petition date less an $800 exemption).

The bankruptcy court denied the motion because Henson did not have possession or control of the funds at the time Shapiro filed the motion for turnover.  Shapiro appealed and the district court affirmed.  Shapiro then appealed to the Ninth Circuit.

Holding

The Ninth Circuit held that a trustee may seek recovery from entities having “possession, custody, or control” of the property sought if the property was in the entity’s possession, custody, or control at any point during the pendency of the bankruptcy case.

Reasoning

Section 542(a) states in part that “[A]n entity . . . in possession, custody, or control, during the case, of [property of the estate, or exempt property], shall deliver to the trustee, and account for, such property or the value of such property, unless such property is of inconsequential value or benefit to the estate.”  Relying heavily on the text of the statute, the Ninth Circuit found that the phrase “during the case” means that a trustee may bring a motion for turnover against an entity so long as that entity had possession of that property at any point during the bankruptcy case.  In further support of this reading the Ninth Circuit noted that the phrase “or the value of such property” indicates that the entity need not be in possession of the property itself when the trustee files the motion for turnover.

The Ninth Circuit also found the pre‑Code dual‑method system for turnover significant, noting that possession at the time of a plenary (i.e., not enforced via motion for contempt) turnover motion’s filing was not required, even though present possession in a summary proceeding is required.  The Ninth Circuit also noted the practical challenge to trustee where any Section 542 motion could be defeated by a transfer of possession of the subject property.

Author’s Comment

While the Ninth Circuit’s decision provides a clear rule and is based on a logical reading of Section 542(a), the practical implications could be significant.  In Newman v. Schwartzer (In re Newman), 487 B.R. 193 (9th Cir. BAP 2013), cited by the Ninth Circuit, a chapter 7 debtor failed to list an income tax refund on his bankruptcy schedules and then spent the tax refund when it was received.  The BAP (properly) granted the trustee’s turnover motion even though the tax refund monies were no longer in the debtor’s possession.  In fact, the debtor’s conduct could have been subject to more severe penalties including denial of discharge. 

Based on the Ninth Circuit’s decision, Henson is now subject to the same rule though her situation is more sympathetic.  She did not fail to disclose assets – she simply filed a chapter 7 petition at a time when she had pending checks that had not yet cleared her bank account.  Henson’s situation is probably common, and the Ninth Circuit’s decision will now subject otherwise innocent debtors to turnover of funds they do not have and likely cannot obtain.  In a practical sense, before filing a bankruptcy petition debtors will have to ensure that all pending checks clear or they will have to stop payment on all checks prior to the filing.

The Ninth Circuit’s decision also expands the potential targets for turnover motions.  Before the Ninth Circuit’s decision, entities in possession of estate property could expect a demand letter or turnover motion from a trustee (or debtor in possession).  Now the universe has clearly expanded to entities which had such possession, custody or control of estate property at any time during a bankruptcy case.

These materials were written by Mark Bradshaw of Shulman Hodges & Bastian, LLP, in Irvine, California (mbradshaw@shbllp.com).  Editorial contributions were provided by ILC member Ori Katz of Sheppard Mullin in San Francisco, California (OKatz@sheppardmullin.com). 

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee