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The Magic of Mt. Gox: How Bitcoin Is Confounding Insolvency Law

November 28, 2017


Arthur C. Clarke famously observed: “Any sufficiently advanced technology is indistinguishable from magic.” Our regulatory, legislative, and judicial systems illustrate this principle whenever new technology exceeds the limits of our existing legal framework and collective legal imagination.  Cryptocurrency, such as bitcoin, has proven particularly “magical” in the existing framework of bankruptcy law, which has not yet determined quite what bitcoin is—a currency, an intangible asset, a commodity contract, or something else entirely.

The answer to that question matters, because capturing the value of highly-volatile cryptocurrency often determines winners and losers in bankruptcy cases where cryptocurrency is a significant asset.  The recently-publicized revelation that the bankruptcy trustee of failed bitcoin exchange Mt. Gox is holding more than $1.9 billion worth of previously lost or stolen bitcoins highlights the issue.

The Mt. Gox Case: Timing is Everything

In 2013, Mt. Gox[1] was the world’s largest bitcoin exchange.  By some estimates, it accounted for more than 80% of all bitcoin exchange activity. By February 2014, Mt. Gox had shut down its website, frozen customer accounts, and ceased trading.  A leaked internal document indicated that hackers had gained access to Mt. Gox’s online wallets and stolen nearly 850,000 bitcoins, each then worth approximately $550 (that’s an estimated $467.5 million in lost value, as of when Mt. Gox froze its operations in early 2014). That same month, Mt. Gox commenced insolvency proceedings in Japan, and thereafter filed a corresponding chapter 15 bankruptcy in the United States.  Mt. Gox eventually “found” approximately 200,000 bitcoins previously believed to be among those lost or stolen, but 650,000 were (and are) still missing.

When it became clear that Mt. Gox could not reorganize and would proceed with liquidation, the Japanese court appointed a trustee over Mt. Gox’s assets. A former Mt. Gox exchange customer then filed a lawsuit against the trustee seeking the return of the customer’s purchased bitcoins.  The Japanese court, however, ruled that the bitcoins at issue were not capable of ownership under Japanese law and dismissed the lawsuit. Article 85 of the Civil Code of Japan provides that an object of ownership must be a tangible “thing,” in contrast to intangible rights (like contract or tort claims) or natural forces (like sunlight or electricity).  Bitcoin, the court ruled, does not meet the definition of a “thing” under the statute and, therefore, does not qualify for private ownership.

The ruling effectively left Mt. Gox’s customers with claims for damages in the insolvency proceeding rather than ownership claims for the return of their bitcoins. Accordingly, the value of each claim was fixed at an exchange rate of one bitcoin to ¥50,058.12 (approximately $483), the value of bitcoin shortly before Mt. Gox filed its insolvency proceeding in Japan.

At the time of this post, bitcoin is no longer trading at $550 – it is now trading at more than $9,500. That constitutes more than a 17x increase over the April 2014 exchange rate fixed in the Mt. Gox bankruptcy.  The Mt. Gox bankruptcy estate is holding 202,185 recovered bitcoins, currently worth approximately $1.9 billion.  The value of the estate’s bitcoins exceeds the total claims against Mt. Gox by several hundred million dollars.  That excess value is creating controversy.

Millions for Mismanagement: An Insolvency Sleight of Hand?

In bankruptcy, once all creditor claims are paid in full, surplus assets flow to the owners. In the Mt. Gox case, the owners of Mt. Gox— not the customers who purchased bitcoin and still await repayment—stand to benefit from the dramatic increase in the value of bitcoin over the last three years.  The single largest potential beneficiary is Mark Karpelès, Mt. Gox’s former CEO and majority shareholder, who currently is on trial in Japan for embezzlement.

Customers have repeatedly accused Mr. Karpelès of mismanagement, breach of duties, and outright fraud. Unsurprisingly, the prospect of Mr. Karpelès’ enrichment through the bankruptcy process has galled Mt. Gox’s still unpaid customers, many of whom insist that the rise in bitcoin value should be paid to them rather than the owners of the failed exchange.  To date, however, those customers have not articulated a recognized legal basis for their desired result, particularly in light of the Japanese court’s ruling that bitcoin is not legally susceptible of private ownership.

As Karpelès himself has noted, “Creditors, when filing with the bankruptcy, had to convert any amount to JPY – which makes sense in a purely legal term, as it’d be impossible for anyone to proceed with a bankruptcy if debts had to be re-calculated all the time and could change over time. . . . Nobody in this whole process could have predicted the way the price went, especially as its initial trend was downward, not upward.”

Although Karpelès may be technically correct,[2] bankruptcy is fundamentally an equitable proceeding, and it seems patently unfair to award a windfall to the owners of a failed bitcoin exchange to the detriment of its customers, who have endured the freezing of their accounts and years of uncertainty in multi-national bankruptcy proceedings.  It also makes little sense that bitcoin cannot be legally owned in the same way stocks, gold, Japanese yen, or U.S. dollars are privately owned under applicable civil law.  Unfortunately, such results appear to be a reality in the Mt. Gox case, and they stem from the current legal framework’s shortcomings in addressing this revolutionary technology.


Cryptocurrencies are not going away. Absent an expansion of our existing legal doctrines to account for their unique nature and often volatile trading value, we likely will continue to see results at odds with the spirit and intent of existing bankruptcy law.  The Mt. Gox case hopefully will spur discussion about the need to amend our bankruptcy statutes to account for crypto-assets and how the judiciary may need to expand the existing decisional framework to achieve the policies of insolvency law in cases involving such technologies.

[1]           In a notable thematic coincidence, Mt. Gox is an acronym for “Magic: The Gathering Online eXchange.”

[2]           In the Mt. Gox case, some creditors urged the trustee to provide them the option of receiving crypto-tokens, “Goxcoins,” representing the customer’s pro-rata share of the estate’s distributable bitcoins, rather than reducing their claim amounts to yen.  The customers who chose this option would assume the risk of fluctuation of bitcoin exchange rates and ultimately receive bitcoins back, albeit fewer bitcoins than they purchased on the Mt. Gox exchange.  Essentially, they would agree to take a pro rata share of a smaller pie, betting that each slice of that pie would increase in value.  As it turns out, they were correct.  The trustee did not adopt that approach in the Japanese insolvency proceeding, but in fairness, the court had ruled that customers did not own the bitcoins, and bitcoin’s value appeared to be on the decline in mid-2014.  Although it may be difficult to impose such a structure in a U.S. chapter 7 bankruptcy case, it may be viable under a chapter 11 liquidating plan in certain cases.

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It’s Not Final, and That’s Final: The Ninth Circuit’s Gugliuzza Decision

April 11, 2017


appellate court concept with gavel. 3D rendering

As we have noted in another post, Non-Final Finality: Does One Interlocutory Issue Resolved in a Bankruptcy Court Order Render All Issues Addressed in the Order Non-Appealable?, not all orders in bankruptcy cases are immediately appealable as a matter of right.  Only those orders deemed sufficiently “final” may be appealed without additional court authorization.  See 28 U.S.C. § 158(a)(3) (interlocutory order may be appealed only with leave of the court).  Appeals from “final” bankruptcy-court orders usually are first heard by a United States district court or a bankruptcy appellate panel (a “BAP”), which have jurisdiction “to hear appeals from final judgments, orders, and decrees” from bankruptcy courts.  Id. § 158(a)(1).

What happens when a district court or a BAP properly exercises appellate jurisdiction over a bankruptcy court’s order, and ultimately remands the matter back to the bankruptcy court for further fact finding?  Is the district court or BAP’s appellate mandate sufficiently final to appeal as a matter of right to the Circuit Court of Appeals?  The Ninth Circuit Court of Appeals recently wrestled with this question in In re Gugliuzza, Case No. 15-55510 (9th Cir. Mar. 24, 2017).

Bullard v. Blue Hills Bank

In Bullard v. Blue Hills Bank, the United States Supreme Court held that a bankruptcy court’s order is final only if it “alters the status quo and fixes the rights and obligations of the parties.”  Bullard v. Blue Hills Bank, 135 S. Ct. 1686, 1689 (2015).  An order denying plan confirmation generally does not satisfy this standard, as long as it leaves the debtor free to propose another plan, because “[t]he parties’ rights and obligations remain unsettled” and the “possibility of discharge lives on.”  Id. at 1693.  In the Supreme Court’s view, “final” simply “does not describe this state of affairs.”  Id.

The Court also observed that every “climb up the appellate ladder and slide down the chute can take more than a year.”  Id.  Given this reality, it would “not make much sense to define the pertinent proceeding so narrowly that the requirement of finality would do little work as a meaningful constraint on the availability of appellate review.”  Id.

Despite providing relative clarity on the non-finality of orders denying plan confirmation, Bullard did not create a new set of bright-line rules.  Rather, it attempted to provide relative guideposts for the rules of finality, which the Court acknowledged “are different in bankruptcy.”  Id. at 1692.  Whether Bullard actually provided meaningful overall clarity remains subject to debate.  Furthermore, Bullard did not directly address the finality of a district court or BAP’s intermediate appellate ruling when the mandate remands a matter back to bankruptcy court.

The Ninth Circuit’s Prior Decisions:  In Conflict with Bullard?

The Ninth Circuit Court of Appeals recently wrestled with the apparent tension between Bullard and the Ninth Circuit’s earlier decision of In re Bonner Mall Partnership, 2 F.3d 899 (9th Cir. 1993).  In Bonner Mall, the Ninth Circuit held that, under certain circumstances, it could exercise jurisdiction over an appeal of a decision by a district court sitting in an appellate capacity “even though a district court has remanded a matter [to the bankruptcy court] for factual findings on a central issue.”  Under Bonner Mall, a district court’s appellate ruling is sufficiently final, despite a remand, if the central issue “is legal in nature and its resolution either 1) could dispose of the case or proceeding and obviate the need for factfinding; or 2) would materially aid the bankruptcy court in reaching its disposition on remand.”  Bonner Mall, 2 F.3d at 904.

Later, in the post-Bullard decision of Landmark Fence, the Ninth Circuit questioned whether the “flexible approach” to finality remained valid after BullardIn re Landmark Fence, 801 F.3d 1099, 1103 n.1 (9th Cir. 2015).  The court went so far as to observe that the “flexible test is arguably in conflict with the Supreme Court’s decision in Connecticut National Bank v. Germain, 503 U.S. 249, 253 (1992),” as well as BullardId.  The Ninth Circuit declined to reconcile the apparent doctrinal conflict, however, because even the flexible approach was “stretched beyond its breaking point” by the appeal in that case, which involved “a district court order that includ[ed] a remand to the bankruptcy court with explicit instructions to engage in ‘further fact-finding.’”  Id. at 1101.

In evaluating appellate jurisdiction over district court order in that case, the court analyzed four factors:  “(1) the need to avoid piecemeal litigation; (2) judicial efficiency; (3) the systemic interest in preserving the bankruptcy court’s role as the finder of fact; and (4) whether delaying review would cause either party irreparable harm.”  Id. at 1102.  The Ninth Circuit ultimately dismissed the appeal, observing that when “an intermediate appellate court remands a case to the bankruptcy court, the appellate process likely will be much shorter if we decline jurisdiction and await ultimate review of all the combined issues.”  Id. at 1103.

In re Gugliuzza:  A New Per Se Rule?

Against this backdrop, in Gugliuzza, the Ninth Circuit considered whether a district court’s order was sufficiently final to confer appellate jurisdiction under 28 U.S.C. § 158(d)(1), when the order affirmed in part and reversed in part a bankruptcy court’s grant of summary judgment, and remanded a discrete issue to the bankruptcy court for further fact finding.  The appeal arose from an adversary proceeding, in which the Federal Trade Commission (“FTC”) obtained a judgment of non-dischargeability against the debtor under 11 U.S.C. § 523(a)(2)(A), on a motion for summary judgment.  The debtor appealed the judgment to the district court, which affirmed in part, reversed in part, and remanded for factual findings on one of the counts asserted by the FTC.

The debtor appealed the district court order to the Ninth Circuit, arguing that despite the remand, the district court’s ruling was immediately appealable under Bonner Mall and its progeny.  The debtor argued that under Bonner Mall, the Ninth Circuit could exercise appellate jurisdiction because the appeal raised “purely legal issues” and a decision could materially aid the bankruptcy court in its decision-making process on a central issue in the case.

The FTC, by contrast, argued that Bullard and Landmark Fence required dismissal of the appeal, so that the bankruptcy court could promptly consider the issue on remand.  The Ninth Circuit agreed, holding that the Bullard and Landmark Fence decisions “clearly limit the applicability of the Bonner Mall line of cases.”  Bullard established that orders may be considered “final” for purposes of Section 158(d) “only when they ‘finally dispose of [a] discrete dispute[] within the larger case.’”  A decision that “remands a case for further fact-finding will rarely have this degree of finality, unless the remand order is limited to ministerial tasks.”

Thus, to the extent Bullard did not already do so, the Gugliuzza decision effectively overrules Bonner Mall and its progeny.  In addition, although the Ninth Circuit professed consistency between its remaining “longstanding precedent” and Bullard, the Gugliuzza decision arguably creates a new bright-line rule that alters, or at least simplifies, the four-factor test for finality previously employed in Landmark Fence and other decisions.  That rule may be summarized as follows:  A decision that remands a case for further fact-finding is not final under 28 U.S.C. § 158(d) unless the remand order is limited to purely ministerial tasks.

Gugliuzza appears to bring additional clarity to a narrow set of cases involving remand orders at the intermediate appellate level.  It remains to be seen whether the Ninth Circuit and other courts will ultimately revise or replace their “flexible standard” tests in other contexts.  Bankruptcy and appellate practitioners should carefully consider finality issues with every bankruptcy court order and at every stage of a bankruptcy appeal, and would be wise to keep an eye on this evolving doctrine.

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Handy List of Basic Issues to Consider for the Transactional Workout

February 2, 2017


While significant energy here at the Bankruptcy Cave is devoted to substantive bankruptcy matters, not all aspects of a general insolvency practice are always fun and litigation.  Oftentimes insolvency lawyers add the most value by helping clients avoid a bankruptcy filing, or by successfully resolving a case through a consensual transactional restructuring.  Below are a few key issues diligent counsel for creditors and debtors should think through in connection with a transactional restructuring.[1]

1. Notice and Demand After Default. As anyone reading this knows, a lender often sends a notice of default and maybe even a demand for payment after its borrower defaults.  However, simply sending a notice of default and demand for payment may not always be sufficient or have the intended effect.  Most loan documents provide a cure period before a breach becomes an actionable default.  Some loan documents will only permit a lender to accrue default interest after specific notice is given to the borrower.  And sometimes no notice or demand is required at all.  While it is generally considered best practice for a lender to notify a borrower of a breach, demand repayment, and affirmatively elect to accrue default interest after a breach, a careful reading of the loan documents is an absolute necessity.  Also, remember that a lender doesn’t always have to react to a breach by attempting to exercise every possible remedy.  Sometimes a simple reservation of rights letter that notifies the borrower of the breach and reserves the lender’s rights and remedies may be sufficient to protect the lender and yet not scare the borrower into precipitously considering extreme countermeasures like bankruptcy.  After all – all you can control is your actions; you cannot control (or sometimes even predict) how others may react or overreact to your actions.

2.  Pre-negotiation Agreements. Post-default discussions between a lender and a borrower can be tense, with both sides guarded so as not to say or do something that they may later regret. A critical tool to cut through some of the tension is a pre-negotiation agreement between the parties, which in general is a contractual agreement regarding the parameters of negotiations between the parties regarding the defaulted debt, an acknowledgment that things said in those discussions will not be used in future litigation, and an acknowledgement that the discussions will result in an agreement regarding the defaulted debt only if put into writing.  Often these agreements will include additional features, such as acknowledgments of defaults and debts or a tolling of the statute of limitations, but the primary function is to allow the parties to negotiate without fear that statements made during negotiations may be used against them in the future.  All it takes is a single offhand comment by a lender or its counsel in an email, such as “we think that sounds like a good proposal” for an unscrupulous debtor to argue that the loan was modified, or a concession was granted by the lender.  The pre-negotiation agreement will prevent these sorts of arguments; we highly recommend them in all workout discussions.

3.  Document Review and Cleanup. A lender will have no better opportunity to scrub its documents and fix any documentation gaps than after a default.  We consider it best practice when in-taking any distressed matter for a lender client to thoroughly scrub all loan documents and identify any potential issues that the lender should address.  We consider it best practice to do the same for a borrower representation.  Did the lender fail to obtain signatures for all of the loan documents?  Do the loan documents contain any significant errors affecting the deal?  Did the lender fail to properly perfect its security interest?  (Consider especially any sorts of unusual collateral, where the perfection rules can be different.)  Did the lender opt at origination not to get a guarantee from the trust holding all of the assets of the borrower’s principals, and now the lender wishes it had?  Did the lender receive non-ordinary course payments recently?  In a situation where the borrower is in default and is probably asking for more time or other financial accommodations, the lender has unparalleled leverage to clean up errors, grab the additional guarantees or collateral that it didn’t require previously, and otherwise manage things like preference exposure.  And where a borrower identifies that some of these issues exist, it too may have significant leverage to obtain the accommodations it seeks.  (By the way, for more specific tips on collateral issues you really need to check in advance of any workout, check out this ABI post by our colleagues Leah Fiorenza and Wendy Godfrey.)

4.  Forbearance Agreements. Sometimes a workout doesn’t result in a waiver of defaults and new deal terms.  Rather, many times a lender may be looking to exit the relationship but may be willing to give a borrower time to get its affairs in order to accomplish a payoff, refinancing, sale, etc.  In this situation, the lender may agree to forbear from exercising rights and remedies with respect to a default for a limited period.  The lender will often agree to modify covenant compliance requirements or other terms of the loan during the forbearance period, but the existing defaults are not waived.  If the borrower doesn’t repay the debt at the end of the forbearance period, the lender then once again has the ability to exercise its rights and remedies due to the default.

5.  Modification Agreements. And sometimes a workout does result in a waiver of defaults and new deal terms.  That is often accomplished through a modification of loan documents, where the parties agree to waive existing defaults and modify the terms of the loan.  While the goal here may still be an early exit (i.e., where the parties agree to shorten maturity), the loan modification will bring the borrower back into compliance and eliminate the threat of default interest and enforcement actions.

6.  Acknowledgments and Reaffirmations. Whether through a forbearance agreement, a modification agreement, or any other variation of agreement, acknowledgments and reaffirmations are critical.  A lender will expect to receive from the borrower and any guarantor in any such agreement an acknowledgement of the debt owing to the lender, an acknowledgment of the loan defaults, and a reaffirmation of all of the loan documents and of the security interests granted to the lender.  These, and the releases discussed below, are often the only consideration, and sometimes the most important consideration, that a lender will receive in a workout.

7.  Releases. Perhaps the most critical consideration that a lender will expect to receive, and any borrower or guarantor should expect to be asked to give, in a workout is a general release of claims.[2]  While releases come in many varieties, a well-crafted release will provide for an immediate and complete release by all borrowers and guarantors in favor of the lender of any and all claims, known or unknown, that may exist as of the time of the written workout agreement, an agreement by the borrowers and guarantors not to bring suit based on any released claims, and an acknowledgment that the release may be pled as a full and complete defense to any such suit. Of course, state law differs regarding releases.  We always recommend a thorough review of applicable state law regarding releases and that practitioners include all relevant statutory release and waiver language where applicable.

8.  Authority. Finally, one of the most overlooked aspects of any transaction, and particularly a workout transaction, is ensuring all necessary corporate, trust, or other authority has been granted for the parties to enter into the agreements evidencing the transaction.  We often see practitioners either ignore this issue or, perhaps, rely on representations in the written agreement along with the provisions of any applicable corporate or LLC statute to confirm the authority of the parties to enter into the agreement.  However, that does not substitute for an actual review of the relevant organizational or trust documents to determine who is actually authorized to sign on behalf of the entity.  For instance, you may find that although your signer is a member of the LLC borrower, the LLC’s operating agreement gives the member no power to enter into agreements on behalf of the LLC and rather all power is vested in a manager or board that must approve all transactions.  Taking the time to analyze these authority issues and obtain the necessary authorizing resolutions as part of the transaction will eliminate any pesky argument down the road that the person who signed the documents had no authority to bind the entity to the agreement.

The foregoing is, of course, just a brief discussion of some of the many issues insolvency lawyers may need to address in a transactional workout, but each is an important component to consider in any distressed debt representation where a transactional workout is a possibility.

[1]           While we talk here about lenders, borrowers, and loan debts specifically, this discussion is generally applicable to any sort of debtor-creditor relationship.

[2]           Of course, there will be situations where borrowers and guarantors will rightfully expect releases as well. That is not often the case for a general workout in our experience, but these same principals would apply for any release in favor of borrowers and guarantors.

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Non-Final Finality: Does One Interlocutory Issue Resolved in a Bankruptcy Court Order Render All Issues Addressed in the Order Non-Appealable?

August 22, 2016


appellate court concept with gavel. 3D rendering

As the Supreme Court recently reminded us in Bullard v. Blue Hills Bank, not all orders in bankruptcy cases are immediately appealable as a matter of right.  Only those orders deemed sufficiently “final” may be appealed without leave under 28 U.S.C. § 158(a).  In light of the numerous parties and controversies involved in a typical bankruptcy case, determining whether an order is “final” can be complicated affair.  Thus, finality in bankruptcy is a “flexible standard” applied to discrete disputes that arise within the larger case. See generally 14 Wright, Miller & Cooper, Federal Practice and Procedure § 3926.2 (collecting examples of final and non-final orders).  That flexibility, however, has led to disparate results.

In In re Wolff, B.A.P. No. CO-16-016 (B.A.P. 10th Cir. Jul. 18, 2016), the Tenth Circuit Bankruptcy Appellate Panel (the “BAP”) dismissed an appeal filed by debtors Deris and Cheryl Wolff (the “Debtors”) on the grounds that the appeal was taken from an order that was interlocutory, and thus, non-appealable absent leave.  That order resolved two issues, one of which was interlocutory and the other of which ordinarily would be entitled to immediate appellate review.  The Wolff decision is an interesting example of what can occur when a single bankruptcy-court order resolves a typically final matter in connection with a non-final one.

An Order Determining Property of the Estate Is Interlocutory?

In Wolff, the Debtors filed a voluntary chapter 13 case, but their case was later converted to chapter 7.  The Debtors’ schedules listed two parcels of real property as assets, but the Debtors failed to claim either property as exempt.  The chapter 7 trustee filed two separate motions seeking approval to retain real estate brokers to market the properties.  The Debtors objected to the motion as to the first property and filed a motion for reconsideration of the order granting retention of the broker as to the second property.  In both the objection and the motion to reconsider, the Debtors argued that the properties could not be sold because they were not property of the bankruptcy estate, and that any post-petition appreciation in value belonged to the Debtors rather than the estate.

The bankruptcy court entered an order overruling the objection, denying the motion for reconsideration, and approving the trustee’s retention of a real estate broker to market and sell both properties. The bankruptcy court rejected the Debtors’ arguments that the properties were not part of the estate because 11 U.S.C. § 348(f)(1) provides that when a case is converted from chapter 13 to chapter 7, “property of the estate in the converted case shall consist of property of the estate, as of the date of the filing of the petition, that remains in the possession of or is under the control of the debtor on the date of conversion.”  Because the two parcels of real property were scheduled as estate property on the date of filing, they remained estate property upon conversion.  Moreover, the Debtors’ failure to claim any exemptions relating to the properties was binding upon them, and was ultimately inapposite, as the court concluded that the trustee could sell the property even if the exemption had been claimed.  The Debtors appealed.

On appeal, the BAP considered whether the order was interlocutory because it involved the employment of a broker, or whether the bankruptcy court’s ruling on property of the estate rendered the entire order final for appeal purposes. The BAP reasoned that an interlocutory order is one that constitutes part of the “process” of a bankruptcy case but does not otherwise substantively alter the rights of the parties.

Despite the ruling regarding property of the estate, the BAP concluded that the order was not final and appealable as a matter of right. Sales of estate property in a chapter 7 case involve a two-step process, according to the BAP.  First, the trustee must retain a broker with court approval.  Second, only after that broker has marketed the property in question, the trustee must file a separate motion for approval of the sale.  In this case, the bankruptcy court’s order represented only the first step in the process.  The BAP concluded that the Debtors’ rights were not substantively affected by the order because any decision as to the sale of the properties would require a separate motion, notice, and hearing.  “As a result,” concluded the BAP, “Appellants’ rights in the Colorado and Nebraska Properties, and any equity associated therewith, are not yet altered.”  The BAP also indicated that the Debtors would be able to seek review of “prior intermediate orders” if an order approving a sale were eventually entered.

Analysis and Conclusion

The Wolff decision is puzzling.  It certainly did not help the Debtors that they failed to claim the real property as exempt, and that their substantive arguments on the property-of-the-estate issue appeared to be weak.  Still, it is difficult to conceive of an order more “final” than one determining that an asset is property of the estate within the meaning of section 541 of the Bankruptcy Code.  Under the Wolff decision, such a determination may be deemed non-final if it is tied to a matter (e.g., retention of a broker) typically the subject of interlocutory orders.  Crafty litigants could use such a rule to deprive affected parties of immediate appellate review, even with respect to key issues if they are included in an order resolving other, interlocutory matters.

Moreover, the BAP failed to consider the impact of its ruling on the value of the properties. No rational buyer will bid as much when they learn that their bid could be held up in litigation, and appeals, over whether the property can be sold at all.  Buyers will discount their price for the likely attendant risk, and the fact that they may be “on hold” for months or years of litigation and appeals over a threshold issue.  If that threshold issue had been resolved, much of the cloud would be lifted over the property, and buyers obviously tend to bid more for a certainty.

In Wolff, the BAP appears to have justified the inclusion of a section 541 finding in a broker’s retention order on the rationale that if an asset “is not property of the estate, generally there would be no reason for a trustee to retain a broker to sell the property and the bankruptcy court would not approve a sale.”  But that somewhat circular reasoning does not consider the procedurally proper (and arguably more orderly) possibility of resolving the threshold question—whether the real estate was property of the estate—in an adversary proceeding and deferring the motion to retain a broker until after resolution of that fundamental question.[1]  As a middle ground, the court perhaps could have approved the broker’s retention conditionally, pending a ruling on property of the estate.  In fairness, the Debtors do not appear to have raised these possibilities, nor did they insist that resolution of a section 541 issue requires a properly filed adversary proceeding.  Had they done so, the result may have been quite different.

As the Wolff decision demonstrates, litigants in bankruptcy cases would be wise to identify important issues that a debtor, trustee, or other adverse party might attempt to bootstrap into a non-final order.  In particular, litigants should identify and zealously guard those matters subject to adversary-proceeding requirements under Federal Rule of Bankruptcy Procedure 7001.  Absent resolution of “final” matters in separate proceedings and orders, litigants could find themselves forced to await appellate review on key issues until far later in a bankruptcy case, when subsequent events could weaken the relevance of their appeal or simply render the appeal moot.

[1]    Contested issues regarding property of the estate generally require an adversary proceeding and all of the procedural safeguards associated therewith. See Fed. R. Bankr. P. 7001(2).

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Are Those Taxes Owing On Your Late-Filed Tax Return Dischargeable? Maybe, But You Better Be In The Right Circuit

July 25, 2016


File Tax Return!

Individual debtors with old tax debts relating to late-filed tax returns may be surprised to find that those tax debts may not be dischargeable under section 523(a) of the Bankruptcy Code due to the lateness of the tax filing.  There is a current Circuit split regarding whether a late tax filing constitutes a “return” at all, which is critical to the dischargeability inquiry.  The Ninth Circuit weighed in last week in In re Smith, 2016 WL 3749156 (9th Cir. July 13, 2016), further cementing the split.  Individuals considering whether to file bankruptcy to obtain a discharge of old tax debts would be well-advised to assess the current legal landscape and plan accordingly.

Section 523(a)(1)(B)(i) Exemption From Discharge For Tax Debts

Section 523(a)(1)(B)(i) of the Bankruptcy Code exempts from discharge any debt for a tax “with respect to which a return, or equivalent report or notice, if required . . . was not filed or given.”  In other words, a debtor may not obtain a discharge for taxes where it has failed to file a required tax return.  For a late-filed tax return, the issue becomes whether it is a “return” at all.

Prior to the 2005 BAPCPA amendments, the Bankruptcy Code did not define “return.”  Courts generally adopted the Tax Court’s definition of return set out in Beard v. Comm’r of Internal Revenue, 82 T.C. 766 (1984), which is commonly articulated as a tax filing that: (1) purports to be a return; (2) is executed under penalty of perjury; (3) contains sufficient data to allow calculation of tax; and (4) represents an honest and reasonable attempt to satisfy the requirements of the tax law.  Where a debtor files a late Form 1040 or similar tax form, elements one through three generally will be satisfied. It is element four that has been the subject of significant dispute.

In the 2005 BAPCPA amendments, Congress defined “return” in a new hanging paragraph at the end of section 523(a).  Under this definition, a return is “a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements).”  This new definition has given rise to a significant split in authority regarding late-filed tax returns.

The Majority View.

Under the majority view followed in the Fourth, Sixth, Seventh, Eighth, Ninth, and Eleventh Circuits,[1] the Beard test governs the “return” inquiry.  As elements one through three are usually satisfied where a tax payer files an appropriate tax form, even if late, the inquiry inevitably becomes whether the debtor’s late filing represents an honest and reasonable attempt to satisfy the tax law requirements.  The timing of the late filing is generally considered relevant,[2] as is the debtor’s justification for the late filing, whether the IRS has already assessed the past-due taxes, and whether the late filing serves the purposes of the tax system.

The Ninth Circuit’s recent In re Smith decision is instructive.  There, the debtor failed to timely file his 2001 federal tax return.  The IRS calculated the debtor’s 2001 tax liability based on information gathered from other sources, and in 2006 assessed a deficiency against him.  In 2009, the debtor filed a Form 1040 for the 2001 tax year and thereafter sought to reach a compromise with the IRS on the 2001 taxes.  Unable to do so, the debtor filed his chapter 7 petition and sought a discharge of the 2001 taxes.  The bankruptcy court granted the discharge, and the district court reversed.

In affirming the district court, the Ninth Circuit considered the fourth Beard element and ruled that the debtor’s “belated acceptance of responsibility” was not a reasonable attempt to comply with the tax laws where, without justification, he waited three years after the IRS assessment and seven years after the tax return due date to file his Form 1040.  To the court, this simply was not a close case.  Because the debtor’s late-filed Form 1040 did not constitute a “return,” the debtor’s 2001 tax debt was exempt from discharge under section 523(a)(1)(B)(i).

The test adopted by the majority is fact-intensive, but provides an avenue for the honest but unfortunate debtor to obtain a discharge of tax debts where there is some justifiable excuse for the untimely tax filing.  This is not the case under the minority view.

The Minority View.

Under the minority view adopted in the First, Fifth, and Tenth Circuits, tax debts are not dischargeable if the tax return is filed after the applicable deadline—even if late by a single day.[3]  The rationale for this so-called “one-day-late rule” is that, under the plain language of the BAPCPA amendments’ new definition, a tax filing is only a return if it satisfies the requirements of the applicable nonbankruptcy law, “including applicable filing requirements.”  Under this view, the applicable filing requirements include filing deadlines.  Thus, late tax filings simply do not constitute returns for purposes of section 523(a).

The minority view is quite hostile even to the most honest debtor seeking to discharge tax debts for which he or she filed a late return.  But, to these courts, Congress has determined that debtors who miss tax filing deadlines simply are not entitled to a discharge of the associated tax debts.


The Ninth Circuit’s In re Smith decision reaffirms the stark divide between the majority and minority views on the dischargeability of tax debts where the debtor failed to timely file a return.  Unless and until the split is resolved by the Supreme Court, an individual debtor with significant tax liabilities should consider carefully whether a bankruptcy filing is appropriate in light of the current legal landscape.


[1]           In re Moroney, 352 F.3d 902 (4th Cir. 2003); In re Hindenlang, 164 F.3d 1029 (6th Cir. 1999); In re Payne, 431 F.3d 1055 (7th Cir. 2005); In re Colsen, 446 F.3d 836 (8th Cir. 2006); In re Smith, 2016 WL 3749156 (9th Cir. July 13, 2016); In re Hatton, 220 F.3d 1057 (9th Cir. 2000); In re Justice, 817 F.3d 738 (11th Cir. 2016).

[2]           In the Eighth Circuit, “the honesty and genuineness of the filer’s attempt to satisfy the tax laws should be determined from the face of the form itself, not from the filer’s delinquency or the reasons for it. The filer’s subjective intent is irrelevant.” In re Colsen, 446 F.3d at 840.

[3]           In re Fahey, 779 F.3d 1 (1st Cir. 2015); In re McCoy, 666 F.3d 924 (5th Cir. 2012); In re Mallo, 774 F.3d 1313 (10th Cir. 2014).

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Bitcoin after Brexit: Safe Haven or Harbinger of Future Distress?

June 27, 2016


Currency icons consept : Businessman touching the screen about currency icons

What a difference a week makes! On June 17, 2016, bitcoin was trading at more than $750. Five days later, as polls showed the Brexit vote leaning heavily to “remain,” bitcoin dropped as low as $585. After the vote to leave the European Union became final, the British Pound, the Euro, the Chinese Yuan, and global stocks dropped precipitously. Bitcoin, on the other hand, spiked to more than $676, and was trading in the $660s on Friday. Could this mean bitcoin is being perceived as a new safe-haven asset?

A Brief Background on Bitcoin Generally

Bitcoin often is described as a “digital currency.” On a more technical level, bitcoin is a digital asset within a peer-to-peer computer network payment system created in 2008 by an anonymous cryptographer going by the pseudonym Satoshi Nakamoto. Because the computer network uses open-source, peer-to-peer software, no truly central authority administers and oversees transactions, and no government controls or backs the digital “currency.” Instead, users or “nodes” on the network verify transactions by solving complex computer algorithms. The verified transactions are then recorded on a public ledger (called the blockchain) for all to see. Because transactions employ lengthy key codes rather than traditional personally-identifiable information, users can trade bitcoin quasi-anonymously.

Because bitcoin lacks government or centralized control, conceptually it is accessible to anyone with an internet connection and eliminates many of the transaction costs associated with traditional currency trading. For the same reasons, however, it can be highly volatile. At the inception of the network in 2009 and through 2012, a single bitcoin was worth mere pennies. In 2013, amid a financial crisis and the seizure of bank accounts in Cyprus, holders of Cypriot accounts began buying massive amounts of bitcoin, which drove the price of bitcoin to more than $260 for the first time. By November 2013, the value of bitcoin peaked at $1,242. The price of bitcoin declined thereafter amid hacking scandals, the insolvency proceeding of Mt. Gox (bitcoin’s then largest exchange), and negative perceptions created by the high-profile criminal case involving the elicit online marketplace known as Silk Road. Despite its volatility over the last seven years, however, bitcoin has endured and shows no signs of disappearing.

Bitcoin as a Safe Haven?

Bitcoin’s sharp rise after the Brexit vote appears to evidence a new confidence in bitcoin as a safe haven. Investment professionals, however, have been extremely reluctant to give bitcoin such status. One recent research note observed that calling bitcoin a safe haven “obfuscates the fact that bitcoin is a high-risk and volatile investment” and ignores that “bitcoin’s correlation to other traditional safe-haven assets has fluctuated significantly.” Instead, bitcoin can be viewed as “something entirely different that does not fit into the normal buckets that investments are typically bracketed into.”

The inability to categorize bitcoin into a traditional “bucket” is equally visible in the legal context, and perhaps particularly in the bankruptcy context. In a recent widely-circulated decision, for example, a bankruptcy judge concluded that bitcoin is not currency for purposes of a trustee’s recovery of avoidable transfers. See In re Hashfast Technologies LLC, No. 15-3011DM (Bankr. N.D. Cal. Feb. 19, 2016). The case involved a “bitcoin mining” computer company that paid 3,000 bitcoin to an individual to promote the company’s products. After the company’s bankruptcy filing, a trustee was appointed. The trustee sought the return of the value of the bitcoin paid to the promoter. The total value of the bitcoin in question had increased from $363,861 at the time of payment to nearly $1.3 million as of the Feb. 19, 2016 ruling.

The arguments on each side were predictable. The promoter argued that the company intended to use the bitcoin as currency and that the trustee should be able to recover only the value of the bitcoin at the time of the payment. The trustee, on the other hand, argued that the bankruptcy estate should be able to recover the fully appreciated value of the bitcoin as a commodity. The bankruptcy court did not fully resolve the issue. Rather, it concluded solely that “bitcoin are not United States dollars,” and left for another day the question of whether the trustee could recover the value of the bitcoin at the time of payment or the subsequent appreciated value.

As the Hashfast case demonstrates, the current legal framework is still deciding whether bitcoin fits into any familiar “buckets” or whether Congress or the judiciary will have to create new ones. Characterizing bitcoin as a commodity versus a currency, versus some other property right, is just one example of the many issues bitcoin presents in a financially distressed situation. In short, the legal outcomes, particularly in bankruptcy, currently lack any degree of predictability.


From a legal perspective, bitcoin does not appear to share the features of traditional safe-haven investments such as government bonds or stable fiat currency. Whether traders treat it as a safe haven, however, ultimately will be the true test. Over time, their collective decisions may give rise to bitcoin as an alternative safe haven, or those decisions may bring a wave of novel legal issues to our federal bankruptcy courts. In either case, insolvency professionals would do well to keep their eye on this growing and rapidly evolving field.

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Click To Appeal: Recent Second Circuit Decision A Cautionary Tale Regarding Electronically Filed Notices Of Appeal

November 9, 2015


mouse click

A recent Second Circuit Court of Appeals decision, Franklin v. McHugh, 2015 WL 6602023 (2d Cir. 2015), illustrates the dire consequences of failing to comply fully with all electronic filing requirements for a notice of appeal. Although appellant’s counsel in that case attempted to file a timely notice of appeal, properly initiated the electronic filing process, paid the filing fee, and received payment confirmation, the Second Circuit dismissed the appeal for lack of appellate jurisdiction due to the technical failure of appellant’s counsel to “click all the buttons” required to complete the filing. In jurisdictions that require electronic filing, counsel must be mindful not only of the applicable procedural rules but also of the electronic filing requirements.

The Applicable Rules Minefield

Appeals are rule intensive, particularly in the bankruptcy context where several sets of rules may dovetail with, complement, or exclude one another. For instance, the time for filing a notice of appeal from a bankruptcy court decision is generally 14 days, a period substantially shorter than in federal civil appeals. Compare Fed. R. Bankr. P. 8002(a) with Fed. R. App. P. 4(a). Further complicating matters, an appellant in an appeal from a bankruptcy court may choose to appeal to a district court acting as an appellate court or to a bankruptcy appellate panel (BAP), if a BAP exists in the relevant judicial circuit. 28 U.S.C. § 158(c)(1). Even if the appellant chooses to appeal to the BAP, any other party to the appeal may elect to have the appeal heard by the district court. Id.

Once the appellate venue is determined, application of the Federal Rules of Bankruptcy Procedure, the Federal Rules of Appellate Procedure, and the Federal Rules of Civil Procedure (or some combination thereof) largely depends on, and those rules often are modified by, the applicable local rules adopted by the district court or BAP. The same applies for appeals taken from a district court or BAP to a circuit court of appeals. These courts often also adopt standing orders and guidance manuals regarding practices and procedures. The astute practitioner, of course, will always ensure compliance with the applicable rules and procedures.

In addition to requiring mastery of the applicable rules, most federal jurisdictions require or allow the electronic filing of court documents through the Case Management/Electronic Case Files (CM/ECF) system, which is the “Federal Judiciary’s comprehensive case management system for all bankruptcy, district, and appellate courts.” Case Management/Electronic Case Files, The CM/ECF system “allows courts to accept filings and provides access to filed documents online . . . gives access to case files by multiple parties, and . . . offers the ability to immediately update dockets and download documents and print them directly from the court system.” Id. Use of CM/ECF is generally governed by local rules, which often incorporate a CM/ECF user’s guide, standing administrative order, or other instructions published by the applicable court. See, e.g., D. Ariz. Local Civ. R. 5.5; D. Ariz. Local Bankr. R. 5005-2(a)(1); E.D.N.Y. & S.D.N.Y. Local Civ. R. 5.2(a).

The importance of full and faithful compliance with electronic filing requirements is perhaps nowhere better illustrated than in filing a notice of appeal. Courts generally regard the provisions of Bankruptcy Rule 8002 governing the time for filing a notice of appeal from a bankruptcy court decision to be jurisdictional such that the untimely filing of a notice of appeal deprives the appellate court of jurisdiction to review the bankruptcy court’s order. E.g., In re Coudert Bros. LLP, 673 F.3d 180, 185 (2d Cir. 2012); In re Mouradick, 13 F.3d 326, 327 (9th Cir. 1994). Rigid enforcement of the appeal deadline is “justified by the ‘peculiar demands of a bankruptcy proceeding,’ primarily the need for expedient administration of the Bankruptcy estate aided by certain finality of orders issued by the Court in the course of administration.” In re Nucorp Energy, Inc., 812 F.2d 582, 584 (9th Cir. 1987). An untimely appeal of a district court or BAP order similarly divests a circuit court of appeals of jurisdiction to consider the appeal. Bowles v. Russell, 551 U.S. 205, 214 (2007).

Franklin v. McHugh: Non-Compliance With All Electronic Filing Requirements May Not Be Excusable

In Franklin, the Second Circuit put practitioners on notice that failure to timely and fully complete the electronic filing process implemented by the applicable court may, with respect to a notice of appeal, result in the appellate court lacking jurisdiction to consider the appeal.

In the underlying lawsuit, the district court dismissed the appellant’s complaint for lack of subject matter jurisdiction. Four days before the applicable deadline, appellant’s counsel used the district court’s CM/ECF system to upload a notice of appeal and other required documents, paid the filing fee, and thereafter received email confirmation of payment of the filing fee. Counsel, however, missed the last “click” in the CM/ECF software required to complete the electronic filing, and the notice of appeal was not filed with the district court.

Five days later, and one day after the filing deadline, appellant’s counsel learned that the district court’s docket did not reflect the filing of the notice of appeal. Counsel contacted the district court clerk’s office, which instructed him to refile the documents and pay the fee again. Counsel recounted that the clerk’s office also assured him that the notice of appeal would relate back to the first filing attempt, which was unsuccessful “due to issues with the ECF system.” Counsel refiled the documents and paid the fee as directed, and the notice of appeal thereafter appeared on the district court’s docket.

In the circuit court, the appellee moved to dismiss the appeal as untimely filed. The appellant argued that the notice of appeal was timely filed when his counsel first uploaded the notice of appeal and paid the filing fee, notwithstanding that the notice of appeal was not docketed until after the filing deadline. The Second Circuit granted the appellee’s motion to dismiss the appeal.

The Second Circuit reiterated that the time limits for filing a notice of appeal are jurisdictional and are not subject to “judicially created equitable exceptions.” Franklin v. McHugh, 2015 WL 6602023, at *2 (2d Cir. 2015). In this case, the district court adopted local procedures for electronic filing, which require compliance with the “instructions regarding Electronic Case Filing (ECF) published on the website of [the district court].” Id. According to the applicable instructions, the electronic filing of a document is only deemed complete when “the last screen you see is a Notice [o]f Electronic Filing screen.” Id. at *3. According to the Second Circuit, “[a]lthough the Eastern District’s instruction could have been more explicit, it plainly implies that ‘an electronic filing’ is not ‘complet[e]’ until ‘the last screen,’ called ‘Notice of Electronic Filing,’ appears on the user’s computer.” Id.

Although recognizing that appellant’s counsel intended to timely file, and otherwise took all necessary steps to timely file, the notice of appeal, the Second Circuit ruled that his failure to click the button in the CM/ECF system that would have generated the “critical Notice of Filing screen” and completed the filing process resulted in the notice of appeal not being filed at all on the date of the initial filing attempt. Id. While the situation is understandable and counsel’s position certainly sympathetic, the Second Circuit made clear that it lacks discretion to craft an equitable result despite such understandable circumstances and dismissed the appeal for lack of jurisdiction. Id.

As an important practice pointer, this result might have been avoidable under a different procedural mechanism. Although the Second Circuit had no power to correct the untimely filing defect, it did note that the appellant could have moved the district court for an extension of the filing deadline for excusable neglect or good cause under Federal Rule of Appellate Procedure 4. Id. at *4. Unfortunately, in this case the appellant did not do so and the time for seeking such an extension had since expired.

Although Franklin did not involve an appeal from a bankruptcy court order, its lessons are equally applicable in the bankruptcy context. Franklin teaches in vivid terms that counsel must be extremely diligent with electronic filing. One failed or missed mouse click could render an appeal untimely and result in dismissal. Familiarity with the appellate procedural rules is not enough. Counsel must also become a competent computer user under the CM/ECF procedures and any administrative order, user’s guide, or other instructions published by the applicable court.

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Earth to Creditors: Triangular Payment Arrangements May Constitute “Reasonably Equivalent Value”

September 23, 2015


Satellite Orbiting Earth.

The Eleventh Circuit Court of Appeals recently clarified the meaning of “reasonably equivalent value” in a complex fraudulent transfer case.  Its decision in In re PSN USA, Inc., Case No. 14-15352 (11th Cir. Sept. 4, 2015), provides particular insight on fraudulent transfers in the context of parent-subsidiary and other triangular payment arrangements.  The Eleventh Circuit held that even though the debtor, a cable television channel, was not a party to the underlying satellite services contract at issue, payments made from the debtor to the satellite services company pursuant to its parent company’s contracts constituted “reasonably equivalent value” and could not be avoided as constructive fraudulent transfers.

PSN USA, Inc. (the “Debtor”) operated the PSN Channel, a cable television station that broadcasted live and recorded sporting events throughout Latin America.  Pan America Sports Network International (“PSNI”) was a holding company that wholly owned the Debtor.  PSNI contracted with cable and satellite operators, who, in turn, offered and distributed the PSN Channel to subscribers in South America and the Caribbean.  PSNI paid a fee to the Debtor to operate the PSN Channel.  Although the Debtor was not a party to these cable and satellite contracts, the network’s policy and practice required the Debtor to cover all production expenses, including paying PSNI’s contractual obligations to cable and satellite operators.

Consistent with this arrangement, PSNI entered into several contracts with Intelsat Corporation and Intelsat International Systems, LLC (collectively, “Intelsat”) to broadcast the PSN Channel.  Between 2000 and 2002, the Debtor made a total of $3 million in payments to Intelsat under these contracts.  During this period, the Debtor became insolvent and, in March 2002, filed a voluntary bankruptcy petition.

Six years later, the PSN Liquidating Trust (the “Trust”) filed an adversary complaint against Intelsat alleging that the payments from the Debtor were recoverable as constructive fraudulent transfers pursuant to section 548 of the Bankruptcy Code and the Florida Uniform Fraudulent Transfer Act.  See 11 U.S.C. § 518(a)(1)(B) & (ii)(I); Fla. Stat. § 726.105(1)(b).  The Trust argued that the payments were avoidable fraudulent transfers because the Debtor was not a party to the satellite contracts, did not own the satellite services, and did not benefit from them.  Essentially, the Trust took the position that the Debtor received less than reasonably equivalent value in exchange for the transfers at issue.  According to the Trust, payment or assumption of a third party’s debt by an insolvent entity is per se a fraudulent transfer because it necessarily lacks adequate consideration.

The Eleventh Circuit Court of Appeals, however, rejected a per se approach and concluded that payments made to fulfill contractual obligations of third parties may not be fraudulent transfers where an economic benefit is directly or indirectly conferred upon the transferor.  In this case, although the Debtor was not a party to the satellite contracts of its parent company, the Debtor derived a benefit from those contracts.  Specifically, the satellite services permitted the Debtor to operate the PSN Channel, and the Debtor earned a service fee from PSNI from that operation.  This indirect benefit to the Debtor through PSNI was sufficient to satisfy the “reasonably equivalent value” requirement, and the Eleventh Circuit affirmed the bankruptcy court’s order that the Trust could not avoid the transfers.

As parent-subsidiary and other affiliate relationships are increasingly common, the shrewd practitioner needs to be aware of the potential virtues and pitfalls of triangular payment relationships, which almost certainly will be called into question as fraudulent transfers in the event of an insolvency.

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Ninth Circuit Holds Twombly / Iqbal “Plausibility” Standard Does Not Apply To Denials

December 23, 2014


In a seminal pair of decisions, Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007) and Ashcroft v. Iqbal, 556 U.S. 662 (2009), the United States Supreme Court clarified that the pleading standard under Federal Rule of Civil Procedure 8(a) requires that a complaint contain sufficient factual allegations to state a claim to relief “that is plausible on its face.” Neither Twombly nor Iqbal addressed, however, whether this “plausibility” standard also applies to denials under Federal Rule of Civil Procedure 8(b). In its recent decision in In re Mortgages Ltd., 771 F.3d 623 (9th Cir. 2014), the Ninth Circuit Court of Appeals weighed in and held that the “plausibility” standard does not apply to denials.

The debtor in this case, Mortgages Ltd., was a private lender that made loans secured by real estate located in Arizona. Mortgages Ltd. funded its lending operations, in part, by selling fractional interests in its loans to investors. Under this arrangement, the investors owned their fractional interests in the Mortgages Ltd. loans in which they invested.

After Mortgages Ltd.’s bankruptcy filing, the Bankruptcy Court confirmed a plan that created an entity known as ML Manager LLC to manage and liquidate Mortgages Ltd.’s loan portfolio. Issues arose regarding ML Manager LLC’s authority to manage and liquidate the fractional interests in the Mortgages Ltd. loans owned by various investors, including a group of investors known as the Rev Op Group.

ML Manager LLC eventually filed a complaint seeking a declaratory judgment from the Bankruptcy Court on the issue of its authority to control and sell investors’ loan assets. ML Manager LLC asserted in its complaint that the Rev Op Group and other investors executed certain documents that granted Mortgages Ltd. an irrevocable agency power to manage and liquidate their loan assets, that the agency power was transferred to ML Manager LLC by the confirmed plan, and that ML Manager LLC therefore had authority to control and liquidate the Rev Op Group members’ assets over their objections. In their answers, the Rev Op Group members admitted signing certain documents in connection with their investments, but denied executing documents that granted any agency authority with respect to their loan assets.

In a novel ruling, the Bankruptcy Court held that the Twombly / Iqbal “plausibility” standard applied to the Rev Op Group’s denials and that, based solely on the pleadings, the Rev Op Group’s denials regarding the alleged agency authority were not plausible. Accordingly, the Bankruptcy Court entered judgment in favor of ML Manager LLC on the agency authority issue.

On appeal, the Ninth Circuit held that the “plausibility” standard does not apply to denials and reversed the Bankruptcy Court’s declaratory judgment. In doing so, the Ninth Circuit reasoned that a court may only disregard statements in a pleading under Rule 11 (for bad faith) or under Rule 12(f) (for matters that are scandalous, immaterial, impertinent, etc.), and that the Bankruptcy Court had not tested the Rev Op Group’s denials under either of those standards. “Courts cannot examine statements in an answer or other pleading and decide, on the basis of their own intuition, that the statements are implausible or a sham and thus can be disregarded.” Accordingly, the Bankruptcy Court erred by “effectively resolv[ing] those allegations” in the Rev Op Group’s denials “on the merits.”

With this decision, the Ninth Circuit has now clarified that Rule 8(b) does not require defendants to plead denials under a heightened “plausibility” standard in federal court. This decision is also notable for providing further clarification on other bankruptcy-related issues, including equitable mootness and substantial consummation of a bankruptcy plan.

In the interest of full disclosure, Bryan Cave LLP represented the appellants—the Rev Op Group—in the bankruptcy case and appeal discussed herein.

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