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“Singular” Cases on Nondischarge and Dischargeability

March 27, 2017

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Liar businessman with crossed fingers at back .

Two recent cases analyzed the misrepresentations of a debtor regarding a single asset and held a written misrepresented value of a single scheduled estate asset would result in nondischargeability under Section 727, and that a verbal misrepresentation of a pre-petition asset to a creditor did not result in an exception to discharge under Section 523.

In Worley v. Robinson,[1]/ the Fourth Circuit affirmed nondischarge where a financially sophisticated debtor’s Schedules substantially undervalued his estate’s only substantial asset.  In Appling v. Lamar, Archer Cofrin LLP,[2]/ the Eleventh Circuit reversed a district decision and held that a false oral statements to a creditor regarding one pre-petition asset would not render the associated debt nondishargeable because they were statements of “financial condition” that must be in writing to support denial of discharge of a debt.

Litigation seeking nondischarge under Section 727 or the dischargeability of a debt under the exceptions of Section 523 is a broad topic. In general terms:

  • Section 727 provides a broad scope of discharge for the debtor, but sets out certain misconduct that will result in nondischarge, which denies the remedy of discharge of any of the debtor’s obligations.  The scope of such misconduct is generally some manner of fraudulent representation or activity in the context of the bankruptcy case, though it can involve pre-petition conduct.  The issue of nondischarge is raised procedurally by an objection to discharge filed by a creditor, the Trustee, or the U.S. Trustee.
  • Section 523, on the other hand, provides for exceptions to the general discharge of the debtor. These exceptions can render a specific obligation nondischargeable. Many of the exceptions are based on legal policies surrounding the character of the indebtedness, like certain taxes, child support obligations, and student loans.  But the commonly litigated exceptions generally involve some manner of pre-petition fraud upon a specific creditor.  The offended creditor typically initiates an adversary proceeding to obtain such an exception to discharge.

The Worley and Appling cases offer illustrations of nondischarge and dischargeability from the most singular perspective where the debtor’s misrepresentation pertains to only one asset.  The very limited facts regarding the assets actually help to identify the very important governing principals and policies of these different Bankruptcy Code treatments of alleged debtor misconduct.

In Worley, the debtor suffered nondischarge where he used a capitalization of income method to value an investment at $2,500, but the Court found it to be worth at least $13,200 under different considerations.  While just those facts may make it seem the Court was slicing it pretty thin against this debtor, other facts leveraged the adverse holding.  The debtor was an MBA with 10 years of brokerage experience who assumedly knew that the valuation method he used would undervalue the basically non-income producing asset, and that the “no asset” appearance of his bankruptcy Schedules would tend to chill further investigation by creditors or the trustee or even lead to abandonment of the property.  The Court found no clear error in the bankruptcy court’s denial of discharge under Section 727(a)(4), for the making a false oath or account.

Appling also involved very simple facts: the debtor lied to his lawyers to obtain pre-petition legal services on credit, first saying that he expected a big tax refund that would enable him to pay his legal bills, then after getting the refund, using it in his business and telling his lawyers he didn’t get the refund.  But again, the simple facts regarding this asset assist the clarity of the legal issues involved.  Section 523(a)(2)(A) and (B) both provide for exceptions from a discharge a debt obtained by misrepresentations.  However, (B) governs any misrepresentation “respecting the debtor’s … financial condition”, and requires that the misrepresentation be in writing.  Misrepresentations regarding other topics are governed by (A), and may be oral statements.  So, the question in Appling turned to whether debtor’s oral statements about this one asset were statements “respecting the debtor’s … financial condition.”  If they were, then Section 523(a)(2)(B) controls, and if the creditor does not have a written statement, the creditor loses.  Here, the existence vel non of a tax refund did relate to financial condition, and lacking any writing by the debtor about it, the debt was dischargeable.[3](We at The Bankruptcy Cave found this confusing – what oral statements do not relate to financial condition, and thus could lead to nondiscahrgeability?  The opinion answers it – “false [oral] representations about job qualifications and lies about the purpose and recipient of a payment,” for example, are the stuff that can lead to nondischargeability.  But if the creditor is complaining about a falsehood regarding financial condition, it should have gotten it in writing, the Eleventh Circuit held.)

Together the Worley and Appling cases show the varied levels of legal scrutiny of debtor intent and creditor reliance, and variable levels of materiality in the landscapes of nondischarge and dischargeability.  (My colleague Mark Duedall from BC Atlanta also wrote recently on this, in the context of a lender’s failure to perform any real diligence on a debtor’s statements, rendering the lender’s reliance unreasonable and foiling another effort to deny a discharge, here.)  It is intuitively useful to first remember that discharge and a “fresh start” are basically the whole point of the Code, and that variance of that result would be relatively rare.  (See a nice collection of Supreme Court statements on this point here.)

In the context of Section 523 dischargeability and misrepresentations, there is, in practical effect, a relatively lower expectation of debtor intent and a higher scrutiny of creditor reliance. For example, the Appling case arguably weighs “fresh start” against a legally sophisticated creditor’s unsecured lending to a financially distressed guy based on his oral statement that he was going to get a tax refund.  Is that really the creditor due diligence or underwriting standard that the Courts are endeavoring to protect in the scheme of Code policy goals?  Is that the creditor we should break “fresh start” for?  Is it too much to ask for unsecured creditors to obtain written statements of the borrower’s financial condition?  Were the oral statements really material to any reliance upon which credit was extended?  The result in Appling would indicate a negative answer to each of those rhetorical questions.

However, in the context of Section 727 nondischarge and misrepresentations, there is, in practical effect, a relatively higher expectation of debtor intent and a lower scrutiny of creditor reliance.  For example, the Worley case arguably weighs the debtor’s “fresh start” against his own financially sophisticated methods of asset valuation without any consideration of whether reasonably diligent creditors or trustees would have, in fact, been fooled.  Section 727 is itself the “fresh start”, and so the expectations of debtor conduct in the proceeding are high.  Does a debtor have to be scrupulously honest in characterizing his financial condition?  Can a Court scrutinize errors in a debtor’s Court statements down to the level of a single asset and the debtor’s subjective experience and expertise?  In the right circumstances, can a single asset be so material as to support nondischarge?  The result in Worley would yield positive answers to all those questions.

While the Worley and Appling cases involve unusual matters in their analysis of single asset factual disputes, the cases do illustrate that disputes involving nondischarge and dischargeability do not tend to provide safe harbors, and rather always involve a facts-and-circumstances analysis and a result that will largely depend on issues of intent, reliance, and materiality.

 

[1]/          Worley v. Robinson (In re Worley), 15-2346 (4th Cir. Feb. 28, 2017).

[2]/          Appling v. Lamar, Archer Cofrin LLP (In re Appling), 16-11911 (11th Cir. Feb. 15, 2017).

[3]/          The Appling Court noted a substantial Circuit split on this issue.

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For Whom the Bell Tolls: Obligations and Risks of Third-party Witnesses under Rule 2004 Examinations.

November 27, 2016

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Two recent Bankruptcy Court cases both remind and illustrate the power and risks presented by discovery of facts and documents under Bankruptcy Rule 2004, showing that it can compel third parties to provide information to support later litigation against them or cause them to lose their 5th Amendment right against self-incrimination.

  • In re Great Lakes Comnet, Inc.[1]/ (a copy of the case is here: great-lakes-comnet-inc), the Bankruptcy Court for the Western District of Michigan held that the Committee of Unsecured Creditors was entitled to conduct a Rule 2004 examination of a third-party company while explicitly recognizing that the intent of the examination was to prepare for and inform the committee regarding later litigation against the third-party.
  • In re Mavashev[2]/ (a copy of the case is here: in-re-mavashev), the Bankruptcy Court for the Eastern District of New York held that a third-party witness would not be prejudiced by any self-incrimination in the act of producing a document central to what was very likely a criminal transaction in association with the debtor, and further that such witness had waived his privilege against self-incrimination by prior, limited testimony in the Rule 2004 examination.

Discovery of facts and documents in bankruptcy litigation takes place under three broad categories of Bankruptcy Rule practice: (1) a Meeting of Creditors under Section 341 and Rule 2003, (2) examination and production of documents under Rule 2004, and (3) mirror-image federal civil rules discovery under Rules 7026-7037 for adversary proceedings or contested matters.  For all such discovery, the compulsory participation and scope of inquiry is relatively contained and governed under statutes, rules, and case law, and it is the tendency of jurisprudence over the years to make the rights and obligations thereunder more and more clear.  However, the broad scope of subject matter and proper parties to discovery under Rule 2004 seems to yield a staying power against attempts to limit it on the basis of anything other than a facts-and-circumstance, case-by-case approach.

The amorphous, yet clearly large and powerful, scope of subject matter and parties for compulsion under Rule 2004 seems particularly consternating in the recurrent problem of third-party witnesses. These are persons or entities that are not debtors or creditors, yet find themselves under substantial obligations to appear, testify and produce documents under Rule 2004.  Most lawyers in this area of practice will be familiar with the scenario of a client who is understandably incredulous that she has to comply with a burdensome obligation of appearance and production pursuant to a subpoena served under Rule 2004.

Practice under Rule 2004 involves many substantive and procedural issues.[3]  For purposes of this limited treatment of the subject, the general background of Rule 2004 practice includes:

  • The Rule 2004 inquiry may be made by any person with a legitimate interest in the case (i.e., not limited to the Trustee, Debtor, etc.) and upon any person or entity that has the required information (i.e., not limited to a party to the bankruptcy proceeding).
  • The scope of Rule 2004 inquiry is very broad and relates to any “acts, conduct, or property or to the liabilities and financial condition of the debtor, or to any matter which may affect the administration of the debtor’s estate, or to the debtor’s right to discharge.”
  • In Chapter 11 and Chapter 13 cases, the permissible scope includes the above, plus: inquiry related to “the operation of any business and the desirability of its continuance, the source of any money or property acquired or to be acquired by the debtor for purposes of consummating a plan and the consideration given or offered therefore, and any other matter relevant to the case or to the formulation of a plan.”
  • Generally, the breadth of permissible subject matter and potential witnesses has been likened to a “fishing expedition.”  However, limits on Rule 2004 include that it cannot be used: to harass parties or witnesses, as a substitute for civil rule or adversary proceeding rule discovery where an action is pending (with limited exceptions), in a post-confirmation or closed case scenario where there is no property of the estate, or where the inquiry is upon a dispute that is barred by res judicata.
  • Protections of privileged or confidential subject matter apply in the same way they do to deposition or trial testimony.

One of the most common objections seen in response to Rule 2004 notices and subpoenas to third-party witnesses is that the inquiry appears to be preparation for later litigation and therefore inappropriately attempts to avoid the witness and party protections of discovery under rules of civil cases and adversary proceedings.  This was the nature of the objection raised by the witness in the Great Lakes Comnet case.  The case was before the Court as a Chapter 11 case, and so involved the broadest scope of Rule 2004 inquiry as set out above.  The Debtors in the case had become the subject of a regulatory complaint by the Federal Communications Commission and AT&T that implicated the Debtors and Local Exchange Carriers of Michigan, Inc., a/k/a 123.net (“LEC-MI”) as to improper payments under a revenue sharing agreement.

The Committee of Unsecured Creditors (“Committee”) undertook investigation of potential claims against various parties, including LEC-MI.  For its part, LEC-MI voluntarily cooperated with the investigation up to a point, and then declined further participation.  The Committee then filed a motion requesting authority to conduct a Rule 2004 examination of LEC-MI, and LEC-MI’s responsive objections included that the Committee motion was a “clandestine attempt” to “circumvent the discovery rules.”  The Court found that “good cause” for a Rule 2004 examination includes seeking additional information to determine whether the Debtor estate has causes of action against third parties, noting that the permissible scope of the inquiry can be a “fishing expedition”, “exploratory”, and even “groping”.  In granting the Committee motion, the Court discussed with approval that making an extensive preliminary inquiry under Rule 2004 in advance of intended litigation supports goals of civil and adversary proceedings litigation practice by narrowing the eventual causes of action, exploring the potential of defenses and affirmative defenses, and supports the ability of a plaintiff to meet federal pleading standards for “plausible” causes of action or the heightened pleading standard for fraud.[4]/

In re Mavashev was a converted Chapter 7 case and therefore dealt with the comparatively lesser scope set out above.  However, this case dealt with “property of the debtor” and so was squarely within the scope of permissible subject matter even though the inquiry was of a third-party business entity and individual who had done business with the debtor.  The Trustee was pursuing investigation stemming from several transactions wherein the Debtor had delivered a total of $300,000 worth of diamonds to a business called LA Diamonds, but never received payment for them.  The course of the investigation yielded the testimony of an informed witness that the Debtor had some manner of arrangement with a convicted felon wherein they would acquire diamonds for no consideration and sell them to pawn shops.  The investigation led the Trustee to a pawn shop called Elegant Jewelry and its principal Elie Hanono (“Hanono”).

Basically, Hanono was reasonably cooperative up to a point, and then tried to stop providing information.  His Rule 2004 testimony included raising 5th Amendment objections on a question-by-question basis, testifying in some detail regarding transactions with the debtor, but in the end refusing on 5th Amendment grounds to produce a pawn ticket document that was of particular interest to the Trustee.  Points of interest covered by the Court in its decision included:

  • The 5th Amendment privilege applies in Rule 2004 examinations.
  • Corporations and artificial entities do not have 5th Amendment privilege.
  • Neither the entity nor an individual custodian of entity records in such capacity has a 5th Amendment privilege against producing entity records, no matter how small the entity may be.
  • 5th Amendment protection under the “act of production” doctrine requires that the act be both testimonial and incriminating, and whoever raises the objection must prove that it is both.
  • A witness waives the 5th Amendment privilege regarding a transaction by testifying about that transaction.Under these principals, the Court compelled Hanono to produce the pawn ticket over his 5th Amendment objection because the corporate record had not privilege, Hanano had no privilege as its custodian, Hanano had not met his burden of proof that the act of production would be testimonial and incriminating, and had in any event waived any 5th Amendment privilege regarding the production of the pawn ticket by testifying about the transaction the ticket regarded.

Together, these recent cases illustrate the continuing vitality of disputes arising under Rule 2004.  In re Great Lakes Comnet, Inc. reminds us of the broad scope of the rule, its use to explore claims and defenses, and perhaps even a bankruptcy court’s preference that eventual adversary cases be well-informed and well-pleaded.  From the witness’ perspective, In re Mavashev illustrates the perils of self-incrimination that can evolve along the way in inquiry to a third-party regarding a questionable transaction with a debtor.

[1]/              In re Great Lakes Comnet, Inc., No. GL 16-00290-JTG, 2016 WL 6081100 (Bankr. W.D. Mich. Oct. 17, 2016).

[2]/              In re Mavashev, No. 14-46442-CEC, 2016 WL 5854204 (Bankr. E.D.N.Y. Oct. 5, 2016)

[3]               For a broader treatment of Rule 2004, see T. Horan and M. Busenkell, “Gone Fishing: The Fundamentals of Rule 2004”, ABI Journal, Vol. XXIX, No. 1, February 2010.

[4]/              This approving view of the exploration of claims and defenses is stated in the context of claims directly related to the interests of the unsecured creditors of the estate.  A Rule 2004 examination may not be used to explore claims that are unrelated to the bankruptcy estate.  In re Rosenberg, 303 B.R. 172, 176-77 (B.A.P. 8th Cir. 2004).

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Stern Amendments to Bankruptcy Rules

September 19, 2016

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Stern Amendments to Bankruptcy Rules

September 19, 2016

Authored by: James Maloney

While it has taken five years of committee and court efforts, the “Stern Amendments” to the Federal Rules of Bankruptcy Procedure will become effective December 1, 2016.  These amendments will streamline litigant and court procedures in resolving subject matter jurisdiction matters as between district courts and bankruptcy courts.

The Bankruptcy Cave has followed many procedural issues since Stern v. Marshall.[1]/ Stern held certain claims designated by statute for final adjudication in bankruptcy court, are nonetheless required by the Constitution to proceed in an Article III district court (Stern post). Various Stern progeny has explored the role of parties’ consent to final adjudication in the bankruptcy court, the ability of the bankruptcy court to make findings of fact and conclusions of law for final determination by the district court, emerging local rule accommodations of jurisdictional uncertainty, and a special practitioner’s peril where a trial in district court is (oddly) governed by bankruptcy rules.  See our posts from the Bankruptcy Cave’s “Stern Series” on In re Fisher Island Invs., Inc., 778 F.3d 1172 (11th Cir. 2015), the sequence of Executive Benefits Ins. Agency v. Arkison, 134 S. Ct. 2165 (2014) and Wellness Int’l Network, Ltd. v. Sharif, 135 S. Ct. 1932 (2015), and Rosenberg v. DVI Receivables XIV, LLC, 818 F.3d 1283 (11th Cir. 2016).

The delay in rule amendments responsive to Stern was in no way due to inaction by the courts or rule committees involved.  In fact, the prime cause of the extended timeline was that the Supreme Court continued to attend to developing Stern issues through Executive Benefits and Wellness, cited above.  It was deemed inappropriate for the Supreme Court to consider rule changes involving the same subject matter as cases before the Court.

To understand the Stern Amendments, a brief background:  Constitutionally, there is a limit on the scope of rights that Congress can direct to resolution in an Article I court instead of an Article III court.  A part of this constitutional division is provided by statute at 28 U.S.C. § 157(b) and (c).  Section 157(b) lists core proceedings as to which bankruptcy courts can determine and issue final judgments and orders.  Section 157(c) provides that for non-core matters, a bankruptcy court may hold hearings and submit proposed findings of fact and conclusions of law to its district court, unless the parties consent to bankruptcy court final adjudication.  These statutory core versus non-core provisions were further reflected in bankruptcy rules.

However, in 2011 Stern identified a third kind of proceeding that was “core” but also beyond the constitutional authority of the bankruptcy court—a constitutionally non-core proceeding.  Through Executive Benefits and Wellness, along with responsive changes to Local Rules in the bankruptcy courts (See, Wellness post), it became increasingly apparent that litigant consent to final determination by the bankruptcy court could solve a lot of problems that would otherwise engender uncertainty (by both courts and litigants) as a case moved forward.

The Stern Amendments change Bankruptcy Rules 7008, 7012, 7016, 9027, and 9033.  Collectively, they eliminate the requirement that a litigant state whether a proceeding is core or non-core, and rather go straight to a requirement that the pleader state whether it consents to final adjudication in bankruptcy court.  If all parties to the dispute consent, then it does not matter if a matter is core or non-core.  However, if any party does not consent, then the bankruptcy court must act under Rule 7016(b) and decide whether the proceeding is within its core jurisdiction and constitutional authority, and also determine whether to issue final judgments and orders, to submit proposed findings of fact and conclusions of law to the district court, or to take some other approach.  The Stern Amendment changes include:

 

  • BR 7008 – General Rules of Pleading – Changes eliminate the requirement for the pleader to state whether the proceeding is core versus non-core in favor of stating whether the pleader does or does not consent to final determination by the bankruptcy court.
  • BR 7012 – Defenses and Objections – Changes to subdivision (b) regarding responsive pleading again eliminate distinctions of core versus non-core in favor whether the pleader does or does not consent to final determination by the bankruptcy court.
  • BR 7016 – Pretrial Procedures – Changes with new subdivision (b) provide three options for the bankruptcy court on consent or non-consent of parties: (1) to hear and determine the dispute, (2) to hear it and issues proposed findings of fact and conclusions of law for the district court, or (3) to take some other action. Option (3) will allow some measure of responsiveness to the many variations of scenarios the bankruptcy court might face in the operation of these amendments.
  • BR 9027 – Removal – Changes to subdivision (a)(1) and (e)(3) regarding removal again eliminate distinctions of core versus non-core in favor whether the pleader does or does not consent to final determination by the bankruptcy court.
  • BR 9033 – Proposed Findings of Fact and Conclusions of Law – Changes to subdivision (a) make the service of proposed findings of fact and conclusions of law applicable to both core and non-core proceedings.

 

 

 

 

 

 

 

After the Stern Amendments take effect, the complicated and sometimes esoteric constitutional issues involved in the identification of a statutorily core but constitutionally non-core Stern proceeding will remain.  However, all those substantive issues should now find their procedural expression under the Rules cited above.  The changes should “weed out” casual or uncommitted expressions of non-consent, yet give real jurisdictional disputes a dedicated and explicitly flexible means for adjudication.

[1]/ 131 S. Ct. 2594 (2011).

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Losing Both Ways: Debtor Diligence in the Identification of Claims

August 3, 2016

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Two recent cases serve as reminders the devil is truly in the details. As to the front-end risks associated with an early § 363(f) sale, in In re Motors Liquidation Company[1](the “GM” case) we have seen a $10 billion reminder that identification and actual notice to persons with claims against the Debtor is an indispensable element to the “free and clear” result intended by such a sale.  On the back-end risks of a confirmed Chapter 11 Plan, In re AmCad Holdings, LLC[2]teaches that failing to specifically identify claims of the Debtor against others for retained jurisdiction under the Plan can defeat the intended jurisdiction of the Bankruptcy Court to adjudicate those omitted claims.

GM involves the ongoing troubles from the 2009 insolvency of the General Motors Corporation, the United States’ largest car manufacturer.  As opposed to the usual reorganization procedures of 11 U.S.C. §§ 1121?1129, which can take years to accomplish (if ever), the debtor opted for an expedited sale under § 363, which can close in a matter of weeks and did so even here.  The sale resulted in a split between “Old GM”, the seller who remained the debtor-in-possession with limited assets, and “New GM”, the purchaser of substantially all of the Old GM assets which would use the purchased assets to carry on the majority of the business of the prior Old GM.   The proposed sale, the hundreds of objections, and resulting Sale Order all anticipated that New GM would take these assets “free and clear” of liabilities under § 363(f) and that the Sale Order would therefore act as a liability shield to prevent individuals with claims against Old GM from suing New GM.  Among its findings in the GM case, the Second Circuit effectively held that New GM was not shielded from certain large categories of tort claims related to defects in its cars because the debtor had the ability to notify the owners of such cars of the bankruptcy filing and of the proposed § 363(f) sale, yet failed to do so.  (This was not the first ruling out of the GM case addressing snafus – for our prior coverage on the mistaken release of $1.5 billion in liens, see here.)

AmCad Holdings involved the more traditional route of reorganization and Plan confirmation. As part of the Plan, a liquidation trust was established and certain estate assets, including causes of action, were assigned to the liquidating trust. Five months after confirmation, the Trustee brought an adversary proceeding against some prior managers and officers of the debtor, including three counts asserting defendants breaches of fiduciary duty.  The defendants moved to dismiss the fiduciary claims for lack of subject matter jurisdiction.  The Trustee asserted the Court had jurisdiction over the fiduciary claims under the Plan’s provisions for retention of post-confirmation jurisdiction over “Causes of Action”, which were defined in a very broad and inclusive, but annoyingly general manner.  The Plan had no specific retention of claims for breach of fiduciary duty.  In dismissing the fiduciary claims, the Court noted that its post-confirmation jurisdiction over non-core but related matters was narrow and limited to matters that had a close nexus to the Plan.  The Court reasoned that while a Chapter 11 Plan that retains jurisdiction over a specific cause of action generally satisfies this nexus, a wholesale assignment of causes of action to the post-confirmation trust did not.

In both cases, we observe that the attention to detail in the identification of claims – and in the case of AmCad Holdings, a proper disclosure of those claims – is not only important, but can be dispositive. Setting aside the sheer scale of the GM case, it’s still illustrative of the very basic issues of fairness and notice present in any § 363(f) sale on the front-end of a bankruptcy.  AmCad Holdings is on a more common scale, yet illustrates the back-end, post-confirmation risk of relying on broad-brush treatment of retained jurisdiction and perfunctory, generic disclosures of claims to be brought in the future. But once you have processed the facial lessons: (1) give actual notice to potential claimants and creditors in § 363 sale, (2) specifically identify claims for retention of post-confirmation jurisdiction, there is still more to be observed.

If the specific identification of claims and claimants can prove dispositively important, then isn’t the indicated level of diligence in this area of practice of like import? We live in the Information Age and practice among colleagues and clients of high sophistication.  Both the law firms and the clients hold information now measured in gigabytes and terabytes.  It is not a good bet that Courts will accept the proposition that it was too hard to identify a debtor’s customers, or to be aware of potential claims, or to foresee the claims that might be brought by an estate or liquidating trust post-confirmation.  But we also practice in a commercial and legal environment that is increasingly demanding, competitive, fast-paced, specialized, and that inherently involves delegation of detail work—both within the organization of the client and in that of the attorney.  These two recent cases should remind attorneys and clients in this area that attention to the identification of claims and the indicated parties to claims are important enough to support the investment of time, information, and data management, adequate staffing, full communications between client and counsel, and both factual and strategic scrutiny.  We can all learn from these cases – and adjust our habits and practices accordingly.

[1]               In re Motors Liquidation Company, Case No. 15-2844 (2d Cir., July 13, 2016).

[2]               Gavin Solmonese, LLC v. Shyamsundar (In re AmCad Holdings, LLC), United States Bankruptcy Court for the District of Delaware, Adv. No. 15-51979 (June 15, 2016) (Walrath, J.).

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Failure to Observe Bankruptcy Rule Deadline in An Adversary Proceeding Tried in District Court Costs Defendants Opportunity to Appeal $6,000,000 Verdict.

May 17, 2016

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A recent case from the 11th Circuit illustrates the procedural perils of litigation arising from a bankruptcy case but ultimately tried in the district court.  In Rosenberg v. DVI Receivables XIV, LLC,[1] the defendants lost their appeal not on the merits, but based upon the difference between civil rules and bankruptcy rules regarding what are timely post-trial motions.

BC has previously addressed procedural issues between bankruptcy courts and district courts arising from the Supreme Court’s ruling in Stern v. Marshall.[2]   As we have written when Stern was first decided, Stern held certain claims designated by statute for final adjudication in bankruptcy court, are nonetheless required by the Constitution to proceed in an Article III district court.  Relevant Stern progeny has explored the role of parties’ consent to bankruptcy court proceedings, the ability of the bankruptcy court to make findings of fact and conclusions of law for final determination by the district court, and emerging local rule accommodations of jurisdictional uncertainty, including posts on In re Fisher Island Invs., Inc., 778 F.3d 1172 (11th Cir. 2015), and the sequence of Executive Benefits Ins. Agency v. Arkison, 134 S. Ct. 2165 (2014) and Wellness Int’l Network, Ltd. v. Sharif, 135 S. Ct. 1932 (2015).

Rosenberg featured an adversary proceeding tried by a jury, conducted in the district court after withdrawal of the reference in the related bankruptcy case.  Rosenberg teaches us that just because a case is tried before a U.S. District Court judge in a U.S. District Court courtroom, it does not mean that the Federal Rules of Civil Procedure apply.  For cases arising under the Bankruptcy Code, the Federal Rules of Bankruptcy Procedure apply, regardless of whether the case is being heard in bankruptcy court or in the district court.  As recounted by the 11th Circuit opinion, a failure to abide by the shorter time frame for filing a post-trial motion imposed by the Bankruptcy Rules resulted in several defendants losing their right to appeal a $6,000,000 jury verdict.  The specific holdings in Rosenberg were:

  • Even though tried before a jury in district court, adversary proceeding are still governed by Fed. R. Bankr. P. 9015, which requires any motion for judgment as a matter of law or for a new trial be filed within 14 days of the final judgment, as opposed to the 28 days allowed by the Federal Rules of Civil Procedure.
  • Where a district court has withdrawn the reference for some claims asserted in an adversary proceeding, while leaving others before the bankruptcy court, two separate proceedings are created with their own, independent timelines.  Thus, a judgment in the district court, which does not resolve all issues raised in the adversary proceeding is still final for purposes of appeal.

Rosenberg arose from an involuntary bankruptcy proceeding, dismissed after a determination that some petitioners were not eligible creditors, and, alternatively, were judicially estopped from prosecuting the case.  The bankruptcy court retained jurisdiction to hear the debtor’s claims against the petitioning creditors under 11 U.S.C. § 303(i), which allows an involuntary debtor who has won dismissal of his case to recover costs, attorney’s fees and, in cases where a petitioner is determined to have acted in bad faith, actual and punitive damages.

The debtor filed an adversary proceeding on these claims, and demanded a jury trial.  The defendants would not consent to a jury trial in the bankruptcy court.  The district court granted the defendants’ motion to withdraw the reference on the claims for damages under 303(i)(2), reasoning that they were analogous to common law claims for malicious prosecution.  The bankruptcy court retained jurisdiction over the claim for attorney’s fees.  The case was tried in the district court and the jury found that the defendants had acted in bad faith by filing the involuntary petition.  The jury awarded $1,120,000 in compensatory damages and $5,000,000 in punitive damages. The district court entered a “final judgment” on its docket on March 14, 2013.

The defendants moved for judgment as a matter of law 28 days after the final judgment was entered.  This motion would be timely under Fed. R. Civ. P. 50(b), which allows 28 days to file.  But the debtor moved to strike, arguing that the motion was untimely because 14 day deadline established by Fed. R. Bankr. P. 9015(c) applied.  The district court overruled the motion to strike and reduced the damage award to $350,000.

The 11th Circuit ruled in favor of the debtor, finding that the motion for judgment as a matter of law was untimely and should have been denied.  The 11th Circuit first noted that Fed. R. Bankr. P. 1001 provided that the bankruptcy rules were to apply in cases under Title 11 of the United States Code (i.e., the Bankruptcy Code).  It was observed that a 1987 amendment to Fed. R. Bankr. P. 1001 was enacted specifically to make the bankruptcy rules applicable in all courts hearing bankruptcy matters.  The opinion quotes the advisory committee notes as stating: “[t]his amended Bankruptcy Rule 1001 makes the bankruptcy rules applicable in cases and proceedings under title 11, whether before the district judges or the bankruptcy judges of the district.”

The 11th Circuit further observed that the Federal Rules of Civil Procedure themselves provide for the primacy of the bankruptcy rules when bankruptcy proceedings are adjudicated in the district court, by way of Fed. R. Civ. P. 81(a)(2) (“These rules apply to bankruptcy proceedings to the extent provided by the Federal Rules of Bankruptcy Procedure.”).  The opinion notes that the rule refers to “bankruptcy proceedings” and not to “proceedings in a bankruptcy court,” and thus it does not matter where the matter is being heard – the Bankruptcy Rules control in any “bankruptcy proceeding” in whatever court.  As to application of Fed. R. Civ. P. 50 to bankruptcy proceedings, it is made applicable under Fed. R. Bankr. P. 9015, but is specifically modified to provide that a renewed motion for judgment or request for a new trial must be made no later than 14 days after the entry of judgment.  Consequently, defendants’ motion filed on the 28th day was untimely.

Also worth noting from Rosenberg is the 11th Circuit’s rejection of the defendants’ argument that the “real” final judgment in the adversary proceeding was not entered until April 11, 2013, when the bankruptcy court entered an order on the separate attorneys’ fees action.  Under normal circumstances, a judgment is only final if it resolves all issues.  However, the opinion declares that once the district court withdrew the reference for the damages claim, while leaving the attorney’s fee claim before the bankruptcy court, it created two separate claims operating on their own timelines in separate courts.

Readers, this opinion is a good reminder that regardless of the court, litigators must be students of procedure, first and foremost.  When coming across a tough procedural issue, think, read, talk to your colleagues, and then think and read again.  Jurisdictional and Stern issues are tough, and the multi-court proceedings that sometimes flow from these issues require a lot of deep analysis.  Rosenberg is a scary reminder of the worst that can happen.

 

[1] 2016 WL 1392642 (Case No. 14-14620, April 8, 2016).

[2] 131 S. Ct. 2594, 180 L. Ed. 2d 475 (2011).

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The Stern Files: Evolving Jurisdiction by Consent, Wellness International Network Ltd. v. Sharif.

August 3, 2015

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Directional text on stone

In a previous post this blog addressed the Supreme Court’s 2011 ruling in Stern v. Marshall.[1] In Stern, the Court held that Article III of the Constitution limited bankruptcy courts from entering final orders on certain state law counterclaims despite such claims being designated as “core” proceedings by statute (now known as Stern Claims).

The Supreme Court left questions of great interest unanswered in Stern, but two emerged quickly: 1) can a bankruptcy court treat a “core” Stern Claim by the same procedures as “non-core” (disputes not significantly related to a bankruptcy case) under 28 U.S.C. Section 157, and thereby carry the dispute through proposed findings of fact and conclusions of law to forward to the district court; and 2) can a bankruptcy court enter a final judgment on Stern Claims with the parties’ consent?

In Exec. Benefits Ins. Agency v. Arkinson,[2] the Supreme Court addressed the availability of non-core procedures for Stern Claims. While the Ninth Circuit had described Stern as creating a statutory gap where Stern Claims fell somewhere in between a bankruptcy court’s jurisdiction over core and non-core proceedings, the Supreme Court disagreed. Rather it held that Stern Claims do not create a statutory gap and that these claims can proceed in bankruptcy court as non-core claims. As such, the bankruptcy court must treat the Stern Claim as a “non-core” matter and issue proposed findings of fact and conclusions of law for review by the district court.

In what would be in some ways a preview of Supreme Court treatment of jurisdiction by consent, the Eleventh Circuit stepped forward in In re Fisher Island Invs., Inc.[3] and took up the issue. Fisher, as discussed in a previous post, held bankruptcy court jurisdiction to exist where the parties “expressly consented to the bankruptcy court’s final adjudication” of the matters at issue in the case.

The Supreme Court took up the issue of consent in Wellness Int’l Network Ltd. v. Sharif.[4] In Wellness, the creditor, Wellness, sought a finding in the debtor’s Chapter 7 bankruptcy that a state court judgment against the debtor was non-dischargeable and that certain assets contained in a trust were included as part of the bankruptcy estate. Creditor obtained its remedy by default and the debtor appealed. On appeal, the parties completed all briefing prior to the debtor’s attempt to object to jurisdiction under Stern. Among its rulings, the Seventh Circuit held that a party cannot waive a constitutional objection based on Stern.[5]

The Supreme Court granted certiorari on the issues of consent to jurisdiction. The Court upheld the constitutionality of a bankruptcy court final judgment on a Stern Claim by reason of the parties’ consent, and that such consent may arise either impliedly or expressly.[6]

While, as discussed above, Stern progeny has developed on the Stern Claim issues of utilizing non-core procedures and establishing bankruptcy court jurisdiction by consent, bankruptcy law participants still await the clarity that would come from more direction of the Supreme Court on the scope of, limits of, and safe harbors of a Stern Claim—or what the bankruptcy courts could efficiently do in the case of a non-consenting party to a Stern Claim.

However, as for such efficiencies as may be available currently under Stern and its progeny, the United States bankruptcy courts and committees have moved forward.

In response to Stern, and before Wellness, the Bankruptcy Rules Committee proposed amendments that would require parties to indicate whether they consent to bankruptcy court jurisdiction. However, when the Court granted certiorari in Wellness, the Rules Committee withdrew the proposed amendments.[7] In light of the eventual holding in Wellness, it would not be surprising if the Rules Committee were to re-introduce a version of these proposed amendments. Further, some individual bankruptcy courts have amended their local rules to require a statement regarding the parties’ consent to final adjudication of the claims. (Southern District of Indiana in 2012 (B-7008-01, 7012-1, 9027-1 and 9033-1); Local Bankruptcy Rules for the United States Bankruptcy Court for the Central District of California (effective 1/1/15) (Rule 7008-1(mandating that statements required by FRBP 7008(a) and 7012(b) be “plainly stated in the first numbered paragraph of the document.”)).)

Beyond procedural changes, since Wellness, Courts appear to have moved forward on the development of holdings finding implied consent where: 1) the parties failed to object to the entry of an order;[8] 2) the parties identified the matter as a core matter on which the bankruptcy court could enter final judgment;[9] 3) a party requested the bankruptcy court issue an order where the party never filed a motion to withdraw the reference;[10] 4) a scheduling order required parties to file objection to entry of final order and failure to do so amounted to consent (“[t]he failure to comply with the terms of this paragraph shall be deemed to constitute consent to the entry of final orders by the Bankruptcy Judge”);[11] and 5) the parties have made a preliminary statement expressly consenting to the bankruptcy court entering a final order on the subject claims.[12]

So, while bankruptcy law participants look forward to further clarity from the Supreme Court regarding the scope, limits, and safe harbors of Stern Claims, we do see headway on the use of non-core procedures for use in Stern Claims where one or more parties do not consent, as well as developing rules and jurisprudence enhancing the clarity of express and implied consent.

[1] Stern v. Marshall, 131 S. Ct. 2594, 180 L. Ed. 2d 475 (2011); In re Newton Enters., No. 9:13-BK-12388-PC, 2015 WL 3524603, at *2 (Bankr. C.D. Cal. June 3, 2015).

[2] Exec. Benefits Ins. Agency v. Arkison, 134 S. Ct. 2165 (2014).

[3] In re Fisher Island Invs., Inc., 778 F.3d 1172 (11th Cir. 2015).

[4] Wellness Int’l Network, Ltd. v. Sharif, 135 S. Ct. 1932 (2015).

[5] Wellness Int’l Network, Ltd. v. Sharif, 727 F.3d 751, 772 (7th Cir. 2013).

[6] Wellness Int’l Network, Ltd. v. Sharif, 135 S. Ct. 1932 (2015).

[7] http://www.tnwb.uscourts.gov/PDFs/news/NoticeReRulesAmendments.pdf.

[8] In re Revel AC, Inc., 2015 WL 3929581, at *5 (Bankr. D.N.J. June 24, 2015) (sale order); In re Crawford, 2015 WL 3948013, at *4 (Bankr. D.S.C. June 8, 2015) (failure to object to plan); In re Hackman, No. 10-17176-BFK, 2015 WL 4454999, at *1 (Bankr. E.D. Va. July 20, 2015) (where the parties litigated the case for eight years and never objected).

[9] In re Smalis, 2015 WL 3745352, at *1 (Bankr. W.D. Pa. June 12, 2015).

[10] In re Perkins, 2015 WL 4312313, at *4.

[11] In re Labgold, 532 B.R. 276, 285 (Bankr. E.D. Va. 2015) (scheduling order required objecting party to file a motion or seek other relief within 30 days of order).

[12] In re ATP Oil & Gas Corp., No. 12-36187, 2015 WL 4381068, at *3 (Bankr. S.D. Tex. July 15, 2015).

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