Site Name

BANKRUPTCY AND
RESTRUCTURING

Chapter 7 Bankruptcy

Main Content

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

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.

Conclusion

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.

Read More

No Notice: How Unnotified Creditors Can Violate a Discharge Injunction

Here is the scenario: You are a creditor.  You hold clear evidence of a debt that is not disputed by the borrower, an individual.  That evidence of debt could be in the form of a note, credit agreement or simply an invoice.  You originated the debt, or perhaps instead it was transferred to you — it does not matter for this scenario.  At some point the borrower fails to pay on the debt when due.  For whatever reason, months or even years pass before you initiate collection efforts.

Finally, you seek to collect on the unpaid debt. Those collection efforts include letters and phone calls, and maybe even personal contact, all of which are ignored.  Then you employ an investigator and an attorney.  You eventually obtain a default judgment from a state court, which the borrower (unsurprisingly) refuses to pay.  You then garnish the borrower’s wages to pay the debt.  You collect a few payments before the borrower informs you that the debt was discharged in bankruptcy.  Wait . . . how could that be?  You never received notice of the bankruptcy, you didn’t have an opportunity to file a proof of claim, until now you never saw the discharge order.  Indeed, you come to find out that the borrower never listed you on his bankruptcy schedules and you never received notice that there was a bankruptcy.

The way the borrower informs you of the bankruptcy is even more disturbing. The borrower serves a Motion for Sanctions that he filed in the bankruptcy court.  He is asking the bankruptcy court to set aside your state court judgment, for the return of his garnished wages, for emotional distress damages, and for a whole bunch of attorney’s fees that he incurred to reopen the case and file the Motion for Sanctions.[i]

You say to yourself, “No way!” Surely, the bankruptcy court cannot punish you for a case you knew nothing about.  After all, isn’t it the Debtor’s burden to list all of his creditors.  There was no way that your debt was discharged.  Think again, you could be in trouble!

Here’s why. Due to the complicated interaction of multiple sections of the bankruptcy code and the way in which courts have interpreted that interaction in no-asset Chapter 7 Bankruptcy cases, your debt was discharged and your collection efforts were in violation of the discharge injunction despite the fact that you lacked knowledge of the bankruptcy.  In a Chapter 7 case, § 727(b) discharges a debtor “from all debts that arose before the date of the order for relief” except as provided in § 523.  Section 524, also known as the discharge injunction, applies to any “debt discharged under section 727” and operates as an injunction against the commencement or continuation of an action, or an act, to collect, recover or offset any personal liability of a debtor.  Generally speaking, Debtors receive a discharge under § 727(a), and the scope of that discharge is set forth by § 727(b).  Pursuant to § 727(b), a prepetition debt is discharged as a matter of law, unless it is nondischargeable under § 523.

Ahah-your debt must fall under § 523, or so you think. After all, § 523(a)(3)(A) states “A discharge under section 727 . . . does not discharge an individual debtor from any debt neither listed nor scheduled under section 521(a)(1) of this title, with the name, if known to the debtor, of the creditor to whom such debt is owed, in time to permit . . . timely filing of a proof of claim, unless such creditor had notice or actual knowledge of the case in time for such timely filing.”  You never had notice, did not to get to file that proof of claim, and you knew nothing about the case until that sanctions motion arrived on your doorstep.  Sure you are protected by § 523, right?

Not so fast. Section 523 does not apply to all Chapter 7 cases.  It is “well accepted that the failure to give notice to a creditor will be disregarded in a Chapter 7 no asset case and that in such cases failure to schedule a prepetition debt will not preclude the discharge of that debt.”[ii] When a debtor’s case is administered as a no-asset case with no set claims bar date and, therefore, has no cut off for the “timely filing of a proof of claim,” an unlisted creditor is not deprived the opportunity to file a timely proof of claim.[iii]  Because the time to file a proof of claim never passes, it matters not that the debtor failed to list a creditor in the first place.  Nor does it matter why the debt was not listed.  The 10th Circuit, for example, says that “equitable considerations,” such as the Debtors’ reasons for failing to schedule the debt or the creditor, “do not impact the dischargeability” of the prepetition debt under § 523(a)(3)(A).[iv]

All this bouncing around the Bankruptcy Code takes us back to § 524 for an explanation of why no notice is actually required. Section 524(a)(2) of the Bankruptcy Code, which creates the discharge injunction, is unambiguous and makes no distinction between debts which are discharged following notice to a creditor and those that are discharged despite a lack of notice. Section 524 provides:

(1)        discharge in a case under this title–

(2)        operates as an injunction against the commencement or continuation of an action, the employment of process, or an act, to collect, recover or offset any such debt as a personal liability of the debtor, whether or not discharge of such debt is waived[v]

Thus, a lack of knowledge of the discharge does not provide a defense for a creditor who attempts to collect in violation of the discharge injunction.

All is not lost. Despite the mandate of § 524, not all bankruptcy courts (which are still courts of equity) have divorced themselves from equitable principals. The court in In re Wilcox refused to sanction an unlisted creditor for violation of the discharge injunction despite the creditor’s prosecution of a state-court collections case. The Wilcox Court stated that it:

cannot blame the Creditors for their confusion which, after all, proceeds in large measure from the Debtor’s incomplete disclosure in Schedule F and the mailing matrix. Under the circumstances, and up to this point in time, their filing and prosecution of the [state court] lawsuit is not contemptuous. If, however, they continue to pursue their claims against the Debtor without also seeking a declaration . . . that their claims are excepted from discharge under § 523(a)(3), they run the risk of violating the Discharge, especially now that they have a better understanding of their rights.[vi]

The ultimate lesson to be learned is that creditors need to exercise the utmost caution in their pursuit of borrowers, especially if there is reason to believe that borrower filed bankruptcy. A search of public bankruptcy filings before collection efforts are begun, may be the ounce of prevention that is worth a pound of cure.  If the borrower produces a bankruptcy discharge, a creditor should retain counsel to review the case and determine whether § 523 applies to the case.  Lack of notice is not enough to prevent liability.

[i]  The scenario is based on the recent case out of the District of Utah, In re Slater, No. 09-21947, 2017 WL 2656119, at *1 (Bankr. D. Utah June 20, 2017), where the Court concluded that creditor “should be placed in civil contempt for violation of the discharge injunction of 11 U.S.C. § 524. The Default Judgment in the State Action is void pursuant to § 524(a).”  The court also found the creditor liable to Debtors for actual damages for all wages garnished, as well as costs and reasonable attorney fees incurred by the Debtors in bringing the motion to enforce the discharge order. Other cases in other jurisdictions have come to similar conclusion based on similar rational, although facts and the creditors level of knowledge of the bankruptcy tend to vary slightly. Cf. In re Greenberg, 526 B.R. 101 (Bankr. E.D.N.Y. 2015) and In re Haemmerle, 529 B.R. 17, 20 (Bankr. E.D.N.Y. 2015).

[ii]   In re Delafied 246 Corp., No. 05-13634ALG, 2007 WL 2332527, at *2 (Bankr. S.D.N.Y. Aug. 14, 2007)); In re Herzig, 238 B.R. 5 (E.D.N.Y.1998).

[iii] It should be noted that there is currently a Circuit split on the issue of whether an unlisted debt in a no-asset bankruptcy is automatically discharged by operation of law. The Third, Sixth, Ninth, and Tenth Circuits follow the “mechanical approach” and hold that any such debt is discharged by operation of law; therefore, there is no need to reopen the case and determine dischargeability regardless of the debtor’s reason for failing to list the debt. See In re Parker, 264 B.R. 685, 694 (10th Cir. 2001); In re Madaj, 149 F.3d 467, 471 (6th Cir. 1998); In re Judd, 78 F.3d 110, 115 (3d Cir. 1996); In re Beezley, 994 F.2d 1433 (9th Cir. 1993); see also In re Cruz, 254 B.R. 801, 807 (Bankr. S.D.N.Y. 2000) (summarizing cases).  In contrast, the First, Fifth, Seventh, and Eleventh Circuits have held that motions to reopen a no-asset Chapter 7 case should be granted to amend the list of creditors—thus subjecting the unlisted creditor to the bankruptcy discharge—unless the omission was the result of fraud or intention. See Colonial Surety Co. v. Weizman, 564 F.3d 526 (1st Cir. 2009); In re Faden, 96 F.3d 792, 797 (5th Cir. 1996); In re Baitcher, 781 F.2d 1529, 1534 (11th Cir. 1986); In re Stark, 717 F.2d 322 (7th Cir. 1983).  In these jurisdictions, the Debtor’s basis for failing to list the Debt could be scrutinized as part of the process to reopen the case.  While this doesn’t mean that the debt will not be discharged, it adds a level of scrutiny to the debtor’s failure to list the debt in the first place and provides a creditor additional notice of the bankruptcy.

[iv] In re Parker, 313 F.3d 1267, 1268 (10th Cir. 2002).

[v] See 11 U.S.C. § 524(a)(2). See Green v. Welsh, 956 F.2d 30, 32 (2d Cir.1992).

[vi] In re Wilcox, 529 B.R. 231, 238 (Bankr. W.D. Mich. 2015); see also In re Johnson, 521 B.R. 912, 916 (Bankr. W.D. Ark. 2014)(finding that the debtor failed to notify the creditor. Therefore the creditor was under no obligation to return the money it had collected from the debtor’s state tax return and the debtor’s motion for contempt was denied.)

Read More

“Singular” Cases on Nondischarge and Dischargeability

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.

Read More

Tenth Circuit Joins Missouri River to Divide Kansas City Over What Constitutes A Stay Violation

On February 27, 2017, the United States Court of Appeals for the Tenth Circuit joined a minority approach followed by District of Columbia Circuit:  failing to turn over property after demand is not a violation of the automatic stay imposed by 11 U.S.C. § 362.  WD Equipment v. Cowen (In re Cowen), No. 15-1413, — F.3d —-, 2017 WL 745596 (10th Cir. Feb. 27, 2017), opinion here.

In Cowen, one secured creditor (WD Equipment) repossessed a vehicle in need of repairs for which the debtor (Cowen) could not pay.  Id. at *1.  Another secured creditor (Dring, the debtor’s father-in-law who is likely no longer welcome at Thanksgiving) repossessed a separate vehicle through the use of false pretenses, a can of mace, and five goons helpful colleagues:

“Mr. Dring lured Mr. Cowen under false pretenses to his place of business to repossess the Kenworth [truck].  Mr. Dring asked Mr. Cowen, who had brought along his young son, to leave the keys in the ignition, engine running, and to step out of the truck.  As Mr. Cowen exited the vehicle, Mr. Dring jumped in, grabbed the keys, and declared the truck ‘repossessed.’  When Mr. Cowen asked what was going on, Mr. Dring told him to take his son and leave—immediately.  A group of five men gathered around Mr. Dring while he brandished a can of mace above his head and threatened to use it if Mr. Cowen did not leave.  Mr. Cowen pushed his young son behind him to protect him, and the two left the lot on foot.” Id.

(Editor’s Note from the Bankruptcy Cave:  You can’t find these stories anywhere in the judicial system except in Bankruptcy Court; we love it.  Here is also a Bankruptcy Cave rendering of what we think these fine young lads looked like.)

Dangerous zone

 

 

Within days of the repossessions, Cowen filed for chapter 13 bankruptcy protection in the Bankruptcy Court of the District of Colorado and demanded the return of both trucks, but WD Equipment and Dring both refused.  Id.  Cowen then obtained a show cause order from the bankruptcy court, which ordered the Defendants to “immediately turn over” the trucks to Mr. Cowen; “[c]ontinuing failure to turn over the Truck[s],” the bankruptcy court warned, “may result in the imposition of monetary damages against the Creditors for willful violation of the automatic stay.”   Id. at *2.

After the Defendants failed to comply with the bankruptcy court’s show cause order, Cowen instituted an adversary proceeding against Defendants WD Equipment and Dring for willful violation of the automatic stay.  Id.  During the adversary proceeding, the Defendants argued that Cowen’s rights in the trucks had been properly terminated by Defendants before the bankruptcy petition was filed.  But the bankruptcy court did not find the Defendants’ testimony credible, found that Defendants likely manufactured and forged documents regarding transfer of title, and found that because Defendants’ actions contravened Colorado law, Defendants did not effectively terminate Cowen’s ownership interest in the Trucks.  The bankruptcy court ultimately concluded, “[f]ailing to return the Trucks violated § 362(a)(3) of the Bankruptcy Code,” and it imposed actual and punitive damages under 11 U.S.C. § 362(k)(1). Id.

The district court affirmed, noting that the bankruptcy court had applied the majority rule followed by the Second, Seventh, Eighth, and Ninth Circuits: “that the act of passively holding onto an asset constitutes ‘exercising control’ over it, and such action violates section 362(a)(3) of the Bankruptcy Code.” Id. at *4 (citing Thompson v. Gen. Motors Acceptance Corp., 566 F.3d 699, 703 (7th Cir. 2009); Weber v. SEFCU (In re Weber), 719 F.3d 72, 81 (2d Cir. 2013), California Emp’t Dev. Dep’t v. Taxel (In re Del Mission Ltd.), 98 F.3d 1147, 1151 (9th Cir. 1996), Knaus v. Concordia Lumber Co. (In re Knaus), 889 F.2d 773, 775 (8th Cir. 1989), Unified People’s Fed. Credit Union v. Yates (In re Yates), 332 B.R. 1, 4 (10th Cir. BAP 2005).

The Tenth Circuit reasoned that the majority approach relied too much on legislative history and “practical considerations.”  Id.  In choosing to follow the minority approach followed by the D.C. Circuit (see United States v. Inslaw, 932 F.2d 1467, 1474 (D.C. Cir. 1991)), the Tenth  Circuit stated as follows:

Here again is § 362(a)(3), in relevant part: a bankruptcy petition “operates as a stay … of … any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate.” Breaking down the sentence, “any act” is the prepositive modifier of both infinitive phrases.  In other words, § 362(a)(3) prohibits “any act to obtain possession of property” or “any act to exercise control over property.”  “Act”, in turn, commonly means to “take action” or “do something.” New Oxford American Dictionary 15 (3d ed. 2010) (primary definition of “act”).  This section, then, stays entities from doing something to obtain possession of or to exercise control over the estate’s property. It does not cover “the act of passively holding onto an asset,” Thompson, 566 F.3d at 703, nor does it impose an affirmative obligation to turnover property to the estate.  “The automatic stay, as its name suggests, serves as a restraint only on acts to gain possession or control over property of the estate.”  Inslaw, 932 F.2d at 1474.  Stay means stay, not go.

Id. The Tenth Circuit concluded: “[a]nd so, adhering to the text of the statute, as we must, we adopt the minority rule: only affirmative acts to gain possession of, or to exercise control over, property of the estate violate § 362(a)(3).  Id. at *5.

Despite the reversal, the Defendants were not absolved of liability.  While simply refusing to turn over the trucks did not constitute affirmative acts of the Defendants, the Tenth Circuit stated that the Defendants’ manufacturing of paperwork, forging of documents, potentially perjured testimony, and coaching of witnesses, “would qualify as post-petition acts to exercise control over the debtor’s property in violation of the automatic stay.”  Id. at *6.

Potential Ramifications

Cowen could prove useful to banks and credit card companies who are faced with allegations that account freezes violate the automatic stay.   Cowen will also necessitate that lawyers practicing on the borders of the D.C. or Tenth Circuits (such as in Kansas City, which is divided between the Eighth and Tenth Circuits) be mindful of the location of repossessions and turnover demands and denials.

Read More

No Trustee Left Behind – Another Bankruptcy Court Requires Colleges to Return Tuition to the Bankruptcy Estate

b09036864402bfedc690a2f80d6de804Another bankruptcy trustee catches another hapless college unaware.  In Roach v. Skidmore College (In re Dunston), Bankr. S.D. Ga. (Jan 31, 2017), a trustee appears to win the next battle of “bankruptcy estates v. child’s college,” ruling that an insolvent parent who paid the college tuition of an adult child made a fraudulent transfer to the college.  Thus, the unsuspecting college will likely have to return the tuition to the parent’s bankruptcy estate.

The theory is simple (albeit unsettling to some).  Under Section 548 of the Bankruptcy Code (and applicable state law, as a back-up), if any debtor makes a transfer to a third party while insolvent, and does not receive reasonably equivalent value in return, the debtor’s bankruptcy trustee may reclaim such transfer for the benefit of unsecured creditors (and for the benefit of the trustee’s fees, of course).  In plain English, the recipient got the money, and didn’t provide anything to the insolvent party which made the payment.  That’s unfair to the insolvent payor’s other creditors (who are left with crumbs, or nothing), and thus a “fraudulent transfer” can be reclaimed for all such other creditors.  Congress has excluded some charitable contributions and tithes from attack. 11 U.S.C. § 548(a)(2).  But Congress did not include tuition paid for an adult child in the list of exceptions, and so it is not the place of courts to graft a “adult child college tuition” exclusion to the statute.

We had a prior post on this, here.  In that post, we went over a contrary ruling from the District of Massachusetts, DeGiacomo, as Chapter 7 Trustee v. Sacred Heart Univ. (In re Palladino), Bankr. D. Mass. (Aug. 10, 2016).  In that case, the Bankruptcy Court ruled against the Chapter 7 trustee by holding that the future benefits an adult child may get from a college education can provide “reasonably equivalent value” such that the parent’s tuition payment to the college is not voidable.  As the Palladino Court held, “[a] parent can reasonably assume that paying for a child to obtain an undergraduate degree will enhance the financial well-being of the child which in turn will confer an economic benefit on the parent.  This, it seems to me, constitutes a quid pro quo that is reasonable and reasonable equivalence is all that is required.”  (Other coverage of Palladino and opinions like it, including this recent ruling from Georgia, can be found in the outstanding coverage of Katy Stech of the Wall Street Journal  here, here, and here (alas, WSJ subscriptions required)).

Now, in Roach v. Skidmore College (In re Dunston), the Bankruptcy Court for the Southern District of Georgia has ruled to the contrary.  In Dunston, the Court rejected the argument that an indirect economic benefit of having a well-educated and (hopefully) a gainfully employed adult child is “reasonably equivalent value.”  Instead, according to Dunston, paying an adult child’s tuition is simply honoring a “moral obligation,” and not any legal duty or actual, monetary obligation of the parent.  The college – in this case, the august institution Skidmore College, near beautiful Saratoga Springs and home to some seriously rockin’ a cappella – provided no value to the debtor parent.  Thus, the Dunston court allowed the fraudulent transfer action to go forward – and its will eventually be successful, in The Bankruptcy Cave’s view.

Our previous post on this issue criticized what we believed was a results-oriented decision in Palladino.  To be sure, few like the idea of our educational institutions having to fully refund tuition payments which they accepted innocently, without knowing of the parent’s insolvency.  But despite these misgivings, Palladino was incorrect under a plain reading of the statute – any time an insolvent debtor gives money to a third party, and receives nothing in return, that money should come back to the bankruptcy estate to benefit all other innocent creditors.  The Dunston decision is right.

This problem cries out for a legislative solution.  Until then, bankruptcy courts will honor the wording of the fraudulent transfer status and require colleges to return the tuition (Dunston) or find “future economic value” to the parent that is, in the view of The Bankruptcy Cave, entirely speculative (Palladino).  While there are many problems with our current bankruptcy statutes, this one really needs a solution.

Read More

A Debtor’s Allegedly False Financial Statement Doesn’t, At All, Excuse a Lack of Lender Diligence

A decision rendered during the sometimes peaceful interlude between Christmas and New Year’s is worth reading, and heeding.  Hurston v. Anzo (In re Hurston), Adv. Proc. No. 15-2026 (Bankr. N.D. Ga. Dec. 27, 2016) is a helpful reminder to anyone representing lenders or creditors which are hell-bent-for-leather to pursue a non-dischargeability claim against a debtor that submits a false written statement (e.g., a personal financial statement) to obtain credit.  Often, in the fervor of the start of a bankruptcy case, the creditor (and its lawyer) will make great hay from the fact that a debtor may have lied in a pre-petition credit application, or forbearance agreement, or other written medium.  However, the facts of Hurston show that a creditor (and its lawyer) should pause, take a breath, and critically evaluate whether the creditor actually relied on the pre-petition writing from the debtor, and whether that creditor’s reliance was also, in fact, reasonable.  If not, then the creditor deserves a serious challenge from its own counsel on the wisdom of pursuing a expensive, and likely unsuccessful, non-dischargeability claim.

We don’t need to go in detail on the debtor’s alleged falsehoods – that is not the point of Hurston.  Instead, Judge Sacca of the Bankruptcy Court for the Northern District of Georgia covered in great detail how the creditor didn’t not rely on the allegedly false statements, and even if it did, its reliance was not reasonable.  The key takeaways from the opinion – and helpful advice for any lawyer that is thinking about taking on a “false statement” non-dischargeability action under 11 U.S.C. sec. 523(a)(2)(B) – are what the creditor in Hurston did and didn’t do.

First, where the creditor does not perform any material diligence on the false statement (here, a personal financial statement), then the creditor will have a difficult or impossible time showing that it “reasonably relied” on the allegedly false financial statement.  The creditor should ask for bank statements, tax returns, information from accountants, or other, third party evidence to back up information form a debtor.  If the creditor didn’t perform any follow up diligence, you should advise the creditor (right at the outset) that its claim may fail.

Second, this is especially true where the creditor and debtor do not have a prior relationship.  A prior relationship might (we emphasize, might) provide indicia of reliability of the debtor and its financial wherewithal to overcome a lack of diligence.  But if there is no prior relationship, the creditor should be ready to show that it did more diligence.

Third, where a financial statement (or other writing on which the non-dischargeability claim is based) contains “red flags,” including matters a reasonable creditor would question or that the specific creditor should know to question, the creditor must show that it followed up on those “red flags.”

Fourth, a debtor with an alleged strong financial reputation, or that appears to be wealthy based on appearance and community activity, does not excuse the creditor’s obligation to perform diligence on any written statement or financial statement.  In short, an argument based on “the debtor was a pillar of the community” will not go to show reasonable reliance by the creditor on an otherwise questionable financial statement or other writing.

Fifth, the creditor should be able to show it had established criteria to evaluate the credit being extended – and that those criteria were used and evaluated as a critical part of making any decision to extend credit.  A lack of rules and procedures to evaluate financial statements or other written submissions, or a failure to follow those procedures, will be very harmful to the creditor’s claim.

When you read 11 U.S.C. sec. 523(a)(2)(B), and in particular its requirement that the creditor “reasonably relied” on any alleged false statement, the Hurston decision is not surprising.  But Hurston remains a very helpful reminder for any creditor’s lawyer to critically examine the creditor’s case at the start of the matter.  The lawyer must cross-examine the creditor to get past the allegations of the debtor’s falsehoods (which the creditor will trumpet as much as you let it), and spend a great deal more time on whether the creditor did any diligence on the allegedly false written statements.  This can be an awkward conversation with your client – and perhaps perceived as blaming the victim – but it will be far more awkward to later explain to your client why the non-dischargeability action did not succeed.

Read More

Helpful Cases for Mortgage Servicers Attempting to Comply with Mortgage Servicing Regulations After a Bankruptcy Discharge

Mortgage lenders and servicers face several regulations in servicing residential mortgages. There are requirements under the Truth in Lending Act (“TILA”), Real Estate Settlement Procedures Act (“RESPA”), the Equal Credit Opportunity Act (“ECOA”), the Fair Debt Collection Practices Act (“FDCPA”), state law, and new regulations implemented by the Consumer Financial Protection Bureau (“CFPB”).  Failure to comply with these regulations and laws may give rise to litigation, as well as statutory penalties.  In many cases, the mortgage borrower files for bankruptcy.  When the mortgage borrower states an intention to surrender the mortgaged property in bankruptcy, non-bankruptcy statutes and regulations often conflict with or at minimum create great uncertainty about the mortgage servicer’s obligations to communicate with these borrowers after discharge.  Neither the Supreme Court nor many of the Circuits have provided clarity for mortgage servicers on whether, how, and to what extent they may communicate with a discharged debtor who still owns the mortgaged property.  Accordingly, for the time being, mortgage servicers must attempt to comply with every applicable statute and regulation while not running afoul of any applicable bankruptcy discharge rules.  The following is a compilation of cases dealing with this dichotomy.

  • “[N]ot every communication from a creditor following the conclusion of a Chapter 7 case violates the discharge injunction.” In re Henriquez, 536 B.R. 341, 345 (Bankr. N.D. Ga. 2015).
  • Correspondence does not violate Section 524 unless it includes a clear demand for payment, accompanied by coercion in the form of a threatened action or some other consequence for nonpayment to induce the debtor to pay. In re Gill, 529 B.R. 31, 40 (Bankr. W.D.N.Y. 2015).

A.  Cases Discussing Foreclosure Notices Required by State Law.

  • Foreclosure notices have been held not to violate the discharge injunction because they are required under both the mortgage and state law. Gill, 529 B.R. at 41; In re Ladebush, No. AP 13-1154-JMD, 2016 WL 675580, at *7 (Bankr. D.N.H. Feb. 18, 2016).
  • The Eighth Circuit has held that foreclosure notices from a secured creditor to a debtor that contain a declaration that they were provided “for information purposes” about the status of the property are not an attempt to collect against the debtor personally, as a matter of law. In re Pennington-Thurman, 499 B.R. 329, 332 (B.A.P. 8th Cir. 2013), aff’d, 559 F. App’x 600 (8th Cir. 2014).
  • Several courts have held that a secured creditor’s communication that acknowledges a bankruptcy discharge has been entered and states the notice is not an attempt to collect personally against the debtor does not violate Section 524. Id.; Pearson v. Bank of Am., No. 3:12-CV-00013, 2012 WL 2804826, at *5-6 (W.D. Va. July 10, 2012); Anderson v. Bank of Am., No. 6:12-CV-00017, 2012 WL 4458474, at *3-4 (W.D. Va. July 11, 2012); In re Mele, 486 B.R. 546 (Bankr. N.D.Ga. 2013); Jones, No. 08–05439, 2009 WL 5842122, at *3 (Bankr. S.D.Ind. Nov. 25, 2009); In re Schatz, 452 B.R. 544, 550 (Bankr. M.D. Pa. 2011).

B.  Cases Discussing Escrow Account Review Statements Required by RESPA and State Law.

 

RESPA and some state law require mortgage servicers to provide escrow account review statements at least annually. 24 C.F.R. 3500.17; see e.g., Fla. Stat § 501.137(2)).

  • Escrow account review statements have been held not to violate the discharge order. Pearson, 2012 WL 2804826, at *5-6; In re Whitmarsh, 383 B.R. 735, 736-37 (Bankr. D. Neb. 2008).
  • One court noted that although the Bankruptcy Code prohibits a mortgagee from exerting pressure on the mortgagor to repay an advance or escrow deficiency, it does not prohibit a mortgagee from providing information or notice to a mortgagor of escrow deficiencies. Chase Manhattan Mortg. Corp. v. Padgett, 268 B.R. 309, 314 (S.D. Fla. 2001).

C.  Cases Discussing Foreclosure Alternative Letters Required by RESPA and Allowed by the Bankruptcy Code.

 

Federal regulations require loan servicers to provide post-discharge communications about loss mitigation options and periodic mortgage statements. Regulation X, which implements RESPA, requires loan servicers to fulfill the “early intervention” obligations of 12 C.F.R. 1024.39 – but to suspend compliance during a borrower’s bankruptcy. Effective January 10, 2014, the CFPB amended Regulation X to require loan servicers to resume compliance upon the first delinquency after a bankruptcy discharge. Comment, 12 C.F.R. 1024.39(d)(1)-2 Cmt.; 12 C.F.R. 1026.41(e)(5)-2 Cmt. In implementing this regulation, the CFPB acknowledged the Bankruptcy Code may prevent attempts to collect a debt personally, but concluded the Bankruptcy Code did not prevent servicers from sending consumers information about the mortgage.

  • Several courts have found that letters offering alternatives to foreclosure have been held not to violate the discharge injunction.   Whitmarsh, 383 B.R. at 736-37; Henriquez, 536 B.R. at 344-45.
  • Letters responding to borrowers’ requests for loss mitigation information have also been held not to violate the discharge injunction. Mele, 486 B.R. at 557.
  • In the situation where the debtor indicates an intention to surrender the property but continues to live in the property, courts have found that information provided to debtors about making voluntary payments post-discharge to avoid foreclosure is allowed under 11 U.S.C. § 524(j). Jones, 2009 WL 5842122, at *3.
  • Regulation X’s “early intervention” requirements also include providing the borrower, at least once every 180 days, with contact information for personnel assigned to assist them and examples of potential loss mitigation options. Similarly, an ECOA statement of the estimated property value must be provided to the property owner without regard to bankruptcy. 12 C.F.R. 1002.14(a)(1); see ECOA Valuation Rule: Compliance Guide, Oct. 3, 2013, at 10 (“The rule covers applications for … loss-mitigation transactions, … covered by Regulation B”).
  • These courts have held that customer relationship letters and property value estimates do not violate Section 524. Henriquez, 536 B.R. at 344-45; Best v. Nationstar Mortgage, LLC, 540 B.R. 1, 10 (B.A.P. 1st Cir. 2015); Leahy-Fernandez v. Bayview Loan Servicing, LLC, — F.Supp.3d –, 2016 WL 409633, at * 8 (M.D. Fla. Feb. 3, 2016)(Covington, J.).

D.  Property Insurance Lapse Notices Required by RESPA.

 

RESPA requires servicers to issue at least two notices to property owners before obtaining lender-placed insurance. 12 U.S.C. § 2605(l). RESPA then requires a notice to be sent upon each renewal of a lender-placed policy. 12 CFR 1024.37(e). The CFPB has concluded that a bankruptcy discharge does not relieve mortgagees from this requirement, and its final lender-placed insurance rule provides no notice exceptions for bankruptcy, default, or foreclosure. See Mortgage Servicing Rules Under the Real Estate Settlement Procedures Act (Regulation X), 78 Fed. Reg. 10696-01, at 10,767 (Feb. 14, 2013).

  • These cases held insurance notice communications did not violate the discharge injunction. Leahy-Fernandez, 2016 WL 409633, at * 8; Myers v. Bank of Am., No. 8:14-MP-00007-MGW, ECF 24-1 at 28:18-31:4 (Bankr. M.D. Fla. Nov. 18, 2014).

Since the mortgage crisis began in 2008, Congress has passed additional regulations to help property owners retain their homes. More clarity for mortgage servicers is needed on how these regulations are enforced after the debtor receives a bankruptcy discharge. In the meantime, we hope this compilation of situations and applicable caselaw is of use to you.

Read More

Will Inherited IRAs Be Used As A Tool for Protecting An Inheritance from Creditors?

A recent decision out of a New Jersey Bankruptcy Court highlights a loophole in the Bankruptcy Code which may allow Chapter 7 debtors to keep significant assets out of the hands of trustees and creditors.

In In re Norris,[1] the Bankruptcy Court considered whether an inherited individual retirement account is property of the bankruptcy estate.  Prior to the Debtor filing her bankruptcy case, her stepmother passed away, leaving an inherited IRA naming the Debtor as the beneficiary.  In her amended schedules, the Debtor listed the inherited IRA, claiming it as fully exempt under 11 U.S.C. § 522(d)(12), but also claiming the inherited IRA was not property of the estate.[2]  The Chapter 7 Trustee objected to the exemption and requested the inherited IRA be deemed property of the bankruptcy estate.

The Bankruptcy Court ruled in favor of the Debtor, holding that the inherited IRA was exempt. In reaching its decision, the Bankruptcy Court focused on the threshold question of whether the funds could be deemed property of the estate.  While generally, a debtor’s estate is comprised of all legal and equitable interests of the debtor as of the commencement of the case, there are a few exceptions.[3]  Section 541(c)(2), otherwise known as the spendthrift trust exception, provides that “a restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law is enforceable in a case under this title.”  The Court cited an applicable New Jersey statute which provides that any property held in a qualifying trust and any distributions from that qualifying trust are exempt from all claims of creditors and are excluded from the estate in bankruptcy.[4]  The statute specifically lists trusts created or qualified and maintained under Section 408 of the Internal Revenue Code, which includes IRAs.

Following the Third Circuit’s analysis in In re Yuhas, 104 F.3d 612 (3d Cir. 1997), the Bankruptcy Court applied a five part test to determine whether an IRA is excluded from the bankruptcy estate under Section 541(c)(2) of the Code:

 

  1. The IRA must constitute a “trust” within the meaning of Section 541(c)(2);
  2. The funds must represent debtor’s “beneficial interest” in that trust;
  3. The IRA must be qualified under Section 408 of the Internal Revenue Code[5];
  4. The provision of N.J.S.A. stating that property held is exempt from all claims of creditors must be a restriction on the transfer of the IRA funds; and
  5. The restriction must be enforceable under nonbankruptcy law.

With four of these elements easily satisfied, the ultimate question for the Bankruptcy Court was whether the change from an IRA to an inherited IRA also changes the asset’s “qualifying status” under the applicable New Jersey statute. While there are distinctions between IRAs and inherited IRAs regarding disposition of funds and tax treatment, the Bankruptcy Court nevertheless found that the six requirements of a qualified trust set forth in 28 U.S.C. § 408(a)(1)-(6) were satisfied by the IRA agreement with Mutual of America.

 

In reaching its decision that the inherited IRA was not property of the estate, the Bankruptcy Court ultimately declined to consider the Debtor’s argument that the inherited IRA was exempt.  In this way, the Court deemed the Supreme Court’s decision in Clark v. Rameker,[6] inapplicable on the grounds that the Supreme Court considered only whether an inherited IRA could be considered “retirement funds” for the purpose of the retirement exemption in Section 522(b)(3)(c).

 

Nonetheless, the Bankruptcy Court did acknowledge that key distinctions between IRAs and inherited IRAs raise significant concerns noted by the Supreme Court in Clark v. Rameker – the debtor beneficiary of an inherited IRA may withdraw the entirety of the funds at any time and for any purpose, and in fact, must withdraw the entirety of the funds within five years or take a minimum annual distribution every year.  With no restrictions on distributions from the inherited IRA, the door is left open for future abuse: potentially significant assets can be excluded from a bankruptcy estate, while the debtor is free to use those inherited funds whenever and however he or she sees fit.

 

[1]           In re Norris, Case No. 15-26458, Docket No. 31 (Bankr. D.N.J. Memorandum Opinion dated May 20, 2016).

[2]           Id. at p. 2 (citing In re Yuhas, 104 F.3d 612 (3d Cir. 1997); In re Andolino, 525 B.R. 588 (Bankr. D.N.J. 2015)).

[3]           11 U.S.C. § 541(a).

[4]           In re Norris, Memorandum Opinion at 4-5 (citing N.J.S.A. 25:2-1(b)).

[5]           26 U.S.C. § 408(a).

[6]           134 S. Ct. 2242, 2247 (2014).

Read More

What Do You Mean the Trust Is Not Asset Protected?

In a recent bankruptcy case, Richard Lewiston unsuccessfully attempted to shelter his assets in the Lois and Richard Lewiston Living Trust (the “Trust”) from inclusion in his bankruptcy estate based on the Trust’s spendthrift provision. Here, the bankruptcy court looked to Michigan state law in applying the provisions of the Bankruptcy Code and concluded the Trust property was part of Lewiston’s bankruptcy estate.

Facts about the Trust:

  • Richard and his wife created the Trust in 1986.
  • Richard and Lois were the only beneficiaries of the Trust for as long as either of them were alive.
  • Richard and Lois served as the Trustees, and either Richard or Lois were designated to act as the Managing Trustee with the power to manage the Trust assets.
  • The Trust contained a Spendthrift Provision protecting all beneficiaries from claims by creditors.
  • The Trust also contained a provision allowing it to be “amended, modified or revoked, in whole or in part, but only by the joint action and consent of Richard and Lois.”
  • In 2008, they amended the Trust to provide that the Trust would become irrevocable once one of them died.

In 2012, when Richard filed bankruptcy, he disclosed the Trust for “notice purposes only” and claimed that it was excluded from his bankruptcy estate under Section 541 of the Bankruptcy Code, which provides an exclusion for trust property subject to a transfer restriction “enforceable under applicable nonbankruptcy law.”

The bankruptcy trustee took exception to this claimed exclusion and filed a complaint in the bankruptcy case against both Richard and Lois, taking the following positions:

  • The spendthrift provision of the Trust is not enforceable under Michigan law as to Richard;
  • Self-settled spendthrift trusts are against Michigan’s public policy; and
  • The Trust property was includible in Richard’s bankruptcy estate.

In essence, the Court found Richard had complete control over the Trust property. Richard’s testimony established the following bad facts:

  • He consistently deposited distributions from Trust assets into his personal bank account; and
  • He dealt with Trust property without disclosing the Trust, notwithstanding the Trust provision that the actions of both Lois and Richard were required to remove property from the Trust.

Nevertheless, Richard claimed that the spendthrift provision was enforceable because the Trust could not be revoked without Lois’s consent, making it irrevocable as to him. Lois filed a response claiming that she had contributed her own property over time to the Trust in the total amount of about $1.5 million, but didn’t submit her signed declaration to that effect until the day before the hearing.

The Court was tasked with determining whether there was a restriction on the transfer of Richard’s beneficial interest in the Trust that was enforceable under Michigan nonbankruptcy law. Under controlling common law, a self-settled spendthrift trust that attempts to place the settlor’s own assets beyond the reach of his/her creditors while retaining the beneficial interest in such assets violates Michigan public policy.

Richard, however, claimed that the Trust was irrevocable because he could not revoke the Trust without Lois’ consent, and that the Michigan Trust Code (MTC), enacted in 2010, overruled this common law so that Michigan now permits irrevocable self-settled spendthrift trusts. Specifically, Richard relied on a section of the MTC which states that during the life of a settlor, while a revocable trust is subject to the claims of the settlor’s creditors even if the trust contains a spendthrift provision, if a trust is irrevocable, the settlor’s creditors can only reach the “maximum amount that can be distributed to or for the settlor’s benefit.” Further, if the trust has more than one settlor, the creditors are limited to “settlor’s interest in the portion of the trust attributable to that settlor’s contributions.”

The Court noted that the MTC did not expressly authorize self-settled spendthrift trusts or specifically state whether it “abrogates or continues to recognize the public policy exception against self-settled trusts under Fornell, Johannes and Hertsberg, all of which predate the MTC.” The Court held that the MTC could not be said to abrogate Michigan common law as to Michigan’s public policy against self-settled spendthrift trusts, and this common law prohibition against self-settled trusts retains its vitality. Accordingly, Michigan law did not validate the Trust’s spendthrift provision as to Richard, and the Trust was not an excluded asset under the Bankruptcy Code.

Lastly, the Court rejected Lois’s argument, that Fornell did not apply at least to the funds she contributed to the Trust because she was also a settlor of the Trust. Lois had not submitted her signed declaration concerning the assets she had deposited into the Trust until just one day before the scheduled hearing, which the Court said was not timely and should therefore be ignored as not properly before the Court. The Court also stated that Lois had cited no authority to support her argument that her contributions to the Trust, which did not name her as settlor in the trust instrument, would make her a settlor of the Trust as to those contributions or limit the access of Richard’s creditors to those contributions. All of the assets of the Trust were therefore included in Richard’s bankruptcy estate.

*Thanks to Alex Fersa for drafting assistance.

Read More
The attorneys of Bryan Cave LLP make this site available to you only for the educational purposes of imparting general information and a general understanding of the law. This site does not offer specific legal advice. Your use of this site does not create an attorney-client relationship between you and Bryan Cave LLP or any of its attorneys. Do not use this site as a substitute for specific legal advice from a licensed attorney. Much of the information on this site is based upon preliminary discussions in the absence of definitive advice or policy statements and therefore may change as soon as more definitive advice is available. Please review our full disclaimer.