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Supreme Court Grants Cert on, of all Things, the Standard of Review for Determining Non-Statutory Insider Status

Last December, we updated you that the Supreme Court was considering whether to grant review of In re The Village at Lakeridge, LLC, 814 F.3d 993 (9th Cir. 2016). Our original post is here.  On March 27, 2017, the Supreme Court granted review of Village at Lakeridge, but only as to one question presented, the most boring one in our view.  (Seems like after giving us bankruptcy professionals a thrill with a deep, insightful, and important ruling like Jevic, the Supreme Court is going back to bankruptcy matters that range from the esoteric to the downright irrelevant; oh well.)

In The Village at Lakeridge, a non-statutory insider acquired a $2.76 million claim against the debtor from an insider for $5,000.  Id. at 997.  The debtor attempted to confirm its plan (which included a cramdown of U.S. Bank’s claim) by arguing that the assignee of the insider claim provided the debtor an impaired consenting class.  U.S. Bank moved to designate the assignee’s claim on the basis that he was both a statutory and non-statutory insider, and that the assignment was made in bad faith.  Id. at 997-98.  The bankruptcy court designated the claim and ruled that the assignee was not entitled to vote because, when the claim was assigned, he acquired the insider status of the assignor as a matter of law.  Id. at 998.  However, the bankruptcy court ruled that the assignee was not himself an insider and the assignment was not made in bad faith.  Id.

The United States Bankruptcy Appellate Panel for the Ninth Circuit reversed the bankruptcy court’s ruling that the assignee acquired insider status by way of assignment and affirmed the bankruptcy court’s determinations that the assignee was not himself an insider and the assignment was not made in bad faith. Id.  Three years later (!!), the Ninth Circuit affirmed.

As we advised you in December, U.S. Bank presented three questions that it urged merited review.  Its second question was:  “Whether the appropriate standard of review for determining non-statutory insider status is the de novo standard of review applied by the Third, Seventh, and Tenth Circuit Courts of Appeal, or the clearly erroneous standard of review adopted for the first time by the Ninth Circuit Court of Appeal in this action.”  U.S. Bank’s Petition for a Writ of Certiorari, at i.

U.S. Bank argued a circuit split exists on the standard of review that should be applied to a determination of insider status.  Id. at 19.  U.S. Bank alleged that the Ninth Circuit’s review of the bankruptcy court’s determination of non-statutory insider status for clear error directly conflicts with the standard of review employed by the majority of circuit courts in the Third, Seventh, Tenth, and Eleventh Circuits, which hold that questions of insider status are mixed questions of law and fact to be reviewed de novo.  Id. at 19-20 (citing Schubert v. Lucent Tech. Inc. (In re Winstar Comm’ns., Inc.), 554 F.3d 382, 395 (3d Cir. 2009); In re Longview Aluminum, L.L.C., 657 F.3d 507, 509 (7th Cir. 2011); In re Krehl, 86 F.3d 737, 742 (7th Cir. 1996); Anstine v. Carl Zeiss Meditec AG (In re U.S. Med., Inc.), 531 F.3d 1272, 1275 (10th Cir. 2008); Miami Police Relief & Pension Fund v. Tabas (In re The Florida Fund of Coral Gables, Ltd.), 144 Fed. Appx. 72, 74 (11th Cir. 2005).

On March 27, 2017, the United States Supreme Court granted U.S. Bank’s petition for writ of certiorari, but only as to the question of the proper standard of review.  Case updates for In re The Village at Lakeridge, LLC are available here.

Potential Ramifications

Affirming the appellate rulings in Village at Lakeridge could increase efforts by debtors to confirm plans by assigning insider claims to friendly non-insiders who will vote for the plan.

On the other hand, a ruling in this case could add some clarity to the other little circuit split on whether an assignee of a claim (such as a claims buyer) takes a claim subject to impediments such as potential disallowance due to the claim seller’s receipt of a preference, or whether the assignment frees the claim of such impediments (which is a huge windfall to the claimant, we think).   A great summary of this split – which is far more interesting, in the view of the Bankruptcy Cave – can be found here in an very good article by Simon Fraser of Cozen O’Connor and Benjamin Klehr of Cohen Pollock.

Stay tuned for more developments on this case.

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Supreme Court Completely Endorses Critical Vendor Theory! Well, Not Completely. But Almost!

We at the Bankruptcy Cave are not very surprised by the ruling yesterday in Czyzewski v. Jevic Holding Corp.  The Supreme Court in Jevic reviewed a Bankruptcy Court’s decision to approve a settlement (with a distribution of proceeds that contravened the Bankruptcy Code’s priority scheme) in conjunction with dismissing the bankruptcy case of the Chapter 11 debtor Jevic Holding Corp. According to the Bankruptcy Court, because the distributions would occur pursuant to a “structured dismissal” rather than a confirmed plan, the failure to follow the creditor priority scheme did not bar approval.  In short, the Bankruptcy Court did not confirm a plan of reorganization for the Chapter 11 debtor, in which sufficient creditor support can re-order some of the Bankruptcy Code’s priority scheme.  Nor did the Bankruptcy Court convert Jevic’s Chapter 11 case to Chapter 7, in which the Code’s creditor priority scheme can never be changed. Instead, the Bankruptcy Court allowed a “structured dismissal,” a hybrid unrecognized by the Code (but oh so popular among the Delaware set).  In a “structured dismissal,” a case is dismissed and, through opaque deal making, cash proceeds of the estate are shifted to some creditors that Congress afforded lower priority (like general unsecured claims in Jevic’s bankruptcy case) despite nothing being paid to higher priority creditors (like unpaid wage claims of truck drivers in Jevic’s bankruptcy case).

Nothing in the Bankruptcy Code allows such re-ordering of creditor priorities as part of a dismissal.  Thus, in Jevic, the Supreme Court rejected the proposed “structured dismissal” and sent the case back to the Bankruptcy Court to distribute the money as the Code requires.  In summary, Orwell’s adage that “all animals are equal, but some animals are more equal than others” George Orwell, Animal Farm 112 (Signet 1962 edition) (1946) has no place in the Bankruptcy Code, according to the Supreme Court in Jevic.

But a truly astounding part of the Supreme Court’s opinion in Jevic provided (in dicta, we grudgingly admit) strong support for the oft-criticized “critical vendor” theory used in many large Chapter 11 cases to immediately pay seemingly important (i.e., “more equal”) unsecured creditors while other creditors sit and wait.

Specifically, the Supreme Court’s opinion in Jevic went to great lengths to mention the many valid circumstances in which a bankruptcy court “has approved interim distributions that violate ordinary priority rules.”  The Court specifically noted “‘first-day’ wage orders that allow payment of employees’ prepetition wages, ‘critical vendor’ orders that allow payment of essential suppliers’ prepetition invoices, and ‘roll-ups’ that allow lenders who continue financing the debtor to be paid first on their prepetition claims.”

The Court noted that such orders are based on findings that these priority-skipping payments “would ‘enable a successful reorganization and make even the disfavored creditors better off.’” (Jevic, citing, inter alia, In re Kmart Corp., 359 F.3d 866, 872 (7th Cir. 2004)).  Thus, such payments would (or could? or always? — it is hard to say how strong this dicta is) be allowed due to a “significant offsetting bankruptcy-related justification.”

This was a shocker.  Not because we think it is wrong – the Supreme Court is dead right that the exigencies of the initial days in Chapter 11 can permit certain limited payments to pre-petition, unsecured creditors – but because the Court did not have to delve into these theories to decide Jevic.  The Supreme Court could simply have stated that nothing in the Code’s “dismissal” provisions allow for priority skipping, and that would be that.  But instead, the Court’s expansive reasoning buttresses “critical vendor theory” and similar theories that allow for some creditors to be paid immediately upon a Chapter 11 – if there is a “significant offsetting bankruptcy-related justification.”

In conclusion, Jevic did not surprise us with its ruling, but surprised (and impressed) us with how far it went to provide added support for critical vendor theory.  Jevic is, as one may say, a critical case for those in the bankruptcy world.

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Supreme Court Weighs Granting Cert on Bankruptcy Issues Involving Surcharge and Voting Rights of Assignee of Insider Claim

December 5, 2016

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The Supreme Court is considering whether to grant review of two bankruptcy cases.  On October 3, 2016, the Supreme Court invited the Solicitor General to file briefs expressing the views of the United States.  Because the Supreme Court’s justices normally give significant weight to the federal government’s recommendations regarding interpretations of federal statutes (here, the Bankruptcy Code), the Solicitor General’s forthcoming briefs could influence whether the Supreme Court grants cert. on the two notable bankruptcy cases.

Southwest Securities v. Segner

The first case under consideration is Southwest Securities v. Segner (In re Domistyle, Inc.)811 F.3d 691 (5th Cir. 2015).  At the commencement of this case, the trustee believed the debtor possessed equity in certain real property that could benefit unsecured creditors.  Id. at 693-94.  The property was encumbered by Southwest Securities’ lien.  After marketing the property for a year, the trustee was unable to sell the property and ultimately abandoned it to Southwest and moved to surcharge Southwest for the expenses paid in maintaining the property from the start of the case.  Id. at 694-95.  The Bankruptcy Court for the Eastern District of Texas approved the surcharge over Southwest’s objection that the expenses were incurred to benefit unsecured creditors, and not Southwest.

To surcharge a lender for expenses under 11 U.S.C. sec. 506(c), the trustee bears the burden of proving that: “(1) the expenditure was necessary, (2) the amounts expended were reasonable, and (3) the creditor benefitted from the expenses.”  Id. at 695 (quoting In re Delta Towers, Ltd., 924 F.2d 74, 76 (5th Cir.1991)).  Southwest argued the surcharge was improper because, among other things, the bankruptcy court incorrectly found that the expenses were incurred “primarily” for its benefit simply because it ended up being the only creditor who received any payment from the property.  Id. at 695-96.

Southwest relied on language in Delta Towers that “require[ed] that the claimant incur the expenses primarily for the benefit of the secured creditor.” 924 F.2d at 77 (emphasis added).  In rejecting Southwest’s arguments, the Fifth Circuit reasoned that the word “primarily” is absent from the statute and Section 506(c) did not include an express requirement that funds be spent with any particular beneficiary in mind.  811 F.3d at 696.  The Fifth Circuit affirmed the surcharge because there was a direct relationship between the expenses and the collateral, evidenced by the fact that all of the surcharged expenses related only to preserving the value of the property and preparing it for sale.  Id. at 696.  The Fifth Circuit also noted the equitable nature of the statute, and that there was no evidence that Southwest could have sold the property earlier and thereby avoided the ongoing property preservation and maintenance expenses for which it was surcharged.  Id. at 699.

Finally, in weighing whether to grant cert., the Supreme Court will consider whether a circuit split exists.  Southwest argues that the Fifth Circuit’s opinion conflicts with In re Trim-X, Inc., 695 F.2d 296 (7th Cir. 1982) (holding that “expenses incurred prior to the time the trustee determined [the estate] had no equity in the assets were not for the benefit” of the secured creditor) and split panels from at least two other courts of appeals.  See Loudoun Leasing Dev. Co. v. Ford Motor Credit Co. (In re K&L Lakeland, Inc.), 128 F.3d 203 (4th Cir. 1997); Brookfield Prod. Credit Ass’n v. Barron, 738 F.2d 951 (8th Cir. 1984).

The trustee argued that there is no circuit split because the surcharge was to reimburse for benefits to Southwest itself, not potential benefits to unsecured creditors.  Response of Milo H. Segner, Jr., Trustee, in Opposition to Petition for a Writ of Certiorari, at 18-19.

U.S. Bank v. Village at Lakeridge

In The Village at Lakeridge, a non-statutory insider acquired a $2.76 million claim against the debtor from an insider for $5,000.  In re The Village at Lakeridge, LLC, 814 F.3d 993, 997 (9th Cir. 2016).  The debtor attempted to confirm its plan (which included a cramdown of U.S. Bank’s claim) by arguing that the assignee of the insider claim provided the debtor an impaired, consenting class.  U.S. Bank moved to designate the assignee’s claim on the basis that he was both a statutory and non-statutory insider, and that the assignment was made in bad faith.  Id. at 997-98.  The bankruptcy court designated the claim and ruled that the assignee was not entitled to vote because, when the claim was assigned, he acquired the insider status of the assignor as a matter of law.  Id. at 998.  However, the bankruptcy court ruled that the assignee was not himself an insider and the assignment was not made in bad faith. Id.

The Bankruptcy Appellate Panel for the Ninth Circuit reversed the bankruptcy court’s ruling that the assignee acquired insider status by way of assignment and affirmed the bankruptcy court’s determinations that the assignee was not himself an insider and the assignment was not made in bad faith.  The Ninth Circuit then affirmed the BAP.  Id.

In its Petition for a Writ of Certiorari, U.S. Bank urged that review is warranted for three fundamental reasons.  First, U.S. Bank argued that the Ninth Circuit’s ruling allows an insider claim to be transferred to a third party for the purpose of circumventing the Bankruptcy Code’s statutory prohibition against insider voting under 11 U.S.C. § 1129(a)(10).  U.S. Bank’s Petition for a Writ of Certiorari, at 7-8.  U.S. Bank argued that the Ninth Circuit’s holding ignores the general law of assignment, which holds that an assignment transfers all disabilities of the assignor (here, insider status) to the assignee.  Id. at 8.  (By the way, we at The Bankruptcy Cave would absolutely love it if, assuming cert is granted, the opinion can also resolve whether as assignee of a claim take it subject to disallowance impediments under Section 502(d) of the Code, or if an assignee cannot have its claim disallowed due to prior fraudulent transfers or preferences paid to the assignee.  This split is discussed here, courtesy of a post by our friends at Andrews & Kurth.)

Second, U.S. Bank argues a circuit split exists on the standard of review that should be applied to a determination of insider status.  Id. at 19.  U.S. Bank alleged that the Ninth Circuit’s review of the bankruptcy court’s determination of non-statutory insider status for clear error directly conflicts with the standard of review employed by the majority of circuit courts in the Third, Seventh, Tenth and Eleventh Circuits, which hold that questions of insider status are mixed questions of law and fact to be reviewed de novo.  Id. at 19-20 (citing Schubert v. Lucent Tech. Inc. (In re Winstar Comm’ns., Inc.), 554 F.3d 382, 395 (3d Cir. 2009); In re Longview Aluminum, L.L.C., 657 F.3d 507, 509 (7th Cir. 2011); In re Krehl, 86 F.3d 737, 742 (7th Cir. 1996); Anstine v. Carl Zeiss Meditec AG (In re U.S. Med., Inc.), 531 F.3d 1272, 1275 (10th Cir. 2008); and Miami Police Relief & Pension Fund v. Tabas (In re The Florida Fund of Coral Gables, Ltd.), 144 Fed. Appx. 72, 74 (11th Cir. 2005)).

Third, U.S. Bank argued a circuit split also exists on the proper test for determining nonstatutory insider.  Id. at 24.  Specifically, U.S. Bank argued the Supreme Court should resolve whether courts are to conduct an “arm’s length” analysis as applied by the Third, Seventh and Tenth Circuit Courts of Appeal, or apply a “functional equivalent” test which looks to factors comparable to those enumerated for statutory insider classifications as applied by the Ninth Circuit in this action.  Id. at 24-27 (citations omitted).

The debtor disputes that any circuit split of authority exists, and alleges that the Ninth Circuit applied all appropriate standards for determining insider status.  The Village at Lakeridge, LLC Brief in Opposition, at 6-11.

Potential Ramifications

Denying cert. in Southwest could both increase the risk of a surcharge of a secured creditor and dissuade a trustee from promptly abandoning assets.

Denying cert. in Village at Lakeridge could increase efforts by debtors to confirm plans by assigning insider claims to friendly non-insiders who will vote for the plan.

Stay tuned for more developments on both cases.

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This Just In – Supreme Court to Provide Clarity on Whether Collection of Time-Barred Debts in Bankruptcy Violates the Fair Debt Collection Practices Act.

jabez-stoneWe all remember The Devil and Daniel Webster – the Devil comes to collect a seven year old debt (secured by Jabez Stone’s soul), only to be foiled by the great trial lawyer Daniel Webster – thanks to a skilled litigator, the old debt is forgiven!

But that isn’t the only example of years’ old debt becoming a real matter of contention.  Earlier today, the Supreme Court granted certiorari on an issue that (a) is pretty important in the world of consumer debt collection, and (b) makes some folks pretty darn furious. The issue is this:  if you file a proof of claim in a bankruptcy case, and you know such claim is barred by the applicable statute of limitations, are you committing a “misleading” or “unfair” practice under the Fair Debt Collection Practices Act (FDCPA)?  (Coverage of the case and copies of the briefs can be found here, on the SCOTUSBlog.)

Who does this?  There are lots of funds out there that purchase charged-off consumer debt.  Some of that debt is quite old.  John Oliver has spoken extensively about this industry on his show – here’s a link to the hilarious (or infuriating, it is actually both) episode where he bought, and forgave, $15 million in old, uncollectible medical debt.

Why do people do this?  Those old and cold claims can lead to a nice little recovery when the party owing the funds files a Chapter 13 case that pays creditors 5, or 10, or even a penny on the dollar.  In Chapter 13 cases, no one really has an incentive to scrub all the claims that are filed, and so a great many of these claims – completely invalid, mind you – slip by unnoticed and get a distribution.  If the charged-off debt is sold for pennies on the dollar – or fractions of a penny – the returns are spectacular, even though the old debt is in every way invalid.

How Can These Invalid Claims Get Paid?  It is because no one raises an objection to them during the bankruptcy case.  The Debtor doesn’t have any interest or incentive to scrub the claims – he or she is paying the same amount over the course of the Chapter 13 plan no matter how large or small the creditor pool is.  The Debtor doesn’t have the money to scrub the claims, or any incentive to do so.  The Chapter 13 trustee has no practical ability to scrub the claims – there are thousands, or tens of thousands, of Chapter 13s pending in every single bankruptcy court across this country – no Chapter 13 trustee has the time or ability to review each claim.  The other creditors won’t do it – why would a creditor owed, say, $2,000, scheduled to get a distribution of $100 in the case (over 3-5 years, to boot), spend a few thousand dollars reviewing each and every proof of claim field in the bankruptcy case (there are often a few dozen claims, or more)?  And without any party to note the time-barred claim to the Bankruptcy Court, the Bankruptcy Court never knows to disallow the claim.

So What will The Supreme Court Do?  The Supreme Court will decide if this practice is “misleading” or “unfair” as those terms are used in the FDCPA.  If the Supreme Court rules against the debt collectors, they will be liable for attorneys’ fees and additional damages for each invalid claim that is filed.  The practice will end in an instant, as now there would be penalties for seeking recovery of time-barred debt.  But if this practice does not violate the FDCPA, then the bankruptcy system will continue to be used to collect time-barred debt.  A great post going into the competing considerations in detail can be found here.

This is a tough one for The Bankruptcy Cave.  Legitimacy of the system requires that invalid claims receive no distribution.  Holders of valid claims should not be taxed due to an inability of any other party to practically review the claims.  On the other hand, an expired claim is subject to a defense – and it is not a creditor’s job to raise defenses to its own claims.  We think this will be a great ruling, either way.  Stay tuned!

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High Court Broadens the Definition of “Actual Fraud” under Section 523(a)(2)(A)

The Supreme Court’s Decision:

On May 16, 2016, in Husky International Electronics, Inc. v. Daniel Lee Ritz, Jr., Case No. 15-145, the Supreme Court held that the term “actual fraud” in § 523(a)(2)(A) of the Bankruptcy Code encompasses fraudulent conveyance schemes, even if the scheme does not involve a false representation to the creditor.  In reversing the judgment of the Fifth Circuit, the Supreme Court’s ruling settled a split among the circuits regarding whether “actual fraud” under § 523(a)(2)(A) requires a misrepresentation or misleading omission to the creditor. Compare In re Ritz, 787 F.3d 312 (5th Cir. 2015) with McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000), and Sauer V. Lawson, 791 F.3d 214 (1st Cir. 2015).

The Appeal:

On March 1, 2016, the Supreme Court heard arguments as to whether the “actual fraud” exception to discharge under § 523(a)(2)(A) applied narrowly (i.e. only when the debtor has made a false representation) or broadly (i.e. in situations where the debtor did not make a misrepresentation but entered into a scheme that was intended to defraud a creditor).

Between 2003 and 2007, Husky International Electronics, Inc. (Husky) sold and delivered electronic equipment worth approximately $164,000 to Chrysalis Manufacturing Corp. (Chrysalis).  Chrysalis failed to pay for the goods it purchased on credit.  While this debt was outstanding, between 2006 and 2007, Daniel Ritz (Ritz), a director and partial owner of Chrysalis, transferred funds from Chrysalis to various other ventures in which he owned stock.  In 2009, Husky sued Ritz seeking to hold him personally responsible for payment on the outstanding debt based on the allegation that Ritz’ transfers of Chrysalis’ funds were “actual fraud” and Ritz was therefore liable under a Texas statute.  Ritz then filed his own Chapter 7 bankruptcy petition, and Husky filed an adversary proceeding to have the debt declared nondischargeable under § 523 of the Bankruptcy Code on the basis that the same transfers constituted “actual fraud” under the exception to discharge in § 523(a)(2)(A).  Ritz argued that because he didn’t make a false misrepresentation to Husky, the debt should not be excepted from discharge.  The bankruptcy court ruled that Husky had failed to prove “actual fraud,” by false representation.  Husky appealed to the district court, which affirmed the bankruptcy court’s determination.  Likewise, the U.S. Court of Appeals for the Fifth Circuit also affirmed the lower court judgments and held that the debt was dischargeable, because, in its view, “actual fraud” requires a misrepresentation from the debtor to the creditor.

Analysis and Conclusion:

Justice Sotomayor, writing for the eight justice majority, concluded that the common-law term “actual fraud” is broad enough to incorporate forms of fraud that may not include a misrepresentation, such as a fraudulent conveyance.  At common law, fraudulent conveyances do not require a misrepresentation from a debtor to a creditor.  The Supreme Court also rejected Ritz’ argument that this interpretation of “actual fraud” renders § 523(a)(2)(A) redundant of other subsections of § 523 and of § 727(a)(2).  The Supreme Court noted that although there is overlap between each of these sections and § 523(a)(2)(A), there is also meaningful distinction and that it could “see no reason to craft an artificial definition of ‘actual fraud’ merely to avoid narrow redundancies that appear unavoidable.”  The Supreme Court also rejected Ritz’ argument, which was adopted by Justice Thomas’ dissent, that § 523(a)(2)(A) requires that the debt be “obtained by . . . actual fraud” and therefore the fraud must occur at the inception of the credit transaction.  The Supreme Court distinguished the dissent’s conclusion, and the prior precedent upon which it relies, on the basis that a reliance requirement is imposed only when the fraud is perpetrated through a misrepresentation to the creditor, which was not the case here.

This case potentially opens an avenue for creditors to defensively use a fraudulent transfer scheme that is outside of the one year limitation in § 727(a)(2) to prevent discharge of their claim.  As the Supreme Court noted, “Section 727(a)(2) is broader than § 523(a)(2)(A) in scope—preventing an offending debtor from discharging all debt in bankruptcy.  But it is narrower than § 523(a)(2)(A) in timing—applying only if the debtor fraudulently conveys assets in the year preceding the bankruptcy filing.  In short, while § 727(a)(2) is a blunt remedy for actions that hinder the entire bankruptcy process, § 523(a)(2)(A) is a tailored remedy for behavior connected to specific debts.”

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Supreme Court Rules No Fees for Defending Fee Applications

The Supreme Court of the United States recently addressed whether estate professionals could recover fees expended in defending fee applications. Baker Botts L.L.P. v. ASARCO LLC, 576 U.S. _____ (2015). A divided court ruled that the plain language of 11 U.S.C. § 330(a)(1) allowed compensation only for “actual, necessary services rendered[,]” and that to allow fees for defending fee applications would be contrary to the statute and the “American Rule” that each litigant pay her own attorneys’ fees unless a statute or contract provides otherwise.
Procedural Background

In 2005, ASARCO, a copper mining, smelting, and refining company, filed for Chapter 11 bankruptcy protection. ASARCO obtained the Bankruptcy Court’s permission to hire two law firms, Baker Botts L.L.P. and Jordan, Hyden, Womble, Culbreth & Holzer, P.C. Among other services, the firms prosecuted fraudulent-transfer claims against ASARCO’s parent company and ultimately obtained a judgment against it worth between $7 and $10 billion. This judgment contributed to a successful reorganization in which all of ASARCO’s creditors were paid in full.

After ASARCO’s counsel filed fee applications under § 330(a)(1), ASARCO, controlled again by its parents company, objected to the compensation requested. After extensive discovery and a 6-day trial on fees, the Bankruptcy Court rejected ASARCO’s objections and awarded the firms approximately $120 million for their work in the bankruptcy proceeding plus a $4.1 million enhancement for exceptional performance. The court also awarded the firms over $5 million for time spent litigating in defense of their fee applications.

The Court of Appeals for the Fifth Circuit ultimately reversed the award of fees for defending the fee application, observing that §330(a)(1) provides “that professional services are compensable only if they are likely to benefit a debtor’s estate or are necessary to case administration.” In re ASARCO, L.L.C., 751 F.3d 291, 299 (5th Cir. 2014).

The Supreme Court’s Rationale

The Supreme Court’s affirmance of the Fifth Circuit was rooted in the “American Rule”: Each litigant pays his own attorney’s fees, win or lose, unless a statute or contract provides otherwise. Slip Op. at 3 (citing Hardt v. Reliance Standard Life Ins. Co., 560 U. S. 242, 252–253 (2010)). In a textual analysis, the Court reasoned that defending a fee application against a client was simply not a “service rendered” on behalf of the client. In so concluding, the Court rejected the law firms’ argument that the estate does benefit from lawyers defending fee applications.

The Court also rejected arguments by the United States as amicus curiae, which urged the Court to allow fees incurred defending fee applications on policy reasons and because such fees were part of the “reasonable compensation” awardable under § 330(a)(1). Justice Breyer’s dissent additionally argued that the “reasonable compensation” provision of § 330(a)(1) allows an award of fees incurred defending fee applications because in some cases, unless such fees are allowed, the fee award would be artificially low and, therefore, not “reasonable.” The Court rejected these arguments and stated in passing that Federal Rule of Bankruptcy Procedure 9011 could be used to militate against the risk of frivolous objections to fee applications.
Potential Ramifications

An increase in objections to fee applications should be anticipated. Because defense fees will be unrecoverable, debtor’s counsel may be inclined to efficiently resolve objections rather than engage in protracted litigation.
We anticipate the most likely avenue bankruptcy professionals will employ will be to include a provision in engagement letters that fees incurred defending fee applications are expressly recoverable. This would address the American Rule by expressly providing, in a contract, that fees are recoverable. However, courts could refuse to uphold such provisions based on an argument that the Bankruptcy Code evidences Congress’s intent to preempt state law regarding compensation of bankruptcy professionals. Ultimately, congressional intervention and amendment of the Bankruptcy Code would be the most certain way to ensure fair compensation for bankruptcy professionals.

[1] Justice Thomas delivered the opinion of the Court, in which Justices Roberts, Scalia, Kennedy, and Alito joined, and in which Justice Sotomayor joined as to all but Part III-B-2. Justice Sotomayor filed an opinion concurring in part and concurring in the judgment. Justice Breyer filed a dissenting opinion, in which Justices Ginsberg and Kagan joined.

[2] The Government alleged that requiring bankruptcy professionals to pay the cost of defending their fee applications would dilute fees awarded and result in bankruptcy lawyers receiving less compensation than nonbankruptcy lawyers, thereby undermining the congressional aim of ensuring that talented attorneys will take on bankruptcy work.

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Did the Bankruptcy Code Save Obamacare?

brown gavel and a medical stethoscope

Over the years, the United States Supreme Court has had to interpret ambiguous, imprecise, and otherwise puzzling language in the Bankruptcy Code, including the phrases “claim,” “interest in property,” “ordinary course of business,” “applicable nonbankruptcy law,” “allowed secured claim,” “willful and malicious injury,” “on account of,” “value, as of the effective date of the plan,” “projected disposable income,” “defalcation,” and “retirement funds.” The interpretive principles employed by the Court in interpreting the peculiarities of the Bankruptcy Code were in full view when the Court recently addressed another complex statute that affects millions of Americans each year—the Patient Protection and Affordable Care Act (“PPACA”). Both the majority opinion of Chief Justice Roberts and the dissent of Justice Scalia relied heavily on bankruptcy precedents in support of their interpretations of the PPACA.

In King v. Burwell, No. 14-114 (June 25, 2015), the Supreme Court had to decide whether tax credits critical to the operation of the PPACA are available nationwide or only in certain states. In particular, the parties advanced two possible interpretations of the statutory language “an Exchange established by the State” in 26 U.S.C. § 36B(b)(2)(A). The government argued that “Exchange established by the State” refers to an insurance exchange operating in a particular state, whether the exchange was set up by the state government or, alternatively, by the federal government after the state refused to establish one. The petitioners argued that “Exchange established by the State” refers only to a state-created exchange and excludes a federal exchange. (The petitioners did not want to purchase insurance, and they would not have been required to purchase it if their interpretation had prevailed, because, if they did not receive tax credits, the cost of the insurance would have exceeded 8% of their income.)

The Chief Justice’s first bankruptcy citation was to Lamie v. United States Trustee, 540 U.S. 526 (2004). Bankruptcy practitioners may recall Lamie as the case that established that a debtor’s attorney is not entitled to compensation from the bankruptcy estate in a Chapter 7 case. Id. at 538. The Bankruptcy Reform Act of 1994 amended Section 330(a)(1) of the Bankruptcy Code so that it read as follows:

After notice to the parties in interest and the United States Trustee and a hearing, and subject to sections 326, 328, and 329, the court may award to a trustee, an examiner, a professional person employed under section 327 or 1103—

(A)      reasonable compensation for actual, necessary services rendered by the trustee, examiner, professional person, or attorney and by any paraprofessional person employed by any such person; and

(B)       reimbursement for actual, necessary expenses.

Before the 1994 amendment, the introductory sentence above ended with “or to the debtor’s attorney—”. The parties’ arguments in Lamie turned on Congress’ failure to insert an “or” in the remaining list of eligible awardees after deleting the reference to the debtor’s attorney, as well as its inexplicable retention of the words “or attorney” in subsection (A).[1] The Court described Section 330(a) as “awkward, and even ungrammatical,” Lamie, 540 U.S. at 534, which is not so different from its description of the PPACA as containing “more than a few examples of inartful drafting.” King, slip op. at 14.

In Lamie, the Court had to address the fee applicant’s argument that the language “or attorney” in subsection (A) would be meaningless unless the statute permitted a debtor’s attorney to apply for compensation. The Court acknowledged that “or attorney” might be surplusage under the government’s interpretation, but it said that “[s]urplusage does not always produce ambiguity and our preference for avoiding surplusage constructions is not absolute.” Id. at 536. Chief Justice Roberts applied the same principle in rejecting the petitioners’ argument that the phrase “established by the State” would be unnecessary if the PPACA’s tax credits applied on both state and federal exchanges. King, slip op. at 14.

After concluding that the phrase “established by the State” was ambiguous, the Chief Justice looked to the rest of the PPACA for clues to the meaning of Section 36B. In this portion of his opinion, he turned for support to United Savings Association of Texas v. Timbers of Inwood Forest Associates, Ltd., 484 U.S. 365 (1988). Timbers was a Chapter 11 case in which the parties disputed the meaning of the phrase “interest in property” in Section 362(d)(1) of the Bankruptcy Code, which requires the court to grant relief from the automatic stay if such an interest is not adequately protected. In particular, the secured lender sought compensation because the debtor’s bankruptcy filing prevented the lender from proceeding to foreclosure, while the debtor argued that the right to foreclose immediately was not a protected “interest in property.” The Court acknowledged that both interpretations were possible but recognized that “[a] provision that may seem ambiguous in isolation is often clarified by the remainder of the statutory scheme . . . because only one of the permissible meanings produces a substantive effect that is compatible with the rest of the law.” Id. at 371. A lengthy review of other provisions of the Bankruptcy Code convinced the Court that the right to immediate foreclosure was not one of the interests in property that must be adequately protected. See id. at 371–79.

The majority took a similar approach in King, recognizing that the elimination of tax credits under the petitioners’ interpretation “would destabilize the individual insurance market in any State with a Federal Exchange, and likely create the very ‘death spirals’ that Congress designed the Act to avoid.” King, slip op. at 15.

Justice Scalia’s dissent in King also relied on several bankruptcy cases, and it echoed another without directly citing it. After a lengthy discussion of the plain meaning of the PPACA—which, he contended, should preclude any recourse to the general purpose of the statute—Justice Scalia turned to the venerable precedent of Sturges v. Crowninshield, 17 U.S. (4 Wheat.) 122 (1819). Sturges preceded the modern Bankruptcy Code by more than 150 years, and in fact the case arose during a period in which Congress had not exercised its power to establish “uniform Laws on the subject of Bankruptcies throughout the United States.” U.S. Const. art. I, § 8. But New York had passed a law that “liberates the person of the debtor, and discharges him from all liability for any debt previously contracted, on his surrendering his property in the manner it prescribes.” Sturges, 17 U.S. at 197. The Court avoided the question whether this law was preempted by the Bankruptcy Clause and instead focused on whether it was a “Law impairing the Obligation of Contracts,” which also is prohibited by the Constitution. U.S. Const. art. I, § 10. The creditor argued that the New York discharge statute was not within the spirit of the constitutional prohibition because colonial and state legislatures had enacted similar legislation without controversy, and the framers of the Constitution intended to bar different types of laws. In response, Chief Justice Marshall wrote that “although the spirit of an instrument, especially of a constitution, is to be respected not less than its letter, yet the spirit is to be collected chiefly from its words” rather than from “extrinsic circumstances.” Sturges, 17 U.S. at 202. Justice Scalia argued for the application of this approach in King, arguing that “[o]nly by concentrating on the law’s terms can a judge hope to uncover the scheme of the statute, rather than some other scheme that the judge thinks desirable.” King, slip op. at 13 (Scalia, J., dissenting).

Justice Scalia returned to Sturges in his response to the majority’s argument that the phrase “established by the State” was inartfully drafted. Chief Justice Marshall had allowed that the plain meaning of a provision might be disregarded if “the absurdity and injustice of applying the provision to the case, would be so monstrous, that all mankind would, without hesitation, unite in rejecting the application.” Sturges, 17 U.S. at 203. He did not find the application of the Contracts Clause to the New York discharge statute to be quite that monstrous, and Justice Scalia argued that interpreting “established by the State” to exclude federal exchanges did not meet the monstrosity standard either. See King, slip op. at 17 (Scalia, J., dissenting).

Justice Scalia also relied on Lamie to support his argument. In the Sturges discussion mentioned just above, he argued that the Court did not have the power “‘to rescue Congress from its drafting errors.’” Id. (quoting Lamie, 540 U.S. at 542). And in the following section of the dissent, he sounded a similar note: “‘If Congress enacted into law something different from what it intended, then it should amend the statute to conform to its intent.’” Id. (quoting Lamie, 540 U.S. at 542).

The final paragraph of Justice Scalia’s dissent echoed a theme he developed decades earlier. In King, he wrote this:

Perhaps the Patient Protection and Affordable Care Act will attain the enduring status of the Social Security Act or the Taft-Hartley Act; perhaps not. But this Court’s two decisions on the Act will surely be remembered through the years. The somersaults of statutory interpretation they have performed (“penalty” means tax, “further [Medicaid] payments to the State” means only incremental Medicaid payments to the State, “established by the State” means not established by the State) will be cited by litigants endlessly, to the confusion of honest jurisprudence. And the cases will publish forever the discouraging truth that the Supreme Court of the United States favors some laws over others, and is prepared to do whatever it takes to uphold and assist its favorites.

King, slip op. at 21 (Scalia, J., dissenting). His discouragement at the result and the potential consequences for future litigation are consistent with those he expressed in Dewsnup v. Timm, 502 U.S. 410, 435-36 (1992) (Scalia, J., dissenting):

The principal harm caused by today’s decision is not the misinterpretation of § 506(d) of the Bankruptcy Code…. The greater and more enduring damage of today’s opinion consists in its destruction of predictability, in the Bankruptcy Code and elsewhere. By disregarding well-established and oft-repeated principles of statutory construction, it renders those principles less secure and the certainty the are designed to achieve less attainable. When a seemingly clear provision can be pronounced “ambiguous” sans textual and structural analysis, and when the assumption of uniform meaning is replaced by “one-subsection-at-a-time” interpretation, innumerable statutory texts become worth litigating…. Having taken this case to resolve uncertainty regarding one provision, we end by spawning confusion regarding scores of others.

So, did the Bankruptcy Code save Obamacare? No, not really. The multiple citations to bankruptcy cases in King are interesting, but both sides employed them effectively in support of their positions. The interpretative principles that emerge from the Supreme Court’s bankruptcy cases are important, but they are hardly unique. For example, Chief Justice Roberts may have relied on Timbers because it contained just the sort of phrasing he was looking for, and no case involving RICO or the Carmack Amendment would have served his purpose quite as well. But it’s also possible that he used Timbers because it was authored by Justice Scalia.

[1] Congress cleaned up these problems in 2005, so the direct impact of Lamie was short-lived.

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U.S. Supreme Court: Inherited IRA Funds not “Retirement Funds”

On June 12, 2014, the Supreme Court issued a unanimous opinion in Clark v. Rameker, Dkt. No. 13-299, 573 U.S. ___ (2014), holding that funds held in inherited Individual Retirement Accounts are not “retirement funds” within the meaning of 11 U.S.C. § 522(b)(3)(c) and therefore not exempt from the bankruptcy estate. This opinion limits retirement funds that remain out of creditors’ reach when an individual files a bankruptcy case.

In Clark, Heidi Clark inherited a traditional IRA account established by her mother. Clark then filed a Chapter 7 bankruptcy case and claimed the inherited IRA account as exempt from the bankruptcy estate under Section 522(b)(3)(C). The trustee and unsecured creditors objected, arguing that the inherited IRA funds were not “retirement funds” within the meaning of the statute.

The Court distinguished between inherited IRAs and traditional IRAs, noting that holders of inherited IRAs are prohibited from making contributions to those accounts, setting them apart from traditional retirement accounts; that holders of inherited IRAs are required to withdraw money from such accounts, regardless of how many years they may be from retirement; and that holders of inherited IRAs may withdraw the entire balance of the account at any time and for any purpose, without penalty. Observing that the funds in an inherited IRA could be spent on even a “vacation home or a sports car,” the Court expressed concern that allowing an inherited IRA to be exempt from the bankruptcy estate would convert the Bankruptcy Code’s purposes of providing a “fresh start” into a “free pass.”

The Clark opinion resolves a split among Circuits. The Fifth Circuit ruled in In re Chilton, 674 F. 3d 486 (5th Cir. 2012) that inherited IRAs constituted retirement funds within the “plain meaning” of § 522 of the Bankruptcy Code and were thus exempt from the bankruptcy estate, under § 522(d)(12) (the federal exemptions). The Seventh Circuit, in Clark, disagreed, emphasizing that the Bankruptcy Code should not be used to exempt from creditors’ reach funds that were freely accessible for current use by the debtor, without penalty.

Although Clark excludes inherited IRAs from exemption under Section 522(b)(3)(c), some states, including Missouri, provide a separate exemption for inherited IRAs under state law. The Clark decision is not likely to affect bankruptcy cases and practices in these states.

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