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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.)

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Ruined, Missing Wine leads to Million Dollar Hangover for Debtor

Old wine bottles in a wooden crate.

A Chapter 7 debtor’s failure to comply with a bankruptcy court order to preserve a $2 million dollar-plus collection of fine wines has led to the imposition of sanctions of over $1 million, most of which could be charged against the debtor’s otherwise exempt property.

The wine in question, after three years of litigation, was determined to be part of the bankruptcy estate of Jeffrey Prosser.  Prosser used to own companies that provided telephone, internet and cable television service to the U.S. Virgin Islands.  Both he and his companies filed bankruptcy in 2006.  A recent, 66-page opinion from the U.S. District Court in the Virgin Islands sets forth this saga of the wine collection in great detail; if you are taken to oenophilia, be ready to despair.  See In re Jeffery L. Prosser, Bankruptcy Case 2006-3009, Civil Action 3:2013-0087 (February 23, 2017, Doc. No. 58).

In its opinion, the district court largely upheld orders by the U.S. Bankruptcy Court of the Virgin Islands holding both Prosser and his wife, Dawn, in contempt for allowing the dissipation and destruction of the wine collection, but reversed an order of the bankruptcy court that would have empowered the trustee to sell real property held by the Prossers to satisfy a $528,086 monetary sanction that would reimburse the trustee for his expenses in prosecuting the contempt action.  The property in question, held by the Prossers as tenants by the entireties (the “TBE Property”), had previously been adjudicated as exempt under 11 U.S.C. § 522(b)(3)(B).

The district court held that a sanction intended to reimburse the estate for attorney’s fees and expenses constituted an administrative expense and was barred by 11 U.S.C. § 522(k).  However, the district court refrained from ruling on whether exempt property could be ordered sold to satisfy a separate contempt sanction in the amount of $419,136, which was the lost value of the wine collection.  Further briefing was ordered.

Background

The Prossers’ wine collection was initially appraised at $2.1 – $2.3 million; Dawn Prosser claimed that that she owned at least a 50-percent interest in the wine.  In December 2008, the bankruptcy court approved a stipulation under which one-half of the wine collection would be turned over to the trustee for sale and the other half retained in Dawn Prosser’s possession until her interest in the wine was adjudicated.

The bulk of the wine was stored (climate controlled, of course, or so everyone thought!) the Prossers’s homes Florida and the U.S. Virgin Islands. The wine had been inventoried in January 2008.  Since December 2007, the Prossers (along with their children) had been subject to a preliminary injunction that required them to “safeguard certain property that the trustee contended was part of the bankruptcy estate in secure locations and to protect the property from destruction, damage, theft, removal or transfer pending its turnover to the trustees.”  The Prossers were further forbidden to “spend, consume, damage, dispose of, sequester, abscond with, secrete or transfer the property” without written consent of the trustees.  The stipulation that allowed Dawn Prosser to retain possession of half the wine collection specifically stated that the preliminary injunction continued in force.

In February 2011, three years since the wine was inventoried, the bankruptcy court determined Dawn Prosser had no interest in the wine and so her half of the collection was to be turned over to the Chapter 7 trustee.  One month later, the wine stored in Palm Beach was inspected, and four months after that, the wine at the Virgin Islands residence was inspected.  What was found was not good; if any of you have ever taken a vacation with the kids left in charge of the house, and then checked the liquor cabinet upon your return, then you know what is coming next.

At the Palm Beach residence, only 459 of the 939 bottles inventoried in 2008 were still in storage. At the U.S. Virgin Islands residence, only 527 bottles remained of the original 980.  Furthermore, at the U.S. Virgin Islands residence, the air conditioners were no longer operating and the room had been given over to storage of “miscellaneous household junk.”  Mold and insect damage was noted.  Most of the labels were damaged and of six bottles sampled, none remained in a condition suitable for sale (although we at The Bankruptcy Cave will drink anything, so we are trying to obtain a bottle).  The expert who inspected the wine opined that “the entire collection has been destroyed by careless or willfully negligent storage.” The wine stored at the U.S. Virgin Islands residence was eventually sold “as is, where is” for just $15,739. Total loss of value to the wine collection was $419,136.

In August 2011, the trustee filed a “Motion to Enforce Turnover Order, for Contempt and for Sanctions” against both Jeffrey and Dawn Prosser. The motion sought, among other things, a finding of contempt, sanctions in the form of all legal fees and expenses associated with the trustee’s investigation and liquidation of the wine, and an order permitting the trustee to collect the value of the missing and damaged wine.  In a series of orders in 2013, the bankruptcy court ordered the Prossers to pay the estate $528,086 to reimburse it for legal fees and costs associated with obtaining turnover of the wine collection and the related contempt proceedings (“Fee Sanction”) and $419,136 for the diminished value of the wine (“Loss of Value Sanction”).

When the Prossers failed to pay, the bankruptcy court once against found them in contempt and entered an order requiring the Prossers to pay the Fee Sanction by way of 60 monthly payments of $8,801. If they failed to make the required payments, the Prossers were further ordered to convey title to the TBE Property to the trustee.  The Prossers never made a single monthly payment and then refused to convey the TBE Property to the trustee.

Upon the trustee’s motion, the bankruptcy court next entered an order pursuant to Rule 70 of the Federal Rules of Civil Procedure (the “Rule 70 Order”) directing the trustee to execute quit claim deeds and any other documents required to transfer the TBE Property to the bankruptcy estate. The property, which had been valued at approximately $2.2 million, was to be sold and the proceeds first applied to the Fee Sanction, with any surplus then applied to the Loss of Value Sanction.

The Prossers appealed everything. The district court upheld the decisions of the bankruptcy court, except for the Rule 70 Order, which was partially reversed, with further briefing ordered on a single issue.  Among the district court’s holdings:

  • The Prossers’ argument that the bankruptcy court lacked subject matter jurisdiction to impose the injunction was untimely and should have been filed when the order commanding turnover of the wine (and making the preliminary injunction permanent) was entered in 2011.  Consequently, subject matter jurisdiction had been established as the law of the case.
  • The bankruptcy court did not err as a matter of law nor abuse its discretion in finding the Prossers in civil contempt for violating the injunction regarding the preservation of assets.
  • That the imposition of sanctions against the Prossers was not barred due to the trustee’s failure to insure the wine (which the Prossers had maintained was not property of the estate).
  • The bankruptcy court’s rejection of a Daubert challenge to the trustee’s wine expert was affirmed. The expert, Mary Ewing-Mulligan, is the author of “Wine for Dummies.” The district court also noted that one argument made by the Prossers, that the expert was not qualified because she had not previously been qualified to provide expert testimony, if accepted would create a world without experts, as every expert witness has to have a first time.
  • The bankruptcy court did not err in denying the Prossers’s motion that the ruined wine be abandoned as an asset of the estate, noting that it would set an unfortunate precedent if a debtor was allowed to destroy a valuable estate asset in violation of a court order and then seek to compel the trustee to abandon the ruined asset.
  • That the as-is, where-is auction of the damaged wine was not commercially unreasonable, an argument the Prossers supported in part by claiming the trustee’s prosecution of the contempt proceeding created bad publicity that disparaged the wines throughout the Virgin Islands.

In all, the district court rejected 12 of 13 arguments made by the Prossers.  However, by reversing (at least in part) the bankruptcy court’s Rule 70 Order, the district court has so far preserved the exemption of the TBE Property.  The district court rejected two arguments for affirming the Rule 70 Order made by the trustee.

First, the trustee took the position that the TBE Property was no longer exempt property because by obtaining sanctions against the Prossers, he had become a creditor of both the husband and wife. Under Virgin Island law, property held as tenants by the entireties is not exempt from process as to creditors of both spouses. The district court held that the bankruptcy estate was created upon the filing of the case and, at that time, the TBE Property was exempt and remained so despite the Prossers having incurred a joint, post-petition debt to the estate.

Having determined that the TBE Property remained exempt, the district court next considered whether the bankruptcy court’s sanction authority under 11 U.S.C. § 105(a) allowed, after a finding of contempt, exempt property to be sold to reimburse the trustee for administrative expenses incurred in the contempt litigation and reimburse the bankruptcy estate for the lost value of the wine.

At least with regard to the administrative expenses that were to be reimbursed under the Fee Order, the district court held that the bankruptcy court lacked authority to order the sale of the TBE Property, relying on a 2014 U.S. Supreme Court decision in Law v. Siegal, 134 S. Ct. 1188 1188.  In Law, the Supreme Court reversed a decision that allowed a trustee to surcharge a debtor’s homestead exemption to recover fees and expenses incurred in overcoming a lien the debtor had fraudulently created in an effort to preserve equity in his home beyond the statutory exemption.

The Supreme Court held that the powers created under 11 U.S.C. § 105(a) did not include the power to override an explicit mandate in another section of the Bankruptcy Code. The Supreme Court held that the prohibition contained in 11 U.S.C. § 522(k), which provides that exempt property “is not liable for payment of any administrative expense,” precluded the surcharge. The district court held the Law case to be applicable here; the Fee Sanction constituted an administrative expense and therefore exceeded the authority provided under 11 U.S.C. § 105(a).

Finally, the district court stated that the effect of Law upon the Loss of Value Sanction, which called for the Prossers to reimburse the estate for losses caused by their contemptuous actions, was less clear.  Noting that Law was issued after briefing on the Prosser appeal had been concluded and that neither party subsequently brought the case to the district court’s attention, the parties were ordered to provide additional briefing on the issue.  Pursuant to a schedule established by the district court, the additional briefing should be concluded by April 6, 2017.

Certainly, this is a sad tale, a complete loss of value and waste of money, and the Prossers come out of this tale with red grape stains running down their formal wear.  By the same token, we are surprised that the trustee did not insure the wine collections, or follow up on their storage.  The case is a helpful reminder to all of the need to really pay attention to collateral or other assets that are so easily moved, spoiled, or drank and celebrated.

 

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