CHAPTER 13 FOR BUSINESS DEBTORS IN MASSACHUSETTS

      Chapter 13 is not just for consumers. An individual in a sole proprietorship (or who is engaged in some business activity, such as renting properties as a landlord) has Chapter 13 available to him or her, provided that he or she meets the debt limits in 11 U.S.C. §109(e) and has regular income (either via the business activities or from other sources, such as separate employment). Chapter 13 is not available to partnerships (although individual partners may file), corporations or LLCs that operate businesses.

     Chapter 13 has much to recommend it over Chapter 11 if the debtor’s goal is reorganization and preservation of his or her business. For one, a Chapter 13 plan is easier to propose and confirm than a Chapter 11 plan (fewer confirmation standards, no absolute priority rule, and no disclosure statement requirement). The debtor also has the ability to stretch out and pay administrative claims and priority debt over years, rather than meeting the Chapter 11 requirement to pay such claims in full on confirmation. Other benefits include the (much) cheaper filing fee; the right to cure mortgage defaults over the life of the plan; no quarterly U.S. Trustee fee; no monthly operating reports; and no requirement that the debtor’s attorney be approved under 11 U.S.C. §327. The enhanced discharge in 11 U.S.C. §1328(a) also applies in business debtor Chapter 13 cases. 

     One possible disadvantage is the 5 year limit on plan payments; if the debtor needs to "cram down" a secured creditor's claim, the debtor has to do so within the 60 month limit on plans. See Bullard v. Hyde Park Savings Bank (In re Bullard), 494 B.R. 92 (BAP 1st Cir. 2013)(11 U.S.C. §1325 requires that the payments on a cram-down of a secured claim equal the present dollar value of the property as of the confirmation date, and that distribution on account of the claim must occur within five years).

     The “business” Chapter 13, however, has several statutes and rules that apply to it and which may be unfamiliar or “traps for the unwary” for attorneys who ordinarily file consumer Chapter 13 cases, and for individuals in business considering the Chapter 13 option. Here are the more significant issues, with the applicable statutes and rules:

·         Debtor Engaged In Business – 11 U.S.C. §1304: 

           §1304(a) states that “[a] debtor that [sic] is self-employed and incurs trade credit in the production of income from such employment is engaged in business”. §1304(b) allows the debtor, unless the court orders otherwise, to operate his or her business, and references the debtor’s right to use property in that business, subject to the limitations on a trustee under §363(c) (cash collateral use requirements) and §364 (limitations on incurring credit).

           §1304(c) requires the debtor in business to perform the same duties that a Chapter 7 trustee performs in §704(a)(8); those duties require the debtor to file with bankruptcy court, the United States trustee, and any governmental unit that collects or determines tax arising out of the debtor’s operation, “periodic reports and summaries of the operation of [the debtor’s] business, including a statement of receipts and disbursements, and such other information as the United States trustee or the court requires.” Fed. R. Bankr. P. 2015(c)(1) is more specific; that rule requires that the debtor;

o   Keep a record of receipts and the disposition of money and property received;

o   Comply with §704(a)(8) and include a statement, if payments are made to employees, of the amounts of deductions for all taxes required to be withheld or paid for and in behalf of employees and the place where such amounts are deposited; and

o   Give notice of the case, ASAP after the petition date, to every entity known to be holding money or property subject to withdrawal or order of the debtor, including any bank, public utility company, landlord with whom the debtor has a deposit, and every insurance company which has issued a policy to the debtor having a cash surrender value payable to the debtor.

     MLBR Appx. 1, Rule 13-2(a)(2) also requires that Massachusetts Chapter 13 debtors in business submit the following to the Chapter 13 trustee:

o   Within 7 days after the petition is filed, both evidence of current and sufficient business insurance, and evidence that the debtor opened “appropriate debtor-in-possession checking accounts”.

o   Within 14 days after the petition, a profit and loss statement for debtor’s fiscal or calendar year preceding the year the case is filed, and a profit and loss statement for the period beginning at the end of the prior year and ending on the petition date.

o   Within 30 days of the close of each quarter, a statement of quarterly income and expenses incurred.

     The United States Trustee’s Handbook for Standing Chapter 13 Trustees (10/1/12) states that the Chapter 13 must monitor the debtor and his or her business to “verify that the ongoing business, while in bankruptcy, does not fall in deeper financial difficulty than at the time of the filing of the case.” According to the handbook (Section G(3)), monitoring, depending on the nature of the business, might include “the debtor meeting with the standing trustee’s business case analyst, if applicable, to review the budget, an evaluation of the debtor’s accounting systems, an on-site tour of the business premises, the requirement that periodic operating reports be filed along with bank statements, tax deposits and payment forms, and monitoring of insurance coverage.”

·         Cash Collateral Use: 

     

           Cash collateral does not often come up in a Chapter 13, but if: (a) your debtor is selling goods and generating accounts receivable subject to a secured claim; or (b) your debtor is collecting real estate rents from property subject to a mortgage, and the mortgage contains an assignment of leases and rents, you must – right after you file the petition -- either get the secured creditor’s/mortgagee’s permission to use the cash collateral post-petition in a stipulation, or get an order (after motion and hearing) from the bankruptcy court allowing you to use the cash collateral. 

               To accomplish either task in Massachusetts, you need to be familiar with §§363(c) & (e) (as well as the definition of “cash collateral” in §363(a) and what does and does not constitute “adequate protection” for cash collateral use); §552; Fed. R. Bankr. P. 4001(b) & (d); and MLBR 4001-2.

·         Limited Powers as Debtor-In-Possession: 

           Unlike Chapter 11, there is always a trustee in a Chapter 13 case. Consequently, the debtor’s powers over his or her property and in operating his or her business have limits.

o   As stated above, the debtor can seek to use cash collateral; the debtor also has the right to incur credit under the terms of 11 U.S.C. §364. This means that the debtor can “obtain unsecured credit and incur unsecured debt in the ordinary course of business” without prior court authorization, and that (post-petition) debt will have administrative claim status. 11 U.S.C. §§364(a), 1304(a). If the debtor is unable to obtain unsecured trade credit on these terms, the debtor can file a motion with the bankruptcy court to allow him or her to grant a lien on property; however, if there is already a lien on the property being offered, the debtor has to offer the existing lienholder “adequate protection” of that lien.

o   A business Chapter 13 debtor retains the right under 11 U.S.C. §363(b) to use or sell his or her assets in the ordinary course of business without prior court authorization, and to sell those assets outside the ordinary course with court authorization.

o   The debtor remains in possession of all property in the estate, except as otherwise provided in a confirmed plan. 11 U.S.C. §1306(b).

o   If the debtor’s estate has preference, fraudulent transfer or other avoidance actions, Chapter 13 is silent regarding who brings those actions. The debtor, however, can provide that he or she will pursue the avoidance actions in the confirmed plan, as permitted in 11 U.S.C. §§1322(b)(9) & (11).

·         Claims: 

           The business debtor has all the rights a consumer debtor has regarding the review of and objection to proofs of claim. The business debtor, however, needs to look out for administrative claims made under 11 U.S.C. §503(b)(9), which are claims for the value of goods received by the debtor within twenty (20) days before the petition date, when the goods were sold to the debtor in the ordinary course of business. Note that MLBR 3002-1 sets a deadline for such claims in Massachusetts: 60 days after the date of the §341 meeting. Business Chapter 13 debtors also need to be aware of the reclamation rights of sellers of goods to the debtor, spelled out in 11 U.S.C. §546(c).

·         Debtor in Business Subject to Chapter 13 Trustee Investigation – 11 U.S.C. §1302(c): 

           Per §1302(c), the Chapter 13 trustee must perform the duties specified in §§1106(a)(3) & (4) in a Chapter 13 business case. Specifically, those duties, unless the bankruptcy court orders otherwise, are to “investigate the acts, conduct, assets, liabilities, and financial condition of the debtor, the operation of the debtor’s business and the desirability of the continuance of the business, and any other matter relevant to the case or to the formulation of a plan.” Once that investigation is done, the Chapter 13 trustee must “as soon as practicable” file a statement of his or her investigation with the court (and provide a copy of such statement to any entity the court designates), “including any fact ascertained pertaining to fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management of the affairs of the debtor, or to a cause of action available to the debtor.”

     Section G(2)(a) of the United States Trustee’s Handbook for Standing Chapter 13 Trustees (10/1/12) states that the Chapter 13 trustee, in filling this role, might ask for:

o   Copies of Federal and State tax returns, along with all supporting schedules, for at least the two years preceding the filing;

o   Copies of financial statements furnished to a third party, such as a trade creditor or a bank, within the two years preceding the filing of the petition, including but not limited to the balance sheet, income statement and cash flow statement;

o   Current books and records of the business, including checks and check registers;

o   Monthly profit and loss statements for at least the year preceding the filing;

o   Current schedule of accounts receivable and accounts payable;

o   Current insurance policies; and

o   Lease agreements.

     The Handbook also outlines what the investigative report might address, such as: the nature and location of the business; number of employees; status of federal, state, and local tax returns and tax delinquencies; insurance; business licenses; condition of books and records; prior balance sheets and profit/loss statements; aging of accounts receivable and accounts payable; debts; work in progress; and turnover actions, if applicable.

·         Additional Work – Schedules and Statement of Financial Affairs: 

           Note that there are many types of business property you have to list in Schedule B, including inventory; accounts receivable; machinery and equipment; office furniture and fixtures; patents; licenses; copyrights; trade names; customer lists; and supplies. The new Schedule I, in ¶8a, requires the debtor to state his or her net income from business operations or rentals, and “attach a statement for each property and business showing gross receipts, ordinary and necessary business expenses, and the total monthly net income” (note that the new Schedule J presumes you identify all of the debtor’s business-related expenses in this statement and not in Schedule J).  The statement of financial affairs has business-related questions that must be answered by an individual debtor, located in questions 18-20. Those questions relate to inventories taken, accountants used, where books and records are kept and by whom, and who received financial statements from the debtor in the last 2 years.

·         Common Chapter 13 Provisions for Consumers and Business Debtors: 

           A debtor’s status as a debtor in business does not change the major aspects of Chapter 13. The debtor still has to take the pre-petition credit counseling course in order to file the case, and must take the post-petition financial management course in order to receive a discharge. The plan must be filed and confirmed pursuant to the standards in §1325, the plan cannot exceed five years in term, and the concept of “disposable income” still applies – with one twist. The debtor in business is allowed to deduct from his or her current monthly income all “amounts reasonably necessary to be expended … for the payment of expenditures necessary for the continuation, preservation, and operation of [the debtor’s] business.” 11 U.S.C. §1325(b)(2)(B).

            Summary: 

           If you are individual debtor who runs even a small side business (like renting out floors in your three-decker residence), the attorney you choose should have at least some passing familiarity with the business issues and how to address them (including making a determination whether you are indeed "a debtor in business" under §1304 and if those business issues do apply to your case). You should also expect to pay the attorney more for a Chapter 13 business case than you would pay for a Chapter 13 consumer case, given the additional reporting and issues involved. [1]

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[1] Based on a presentation made to the Worcester County Bar Association Bankruptcy Section, on April 3, 2014. ©Kevin C. McGee. 

Now in Play: §506(d) "Strip-Offs" in Chapter 7

     On March 31, 2014, the Supreme Court of the United States denied certiorari in Bank of America, N.A. v. Sinkfield, Petition No. 13-700. To put it in terms appropriate to Major League Baseball’s opening day, this was the equivalent of Casey’s mighty whiff at strike three in the ninth inning, with the bases loaded, a full count, and the chance for a walk-off win.

     The elements were all in place; a “rogue” circuit makes a holding that three other circuits would not dare to make, on an issue that many debtor lawyers fantasize about revisiting and that many banks dread like a recurring nightmare. The 11^th Circuit (albeit summarily, in an order) held that a fully unsecured second mortgage lien could be “stripped off” a Chapter 7 debtor’s residence in Georgia, when the value of that residence is only enough to (partially) secure the first mortgage lien. The 11^th Circuit based the order on its previous (unpublished) decision in In re McNeal, No. 11-11352 (11th Cir. 5/11/12), in which the circuit limited the Supreme Court’s decision in Dewsnup v. Timm, 502 U.S. 410 (1992) to prohibiting the strip-down of partially secured first mortgages in Chapter 7.  The McNeal court held that fully unsecured second mortgages are fair game to be stripped off under 11 U.S.C. §506(d), and relied on its own, pre-Dewsnup 1989 decision, Folendore v. United States Small Bus. Admin., 862 F.2d 1537 (11th Cir. 1989), as precedent for doing so. The 4^th Circuit, 6^th Circuit, and 7^th Circuit (as well as many lower courts) all reached opposite results in holding that Dewsnup v. Timm did apply and prohibited any lien stripping in Chapter 7. Throughout most of the country, the old adage that liens float unaffected through a (Chapter 7) bankruptcy is alive and well.

Bankruptcy 101 on Lien-Stripping (in Chapter 7):

     11 U.S.C. §506(d) seems clear on its face. It states that:

  To the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void, unless --  

(1)   such claim is disallowed only under section 502(b)(5)[as an unmatured debt for a domestic support obligation] or 502(e) [as a contingent claim for reimbursement or contribution] of this title; or

(2)  such claim is not an allowed secured claim due only to the failure of any entity to file a proof of claim under section 501 of this title.

      Add to this §506(a)(1), which states that “An allowed claim of a creditor secured by a lien on property in which the estate has an interest … is a secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property … and is an unsecured claim to the extent that the value of such creditor’s interest … is less than the amount of such allowed claim.”  

      Thus, under recent Supreme Court precedent, it seems like a “no-brainer” to hold that the statutes say what they say:  you determine secured claims according the value of the debtor’s property (and we can fight about what that “value” is); there is no secured claim or lien beyond the value of the property;  the only exceptions to the lien-voiding rule in §506(d) are certain unmatured  and contingent secured claims; and a creditor does not have to file a proof of claim to have its lien determined as an “allowed secured claim”.  After all, look at the unanimous decision last month in Law v. Seigel, in which the justices solemnly proclaimed that “’whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of ‘the Bankruptcy Code” and “We have recognized  … that in crafting the provisions of§522, ‘Congress balanced the difficult choices that exemption limits impose on debtors with the economic harm that exemptions visit on creditors.’  … The same can be said of the limits imposed on recovery of administrative expenses by trustees. For the reasons we have explained, it is not for courts to alter the balance struck by the statute.” [1]

But - Dewsnup v. Timm

      As many law school professors will gleefully tell you after you cite this straight-forward analysis – we have the 1992 precedent of Dewsnup v. Timm, in which the Supreme Court held that a partially unsecured first mortgage could not be “stripped down” in Chapter 7 using these two statutes. The pillars of that decision are as follows:

 (a)  Congress could not have meant to change long-standing bankruptcy law that “that liens pass through bankruptcy unaffected”, and courts do not look at a clean slate (with no history) when interpreting Bankruptcy Code provisions;

(b)  even though §506(a) and §506(d) both use the term “allowed secured claim”, it is an ambiguous, undefined term, and does not necessarily mean the same thing in each statute or elsewhere in the Bankruptcy Code;

(c)  the function of §506(a) is to determine the relative interests of secured creditors and debtors in property that is part of the debtor’s estate, while the function of §506(d) is to void “only liens corresponding to claims that have not been allowed and secured”; and

(d)  if the Court were to hold otherwise, it would ignore pre-Code bankruptcy practice and “freeze the creditor's secured interest at the judicially determined valuation.  By this approach, the creditor would lose the benefit of any increase in the value of the property by the time of the foreclosure sale. The increase would accrue to the benefit of the debtor, a result some of the parties describe as a ‘windfall.’”

      Dewsnup contains a dissent authored by Judge Scalia, who – unsurprisingly – disagrees with the majority’s decision because the plain language of both §506(a) and §506(d) compels the voiding of the unsecured portion of the lien, notwithstanding pre-Bankruptcy Code practice. Judge Scalia is still on the Supreme Court;  one of the justices joining the majority, Judge Kennedy, is also still on the Supreme Court. The rest of the participants in the majority opinion – Judge Blackmun (the author of the majority opinion), Judge O’Connor, Judge White, and Judge Stevens – have been replaced. So has Judge Souter, who joined in Judge Scalia’s dissent. But Judge Thomas, who did not participate in the decision and often joins with Judge Scalia, is still on the court.

     So, all the conditions seemed right for a revisiting of §§506(a) & 506(d): a split in the circuits; a (mostly) new cast of characters on the Supreme Court; and a different perspective in recent decisions of the Supreme Court on whether the plain language of the Bankruptcy Code or the historical precedent of bankruptcy practice is more important.  Yet, the petition for certiorari is denied, and mortgagees across the country breathe a sigh of relief -- except, of course, in Georgia, Alabama, and Florida, where motions and adversary proceedings for lien-strip offs in Chapter 7 continue unabated[2].  Casey was expecting a fast ball on a 3 and 2 count, and got a curve ball instead, leaving the home crowd unsatisfied.

     The practical effect is that a debtor’s attorney in the First, Second, Fifth, Eighth, Ninth, or Tenth Circuit will have to take the right case up for an appeal, and obtain a reasoned circuit decision on this issue. The 11^th Circuit has the outlier opinion already in In re McNeal – it’s just a matter of finding an appeal with the right ingredients.

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[1]  Note also that the justices threw an earlier Supreme Court case, Marrama v. Citizens Bank of Mass., 549 U. S. 365 (2007) under the bus, ignoring that the Marrama court had blessed an equitable exception to express statutory language, and then finessing the issue by saying that another statute disqualified the debtor from converting his case to Chapter 13.

[2]  The NACBA’s amicus brief opposing the certiorari petition likely gives the real reason for the order denying certiorari: Bank of America “fast-tracked” the petition by agreeing that the 11 Circuit’s order was final, and deprived the Supreme Court of a “deliberative” decision by a circuit court setting up a true conflict in the circuits on the issue.

©Kevin C. McGee

Exemptions, Objections, and Law v. Siegel

Law v. Siegel  (U.S. Supreme Court opinion March 4, 2014)

Exemptions Safe From Bankruptcy Court’s “Adjustment”

Kevin C. McGee, Esq.

Partner

Seder & Chandler, LLP

Worcester, MA

            On March 4, 2014, the U.S. Supreme Court decided Law v. Siegel, on an appeal from the Ninth Circuit. The facts were that the Chapter 7 debtor (Stephan Law), in his bankruptcy schedules, stated the following: (1) he owned a California residence, which he valued at $363,348.00; (2) he had two liens on the residence, with a $147,156.52 first mortgage held by Washington Mutual Bank, and a $156,929.04 second mortgage held by “Lin’s Mortgage Associates”; and (3) he claimed a $75,000.00 California homestead exemption in the equity in the residence.

            Law’s Chapter 7 Trustee (Alfred H. Siegel) did not object to Law’s claimed homestead within thirty (30) days after Law’s meeting of creditors, as is required under Fed. R. Bankr. P. 4003(b)(1). However, Siegel did suspect that the second mortgage was not a legitimate debt, and started investigating. $500,000.00 in attorneys’ fees later, Siegel obtained an order invalidating the second mortgage as fraudulent. In addition, he petitioned the bankruptcy court to “surcharge” all of Law’s $75,000.00 exemption in the residence for Siegel’s attorneys’ fees (as permitted under 9^th Circuit precedent). The bankruptcy court did so, on the basis that Law’s fraudulent and inequitable conduct permitted it to use 11 U.S.C. §105(a) to deny Law the fruits of his bad faith conduct.

            Judge Scalia delivered the unanimous decision of the Supreme Court justices. In his opinion, Judge Scalia held that neither the plain language of the bankruptcy exemption statute (11 U.S.C. §522), or the debtor’s bad faith actions, allowed a bankruptcy court to invalidate or surcharge an exemption for fees after the exemption had been allowed. He pointed out that, although several provisions in §522 either limit or prohibit exemptions in certain circumstances, §522(k) generally prohibits (with some narrow exceptions) the use of a debtor’s allowed exemptions for payment of administrative expenses, such as Siegel’s attorneys’ fees. In a quote sure to be repeated, he discounted the §105(a) argument as follows: "§522 does not give courts discretion to grant or withhold exemptions based on whatever considerations they deem appropriate.” Finally, he distinguished Marrama v. Citizens Bank of Mass., 549 U. S. 365 (2007) on its facts. In Marrama, the Supreme Court upheld a bankruptcy court’s denial of a Chapter 7 debtor’s motion to convert to Chapter 13. Siegel argued that Marrama supported the idea that a debtor’s bad faith could justify denying a debtor’s statutory right. Justice Scalia focused instead on whether, in Marrama, the debtor could have “qualified” for Chapter 13, and distinguished the case on that basis.

What does Law v. Siegel Mean to Debtors, Trustees and Bankruptcy Practitioners?

            First, it means that Chapter 7 trustees and creditors will need to make a more aggressive push, early in the case, either to object to exemptions or file a motion to extend the time to object to exemptions in order to provide enough time for investigation. Judge Scalia pinned a lot of his decision on Siegel’s failure to timely object to Law’s homestead exemption, and held that the consequence of that failure was that the exemption became ironclad and protected from future attack.

            Law v. Siegel also reaffirms – again – that the words and scheme used in the Bankruptcy Code have meaning and cannot be disregarded merely because a litigant or court wants to reach a result not intended by those words or that scheme. To this point, Judge Scalia wrote:

We acknowledge that our ruling forces Siegel to shoulder a heavy financial burden resulting from Law’s egregious misconduct, and that it may produce inequitable results for trustees and creditors in other cases. We have recognized, however, that in crafting the provisions of §522, ‘Congress balanced the difficult choices that exemption limits impose on debtors with the economic harm that exemptions visit on creditors.’… The same can be said of the limits imposed on recovery of administrative expenses by trustees. For the reasons we have explained, it is not for courts to alter the balance struck by the statute (citations omitted).

            The decision also means that debtors and their attorneys can rest easy once the exemption deadline passes – with one exception not noted in the decision. At the tail end of Law v. Siegel, Judge Scalia lists a variety of alternate means available to punish or sanction a debtor’s bad behavior: denial of a debtor’s discharge, sanctions under Fed. R. Bankr. P. 9011, criminal prosecution, and other unspecified sanction power under 11 U.S.C. §105(a). 

      He fails to mention, however, one path that will be open to trustees after Siegel and after 2008: Fed. R. Bankr. P. 4003(b)(2). That rule provides that a trustee may still file an objection to a debtor’s claim of exemption “at any time prior to one year after the closing of the case, if the debtor fraudulently asserted the claim of exemption.” Trustees who face similar issues as Mr. Siegel have "a second bite of apple" that was unavailable to Mr. Siegel. 

Quick Update

        

          I exchanged e-mails with Steven T. Gruber, Esq., who argued the case for Mr. Siegel. He pointed out to me that Fed. R. Bankr. P. 4003(b)(2) does not apply to his case, because Mr. Law filed his Chapter 7 case before the enactment of BAPCA and before the change in Rule 4003 (in 2008). He also told me that Mr. Law's discharge had been revoked, multiple civil sanctions had been assessed against him, and that Law moved all his personal property to China before he filed his bankruptcy case. There is also a criminal referral outstanding, but no one knows if it will ever proceed.

       Thanks to Mr. Gruber for taking the time to respond to my e-mails - as you can see, this was a very frustrating case and losing a Supreme Court case must be the equivalent of being on the losing side of the Super Bowl. The feelings are the same, whether you are a quarterback or a lawyer. 

©Kevin C. McGee

STERN V. MARSHALL SEMINAR MATERIALS PRESENTED 12/6/12 TO WORCESTER COUNTY BAR ASS'N BANKRUPTCY SECTION

STERN v. MARSHALL, 131 S.Ct. 2594 (2011):

WHY SHOULD YOU CARE?

Kevin C. McGee, Partner

Seder & Chandler, LLP

339 Main Street, 3^rd Floor

Worcester, MA 01608
©Kevin C. McGee

• The Stern v. Marshall Facts:

• Former Playmate of the Year Anna Nicole Smith (real name: Vickie Lynn Marshall) (“Smith”) marries J. Howard Marshall II (“Howard”), who is very old and very rich.

• One year later – Howard dies & leaves Smith out of his will. Before his death, Smith files suit in Texas and accuses Howard’s son – E. Pierce Marshall (“Pierce”) – of shenanigans to keep her out of the will.

• Smith files bankruptcy after Howard’s death, with her claims against Howard’s estate –separate litigation (up and down the federal court system and the Texas court system) ensues.

• In the Smith bankruptcy, Pierce files a non-dischargeability complaint and a proof of claim based upon his allegations that Smith defamed him through having her lawyers publicize (through the press) that Pierce defrauded Smith to gain control of Howard’s assets and estate (the “Pierce Proof of Claim”).

• Smith objects to the Pierce Proof of Claim and asserts a counterclaim against Pierce on the theory of his tortious interference with the gift she expected to get from Howard.

• Determinations in the California bankruptcy court on both claims – Pierce expresses no issue or problem with the bankruptcy court hearing issues on the Pierce Proof of Claim, but objects to the hearing on the Smith counterclaim. Smith gets summary judgment (in 1999)  on the Smith Proof of Claim, and judgment (after a 2000 bench trial) in her favor on her counterclaim -- $400 million in compensatory damages & $25 million in punitive damages.

• Post-trial – Pierce argues that Smith’s counterclaim was not a “core proceeding” & that the bankruptcy court had no authority to issue final findings of fact and rulings of law (“Final Rulings”) on the counterclaim. Smith argues that the counterclaim was “core” under 28 U.S.C. §157(b)(2)(C)[1] (as the bankruptcy court had determined in issuing its final judgment).

• The California US District Court agreed with Pierce that the counterclaim was not “core”, notwithstanding §157(b)(2)(C), because (in essence) it was not a “mandatory” counterclaim to the Pierce Proof of Claim (i.e., arose from different facts and occurrences), & treated the bankruptcy court findings and judgment as “proposed”[2]. The District Court then confirmed the bankruptcy court rulings and issued its own judgment in favor of Smith, in the amount of $44,292,767.33 (combining compensatory & punitive damages).  

• A procedural mess followed, with the case going up to the 9^th Circuit, then up to the SCOTUS (on the issue of a bankruptcy court’s power to decide probate matters), then back to the 9^th Circuit. In the end, the 9^th Circuit concluded that the District Court should have given the Texas jury verdict preclusive effect, and ruled in favor of Pierce. Another writ of certiorari followed and the SCOTUS granted it.

• By the time the SCOTUS decided the case in 2011, both Smith and Pierce were dead, and their respective estates were carrying on the fight.

• The Stern v. Marshall Majority Rulings (Roberts, CJ, with Scalia, Kennedy, Thomas & Alioto, JJ joining):

• “Core” or “Noncore” under 28 U.S.C. §157(b)?

• Under the terms of §157(b)(2)(C), the bankruptcy court had statutory authority to enter Final Rulings on the Smith counterclaim to the Pierce Proof of Claim.

• The bankruptcy court could also enter Final Rulings on the Pierce Proof of Claim because: (i) although Pierce claimed that the Pierce Proof of Claim involved a “personal injury tort” which the bankruptcy court lacked jurisdiction to hear under 28 U.S.C. §157(b)(5), that statute is not jurisdictional; and (ii) Pierce’s expressions of consent to the bankruptcy court determination of the Pierce Proof of Claim waived his objection to such determination based on §157(b)(5). Justice Roberts noted that Pierce did consent to the determination of the Pierce Proof of Claim by filing the proof of claim and then affirmatively stating on other occasions that he had no problem with the bankruptcy court's determination of the Pierce Proof of Claim. 131 S.Ct. at 2607-08.

• On the latter point, Justice Roberts wrote: “If Pierce believed that the Bankruptcy Court lacked the authority to decide his claim for defamation, then he should have said so -- and said so promptly. See United States v. Olano, 507 U.S. 725, 731 (1993)(‘”no procedural principle is more familiar to this Court than that a constitutional right,” or a right of any other sort, “may be forfeited ... by the failure to make timely assertion of the right before a tribunal having jurisdiction to determine it.”’)[.]” 131 S.Ct. at 2608.

• Does the Bankruptcy Court have Authority to Determine Smith’s State Law Counterclaim?

• Despite its conclusion that the Smith counterclaim was a “core” proceeding as defined by the statute, the majority opinion went on to examine the bankruptcy court’s authority to issue Final Rulings under Article III of the U.S. Constitution.

• Justice Roberts first trots out the plurality opinion in Northern Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50, 102 S.Ct. 2858 (1982) and the idea that Congress cannot delegate, through legislation, either the Article III judicial power or the right of litigants to have state law claims heard by an Article III court. 131 S.Ct. at 2608-10.

• The majority then goes on to examine whether the core/non-core distinction in 28 U.S.C. §157, with the bankruptcy courts operating as “adjuncts” of the district courts, fits within the “public rights” exception to Article III jurisdiction permitting legislatively-created adjudicators to necessarily determine state law claims.

• In teasing out the “public rights” exception, Justice Roberts notes that the following situations qualify for the exception: (1) actions in which the U.S. Government is a party to the litigation; and (2) actions in which the rights involved are “integrally related to particular federal government action” or a federal regulatory scheme. 131 S.Ct. at 2611-13.

• Justice Roberts and the majority cite the circumstances in Commodity Futures Trading Commission v. Schor, 478 U.S. 833, 106 S.Ct. 3245 (1986) as a situation in which a state law claim could be determined under the “public rights” exception to Article III jurisdiction: specifically, when a mandatory state law counterclaim, arising from the same facts and occurrences, is asserted in response to a claim that falls within the determination authority of an agency acting within a “specific and limited regulatory scheme.” 131 S.Ct. at 2613-14.

• The majority contrasts the Schor circumstances with a trustee’s pursuit of fraudulent transfer claims in Granfinanceria S.A. v. Nordberg, 492 U.S. 33, 109 S.Ct. 2782 (1989), in which the SCOTUS held such claims, asserted against a noncreditor, were “private rights” as opposed to “public rights,” even if a statute granted the right to pursue the fraudulent transfer action. 131 S.Ct. at 2614.

• After this review, Justice Roberts concludes that the Smith counterclaim is more like the fraudulent transfer claim than it is the counterclaim in Schor, and concludes that the Smith counterclaim neither falls within the public rights exception nor “flows from a federal statutory scheme …[in which the counterclaim’s adjudication] is completely dependent upon ‘adjudication of a claim created by federal law’”.Id.

• Accordingly, the majority concludes that the California bankruptcy court lacked constitutional authority, under Article III, to make Final Rulings on Smith’s counterclaim to the Pierce Proof of Claim, notwithstanding its “core” nature under 28 U.S.C. §157. In making this conclusion, the majority dismisses: (1) any “implied” consent to the determination of the Smith Counterclaim through the filing of the Pierce Proof of Claim – because of the lack of factual connection between the Pierce Proof of Claim and the Smith Counterclaim, and the need for separate findings for each claim, 131 S.Ct. at 2615-18; (2) the bankruptcy court’s “adjunct” status to the district court, since such status is not accompanied by an appropriate limitation as to the areas that a bankruptcy court can decide, 131 S.Ct. at 2618-19; and (3) the concern that a two-tier adjudication of state law claims, with  the need to confirm and approve proposed findings and rulings through de novo review, does not justify overriding Article III constitutional concerns even if the process is inefficient, expensive or impractical, 131 S.Ct. at 2620.

• On the latter point, the majority does appear to backtrack a little on the scope of its decision: “[W]e are not convinced that the practical consequences of such limitations on the authority of bankruptcy courts to enter final judgments are as significant as [Smith] and the dissent suggest…As described above, the current bankruptcy system also requires the district court to review de novo and enter final judgment on any matters that are "related to" the bankruptcy proceedings, § 157(c)(1), and permits the district court to withdraw from the bankruptcy court any referred case, proceeding, or part thereof, § 157(d). Pierce has not argued that the bankruptcy courts ‘are barred from `hearing' all counterclaims’ or proposing findings of fact and conclusions of law on those matters, but rather that it must be the district court that ‘finally decide[s]’ them.... We do not think the removal of counterclaims such as Vickie's from core bankruptcy jurisdiction meaningfully changes the division of labor in the current statute; we agree with the United States that the question presented here is a "narrow" one.” 131 S.Ct. at 2620.

• Is the Stern v. Marshall Effect on Bankruptcy Litigation Broad or Narrow?

• Answers from Circuit Courts:

•  Yes, It is Narrow:

• 11^th Circuit:  Stern v. Marshall involved a “permissive” state law counterclaim to a proof of claim, and has no application when the counterclaim is “mandatory”, i.e. arising from the same facts and occurrences, as in loan payment recoupment claims asserted in response to a secured creditor’s action to determine the validity, extent and priority of its lien. Sundale, Ltd. v. Florida Associates Capital Enterprises, LLC (In re Sundale, Ltd), __ F 3d __ (Case No. 12-11450 11^th Cir. 11/29/12).

• 2^nd Circuit: Stern v. Marshall holding is narrow and has no application to a bankruptcy court injunction issued to stay asbestos litigation against the debtor’s parent company,  in aid of the automatic stay. Pfizer, Inc. v. Law Offices of Peter G. Angelos (In re Quigley Co., Inc.), 676 F.3d 45 (2^nd Cir. 2012).

• 1^st Circuit: Stern v. Marshall is limited in scope and inapplicable to a Truth in Lending rescission action, when the bankruptcy court’s resolution of that action was necessary to its determination of the secured creditor’s motion for relief from stay. DiVittorio v. HSBC Bank USA (In re DiVittorio), 670 F.3d 273, 282 n.4 (1st Cir. 2012)

• “It Depends”:

• 9^th Circuit: Although Stern v. Marshall certainly applied to a bankruptcy court’s determination of a fraudulent transfer case under 11 U.S.C. §548 against a noncreditor, the right to a hearing in an Article III court can be waived by a party, and the bankruptcy court could still issue final findings of fact and rulings of law on the claim when the defendant had failed to object or indicate a lack of consent to such hearing, until the final judgment was challenged on appeal. Executive Benefits Insurance Agency v. Arkison (In re Bellingham Insurance Agency, Inc.), ___ F.3d ___ (Case No. 11-35162 9^th Cir. 12/4/12).

• No, It is Broad and Far-Reaching:

• 6^th Circuit: In determining a debtor’s state law fraud counterclaim against a secured creditor in the context of the debtor’s declaratory judgment action to disallow and discharge the creditor’s secured and unsecured claims, the Sixth Circuit stated: “ Stern thus provides a summary of the law in this area: When a debtor pleads an action under federal bankruptcy law and seeks disallowance of a creditor's proof of claim against the estate—as in Katchen—the bankruptcy court's authority is at its constitutional maximum.(my emphasis – KCM) 131 S. Ct. at 2617-18. But when a debtor pleads an action arising only under state-law, as in Northern Pipeline; or when the debtor pleads an action that would augment the bankrupt estate, but not ‘necessarily be resolved in the claims allowance process[,]’ 131 S. Ct. at 2618; then the bankruptcy court is constitutionally prohibited from entering final judgment. Id. at 2614.” Waldman v. Stone,  ___ F.3d ___, ___ , 2012 WL 5275241 (6th Cir. Oct. 26, 2012).

• What Are the Courts Doing to Accommodate Stern v. Marshall in Practice?

• National Rulemaking: In September 2012, the Advisory Committee on Bankruptcy Rules for the Judicial Conference of the United States  proposed amendments to Bankruptcy Rules 7008, 7012, 7016, 9027, and 9033 to address the “inefficiencies” of Stern v. Marshall. The common theme in each rule is to require each party to state whether or not the party consents to the bankruptcy court’s final determination of facts and final rulings, with opportunities at the pleading stage (proposed Fed. R. Bankr. P. 7008 & 7012), if the case is removed from another court (proposed Fed. R. Bankr. P. 9027), and at pre-trial conferences (proposed Fed. R. Bankr. P. 7016). The proposed rules also eliminate any requirement that the parties state whether each count is “core” or “non-core”[3]. Proposed Fed. R. Bankr. P. 9033 follows this trend in eliminating any reference to 28 U.S.C. §157(c)(1) with respect to proposed findings and rulings issued by a bankruptcy court, thus acknowledging that proposed findings and rulings may be required in “core” matters as well as “non-core” matters.

• Local Rulemaking: At least one bankruptcy court, has adopted the “get consent to everything first” approach taken up by the Advisory Committee to the Judicial Conference. Bankr. SDNY Local Bankruptcy Rule 7008.1 (adopted 4/16/12); see also Local Rule 7012-1 (Bankr. D. Md.) (requiring statement of consent in pleadings); Local Rule 7008 (Bankr. W.D. Mich.)(same). U.S. District Courts have mostly reacted by reaffirming the referral of bankruptcy matters to bankruptcy courts, and requiring that all determinations under Stern v. Marshall be made, in the first instance, by the bankruptcy court (as opposed to through a motion to withdraw reference addressed to the district court). Amended Standing Order or Reference (D. Del. 2/29/12); Standing Order of Ref. 6:12-MC-26-ORL-22 (M.D. Fla. 2/22/12); L.R. 206 (D. Mass. effective 6/5/12); Amended Standing Order of Reference (S.D.N.Y. 1/31/12); General Order No. 2011-12 (S.D. Tex. 11/29/11)[4].

---

[1]  §157(b)(2)(C) provides that “Core proceedings include, but are not limited to, …counterclaims by the estate against persons filing claims against the estate[.]” Pursuant to §157(b)(1), bankruptcy courts “may hear and [finally] determine” all core proceedings arising under title 11, and enter orders and judgments subject to appellate review as a final order, judgment or decree under 28 U.S.C. §158. Cf. 28 U.S.C. §157(c)(1) “A bankruptcy court may hear a proceeding that is not a core proceeding but that is otherwise related to a case under title 11. In such proceeding, the bankruptcy court shall submit proposed findings of fact and conclusions of law to the district court, and any final order or judgment shall be entered by the district court after considering the bankruptcy judge’s proposed findings and conclusions and after reviewing de novo those matters to which any party has timely and specifically objected.”

[2] Interestingly, the Texas state court had conducted a separate jury trial on the parties’ dispute and rendered a verdict in Pierce’s favor; however, the District Court declined to give that verdict preclusive effect.

[3] But see 28 U.S.C. §157(b)(3) – “The bankruptcy judge shall determine, on the judge’s own motion or on timely motion of a party, whether a proceeding is a core proceeding … or is a proceeding that is otherwise related to a case under Title 11. A determination that a proceeding is not a core proceeding shall not be made solely on the basis that its resolution may be affected by State law.” One can assume that the Advisory Committee wants to avoid messy pleadings that state that a matter is “core” under §157, but is otherwise “non-core” for the purposes of the bankruptcy judge’s authority to enter final findings and rulings.

[4] In citing all these rules, I acknowledge the work done by David Mawhinney, law clerk to Judge Frank Bailey of the Massachusetts Bankruptcy Court; he collected these rules in materials presented to the district court judges for Massachusetts and was a driving force in proposing Local Rule 206 to them. 

FIRST LESSON: “A” is for “Avoidance” and “Abandonment”

DISCLAIMER:  Nothing on this blog is intended to be specific or complete legal advice and is for general informational purposes only. In other words, you are only getting the tip of the iceberg in this blog – call and schedule a consultation with me at (508) 757-7721 ext. 112 if you think what you read here might apply to you and your situation. 

First, know that the bankruptcy law and Webster’s Dictionary have different definitions of “avoidance” and “abandonment”. The two terms also describe very different powers that a trustee in bankruptcy may use in your case.

A trustee’s “avoidance” powers are something that most debtors and creditors want to – well, to be honest, avoid. The Bankruptcy Code gives a trustee the right to bring a lawsuit to:

1.                  Avoid and recover payments a debtor made to any creditor on outstanding debts in the period ninety days prior to the date of the bankruptcy filing. These are called “preferences”, and can be hard for a creditor to fight, although there are some defenses available. A preference in a consumer bankruptcy case must be $600.00 or more (made in a single payment or as a total of multiple payments made during the 90 day period) before a trustee can bring a lawsuit to recover the preference; for businesses, the minimum ante is $5,850.00 or more.. One example for consumers: big paydowns on a credit card debt in the 90 day period, especially if the credit card company has stopped any new charges on the card. Businesses know all too well that money that comes in from a troubled account receivable is money that may just be making a brief visit to their bank accounts. There are defenses a creditor can raise -- but that's a separate post.

2.                  Avoid and recover payments a debtor made to his or her “insiders” on outstanding debt in the period one year prior to the date of the bankruptcy filing. These are called “insider preferences”. Who is an “insider”? The usual suspects are your spouse, your parents, your kids, your brothers or sisters, aunts and uncles, grandparents, your in-laws – pretty much anyone related to you by blood or by marriage. Your good friends and your employer are also possible insiders, depending on the closeness of your relationship with them. If you are in business, insiders include anyone who is your partner or who has a significant investment in your business. If you are a corporation or an LLP, the insider category includes the members, directors, officers, and any person who controls 20% or more of the shares or voting power in the business. 

       One quirk is that, if the payment is made within the year but before the three month period prior to a bankruptcy filing, the trustee has to prove that the debtor was “insolvent” at the time of payment – i.e., that the amount of your debts due and owing exceeded the fair value of your assets. In the ninety day period prior to the bankruptcy filing, you are “presumed” to be insolvent, and the trustee does not have to provide evidence on this issue unless the preference defendant comes up with evidence to the contrary. A typical example of a consumer “insider preference” is repaying Mom and Dad for the loans they gave you to help you get over the hump.

3.                  Avoid and recover transfers of your property made for less than a fair payment for the value of the property, if you were “insolvent” at the time (see definition of “insolvency” above). These are called “fraudulent transfers,” and can be very simple or very complicated to try. Simple cases include transferring your house to your spouse or a relative in a deed that recites “for consideration of less than $100.00” – always a bad idea (even for “estate planning” purposes) and usually can be undone by a trustee, if the trustee proves you were insolvent at the time.  Suppose you weren’t insolvent at the time, but you were expecting a big judgment against you or planned to take on a lot of debt in the near future – this is still a “fraudulent transfer” of the “intentional” variety, because you were deeding over the property with the idea of protecting it from your present and future creditors. And the trustee can still get it back.

4.                  Avoid defective liens on your property. If you have a mortgagee or other lien creditor who failed to cross all the “t”s and dot all the “i”s when that creditor took a lien on your property, the trustee can step into the shoes of an imaginary judgment lien creditor or a bona fide purchaser of your property, avoid the bad lien, and take the place of that creditor in the “priority” of distribution on that property – if the defective mortgage would have been first in line for the proceeds of the property’s sale, the trustee takes the place of that mortgagee. One illustration – your mortgage lender records a mortgage on your property with the wrong description of the property attached – the trustee can pretend that he or she is a judgment lien creditor on your property, get rid of the mortgage, and take the mortgage’s place on the property (leaving your mortgage lender with only a general claim in the case and no lien).

Let’s leave the unpleasant topic of “avoidance” and move on to another subject: “abandonment”. In general, a debtor's bankruptcy estate includes all of his, her or its property of whatever kind, wherever located, in whatever manner the debtor holds it (i.e., in the debtor's own name or through a trust), and whether or not the debtor lists it in the schedule of assets filed with the bankruptcy court. If you are a debtor, listing all of your property in your asset schedules is important for many reasons, not the least of which is that listing the property gives the trustee the opportunity to look over the property and decide whether or not the trustee wants to sell the property. Listing all property owned also allows the debtor to claim “exemptions” in certain property, which will prevent the trustee from selling or taking all of the sale proceeds of that property.

 If the trustee decides that he or she cannot sell certain property, that the property is worthless, or decides that he or she does not want the burden of maintaining and insuring the property, the trustee has two options:

A.                 The trustee can decide to take the property out of the bankruptcy estate immediately, and file a “notice of abandonment” with the bankruptcy court. If enough time passes and there is no objection, the debtor will get back control of the abandoned property; however, the automatic stay also stops protecting the property.

B.                 The trustee can hold onto the property until he or she decides to make a final distribution to your creditors and close the case. The legal effect of closing the case is to abandon all property not otherwise sold or previously abandoned back to the debtor. The closing of the case also ends the automatic stay as to all property abandoned.

Important point to remember: if the debtor doesn’t disclose something he, she or it owns (like a lawsuit for injury) and the trustee closes the case, the property is not really “abandoned” because the trustee never had a chance to decide whether or not to turn that property into cash for creditors. There are many consequences – civil and criminal -- coming to the debtor who hides property from a trustee, but one sure consequence is that a case can be “reopened” to deal with newly discovered property that should have been disclosed when the case was originally open. When in doubt, disclose!

Vocabulary Words and Quick Definitions from an Impudent Lawyer :

“Trustee in Bankruptcy” – All powerful being whose sole purpose is to locate property in your case to turn into cash and pay it out to your creditors.

“Avoidance Power”  --  A trustee’s right to take back what is yours, even though you gave it to someone else. Also, a trustee’s right to jump on any mistake a creditor made in putting a lien on your property, and take advantage of that creditor’s misfortune.

“Preference” – A payment you make with a three month string on it, attached to a trustee’s fishing line.

“Insider” – People you know and love, in whom the trustee takes an unnatural interest.

“Insider Preference” – A payment with a one year string on it, sitting in the pocket of someone you know and love.

“Insolvency” – Owing champagne debt and having only beer money to pay for it.

“Presumption” – A fact known to be absolutely true unless and until it is shown to be completely false.

“Fraudulent Transfer” – Giving someone much, much more than you ever get back from them.

“Intentional Fraudulent Transfer” – Giving someone much, much more than you ever get back from them, and liking it that way.

“Priority” – Your creditors’ grown-up version of “King of the Hill,” using your property as the hill.

“Abandonment” – The trustee’s rejection of unloved property.

“Exemption” – Limited protection for your house, your car, and for any of your property that a trustee probably couldn’t sell anyway.  

©Kevin C. McGee