Two provisions of the Bankruptcy Code turn on the existence of a “bona fide dispute.” An involuntary petition may not be filed by an alleged creditor against the alleged debtor if the creditor’s claim is “the subject of a bona fide dispute as to liability or amount.” 11 U.S.C. § 303(b)(1). A trustee may sell property free and clear of an interest that is “in bona fide dispute.” 11 U.S.C. § 363(f)(4). These disparate statutory provisions share a unique phrase.
What is a “bona fide dispute”? Two recent court decisions address this question.
Consistent with canons of statutory construction, the definition of the term “bona fide dispute” is the same in both section 303, where it is one of the requirements for a creditor to be eligible to file an involuntary bankruptcy petition, and section 363, where it is one of the five circumstances in which a trustee (or debtor in possession) may sell assets free and clear of liabilities. The majority of courts have adopted the “objective standard” which “requires the bankruptcy court to ‘determine whether there is an objective basis for either a factual or a legal dispute as to the validity of the debt.’”
In a recent decision, the U.S. Bankruptcy Court for the Middle District of Pennsylvania, examined the standing of creditors to file an involuntary bankruptcy petition against an alleged debtor. Chief Bankruptcy Judge Henry W. Van Eck analyzed whether the petitioning creditors’ claims were the subject of a “bona fide dispute” under applicable Third Circuit precedent. Under such precedent, a petitioning creditor’s claim “is the subject of a bona fide dispute if ‘there is a genuine issue of a material fact that bears upon the debtor’s liability, or a meritorious contention as to the application of law to undisputed facts.’” Applying this standard, the court evaluated each of the petitioning creditors’ claims. The court noted a number of evidentiary deficiencies in the alleged claims, particularly insufficient evidence establishing the validity of the claims or rebutting the alleged debtor’s defenses. Thus, a number of the petitioning creditors’ claims were disqualified. However, since the court declined to find bad faith, additional creditors were not disqualified from joining in the petition, and the court set further proceedings to determine whether including joining creditors in the petition would satisfy the requirements for an involuntary petition.
In another recent decision, the U.S. District Court for the Central District of California addressed whether the bankruptcy court erred when it approved a sale of property over the objections of a secured creditor. The appellant creditor had obtained a state court judgment against the debtor appellee, who was the creditor’s former business partner. The debtor filed for chapter 11 protection after the creditor recorded abstracts of judgments encumbering the debtor’s properties. The case was later converted to chapter 7. The chapter 7 trustee sold a parcel of real property of the debtor. The bankruptcy court authorized the trustee’s sale free and clear of the creditor’s liens on the basis that those interests were the subjects of a “bona fide dispute” within the meaning of section 363(f)(4) of the Bankruptcy Code. On appeal to the District Court, the creditor challenged the bankruptcy court’s determination that there was a bona fide dispute. The creditor argued that the interests were not the subject of a bona fide dispute because the bankruptcy court had previously ruled that the creditors’ liens were not avoided. In that earlier adversary proceeding the bankruptcy court had entered summary judgment in favor of the debtor ruling that the liens were subject to mandatory subordination under section 510(b), although the liens were not avoided. The creditor appealed that decision, and that prior appeal was still pending while the sale motion was before the bankruptcy court. District Court Judge Dolly M. Gee ruled that a dispute as to the priority of an interest is a bona fide dispute within the meaning of section 363(f)(4). Ultimately, the court found the bankruptcy court’s ruling “consistent with the purpose of section 363(f)(4), which seeks to prevent the delay of liquidation of the estate’s assets while disputes regarding interests in the estate are litigated.”
While these two cases involve very different facts and requests for relief, the meaning of “bona fide dispute” appears to be consistent, and courts should be able to rely on the standard established in precedent when addressing a “bona fide dispute,” whether under section 303 or 363 of the Bankruptcy Code.
Law v. Siegel, 571 U.S. 415, 422, 134 S. Ct. 1188, 1195, 188 L. Ed. 2d 146 (2014) (It is a “normal rule of statutory construction” that words repeated in different parts of the same statute generally have the same meaning.”) (internal quotations omitted).
 See In re Vortex Fishing Sys., Inc., 277 F.3d 1057, 1064 (9th Cir. 2002) (quoting In re Busick, 831 F.2d 745, 750 (7th Cir. 1987)), which discussed the standard in the involuntary petition context under section 303. See also the following cases citing Vortex or Busick in the context of sales of estate property under section 363: In re Gaylord Grain L.L.C., 306 B.R. 624, 627 (B.A.P. 8th Cir. 2004) (citing Busick); In re Figueroa Mountain Brewing, LLC, No. 9:20-BK-11208-MB, 2021 WL 2787880, at *8 (Bankr. C.D. Cal. July 2, 2021) (citing Vortex); In re Southcreek Dev., LLC, No. 10-CV-2136, 2010 WL 4683607, at *3 (C.D. Ill. Oct. 25, 2010) (citing Vortex and Busick); In re Lexington Healthcare Grp., Inc., 363 B.R. 713, 716 (Bankr. D. Del. 2007) (citing Busick).
In re Deluxe Bldg. Sols., LLC, No. 5:21-BK-00534-HWV, 2022 WL 16543189, at *4 (Bankr. M.D. Pa. Oct. 28, 2022)
Id. (citing: In re Daufuskie Island Props., LLC, 431 B.R. 626, 646 (Bankr. D.S.C. 2010); In re Farina, 9 B.R. 726, 729 (Bankr. D. Me. 1981); In re TWL Corp., No. 08-42773-BTR-11, 2008 WL 5246069, at *5 (Bankr. E.D. Tex. Dec. 15, 2008); Salerno, et al., Is a Lien Priority Dispute a Bona Fide Dispute?, Advanced Chapter 11 Bankr. Practice § 7.109 (2022)).
Id. (citing In re Clark, 266 B.R. 163, 171 (B.A.P. 9th Cir. 2001)).
The automatic stay that arises in a bankruptcy case can be a heavy shield, but it generally only protects the debtor. When a California attorney was recently sued in an Illinois district court, he tried to invoke the protection of the automatic stay from the Los Angeles bankruptcy cases of his former firm and its owner—Girardi & Keese and Thomas Girardi. The attorney was not entitled to a stay under section 362(a)(1) of the Bankruptcy Code. The district court was the incorrect forum for the request to extend the automatic stay, and the legal basis was unsound. However, the attorney was entitled to a stay under section 362(a)(3), as to the constructive trust that had been requested because it affected property that was asserted to be property of the bankruptcy estates. SeeEdelson PC v. Girardi, 2021 WL 3033616 (N.D. Ill. July 19, 2021).
After an airliner crashed into the Java Sea, killing all 189 persons on board, the families of certain of the victims retained Girardi & Keese to sue Boeing, the plane’s manufacturer, in Chicago. Girardi & Keese, a Los Angeles law firm, engaged the Chicago office of Edelson P.C., as local counsel in the case.
Settlements with each family were struck. By the end of March 2020, Boeing had transferred the settlement moneys to Girardi & Keese’s account. The clients were supposed to be fully paid by the end of the following month. In November 2020, however, Edelson learned that Girardi & Keese failed to fully pay the clients and that it lacked the funds to do so. Edelson therefore filed a motion requesting that Thomas Girardi and Girardi & Keese be held in contempt. Edelson alleged that Girardi had misappropriated client funds. Edelson’s insurance carrier would eventually make the clients financially whole.
Edelson brought a separate action in Chicago against Girardi & Keese, and various attorneys and employees of the firm, including Girardi, David Lira, Keith Griffin, and others. Lira and Griffin were Girardi’s associates. Edelson alleged that Lira and Griffin had worked with Girardi to embezzle the settlement moneys, to commingle those moneys with fees to which Edelson was entitled, and to share in the illicit gains.
Following the revelations in Chicago, creditors of Girardi and Girardi & Keese commenced involuntary bankruptcy cases against them in Los Angeles. An order for relief under chapter 7 of the Bankruptcy Code was entered in each case.
Statement of the Issue
As part of his motion to dismiss Edelson’s action, Lira, who was not himself a debtor in bankruptcy, asserted that the automatic stay in the bankruptcy cases of Girardi and Girardi & Keese prevented Edelson’s action from continuing against Lira.
The Stakes for Lira
If Lira could invoke the automatic stay, then he would avoid the expense of defending against Edelson’s action and the risk of being held liable. It might also have blocked, or at least delayed, the development of a record potentially affecting his interests if an attorney disciplinary proceeding were brought against him in connection with his license to practice law in California.
Section 362 of the Bankruptcy Code is entitled “Automatic stay.” Subsection (a)(1) provides as follows:
. . . a petition filed under section . . . 303 of [the Bankruptcy Code] . . . operates as a stay, applicable to all entities, of . . . the . . . continuation . . . of a judicial, administrative, or other action or proceeding against the debtor that was . . . commenced before the commencement of the [bankruptcy] case under this title, or to recover a claim against the debtor that arose before the commencement of the [bankruptcy] case under this title . . . .
11 U.S.C. § 362(a)(1).
The express terms of the statute did not protect Lira as a non-debtor. In that regard, the general rule is that the automatic stay does not protect third parties who are non-debtors. Nevertheless, Lira advocated that section 362(a)(1), automatically required a stay of Edelson’s action against him.
Lira was correct when he asserted that there are exceptions to the general rule that the automatic stay does not protect third parties who are non-debtors. In “unusual situations,” where there is such a similarity or identity of interests that failing to protect the non-debtor will put the assets of the debtor at risk, or a judgment against the non-debtor will, in practice, be a judgment against the debtor, the automatic stay can protect the non-debtor. An example of an unusual situation is where the non-debtor third party is a defendant in a lawsuit and is entitled to absolute indemnity by the debtor in the event of an adverse judgment. Lira asserted that California labor law afforded him absolute indemnity in the Edelson action by Girardi and/or Girardi & Keese.
However, the basic flaw in Lira’s attempt to enlist the automatic stay from the bankruptcy cases of Girardi and Girardi & Keese based upon such an exception is that Lira presented it in the wrong forum. Courts considering how the automatic stay could protect non-debtor third parties have relied upon two sections of the Bankruptcy Code. They are section 362(a)(1), discussed above, and section 105, which authorizes the court to issue an injunction that is “necessary or appropriate to carry out the provisions” of the Bankruptcy Code. Accordingly, those courts have concluded that extending the automatic stay to protect non-debtor third parties required the issuance of injunctions by the bankruptcy court. The court in Edelson was a federal district court supervising a civil action in Chicago, not the bankruptcy court handling the bankruptcy cases of Girardi and Girardi & Keese in Los Angeles. Thus, the district court in Chicago was not the proper forum to consider whether an injunction should be issued to extend the automatic stay in the bankruptcy cases of Girardi and Girardi & Keese to protect non-debtor Lira from the Edelson action.
While the court was able to dispatch Lira’s effort to invoke section 362(a)(1) on procedural grounds, it decided to discuss the substance of the absolute indemnity exception advanced by Lira. In A.H. Robins, the Fourth Circuit recognized “a suit against a third party who is entitled to absolute indemnity by the debtor on account of any judgment that might result against them in the case” as “[a]n illustration” of an “unusual situation” where a bankruptcy court could properly stay proceedings against a non-debtor co-defendant. In doing so, the Fourth Circuit relied on In re Metal Center, where the Connecticut bankruptcy court stated that “[w]here, however, a debtor and a nondebtor are so bound by statute or contract that the liability of the nondebtor is imputed to the debtor by operation of law, then the Congressional intent to provide relief to debtors would be frustrated by permitting indirectly what is expressly prohibited in the Code.”
Lira cited section 2802(a) of the California Labor Code in support of the absolute indemnity exception. Section 2802(a) of the California Labor Code requires the employer to indemnify its employee for following unlawful directions “unless the employee, at the time of obeying the directions, believed them to be unlawful.” Edelson, however, alleged in its complaint that Lira had knowledge of and took part in Girardi’s misappropriation and conversion of client moneys. In view of Edelson’s allegations, Lira could not be treated as having an entitlement to indemnity from the debtor, absolute or otherwise, that would justify granting him the protections of the automatic stay. Because Edelson’s allegations rendered Lira unable to assert a claim for absolute indemnity, Lira could not successfully invoke section 362(a)(1) in support of his request for a stay of proceedings.
Section 362(a)(3) of the Bankruptcy Code provides as follows:
a petition filed under section . . . 303 of [the Bankruptcy Code] . . . operates as a stay, applicable to all entities, of . . . any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate . . . .
Section 362(a)(3) offered Lira an alternative basis to extend the automatic stay to Edelson’s action.
The district court thought it seemingly “obvious” that Edelson’s request to impose a constructive trust – which Edelson could seek as to moneys transferred from Boeing to Girardi & Keese for which Edelson asserted an entitlement – was subject to being stayed under section 362(a)(3). A constructive trust is “[a]n equitable remedy by which a court recognizes that a claimant has a better right to certain property than the person who has legal title to it.” Here, Edelson was claiming that it held the beneficial interest in certain funds to which Girardi & Keese, i.e., the debtor, had legal title. However, section 362(a)(3) protects property of the debtor’s bankruptcy estate, and property of the bankruptcy estate is defined as including “ . . . all legal or equitable interests of the debtor in property as of the commencement of the [bankruptcy] case.” Accordingly, the funds on which Edelson sought to impose a constructive trust were property of the Girardi & Keese bankruptcy estate.
Invoking section 362(a)(3) so as to stay Edelson’s constructive trust claim was proper, because if Edelson were to succeed on that claim, then the value of the bankruptcy estate would be reduced. “This is because property in which the debtor holds legal but not equitable title as of the commencement of the case—for example, property impressed with a constructive trust under state law—is property of the estate only to the extent of the debtor’s legal title.” Girardi & Keese and Girardi’s bankruptcy cases were commenced after Edelson had discovered and disclosed to the district court the possibility that they had misappropriated client funds. Accordingly, Edelson would argue that the funds at issue should be deemed as having already been subject to a constructive trust, i.e., that Edelson held the beneficial interest in such funds, as of the point when the bankruptcy cases were commenced.
While the district court applied section 362(a)(3) to block the constructive trust request, it declined to do so as to the conversion and breach of contract claims that had been asserted against Lira.
The automatic stay generally does not protect non-debtor third parties. However, as in the case of the constructive trust claim against Lira, a creditor’s pursuit of property of the bankruptcy estate that is in the possession of a non-debtor third party may be a circumstance where the third party is entitled to the protections of the automatic stay.
The problem with Edelson’s constructive trust argument, as suggested, above, is that it would have relied on section 541(d) of the Bankruptcy Code, which states as follows:
Property in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest . . . becomes property of the estate under subsection (a)(1) or (2) of this section only to the extent of the debtor’s legal title to such property, but not to the extent of any equitable interest in such property that the debtor does not hold.
Courts that have construed section 541(d) have noted its limited effect when entities in the position of Edelson try to invoke a constructive trust. The Sixth Circuit, for one, has stated as follows:
With regard to a constructive trust, we have been clear that this section does not authorize bankruptcy courts to recognize a constructive trust based on a creditor’s claim of entitlement to one; rather, section 541(d) only operates to the extent that state law has impressed property with a constructive trust prior to its entry into bankruptcy.
Edelson had not obtained a constructive trust prior to the commencement of the Girardi and Girardi & Keese bankruptcy cases. Therefore, if Edelson were to succeed in its post-petition attempt to impose a constructive trust, the result would necessarily be to remove property that was asserted to constitute property of the Girardi bankruptcy estates. As the district court stated, “Edelson’s request for a constructive trust must be stayed until the bankruptcy litigation is resolved.”
As is apparent from the district court’s reasoning, a non-debtor third party seeking to invoke the automatic stay from a bankruptcy case would be well advised to carefully consider the basis for doing so and to seek that relief from the correct court.
 The litigation is ongoing. Edelson has since amended its complaint. The amended complaint or complaints have been filed under seal.
 The court in an attorney disciplinary proceeding may take judicial notice of the records in a civil action. Mushrush v. State Bar, 17 Cal.3d 487, 489 n.1 (1976) (Supreme Court granted motion to take judicial notice while noting that Supreme Court was not bound by findings of fact of Superior Court); California Evidence Code § 452(d) (“Judicial notice may be taken of . . . [r]ecords of . . . (2) any court of record of the United States . . . .”). The State Bar Court may apply the principles of collateral estoppel in attorney disciplinary proceedings to preclude the attorney who is the subject of the proceedings from re-litigating an issue that was decided adversely to the attorney in a civil proceeding according to the clear and convincing standard of proof. In re Kittrell, No 95-O-14321, 2000 WL 1682426 (Review Dep’t State Bar Court Cal. Oct. 26, 2000) (jury’s finding in a civil action against attorney that was made using clear and convincing evidence was a conclusive determination in later disciplinary proceedings that attorney committed acts involving moral turpitude and was binding on the attorney). Also, in disciplinary proceedings, witness testimony from a civil proceeding is admissible whether or not the witness is available. California Business and Professions Code § 6049.2.
Edelson PC v. Girardi, Case No. 20 C 7115, 2021 WL 3033616 at *14 (N.D. Ill. July 19, 2021) (citing Fox Valley Constr. Workers Fringe Benefit Funds v. Pride of the Fox Masonry & Expert Restorations, 140 F.3d 661 (7th Cir. 1998); A.H. Robins Co. v. Piccinin, 788 F.2d 994 (4th Cir. 1986); In re Fernstrom Storage & Van Co., 938 F.2d 731 (7th Cir. 1991).
See, e.g., Chugach Timber Corp. v. Northern Stevedoring & Handling Corp. (In re Chugach Forest Products, Inc.), 23 F.3d 241, 247 n.6 (9th Cir. 1994) (use of “unusual circumstances” standard contemplates bankruptcy court’s issuance of an injunction to extend the automatic stay pursuant to its equity jurisdiction). The Seventh Circuit has not yet considered the appropriate procedure by which exceptions to the general rule of section 362(a)(1) could be raised. Edelson, 2021 WL 3033616 at *15.
Plessey Precision Metals, Inc. v. The Metal Center, Inc. (In re The Metal Center, Inc.), 31 B.R. 458, 462 (Bankr. D.Conn. 1983).
Bidermann Industries U.S.A., Inc. v. Zelnik (In re Bidermann Industries U.S.A., Inc.), 200 B.R. 779, 784 (Bankr. S.D.N.Y. 1996) (“. . . unusual circumstances do not exist where . . . the right to indemnity is not absolute . . . .”).
 “Though Lira may not invoke section 362(a)(1) to obtain a stay of these proceedings from this Court, he may be able to achieve the same result under section 362(a)(3).” Edelson, 2021 WL 3033616 at *16. “[T]he plain words of the provision go past protecting just the debtor and protect any property of the estate.” Id.
Amedisys, Inc. v. Nat. Century Financial Enterprises, Inc. (In re Nat. Century Financial Enterprises, Inc.), 423 F.3d 567, 576 (6th Cir. 2005) (citing, inter alia, 11 U.S.C. § 541(d)). In Amedisys, a provider of nursing home services brought a Louisiana state court action by which it sought to impose a constructive trust over funds that it asserted to be the proceeds of accounts receivable that it owned. The funds were held in a bank account of the debtor, which provided healthcare accounts receivable financing and had commenced a bankruptcy case in the Southern District of Ohio. The provider’s Louisiana state court action was filed post-petition against the debtor’s bank, and it asserted that the debtor’s account at the bank contained both the proceeds of receivables that had been sold to the debtor and the proceeds of receivables that had not been sold to the debtor. The Sixth Circuit agreed with lower court determinations that the provider’s prosecution of the lawsuit was subject to the automatic stay under section 362(a) because a favorable determination would “potentially deplete the property of the bankruptcy estate.” Amedisys, 423 F.3d at 575. In the view of the Sixth Circuit, the state court action against the debtor’s bank was an act to obtain possession of property of the bankruptcy estate under section 362(a)(3).
Poss v. Morris (In re Morris), 260 F.3d 654, 666 (6th Cir. 2001).
A litigation trust tasked with prosecuting the debtor’s avoidance claims under a reorganization plan sued Verizon. Verizon sought coverage from its insurers for defending against the trustee. The insurers denied coverage. After Verizon settled the avoidance claims by paying the trustee, it sued the insurers in the Delaware Superior Court. The court determined that Verizon was entitled to insurance coverage under the policies.
In March 2008, Verizon Communications, Inc., transferred certain of its landline assets to FairPoint Communications, Inc. The transaction was structured as a sale of assets to Spinco, a “special purpose vehicle” that Verizon had formed, and then a merger of Spinco into Fairpoint.
The purchase price for the landline assets was $1,711,000,000. Spinco paid $551 million of the purchase price by issuing notes in that amount to Verizon. Verizon did not have to bear a repayment risk on Spinco’s notes. Instead, Verizon obtained cash in the amount of the Spinco notes by selling Verizon commercial paper to banks for the same amount. Verizon repaid those banks with the Spinco notes, and the banks then sold the Spinco notes to public holders, i.e., into the secondary market.
In October 2009, Fairpoint – after absorbing Spinco – and its affiliates filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code. As of the petition date, Fairpoint apparently owed $2.7 billion due to the Verizon transaction. The Bankruptcy Court later confirmed a plan that created a litigation trust to prosecute the debtors’ claims against Verizon for the benefit of the bankruptcy estates.
In October 2011, the trustee of the litigation trust sued Verizon and others in district court. The litigation trustee sought to avoid the transaction involving Verizon, Spinco, and the pre-merger Fairpoint. In late 2013, the court held a 10-day bench trial of the trustee’s fraudulent transfer claim, the only cause of action remaining. In 2014, after trial, but before judgment was rendered, the parties settled. Under the settlement, Verizon paid the litigation trustee $95 million. Verizon had incurred defense costs of $24 million.
In August 2018, Verizon sued six insurers in the Delaware Superior Court for failing to cover the defense of the trustee’s fraudulent transfer action. Verizon sought a finding that the insurers had breached their insurance policies and a declaratory judgment for indemnification and defense costs. By opinions addressing the so-called Fairpoint Policy and Verizon Policy issued in February 2021 and October 2022, respectively, the Delaware Superior Court determined that Verizon is covered by both policies. The opinion on the Fairpoint Policy is Verizon Communications, Inc. v. Nat’l Union Fire Ins. Co. of Pittsburgh, PA, C.A. No. N18C-08-086 EMD CCLD, 2021 WL 710816 (Del. Super. Feb. 23, 2021), and the opinion on the Verizon Policy is Verizon Communications, Inc. v. Nat’l Union Fire Ins. Co. of Pittsburgh, PA, C.A. No. N18C-08-086 EMD CCLD, 2022 WL 14437414 (Del. Super. Oct. 18, 2022).
Analysis of the Delaware Superior Court
The insurance policies covered a “Securities Claim” and Verizon contended that the fraudulent transfer claim at issue met the policies’ definition of a “Securities Claim.” The definition included claims other than administrative or regulatory proceedings against an insured:
(1) alleging a violation of any federal, state, local or foreign regulation, rule or statute regulating securities (including but not limited to the purchase or sale or offer or solicitation of an offer to purchase or sell securities) which is:
(a) brought by any person or entity alleging, arising out of, based upon or attributable to the purchase or sale or offer or solicitation of an offer to purchase or sell any securities of an Organization; or
(b) brought by a security holder of an Organization with respect to such security holder’s interest in securities of such Organization; or
(2) brought derivatively on the behalf of an Organization by a security holder of such Organization.
Because a “brought derivatively” claim under paragraph two did not have to allege violations of the securities laws as required by paragraph one, Verizon did not need to show that the litigation trustee’s district court action “implicates a regulation, rule or statute specifically directed towards securities law.” This distinguished the Fairpoint Policy and Verizon Policy from others covering “Securities Claims” on which Verizon had sought and been denied coverage for fraudulent transfer actions. The definition of “Securities Claim” in these other policies differed because it did require a “brought derivatively” claim to allege securities law violations. See In re Verizon Ins. Coverage Appeals, 222 A.3d 566 (Del. 2019).
Still, Verizon had to show that the Spinco Notes were securities. The notes had been issued as the consideration for a sale of corporate control. They were then resold in the secondary market, where the likelihood that the purchasers of the notes would be repaid depended on whether the issuer succeeded as a business, or not. Because these features made the Spinco Notes an “investment,” the court determined that they were securities.
The court then considered whether the trustee of Fairpoint’s litigation trust, who had commenced the fraudulent transfer action against Verizon, qualified as a “security holder.” The insurers asserted that the trustee was not a “true security holder.” They also asserted that holders of the Spinco Notes could not be regarded as creditors of Fairpoint, the debtor in bankruptcy. While it was true that institutional buyers in the secondary market actually owned the Spinco notes, the court rejected the insurers’ position because the trustee under the Bankruptcy Code was the representative of the bankruptcy estate and had the exclusive authority to pursue causes of action that had become the property of the bankruptcy estate. In that regard, the trustee stood in the shoes of the creditors who, but for the bankruptcy case of Fairpoint, would have been able to bring the fraudulent transfer claims. Moreover, the court had to give effect to the terms of the insurance policies, which provided that coverage would not be affected by bankruptcy. Were the insurers’ position that a bankruptcy trustee is not a “security holder” to have prevailed, it would make a section of the insurance policy null. Responding to the insurers’ assertion that holders of the Spinco Notes could not be Fairpoint creditors, the court noted among other things that it was Fairpoint that was insolvent and unable to service the debt.
The court also had to evaluate whether the litigation trustee’s fraudulent transfer claim had been “brought derivatively.” It consulted Third Circuit bankruptcy doctrine on this issue. In bankruptcy, the status of a claim as “derivative” is relevant to whether it constitutes property of the bankruptcy estate, in which case the trustee prosecutes the claim. If not, the creditor may prosecute the claim, itself. The fraudulent transfer claims against Verizon met part one of the applicable test because the transfers occurred prior to Fairpoint’s filing bankruptcy. Part two of such test looks to whether the claim is general to the bankruptcy estate or personal to the creditor. Where the “theory of liability” stems from a harm to the debtor’s bankruptcy estate that “creates a secondary harm to all creditors,” the claim is general. Fraudulent transfer claims fall into the “general claim” category because they allege the diversion of bankruptcy estate assets and, if successful, increase the pool of assets that is available to all creditors.
The insurers asserted that “brought derivatively” included shareholder derivative suits only, which the court dispatched by noting how the definition of a “Securities Claim” referred to “security holder,” a broader category not restricted to stockholders. They also asserted that fraudulent transfer claims would be direct claims, not derivative, outside bankruptcy. The court rejected that argument because Delaware law recognizes the derivative standing of creditors outside bankruptcy to bring fraudulent transfer claims where the corporation is insolvent. Moreover, the policy did not distinguish between claims in or outside bankruptcy, contemplated both situations, and expressly prohibited barring coverage where an insured filed bankruptcy.
The court next had to consider whether the trustee’s fraudulent transfer action against Verizon had been brought “on the behalf of” Fairpoint. The insurers contended that the trustee had brought the action on behalf of creditors, not Fairpoint. The court recognized, however, that such a position was contrary to bankruptcy law. The fraudulent transfer claims were derivative (of the debtor) claims that constituted property of the bankruptcy estate. The trustee was the representative of the bankruptcy estate, and had the power to sue. To adopt the insurers’ position would disregard the fact that the commencement of a bankruptcy case by Fairpoint converted the claims of the Spinco Note holders into bankruptcy estate property. A fraudulent transfer claim redresses a “primary injury” to the debtor that causes a “secondary harm” to creditors. The insurers also argued that there was a difference between Fairpoint and its uninsured bankruptcy estate, but a debtor does not cease to exist in a chapter 11 case and, moreover, to advance the difference as a basis to deny coverage would contradict the provisions of the policy prohibiting discrimination due to bankruptcy.
The court’s second opinion, as to coverage under the Verizon Policy, concluded that the litigation trustee for Fairpoint could be considered a “security holder” of Spinco, that the fraudulent transfer action was “brought derivatively” on Spinco’s behalf, and that Spinco qualified as an “organization” for purposes of the definition of a “Securities Claim.” The court’s discussion was directed to the insurers’ contention that coverage under the policy was inappropriate because Spinco, at the time of Verizon’s purchase of the Verizon Policy, was no longer a subsidiary of Verizon.
The second opinion also addressed the insurers’ argument that the settlement of the fraudulent transfer claims against Verizon was “in the nature of disgorgement” such that it was excluded from the definition of “Loss.” The court agreed that a settlement of a fraudulent transfer claim was in the nature of disgorgement. However, what was excluded was “matters which may be deemed uninsurable under the law pursuant to which this policy shall be construed, including . . . settlements . . . in the nature of disgorgement.” The exclusion was unavailing to the insurers because the court, itself, and the Delaware Supreme Court, had previously held that settlements for disgorgement actually are insurable under Delaware law.
The court’s opinion reminds insureds that a careful, thorough review of the insurance policy’s language could lead to a persuasive argument in support of coverage. The Delaware Supreme Court had earlier rejected an attempt by Verizon to obtain coverage under an insurance policy that covered “securities claims.” The definition of “securities claim” in the policies at issue in these cases, however, differed from those on which coverage had been denied. Because Verizon was able to identify those differences and use them to distinguish the policies, Verizon succeeded in persuading the court that “securities claim” coverage included defense of a trustee’s fraudulent transfer claim.
Insurers may be required to provide coverage when their policies state that coverage is not to be affected by bankruptcy and the supervising court applies bankruptcy principles to overcome technical arguments to deny coverage. It did not matter that the litigation trustee was not a “true security holder” because the trustee had exclusive authority as the representative of the bankruptcy estate to pursue fraudulent transfer claims belonging to the bankruptcy estate. The court applied bankruptcy law to determine that the fraudulent transfer claims were “derivative” claims and thus property of the bankruptcy estate. Applying similar analysis, the court also found that the trustee could be regarded as having brought a claim on the behalf of the debtor against Verizon, who was seeking coverage for such claims. Insurers should also be aware that a debtor does not cease to exist in a chapter 11 bankruptcy case. Hence, the attempt to deny coverage on the grounds that there is a difference between the policy’s named insured and its bankruptcy estate may be rejected.
Danning Gill congratulates our partner John N. Tedford, IV, on his recognition as the Century City Bar Association’s Corporate Bankruptcy Lawyer of the Year. John and other award recipients were honored on November 10 at the CCBA’s 54th Annual Installation Banquet and Awards Ceremony. Joining John and his wife Mary at the awards ceremony were the Hon. Alan M. Ahart, DG cofounder David Gill, present and former DG partners, associates, staff and friends.
A creditor obtained judgment against the chapter 7 debtor for denial of the debtor’s discharge under 11 U.S.C. § 727. On the first appeal, the district court affirmed. On further appeal to the Second Circuit, the debtor challenged the court’s determinations that he had an interest in in an entity, that he concealed that interest with an intent to hinder creditors, and that the concealment occurred within the one-year statutory period. The Second Circuit also affirmed.
In the mid-1990s, the chapter 7 debtor, a CPA and financial consultant, was a part owner of several financially challenged manufacturing businesses. The debtor personally guaranteed the debts of those businesses. Creditors obtained judgments against the debtor on account of his guaranties. While these financial struggles were ongoing, in 2001, the debtor and his wife formed Soroban, Inc., a consulting business. The debtor’s wife was listed as the sole owner and chair of the board of Soroban.
However, the debtor took on a larger role than the ownership structure suggested. The debtor ran Soroban’s day-to-day operations, managed the movement of funds between Soroban’s bank accounts, signed promissory notes on Soroban’s behalf, and controlled the company’s finances. The debtor was also Soroban’s sole employee. The debtor’s wife hardly had any involvement with the business of Soroban.
In 2011, Premier Capital, LLC acquired the judgments against the debtor and began pursuing collection. In 2012, the debtor filed for chapter 7 bankruptcy protection in the United States Bankruptcy Court for the Southern District of New York. Premier commenced an adversary proceeding against the debtor seeking denial of his discharge pursuant to 11 U.S.C. § 727(a). The central argument in Premier’s complaint was that the debtor violated section 727(a), specifically subsection 727(a)(2)(A) which states that “(a) [t]he court shall grant the debtor a discharge, unless . . . (2) the debtor, with intent to hinder, delay, or defraud a creditor or an officer of the estate charged with custody of property under this title, has transferred, removed, destroyed, mutilated, or concealed, or has permitted to be transferred, removed, destroyed, mutilated, or concealed—(A) property of the debtor, within one year before the date of the filing of the petition” (emphasis added).
In considering the question of whether the debtor concealed his interest in Soroban in violation of 11 U.S.C. section 727(a)(2)(B), the trial court applied the test established by the bankruptcy court in In re Carl, 517 B.R. 53 (Bankr. N.D.N.Y. 2014). In Carl, the court considered the following five factors to determine whether a debtor had an equitable interest in a company and concealed that interest in an effort to hinder the claims of their creditors:
1. Whether the debtor previously owned a similar business;
2. Whether the debtor left his or her previous business venture under financial duress;
3. Whether the debtor transferred his or her salary, or the right to receive a salary to a family member or to a business entity owned by an insider;
4. Whether the debtor is actively and actually involved in the success of the insider business; and
5. Whether the debtor retains some of the benefits of the salary, such as having expenses paid for by the insider or the business.
Based on its application of the Carl test, the bankruptcy court found that the debtor had an equitable interest in Soroban. The district court affirmed.
The Second Circuit’s Analysis
On appeal to the Second Circuit, the debtor argued that the Carl test is not binding precedent. The Second Circuit agreed that Carl was not binding. Further, the appellate court observed that the Carl decision does not recognize that state law determines a debtor’s property interest in an asset. Accordingly, the appellate court analyzed New York state law on how to establish whether a party has a property interest in an asset.
The court looked at the New York Court of Appeals decision of Andrew Carothers, M.D., P.C. v. Progressive Ins. Co., 33 N.Y.3d 389, 104 N.Y.S.3d 26, 128 N.E.3d 153 (2019). The Carothers court did not endorse a particular list of factors, but, affirmed the trial court because it “satisfactorily directed the jury to the ultimate inquiry of control over a professional corporation.” The trial court had considered the following factors:
1. Whether the purported owners’ dealings with the business were designed to give [them] substantial control over the business and channel profits to themselves;
2. Whether they exercised dominion and control over business assets, including bank accounts;
3. The extent to which business funds were used for personal rather than corporate purposes;
4. Whether they were responsible for hiring, firing, and payment of salaries for the employees;
5. Whether the day-to-day formalities of corporate existence were followed;
6. Whether the business shared common office space and employees with other companies owned by the purported owners; and
7. Whether other parties played a substantial role in the day-to-day and overall operation and management of the business.
While the bankruptcy court’s application of the Carl test did not match the factors in Carothers, per se, the court concluded that, consistent with New York law as demonstrated in Carothers, the bankruptcy court did properly address the “‘ultimate inquiry of control over a professional corporation’ [and] whether the debtor ‘exhibited the attributes of ownership’ in the context of bankruptcy proceedings.” Thus, it was not an error for the bankruptcy court to consider the Carl factors.
Moreover, under the theory of “continuous concealment” the debtor was not able to escape liability by arguing that the concealment did not occur during the one-year lookback period of section 727(a)(2)(A). The concealment was ongoing during the year prior to bankruptcy, even if the original act of creating the hidden ownership interest occurred years earlier.
The Gasson decision is logical and equitable. The debtor’s sole operation and control of a new entity, despite his wife’s “paper” status as owner, revealed the truth that the debtor was the equitable interest holder. The debtor’s technical argument that the trial court’s equitable interest test was not binding precedent did not prevent the Court of Appeals from reaching its own conclusion of law consistent with the bankruptcy court’s holding.
This is also an important reminder that the one-year lookback period for concealment of assets under section 727(a)(2)(A) does not shield a debtor who intentionally concealed assets years earlier and continues to intentionally benefit from that concealment during the one-year lookback period. As noted in footnote 2 of the decision, at least seven circuits (including the Ninth Circuit) have applied a version of the “continuous concealment” doctrine, and none have rejected it. It’s fair to say that there is no safe jurisdiction for intentional asset concealment, and the passing of time will not shield a witting concealer from liability under section 727.
The filing of a bankruptcy case “operates as a stay . . . of . . . any act to create, perfect, or enforce any lien against property of the [bankruptcy] estate.” 11 U.S.C. § 362(a)(4) (emphasis added). The Bankruptcy Code defines the term “lien” as an “interest in property to secure payment of a debt . . . .” Id. at § 101(37). However, there are also exceptions to the stay (often referred to as the “automatic stay”). They include “any act to perfect, or to maintain or continue the perfection of, an interest in property to the extent that the trustee’s rights and powers are subject to such perfection under [Bankruptcy Code] section 546(b) . . . .” Id. § 362(b)(3) (emphasis added). Accordingly, perfecting a mechanic’s lien—and maintaining that lien as a perfected lien—is possible without violating the automatic stay.
The Supreme Court has observed that “. . . Congress has generally left the determination of property rights in the assets of a bankrupt’s estate to state law.” Butner v. United States, 440 U.S. 48, 54 (1978). A creditor desiring to protect itself in bankruptcy must know what state law requires to set up and maintain a lien and also understand that, if its efforts run afoul of the automatic stay, such protection may not be available. The creditor might face the issue that what state law mandates to maintain a lien as perfected could violate the automatic stay if it qualifies as lien enforcement. The problem is that the act of perfecting a lien is supposed to be excepted from the automatic stay. That issue and others will be considered by the Ninth Circuit on November 15, 2022, when it will hear an appeal from the Bankruptcy Appellate Panel’s opinion in Philmont Management, Inc. v. 450 S. Western Ave., LLC (In re 450 S. Western Ave., LLC), 633 B.R. 894 (B.A.P. 9th Cir. 2021).
In Philmont, a general contractor recorded a mechanic’s lien against the debtor’s property in July 2018 after the debtor failed to pay invoices for the contractor’s improvements. The debtor then assured the contractor that it would be paid from the proceeds of a refinance of the debtor’s property. So as not to risk the refinance, the debtor requested that the contractor forbear from suit. The contractor complied. Rather than sue the debtor within 90 days of recording its lien, the contractor re-recorded its lien against the property, four times.
On December 19, 2019, the contractor recorded its last mechanic’s lien. On January 10, 2020, the debtor filed a voluntary petition under chapter 11 of the Bankruptcy Code. On April 29, 2020, the contractor filed in the bankruptcy case a notice of perfection of mechanic’s lien.
The property was sold to the winning bidder at an auction held in October 2020. While the sale proceeds were sufficient to pay the amount owed to the contractor on its lien, the debtor proposed a plan of liquidation by which it disputed the extent, validity, or priority of the lien.
The contractor commenced an action requesting a judgment that it held an enforceable mechanic’s lien in the sale proceeds of the debtor’s property. The debtor responded with a motion to dismiss for failure to state a claim upon which relief can be granted. The debtor argued that the contractor had failed to bring suit to enforce its lien within the period required by state law such that the lien had expired, that there was no basis in equity to extend such period, and that even if the last re-recording of the lien worked to reinstate the lien, the contractor’s notice of perfection was untimely because it was filed more than 90 days later. The bankruptcy court granted the debtor’s motion, and the adversary proceeding was dismissed with prejudice. The Bankruptcy Appellate Panel affirmed the bankruptcy court.
The Statutes Involved
California Civil Code § 8412 governs the recordation of a “claim of lien” by a “direct contractor,” as follows:
A direct contractor may not enforce a lien unless the contractor records a claim of lien after the contractor completes the direct contract, and before the earlier of the following times:
(a) Ninety days after completion of the work of improvement.
(b) Sixty days after the owner records a notice of completion or cessation.
Recording the lien merely makes a contractor eligible to enforce the lien. In that regard, California Civil Code section 8460(a) states in relevant part as follows:
The claimant shall commence an action to enforce a lien within 90 days after recordation of the claim of lien. If the claimant does not commence an action to enforce the lien within that time, the claim of lien expires and is unenforceable.
The creditor must sue within 90 days of recording the lien or risk losing the lien. The statute details what will be given up as a result of failing to timely sue: “. . . a lien attaches to the work of improvement and to the real property on which the work of improvement is situated . . . .” California Civil Code section 8440.
Again, state law requires certain conduct by the creditor to maintain the perfection of its lien, and maintaining the perfection of a lien is excepted from the automatic stay. However, the very conduct that is required to maintain the perfection of a lien—because it appears to involve enforcement—is also prohibited by the automatic stay. The provisions of Bankruptcy Code section 362 excepting certain acts from the automatic stay addresses this dilemma by referring to another section of the Bankruptcy Code, section 546(b). That section states as follows:
(1) The rights and powers of a trustee under sections 544, 545, and 549 of this title are subject to any generally applicable law that—
(A) permits perfection of an interest in property to be effective against an entity that acquires rights in such property before the date of perfection; or
(B) provides for the maintenance or continuation of perfection of an interest in property to be effective against an entity that acquires rights in such property before the date on which action is taken to effect such maintenance or continuation.
(A) a law described in paragraph (1) requires seizure of such property or commencement of an action to accomplish such perfection, or maintenance or continuation of perfection of an interest in property; and
(B) such property has not been seized or such an action has not been commenced before the date of the filing of the petition;
such interest in such property shall be perfected, or perfection of such interest shall be maintained or continued, by giving notice within the time fixed by such law for such seizure or such commencement.
11 U.S.C. § 546(b) (emphasis added). The debtor in Philmont had the rights and powers of a trustee, i.e., the debtor’s rights and powers in that case were subject to the possible perfection, and maintenance of perfection, of a mechanic’s lien by a creditor such as the contractor.
Accordingly, if a creditor must sue to maintain the perfection of the creditor’s lien and the debtor’s bankruptcy case intervenes before an action can be commenced, then that creditor – instead of commencing an action – must give notice, but do so within the state law period for commencing the (now unnecessary) action.
1. Contractor Had to Give Notice During Period to Commence an Action
The contractor and the debtor in Philmont agreed that the first mechanic’s lien, recorded in July 2018, had been timely recorded. For “direct contractors,” a lien must be recorded within 90 days of completing work or 60 days after an owner records a notice of completion or cessation, whichever occurs first. Because the contractor failed to then commence an action within 90 days of recording the lien, any lien based upon the July 2018 recordation expired.
As the last mechanic’s lien, which was recorded in December 2019, fell well beyond the completion of work or the property owner’s giving of notice, it was incapable of being enforced. The contractor invoked equitable estoppel as a bar to the debtor’s claim that the December 2019 lien had been untimely, based upon the contractor’s forbearance at the debtor’s request pending the refinance of the property.
However, because the contractor did not file its notice of perfection of its lien until April 29, 2020, which was 132 days after the contractor had recorded its lien, the contractor failed to meet the time period set forth by state law to maintain or continue the perfection of its lien. Such period is 90 days. Thus, even if the contractor’s fifth recording of its mechanic’s lien in December 2019 were deemed to have been timely, the lien had expired by the date when the contractor filed its notice of perfection. Thus, the BAP ultimately did not need to discuss the contractor’s allegations of equitable estoppel.
Even though the debtor commenced a bankruptcy case during the 90-day period under state law for the contractor to commence an action to maintain the perfection of its lien, the bankruptcy case did not affect the running of those 90 days. Section 546(b) requires that the contractor “give notice” to maintain the perfection of its lien. “Giving notice” to maintain a perfected lien is an alternative in a bankruptcy case to commencing an action that would otherwise violate the automatic stay. However, that alternative must be exercised within the period that governs commencement of the action.
2. Contractor Was Not Entitled to Tolling under Bankruptcy Code § 108(c)
The contractor viewed California law as not requiring the commencement of an action to maintain its lien as perfected. Instead, the contractor contended that commencement of an action under the mechanic’s lien statute is merely an enforcement mechanism. Under that view of the applicable law, the exceptions to the automatic stay afforded by sections 362(b)(3) and 546(b) for maintaining perfection would not apply. Accordingly, the contractor insisted that it had been subject to the automatic stay. The contractor then asserted that its lien claim was entitled to the tolling provisions of the Bankruptcy Code governing “applicable nonbankruptcy law . . . [that] fixes a period for commencing . . . a civil action in a court other than a bankruptcy court on a claim against the debtor . . . [that] has not expired before the date of the filing of the petition.” 11 U.S.C. § 108(c). If so, then the running of the 90-day period for the contractor to commence an action on its lien would have been tolled.
The contractor argued that the Ninth Circuit’s decision in Miner Corp. v. Hunters Run Ltd. Partnership (In re Hunters Run Ltd. Partnership), 875 F.2d 1425 (9th Cir. 1989), supported its position. In Hunters Run, Sunny Day Cement had recorded its mechanic’s lien pre-petition, i.e., it was a perfected lien. However, Sunny Day had failed to commence an action pre-petition to maintain the lien as enforceable.
The Ninth Circuit ruled that the period for Sunny Day to commence an action to foreclose its lien was tolled by section 108(c). In the view of the Hunters Run panel, such an action constituted enforcement activity that the automatic stay prohibited, and Sunny Day was not able to provide notice under section 546(b) because the version of section 546(b) in effect at the time of Hunters Run only permitted the giving of notice to perfect a lien (something that Sunny Day had already accomplished pre-petition) and did not also permit giving notice to maintain or continue perfection of a lien. While Hunters Run did toll the period to commence an enforcement action on a mechanic’s lien, section 546 has since been amended and the Ninth Circuit’s discussion revealed that there would have been no tolling under section 108(c) if Sunny Day had been able to maintain the perfected status of its lien by giving notice instead of having to commence a stay-violating foreclosure action. Under amended section 546(b), giving notice is available both to perfect a lien and to maintain or continue a lien where “generally applicable law” would otherwise mandate bringing suit or seizing property to achieve those ends. The giving of notice in such circumstances is required. Congress also added “acts” to maintain or perfect an interest in property to the exceptions to the automatic stay set forth in section 362(b)(3). Bankruptcy Code sections 362(b)(3) and 546(b) should be considered together. The Hunters Run ruling therefore was of no avail to the contractor in Philmont.
The contractor also did not persuade the panel that the BAP’s opinion in Village Nurseries v. Gould (In re Baldwin Builders), 232 B.R. 406 (B.A.P. 9th Cir. 1999), had been wrongly decided. Village recorded a mechanic’s lien pre-petition after completing landscaping and irrigation improvements. As of the debtor’s filing of its bankruptcy case, Village had still not commenced an action to foreclose its lien. Post-petition, Village filed, but did not serve, two Superior Court foreclosure complaints, recorded a second lien, and filed a proof of claim asserting a secured claim. The bankruptcy court found that the complaints were void as violations of the automatic stay, and determined that the proof of claim was incapable of providing timely notice of the recorded liens. (The opinion includes a thorough discussion of notice, because the principals of the debtor also happened to be partners in Village and had been involved in Village’s strategy with respect to enforcing its mechanic’s liens.)
Like the contractor in Philmont: (1) Village had a perfected lien (the final lien recorded by the contractor in Philmont was treated as perfected even though the debtor disputed such status), (2) Village was subject to a statute requiring the commencement of a Superior Court action to maintain the lien as perfected, and (3) Village had failed to provide timely notice under the alternative to enforcement afforded by section 546(b). By the time Baldwin was decided, sections 362(b)(3) and 546(b) had been amended. Village therefore argued that commencing its foreclosure actions did not violate the automatic stay because such actions were required to maintain the perfected status of its lien, and the new exception to the automatic stay for “any act . . . to maintain or continue the perfection” rendered the foreclosure actions valid. The BAP rejected Village’s position. It acknowledged that a foreclosure suit is required under California law to maintain a mechanic’s lien, but that did not prevent the foreclosure suit from also constituting the type of enforcement activity that would violate the automatic stay in bankruptcy so as to be void. Mechanic’s lien creditors must be aware that commencement of an action on a lien is the device under California law by which the lien is both maintained and enforced. Because commencement of an action is needed to maintain a mechanic’s lien, section 546(b) requires that notice of the lien be given in place of doing so. The holding of Hunters Run that commencing an action to foreclose a lien would violate the automatic stay remains intact. What differs since sections 362(b)(3) and 546(b) have been amended is the addition to the Bankruptcy Code of the ability to give notice to maintain a lien as perfected. Such notice must be given within the time mandated by state law to commence the foreclosure action. Tolling under section 108(c) of the period under section 546(b) in which such notice must be given is not available pursuant to the BAP’s opinion in Philmont.
Practitioners seeking to protect the secured status of their client’s mechanic’s liens after a bankruptcy case has been commenced should beware. The very conduct that on its face constitutes “enforcement” that would violate the automatic stay and be void may also be the same conduct needed to maintain and continue a lien as a perfected lien. Practitioners should not assume that their clients are barred from protecting their secured status and/or that the running of the state law period to start enforcement in order to preserve a lien will be tolled by section 108(c). Rather, in such circumstances the Bankruptcy Code expressly permits the creditor to maintain the secured status of the lien without violating the automatic stay. The creditor does so, not by filing an action, but by giving notice—with the requirement that notice be given before the time to commence an action would otherwise expire. Whether the Ninth Circuit departs from this structure by applying equitable estoppel and permitting tolling will be considered on November 15.
We are pleased to announce that Alphamorlai ‘Mo’ Kebeh is a recipient of the Honorable Cornelius Blackshear Presidential Fellowship for 2022! This fellowship is awarded to those who deserve special recognition for their professional accomplishments to date and show the potential to distinguish themselves in future years as highly respected members of the bankruptcy or debt restructuring bar. Mo is one of nine fellows, selected from across the country, who were recognized at this year’s National Conference of Bankruptcy Judges in Orlando. The firm is extremely proud of Mo for this achievement and the strides he continues to take in his practice.
When deciding what is “reasonable compensation” to award to bankruptcy professionals, including trustees and their counsel, can courts consider the ultimate “results obtained” by the professionals as one of the lodestar factors, even though this factor is not specifically included among the factors enumerated in 11 U.S.C. § 330(a)(3)? The Sixth Circuit Court of Appeals recently answered this question in the affirmative. See In re Village Apothecary, Inc., 2022 WL 3365131 (2022). To read the full opinion, click here.
In Village Apothecary, the debtor’s chapter 7 trustee retained special counsel (the “Firm”) to investigate and pursue potential legal claims worth at least $1,655,962. After a year-long investigation, the Firm identified possible claims against the debtor’s former president. The Firm drafted a complaint but ultimately determined that the claims would be unsuccessful. The trustee agreed to settle the claims for $38,000. This brought the estate’s total assets to $40,710.87. The Firm filed a fee application under 11 U.S.C. § 330, asking for a little over $37,000, representing 90.6% of the estate’s total assets.
The bankruptcy court approved only half of the requested fees. It relied on various lodestar factors, balancing the “amount in controversy” with the “results obtained” by counsel, concluding that the level of success was minimal because it resulted in no distribution to the non-administrative creditors.
On appeal, the district court affirmed, disagreeing with the Firm’s argument that “results obtained” could no longer be used as a lodestar factor under section 330(a)(3).
On appeal of the district court’s decision, the Sixth Circuit Court of Appeals affirmed again. The Sixth Circuit started out by explaining how professional fees are handled under the Bankruptcy Code. Under section 330(a), courts “may” award to professionals “reasonable compensation” for actual and necessary services. The question raised in this appeal was how do courts decide what is “reasonable compensation.”
Prior to 1994, section 330 required courts to consider the time, nature, extent, and value of the services as well as the costs of “comparable services.” Seeking further guidance, courts crafted ways to define “reasonable compensation.” One approach adopted by the Fifth Circuit utilized 12 factors, known as the “Johnson Factors,” that relied on Title VII to analyze reasonableness. Another approach, adopted by the Sixth Circuit, required bankruptcy courts to first calculate a “lodestar amount” by multiplying a professional’s reasonable hourly rate by the number of hours reasonably worked. Once this amount was derived, courts could exercise their discretion by also applying the Johnson Factors. One of the factors was the “amount involved and the results obtained.”
In 1994, Congress amended section 330, codifying some but not all of the Johnson Factors. Section 330(a)(3) now instructs courts to consider, “the nature, the extent, and the value of such services, taking into account all relevant factors, including” many Johnson Factors. (Emphasis added.) The list does not include “results obtained.”The court noted that it has never considered whether the 1994 amendment precludes courts from considering other Johnson Factors, like the “results obtained,” that were not codified into the statute.
Using statutory interpretation canons, the court concluded that by including the modifier, “all relevant factors, including,” Congress did not intend to limit courts to the specific factors codified in section 330(a)(3). Rather, courts may also consider factors not expressly enumerated in the statute. The court was also influenced by the fact that professional fees under section 330(a)(1) are discretionary, stating that courts “may” but are not required to award such fees. This discretion suggests that Congress intended the list of factors in section 330(a)(3) to be illustrative, but not exclusive.
The Sixth Circuit ultimately concluded that the bankruptcy court did not abuse its discretion by reducing the Firm’s fees by half.
Imerys mined, processed, and distributed talc. As of 2019, more than 14,000 claimants had sued Imerys, alleging bodily injuries from talc exposure. Imerys would inevitably face more of such lawsuits because talc injuries often manifest long after exposure.
Accordingly, Imerys considered relief under chapter 11 of the Bankruptcy Code. In particular, Imerys wanted a trust that would compensate both present and future talc claimants, and an injunction to protect the reorganized debtor from future talc liability. Such relief is available under section 524(g) of the Bankruptcy Code, where a debtor is defending actions “for damages allegedly caused by the presence of, or exposure to, asbestos or asbestos-containing products.”
Section 524 recognizes the conflict between present and future claimants over supervision of an asbestos trust. Persons already suffering from exposure want compensation now and have less concern that unwarranted or fraudulent claims might be paid. However, persons who will not begin to suffer from their exposure until a later date want careful supervision of the trust so that it is not depleted early on by payment of undeserving claims. Such persons may be unknown when the trust is created. Therefore, for the injunction under section 524 to be enforceable, the bankruptcy court must “as part of the proceedings leading to issuance of such injunction” appoint a “legal representative” to protect the rights of persons “that might” assert “demands” to recover damages for personal injury, wrongful death, or property damage after the reorganization plan is confirmed.
Imerys’s Future Claims Representative
In preparing for its chapter 11 case, Imerys engaged a “proposed future claimants’ representative,” or “Proposed FCR.” The Proposed FCR was James Patton, a partner in the law firm of Young, Conaway, Stargatt & Taylor, LLP (the “Conaway Firm”). Patton retained the Conaway Firm to represent him as Proposed FCR.
Even though Imerys paid the fees and costs of Patton, Patton’s “sole responsibility and loyalty” ran to the future personal injury claimants. Patton’s engagement as Proposed FCR ended when Imerys commenced its bankruptcy case.
Once before the bankruptcy court in Delaware, Imerys sought appointment of Patton as Future Claimants’ Representative. An application was also filed for the Conaway Firm to serve as Patton’s counsel. The applications disclosed that the Conaway Firm represented many insurers in coverage disputes relating to environmental liabilities, including asbestos claims. The applications also disclosed that, since 2010, the Conaway Firm had represented the Continental Insurance Company and the National Union Fire Insurance Company of Pittsburgh, PA in an ongoing insurance coverage dispute in the Delaware Superior Court over whether pump makers had coverage for asbestos-related injury claims alleged against them. Such matter is known as the “Warren Pumps litigation.”
A group of five insurers that included Continental, but not National Union, filed a limited objection to Patton’s proposed appointment. The insurers were to fund the trust under section 524(g). They expressed concern not over the Warren Pumps litigation but over Patton’s independence from Imerys in view of Patton’s pre-petition work as Proposed FCR. The proposal to engage the Conaway Firm drew no objections.
At the hearing on Patton’s proposed appointment as FCR, the objecting insurers had the opportunity to cross examine Patton. Even though their own attorney had worked on the Warren Pumps litigation, he opted not to pursue a line of questioning based upon the Warren Pumps litigation. The bankruptcy court, however, requested additional disclosures before ruling on Patton’s appointment because it believed that the Conway Firm’s representation of certain insurers in the Warren Pumps litigation regarding asbestos claims coverage did raise concerns about whether Patton—a Conaway Firm partner—was independent and able to act with “undivided loyalty to demand holders.” The bankruptcy court rejected the notion that Patton’s pre-petition service as Proposed FCR affected his independence, which had been the basis of the insurers’ objection to Patton.
Patton responded by disclosing that Continental and National Union, in the engagement letter for the Conaway Firm to represent them in the Warren Pumps litigation, had agreed to a prospective waiver of certain conflicts of interest that might stem from the Conaway Firm’s bankruptcy work. Patton also revealed that the Conaway Firm had screened those involved in representing Patton as FCR from the firm’s work in the Warren Pumps litigation.
Only after these supplemental disclosures by Patton did the insurers, now joined by National Union, object to the proposed appointment on the grounds that the Conaway Firm’s representation in the Warren Pumps litigation presented a concurrent conflict of interest. National Union was one of the two in this group, the other being Continental, that had actually been represented by the Conaway Firm in the Warren Pumps litigation.
The bankruptcy court decided that the prospective conflict waiver by National Union and Continental was valid and that Patton met the appointment standard for a legal representative, as set forth by the bankruptcy court. Patton was appointed as FCR and authorized to retain the Conaway Firm as his counsel. The six insurers appealed to the district court, which affirmed the bankruptcy court. The matter then arrived at the Third Circuit.
The Third Circuit’s Decision
Of the six insurers who had appealed Patton’s appointment, only two—National Union and Continental—were clients of the Conaway Firm in the Warren Pumps litigation. Their standing was unquestioned. The other four insisted that even if Patton’s appointment did not prejudice them, they still had standing to raise the conflict of interest “on behalf of the future claimants.” They cited In re Congoleum Corp., 426 F.3d 675 (3d Cir. 2005), in support of their standing. The Third Circuit rejected their argument and clarified that Congoleum had not eliminated the restrictive “person aggrieved” standard for appellate standing in bankruptcy cases that had been set forth prior to the Congoleum opinion in Travelers Insurance Co. v. H.K. Porter Co., Inc., 45 F.3d 737 (3d Cir. 1995). Unlike Congoleum, it was unnecessary to expand standing because National Union and Continental had been afforded “ample time and opportunity” to present the conflict to the bankruptcy court. Because they found no need to do so, the Third Circuit viewed their later assertion of the purported conflict as just a tactic to delay the confirmation of Imerys’s reorganization plan. In addition, the appointment of a legal representative differed from the proposed employment of special insurance counsel that was at issue in Congoleum. The bankruptcy court is required to appoint a legal representative as part of issuing a channeling injunction meaning that the court, itself, rather than third parties, is responsible for considering conflicts of interest. The judge in Imerys did so, and sought supplemental disclosures from Patton before ruling on his appointment as FCR.
The panel next considered whether the insurers had waived the purported concurrent conflict of interest by failing to raise it in their initial objection to the applications to appoint Patton as FCR. Patton and the Conaway Firm had disclosed the Warren Pumps litigation at the inception of Imerys’s effort to appoint them. However, the insurers waited until after the deadline to object to the proposed appointment had passed before they raised a purported conflict based upon the Warren Pumps litigation. Notice was given, and an opportunity to present the issue in an objection was provided, as well. Rather than do so, the insurers instead asserted that Patton could not be independent because of his pre-petition work as the Proposed FCR. The result was that there was little in the record about whether the Conaway Firm’s involvement in the Warren Pumps litigation was a basis to deny Patton’s appointment. In particular, there was nothing in the record to show that the Conaway Firm had gleaned information from representing Continental and National Union in the Warren Pumps litigation such that their position in Imerys’s chapter 11 case would be at risk from having Patton serve as FCR and the Conaway Firm be his counsel in that role. On this basis, the Third Circuit concluded that there were reasons to find that the conflict had been waived by the insurers while before the bankruptcy court. The appellate case could have been dispatched based upon waiver of the conflict, alone. However, the Third Circuit decided the merits.
Imerys and Patton argued that a legal representative need only be a “disinterested person” under section 101(14). The insurers argued that a legal representative had to be independent and have undivided loyalty to demand holders—the standard adopted by the bankruptcy court—and also be subject to the per se disqualification required by section 327 when a professional holds a conflict of interest.
“Disinterested person” is the standard in at least 11 sections of the Bankruptcy Code, but not section 524(g). The Third Circuit presumed its absence to have been intentional and noted that the absence fitted the statutory scheme: the “disinterested person” standard governs professionals who owe duties to the bankruptcy estate or the court and bars those who represent interests that are adverse to the bankruptcy estate, while a “legal representative” charged with protecting the interests of future demand holders by definition represents an interest that is adverse to the bankruptcy estate. Similarly, the Third Circuit presumed that by including the term of art “legal representative” in section 524(g), Congress intended to adopt the fiduciary duty standard that legal representatives are understood to owe their clients. The text and structure of the Bankruptcy Code suggested that the standard exceeded “disinterestedness.”
While the insurers contended that Congress’s amendment of the Bankruptcy Code after certain lower court decisions had used the “disinterested person” standard to appoint legal representatives constituted legislative acquiescence to such standard, the Third Circuit determined that those decisions were not sufficient in number or type to find acquiescence.
In addition, the standard applied to creditors’ committees guided the standard that should be applied to legal representatives. Even though the Bankruptcy Code requires only that members of a committee be “adequate” representatives, decisional law has established that they owe fiduciary duties to the committee’s constituents. The Third Circuit concluded that such a standard is “equally appropriate” with respect to a “legal representative” under section 524(g).
Accordingly, the Third Circuit required that a future claimants’ representative “be able to act in accordance with a duty of independence from the debtor and other parties in interest in the bankruptcy, a duty of undivided loyalty to the future claimants, and an ability to be an effective advocate for the best interests of the future claimants.” Even though a fiduciary standard applies, the court rejected the categorical approach of the insurers, which would require disqualification of a proposed legal representative based upon any technical conflict, standing alone. Instead, bankruptcy courts exercising their discretion in individual cases can properly evaluate whether an alleged ethical conflict requires disqualification. Also, if the insurers’ per se standard were to be deployed, it would reduce the pool of effective candidates for the position.
The Third Circuit then applied its standard to Patton. The alleged conflict arose from the Conaway Firm’s representation of insurance companies in the Warren Pumps litigation. The court found that the prospective waiver by the insurers in that case did apply to Patton’s proposed service in the Imerys case, and that the waiver was valid. While the insurers believed that they were entitled to decide whether they should consent to the specific conflict presented, a “second round” of consent is not available where there has been a valid prospective waiver. The insurers also argued that Patton would be an ineffective advocate for future claimants because the Warren Pumps litigation involved issues that were “substantially related” to those in Imerys’s case. The insurers were incorrect because “substantially related” would require that the two matters involve the same transaction, which they did not. Also, the insurers had not presented facts to show that Patton and the Conaway Firm would be able to use confidential information obtained from the Warren Pumps litigation matter to the detriment of the insurers in the Imerys case. Moreover, the bankruptcy court—unprompted by the insurers—had inquired about the alleged conflict. That inquiry suggested that the insurers’ position was purely tactical because the supplemental disclosures showed the use of screening at the Conaway Firm, that Patton had never been involved in the Warren Pumps litigation, at all, and that the Conaway Firm had done little work on the Warren Pumps case since 2016.
The belated and tactical press of a purported conflict of interest has yielded a fiduciary standard for the appointment of “legal representatives” for future claimants against asbestos trusts. It is not a guardian ad litem standard because the representative cannot bind future demand holders, but the heightened duties mean that debtors seeking the protections of a channeling injunction should seek to propose experienced and competent professionals for appointment as legal representative.
 While section 524(g) requires a legal representative, that does not necessarily entail a formal attorney-client relationship between the representative and future claimants. Still, given the nature of Patton’s role, how the rules of professional conduct applicable to attorneys would regard the compensation arrangement between Patton and Imerys warrants comment. In California, such an arrangement is permissible where it complies with Rule 1.8.6 of the California Rules of Professional Conduct, which is entitled “Compensation from One Other than Client.” One of the Rule’s three requirements is that the attorney obtain the client’s informed written consent to compensation from another. Obtaining consent from the client is only possible when the client is known. In cases like that of a legal representative for future claimants, however, the identities of all of the clients will not be known because of the period between exposure and manifestation of injury. Rule 1.8.6 appears to recognize the problem by not requiring informed written consent if “nondisclosure . . . is otherwise authorized by law or a court order . . . .” Section 524(g) of the Bankruptcy Code might qualify as law that otherwise permits nondisclosure. Moreover, Comment No. 4 to Rule 1.8.6 provides guidance that appears to be relevant to the position of a legal representative under section 524(g) of the Bankruptcy Code: “In some limited circumstances, a lawyer might not be able to obtain client consent before the lawyer has entered into an agreement for, charged, or accepted compensation, as required by this rule. This might happen in certain commercial settings, such as when a lawyer is retained by a creditors’ committee involved in a corporate debt restructuring and agrees to be compensated for any services to be provided to other similarly situated creditors who have not yet been identified. In such limited situations, paragraph (c) permits the lawyer to comply with this rule as soon thereafter as is reasonably practicable.”
 An injunction issued under section 524(g) may bar actions against third parties that are alleged to be liable for claims and demands against the debtor based upon certain grounds, including the “third party’s provision of insurance to the debtor or a related party.” 11 U.S.C. § 524(g)(4)(A)(III).
 National Union and Continental could assert that their interests in Imerys’s bankruptcy case were somehow capable of being harmed as a result of the Conaway Firm’s ongoing representation of National Union and Continental in the Delaware Superior Court and the Conaway Firm’s representation of Patton as FCR. The other four insurers were raising the other side of the conflict. They were contending that the Conaway Firm’s and Patton’s loyalty to their insurance company clients would limit their advocacy on behalf of future claimants against the trust.
Danning Gill is pleased to announce that John N. Tedford, IV, has been selected as the Century City Bar Association’s Corporate Bankruptcy Lawyer of the Year. John and other award recipients will be honored on November 10 at the CCBA’s 54th Annual Installation Banquet and Awards Ceremony. For more information about the program, please click here.