Dear constituency list members of the Insolvency Law Committee, the following is a case update analyzing a recent case of interest:

SUMMARY

Last August, in Salven v. Galli ( In re Pass), 553 B.R. 749 (9th Cir. BAP 2016), the U.S. Bankruptcy Appellate Panel of the Ninth Circuit held that, where a chapter 7 debtor and her non-debtor husband legally separated and divorced postpetition, the debtor’s ex-husband could, on his own behalf, claim a homestead exemption in property of the estate. To read the full published decision, click here: http://bit.ly/2utaP5P.

FACTS

In 2002, Frances Pass (“Pass”) and her then-husband, Aladino Galli (“Galli”), lived together in a home in Fresno, California (the “Fresno Property”). In 2002, they recorded a declaration of homestead (the “2002 Homestead Declaration”).

At some point, Pass and Galli decided to terminate their marriage.

In September 2009, Pass purchased a house in Coalinga, California (the “Coalinga Property”), and began refurbishing it. Early on December 30, 2009, Pass moved out of the Fresno Property with no intention of returning to reside there.

That very afternoon, Pass and Galli filed a joint chapter 13 petition. Thus, at the time they filed their joint petition, Galli resided in the Fresno Property and Pass resided in the Coalinga Property. They scheduled the Fresno Property as community property, and claimed a homestead exemption in the Fresno Property pursuant to California Code of Civil Procedure (“CCP”) section 704.730.

In September 2010, a state court entered a judgment of legal separation which incorporated a Marital Settlement Agreement and provided that the Fresno Property would be awarded to Galli as his sole and separate property.
In 2011, Galli executed and recorded a grant deed purporting to transfer the Fresno Property to Pass and Galli as joint tenants.

Subsequently, Pass filed a petition for a judgment dissolving the marriage. In April 2013, the state court entered a judgment of marital dissolution (incorporating a new Marital Settlement Agreement) under which Pass and Galli each retained a one-half joint tenancy interest in the Fresno Property.

Pass and Galli did not request relief from stay prior to making any of the purported transfers or obtaining any of the judgments purportedly affecting title to or their ownership of the Fresno Property. (As discussed below, the bankruptcy court later ruled that the purported transfers were void; Galli did not appeal that ruling.)

In September 2013, Pass requested that the bankruptcy court sever the joint chapter 13 case and convert her case to chapter 7. The bankruptcy court granted the request. Soon thereafter, Galli’s chapter 13 case was dismissed.

In Pass’ chapter 7 case, Pass amended her schedules to assert a $75,000 homestead exemption in the Coalinga Property instead of the Fresno Property. The chapter 7 trustee objected to Pass’ claimed exemption, alleging that Pass was not actually living in the Coalinga Property when Pass and Galli filed their joint chapter 13 petition. The bankruptcy court found that Pass had moved out of the Fresno Property, with no intention ever to return, hours before the petition was filed. Thus, the objection was overruled.

In the meantime, the trustee filed a motion for authority to sell the Fresno Property free and clear of liens and interests, as well as a complaint seeking to avoid the unauthorized postpetition transfers. In the adversary proceeding, the bankruptcy court entered summary judgment determining that the Fresno Property was community property (and therefore the entirety of the property was property of the estate), and that the postpetition transfers were void. However, the bankruptcy court also determined that Galli held a “homestead interest” in the Fresno Property by virtue of the 2002 Homestead Declaration, and the trustee could not sell the Fresno Property free and clear of Galli’s homestead interest without compensation to Galli. The trustee appealed.

ARGUMENTS PRESENTED TO THE BAP  

In his appellate brief, the trustee argued that “it is the automatic and not the declared homestead that is needed to invoke the homestead [exemption] within bankruptcy.” The trustee also argued that exemptions are determined as of the petition date, even when the case has been converted from chapter 13 to chapter 7. Citing In re Homan, 112 B.R. 356 (9th Cir. BAP 1989), the trustee further argued that when only one spouse files, the choice of homestead exemption vests solely in the filing spouse. Because Pass and Galli were married on the petition date, and because Pass had chosen to claim an exemption in the Coalinga Property, the trustee argued that Galli was not entitled to claim an exemption in the Fresno Property.

Galli argued that he had “exemption rights” in the Fresno Property pursuant to the 2002 Homestead Declaration. He argued that those rights came into his bankruptcy estate when the joint chapter 13 petition was filed, and revested in him when his chapter 13 case was dismissed. Galli also argued that his right to an exemption was not lost when Pass amended her schedules to claim an exemption in the Coalinga Property because, among other things, after legal separation each spouse is “entitled to a homestead in his or her own right.” Galli also argued that Pass “abandoned” her rights in the Fresno Property when she amended her Schedule C, and that the trustee, as Pass’ successor, was estopped from asserting any interest in the property.

BAP’S RULING AND REASONING

First, the BAP examined whether the 2002 Homestead Declaration precluded the trustee from selling the Fresno Property without compensating Galli.

The bankruptcy court had concluded that because a trustee’s “powers to liquidate estate assets are derived from those of a creditor who holds a judgment lien,” the 2002 Homestead Declaration shielded the Fresno Property from the trustee’s reach in the same way that a homestead declaration shields property from the attachment of judgment liens. Pass, 553 B.R. at 758 (quoting Salvi v. Galli ( In re Pass), Adv. No. 14-01056 at 12 (Bankr. E.D. Cal. Oct. 14, 2015)); see also Cal. Civ. Proc. Code § 704.950. The BAP rejected this conclusion because a trustee’s power to sell estate property is derived from Section 363, not from the trustee’s rights as a hypothetical lien creditor under Section 544.

The BAP also rejected the bankruptcy court’s suggestion that the trustee’s proposed sale of the Fresno Property could be considered a voluntary sale because it “‘is property of the estate over which the Trustee is effectively the owner.’” Pass, 553 at 759 (quoting Salvi v. Galli ( In re Pass), Adv. No. 14-01056 at 10 (Bankr. E.D. Cal. Oct. 14, 2015)). The BAP stated, “We must reject this proposition as inconsistent with our previous decisions holding that the filing of the bankruptcy petition itself constitutes a ‘forced sale’ for exemption purposes.” Id. (citations omitted).

Thus, the BAP concluded that the 2002 Homestead Declaration did not prevent the trustee from selling the Fresno Property.

Second, the BAP examined whether Galli was entitled to assert an “automatic” homestead exemption in the Fresno Property. This required the BAP to answer two questions: “First, whether Galli, as a non-debtor, may assert any exemption in property of the Pass bankruptcy estate; and second, whether Galli is entitled to a homestead exemption under California law.” Id. at 759.

As to the question of whether a non-debtor may claim an exemption in estate property, the BAP noted that there is a lack of case law addressing this issue. In Homan, the BAP had ruled that a non-debtor spouse could not assert an exemption in a home where the debtor had chosen to exempt other property. But the BAP distinguished Homan because “[w]hat is true of spouses . . . is not necessarily true of ex-spouses.” Id. at 760. The BAP stated that, by precluding non-debtor spouses from claiming exemptions in estate property, Congress designed the exemption provisions to encourage spouses to file jointly (something ex-spouses cannot do). The BAP also noted that Galli would not benefit from the community property discharge, which Homan had “identified as a counterbalancing advantage to the otherwise ‘hard result’ of denying non-debtor spouses any say in the selection of exemptions.” Id. (quoting Homan, 112 B.R. at 360). The BAP limited Homan’s holding to situations in which non-filing current spouses of the debtor attempt “to assert exemptions to which he or she would not be entitled as a joint debtor.” Id. The BAP concluded, “The mere fact that Galli is not the debtor does not prohibit him from asserting a state law exemption in property of the bankruptcy estate.” Id.

As to the question of whether Galli was entitled to an “automatic” homestead exemption under California law, the BAP rejected the trustee’s argument that because a debtor’s entitlement to claim exemptions is determined as of the petition date, and because Pass and Galli were married when they filed their joint chapter 13 petition, their exemption rights were limited to those that they enjoyed as a married couple on the petition date. The BAP stated,

The principle that exemption rights are determined as of the petition date cannot be stretched so far as to require that a debtor’s marital status on the petition date is fossilized for the duration of the case. Even less should former joint debtors whose cases have been severed and dismissed be yoked, for state-law exemption purposes, to their ex-spouses who remain in bankruptcy. To hold otherwise would flout the well-established principle that “bankruptcy courts [should] avoid incursions into family law matters….”

Id. at 760-61 (alteration in original) (citations omitted). Therefore, the BAP ruled that Galli’s homestead rights must be determined with reference to his current marital status, not his marital status on the petition date. The BAP stated that, under California law, after a judgment of dissolution or legal separation, each former spouse qualifies for the “automatic” homestead exemption for property in which he or she resides. Thus, the BAP concluded that Galli was entitled to claim a homestead exemption in the Fresno Property, and affirmed the bankruptcy court’s conclusion that the trustee could not sell that property without compensating Galli.

AUTHOR’S COMMENTARY

In the author’s view, the BAP correctly rejected Galli’s argument that the 2002 Homestead Declaration precluded the trustee from selling the Fresno Property. A homestead declaration prevents the attachment of a judgment lien unless there is equity in excess of the amount of the homestead exemption, but it does not diminish a co-owner’s interest in the property. In Pass, the entirety of the Fresno Property was property of the estate. Therefore, the trustee was entitled to sell the property pursuant to Section 363, and to distribute the net sale proceeds in accordance with Sections 724 and 726.

The validity of the BAP’s other two primary rulings is less clear given the paucity of authority on the subject.

First, an analysis of whether a debtor (or anyone else) is entitled to exempt property from property of a bankruptcy estate should begin with Section 522. Section 522(b) allows a debtor to exempt property from the estate. If a debtor fails to file a list of exemptions, “a dependent of the debtor may file such a list, or may claim property as exempt from property of the estate on behalf of the debtor.” 11 U.S.C. § 522( /) (emphasis added). There is nothing in the Bankruptcy Code to suggest that a non-debtor is entitled to exempt property from the estate on his or her own behalf.

There is also nothing in CCP section 704.710, et seq. to suggest that the “automatic” homestead exemption applies when a separated or ex-spouse (as opposed to a judgment lien creditor) seeks to sell a community property homestead. In this regard, footnote 6 of the BAP’s decision is noteworthy:

The Trustee’s counsel further conceded at oral argument that the Trustee’s proposed sale should be treated as involuntary, hence capable of triggering the automatic homestead exemption. . . . [A]s the issue is not disputed, we need not decide it and will treat the proposed sale as an involuntary or forced sale under California law.

Id. at 761 n.6.

Mainly in two contexts, courts have stated that the filing of a bankruptcy petition is the functional equivalent of a forced or involuntary sale: (1) when determining whether California’s “automatic” homestead exemption (as opposed to the declared homestead exemption) applies in bankruptcy cases; and (2) when determining that the petition date is the correct date for determining a debtor’s eligibility to claim an exemption. See, e.g., In re Cole, 93 B.R. 707 (9th Cir. BAP 1988); In re Herman, 120 B.R. 127 (9th Cir. BAP 1990); In re Morgan, 149 B.R. 147 (9th Cir. BAP 1993); In re Kelley, 300 B.R. 11 (9th Cir. BAP 2003). But it does not necessarily follow that a trustee’s Section 363 sale of estate property is the same thing as a judgment creditor’s execution sale of a judgment debtor’s property. In light of footnote 6, courts and practitioners should be careful not to read Pass as definitively holding that a trustee’s Section 363 sale is, in fact, an involuntary sale triggering a non-debtor’s right to claim an exemption in his or her own right.

Second, even if non-bankruptcy law can/does give a separated or ex-spouse an independent right to exempt community property from property of the estate, the BAP’s willingness to look at Pass and Galli’s current marital status (rather than their marital status on the petition date) is questionable. There was no dispute that Pass and Galli were still married on the petition date. Indeed, although not reflected in the record on appeal, a petition for a judgment of legal separation was not even filed until June 2010 (over five months after they filed for bankruptcy). Also, the state court’s September 2010 judgment of legal separation incorporated a Marital Settlement Agreement in which Pass and Galli agreed that the date of legal separation was January 1, 2010 (two days after they filed their joint chapter 13 petition).

The BAP was rightfully reluctant to interfere in family law matters. For example, courts have been hesitant to interfere with a state court’s award or modification of spousal support. See In re Allen, 275 F.3d 1160 (9th Cir. 2002); In re MacDonald, 755 F.2d 715 (9th Cir. 1985). However, it is unclear whether that policy should apply when a non-debtor spouse legally separates from the debtor postpetition and then seeks to exclude property from the estate by exercising exemption rights that did not exist on the petition date.

These materials were written by John N. Tedford, IV, of Danning, Gill, Diamond & Kollitz, LLP (jtedford@dgdk.com). Editorial contributions were provided by Michael J. Gomez of Frandzel Robins Bloom & Csato, L.C. in Fresno, California.

Thank you for your continued support of the Committee.
Best regards,

Insolvency Law Committee
Co-Chair
Radmila A. Fulton
Law Offices of Radmila A. Fulton
Radmila@RFultonLaw.com

Co-Chair
John N. Tedford, IV
Danning, Gill, Diamond & Kollitz, LLP
JTedford@dgdk.com

Co-Vice Chair
Marcus O. Colabianchi
Duane Morris LLP
MColabianchi@duanemorris.com

Co-Vice Chair
Rebecca J. Winthrop
Norton Rose Fulbright US LLP
rebecca.winthrop@nortonrosefulbright.com

Return to  John N. Tedford, IV 

Dear constituency list members of the Insolvency Law Committee,the following is a case update analyzing a recent case of interest:

Summary

In Blixseth v. Brown (In re Yellowstone Mountain Club, LLC), 841 F.3d 1090 (9th Cir. 2016), the Ninth Circuit Court of Appeals addressed whether members of unsecured creditors’ committees can be sued outside of the bankruptcy court without bankruptcy court authority. The court determined that the Barton doctrine established in Barton v. Barbour, 104 U.S. 126 (1881), which prevents suit against a trustee or receiver without the authorization of the appointing court, also applies to claims against a committee member relating to his or her conduct as a committee member. To read the full decision, click here: http://bit.ly/2jxLX7o.

Facts

Timothy Blixseth was the founder and principal, together with his wife, Edra, of Yellowstone Mountain Club, a luxury Montana resort. Stephen Brown represented Blixseth at the time Blixseth borrowed $375,000,000 on behalf of the Yellowstone Mountain Club and related entities. Blixseth, allegedly on Brown’s advice, used some of the loan proceeds to pay personal debts. As a result, shareholders sued Blixseth and, on Brown’s advice, Blixseth settled. Later, when Blixseth and Edra divorced, Blixseth, who was again represented by Brown in those proceedings, transferred the Yellowstone entities to Edra.

Some time following the divorce, Edra caused the Yellowstone entities to file chapter 11 bankruptcy petitions. An unsecured creditors’ committee (“UCC”) was appointed. Brown became the chair of the UCC. Concerned that Brown was using confidential information he obtained as Blixseth’s counsel against Blixseth in the bankruptcy cases, Blixseth sued Brown in the district court. Brown moved to dismiss under the Barton doctrine, which was established in Barton v. Barbour, 104 U.S. 126 (1881). The Barton doctrine prohibits suits in other forums against officers appointed by a court (typically trustees or receivers) for actions taken in their official capacities and within their authority, absent the appointing court’s authorization. The district court found that the protection afforded officers appointed by the bankruptcy court should be extended to committee members and, based thereon, dismissed the suit.

Blixseth thereafter moved the bankruptcy court for permission to sue Brown in district court, arguing that some of his claims were based on prepetition conduct. The bankruptcy court denied the motion and dismissed the claims based on its conclusion that it would be “impossible. . . to isolate” the alleged “pre-petition malpractice and malfeasance” claims from Brown’s work on the UCC. Blixseth appealed to the district court, which affirmed. Blixseth subsequently appealed to the Ninth Circuit.

Reasoning

The Ninth Circuit first considered whether the Barton doctrine applies to members of an official committee of unsecured creditors. No court of appeals has previously extended Barton to committee members. However, courts have found that Barton extends to parties other than receivers or trustees, such as trustees’ lawyers or parties handling sales of estate assets. See In re DeLorean Motor Co., 991 F.2d 1236, 1241 (6th Cir. 1993) (applying Barton to a trustee’s lawyer); Carter v. Rodgers, 220 F.3d 1249, 1251, 1252 n.4 (11th Cir. 2000) (applying Barton to an auctioneer). Here, the court found that the UCC’s interests were aligned with the estate’s, noting that committees can seek appointment of a trustee, have a duty to investigate the debtor and its financial condition, and participate in the formulation of a plan. Indeed, the Ninth Circuit pointed out that the duties of a committee and a trustee may overlap. Lawsuits against committee members, or even the potential for such lawsuits, may have the effect of chilling actions on the part of committee members attempting to fulfill their statutory duties. Thus, the court decided that Barton’s protections extend to committee members “sued for acts performed in their official capacities.” Yellowstone, 841 F.3d at 1095.

Next, the Ninth Circuit considered whether Blixseth needed bankruptcy court permission to sue Brown for Brown’s conduct prior to the bankruptcy case, on claims amounting to allegations of prepetition malpractice. The Ninth Circuit concluded that the bankruptcy court erred in finding that it was “impossible” to untangle the claims based on prepetition conduct from those based on postpetition conduct—Blixseth had clearly identified and separated the prepetition claims in his Barton motion and the prepetition claims had nothing to do with Brown’s role on the UCC. As a result, the Ninth Circuit held that Blixseth did not need bankruptcy court authority to pursue his prepetition claims against Brown in district court and that the bankruptcy court and district court had erred in concluding otherwise.

Turning next to the claims alleging postpetition misconduct by Brown in his capacity as chair of the UCC, the Ninth Circuit held that Blixseth could not pursue those claims in another forum absent the bankruptcy court’s authorization. In reaching this conclusion, the Ninth Circuit applied the following five factors:

(1) whether the acts complained of “relate to the carrying on of the business connected with the property of the bankruptcy estate,” (2)whether the claims concern the actions of the officer while administering the estate, (3) whether the officer is entitled to quasi-judicial or derived judicial immunity, (4) whether the plaintiff seeks a personal judgment against the officer and (5) whether the claims seek relief for breach of fiduciary duty, through either negligent or willful conduct.

Id. at 1096 (citing In re Kashani, 190 B.R. 875, 886–87 (9th Cir. BAP 1995)(also holding that satisfaction of any “one . . . factor[] may be a basis for the bankruptcy court to retain jurisdiction.”)). Because the fourth factor was satisfied by Blixseth’s seeking of a personal judgment against Brown, the Ninth Circuit held that the bankruptcy court did not err in denying Blixseth authority to sue Brown in district court.

Finally, the Ninth Circuit addressed Blixseth’s argument that the bankruptcy court lacked authority when it decided his claims against Brown. Brown asserted that Blixseth consented to the court’s authority, but there was no express consent and, in fact, Blixseth sought through his motion to litigate in district court. Further, Blixseth argued that the bankruptcy court exceeded its authority under Stern v. Marshall, 564 U.S. 462 (2011), which prohibits bankruptcy courts from adjudicating common law claims that are not constitutionally core to bankruptcy. However, the Ninth Circuit found that because Barton claims necessarily “stem[] from the bankruptcy itself,” Stern does not preclude bankruptcy courts from adjudicating such claims. The court ultimately remanded the case to the bankruptcy court to determine whether, with respect to Blixseth’s claims based on Brown’s postpetition conduct, Brown acted within the scope of his authority and with proper disclosures and, therefore, was entitled to derived judicial immunity for his acts as UCC chair.

Analysis

Though its facts are unique, this Ninth Circuit decision sets an important precedent by expressly extending the protections of Barton to members of creditors’ committees. A committee can play an important role in a chapter 11 case—supervising the actions of the debtor in possession, investigating the debtor’s business and financial affairs, participating in the plan process, and otherwise advocating on behalf of all of the unsecured creditors. In some cases, a committee may be the only party with an economic interest in the case actively participating to ensure that the debtor is held accountable and is acting in the best interests of the estate. Accordingly, it makes sense to afford to committee members the same protections from suit in an outside forum afforded to trustees. A contrary decision would, as the court observed, chill committee actions. More than that, a contrary decision could dissuade creditors considering participation on a committee from doing so, which could ultimately detriment the bankruptcy system by minimizing the involvement of committees. This decision, however, should give comfort to creditors willing to serve as members of committees that their actions, if properly disclosed and authorized, will be subject to derived judicial immunity as well as protection from suit in an outside court pursuant to the Bartondoctrine—the same important protections long enjoyed by trustees.

These materials were written by Zev Shechtman of Danning, Gill, Diamond & Kollitz, LLP, in Los Angeles (ZShechtman@dgdk.com). Editorial contributions were provided by Kyra E. Andrassy of Smiley Wang-Ekvall, LLP in Costa Mesa.

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee

Co-Chair
Asa S. Hami
SulmeyerKupetz, A Professional Corporation
ahami@sulmeyerlaw.com

Co-Chair
Reno Fernandez
Macdonald Fernandez LLP
Reno@MacFern.com

Co-Vice Chair
Radmila A. Fulton
Law Offices Radmila A. Fulton
Radmila@RFultonLaw.com

Co-Vice Chair
John N. Tedford, IV
Danning, Gill, Diamond & Kollitz, LLP
JTedford@dgdk.com

Dear constituency list members of the Insolvency Law Committee:

In April 2016, the Supreme Court submitted to Congress proposed revisions to the Federal Rules of Appellate Procedure (“FRAP”), Federal Rules of Bankruptcy Procedure (“FRBP”), and Federal Rules of Civil Procedure (“FRCP”).  The proposed revisions will go in effect on December 1, 2016, unless Congress rejects or defers the proposed amendments.

The entire package of materials transmitted to Congress may be accessed here: http://bit.ly/2fms8Kk.  Some of the proposed revisions are described below.

Bankruptcy Rule 9006(f) – Elimination of the 3-day rule when papers are served by electronic means

Current FRBP 9006(f) provides that when a party may or must act within a prescribed period after being served “and that service is by mail or under [FRCP] 5(b)(2)(D), (E), or (F),” 3 days are added to the period.  FRCP 5(b)(2)(E) allows for service of papers by electronic means.  Therefore, under the current rules, if a movant serves notice of a motion electronically and parties have 14 days from the date of service to file an opposition, an opposing party actually has at least 17 days to file its opposition.

Under revised FRBP 9006(f), service by electronic means is effective upon service.  Three days will be added only if service is by mail or under FRCP 5(b)(2)(D) (leaving with the clerk) or (F) (other means consented to).

As discussed below, similar changes are being made to the FRAP and FRCP, where all parties in each case are more likely to be (a) small in number and (b) CM/ECF users.  Eliminating the 3-day rule when parties are served via the court’s Notice of Electronic Filing (“NEF”) system generally makes sense, but the overall benefit of eliminating the rule may prove small since many notices are served by mail on at least one recipient.  The revision may also create unnecessary confusion, since one class of creditors (NEF recipients) will have a certain amount of time to act while others (mail recipients) will have additional time.  In jurisdictions such as the Central District of California, where movants can file motions and give notice that parties have 14 days to file objections and request hearings, courts must now do more to ensure that movants wait the right amount of time before filing declarations of non-opposition and lodging proposed orders.  (The Central District has also started the process of revising its local bankruptcy forms to conform to the revised FRBP 9006(f).)

Bankruptcy Rules 7008, 7012, 7016, 9027 and 9033 – The “Stern Amendments”

Proposed “Stern Amendments” were submitted to the Supreme Court in 2013, withdrawn a few months later because the Court granted cert in Arkison, and resubmitted after Wellness was decided in 2015.  Generally, the revisions remove the terms “core” and “non-core” to avoid possible confusion in light of Stern, require all parties to state whether they consent to the entry of final orders and judgment by the bankruptcy court, and revise the pretrial procedures to direct bankruptcy courts to decide how each proceeding should be treated.

Current FRBP 7008 provides that a complaint or similar pleading must state whether the proceeding is core or non-core and, if non-core, whether the pleader consents to entry of final orders or judgment by the bankruptcy court.  Revised FRBP 7008 eliminates the need to state whether the proceeding is core or non-core.  Now, regardless of whether the proceeding is core or non-core, the pleading must state whether the pleader consents to entry of final orders or judgment.

Similarly, revised FRBP 7012(b) eliminates the need for a defendant to admit or deny an allegation that the proceeding is core or non-core.  Instead, in both types of proceedings, a responsive pleading must state whether the party consents to entry of final orders or judgment.

Likewise, revised FRBP 9027(a)(1) and (e)(3) require that, when an action is removed to the bankruptcy court, the parties who have filed pleadings must state whether they consent to entry of final orders or judgment by the bankruptcy court, regardless of whether the proceeding is core or non-core.

Current FRBP 7016 simply provides that FRCP 16 applies in adversary proceedings.  New FRBP 7016(b) also provides that a bankruptcy court must decide, on its own motion or a party’s timely motion, whether (1) to hear and determine the proceeding, (2) to hear the proceeding and issue proposed findings of fact and conclusions of law, or (3) to take some other action.

Bankruptcy Rule 3002.1 – Notices given in chapter 13 cases by creditors holding claims secured by debtors’ principal residences

Current FRBP 3002.1 provides that, in chapter 13 cases, creditors whose claims are secured by the debtor’s principal residence must provide the debtor and the trustee notice of any changes in the periodic payment amount or the assessment of any fees or charges during the bankruptcy case.  Revised FRBP 3002.1(a) provides that, unless the court orders otherwise, the notice requirements cease to apply when an order terminating or annulling the automatic stay becomes effective with respect to the residence that secures the claim.

Appellate Rule 26(c) – Elimination of the 3-day rule when papers are served by electronic means (and the Ninth Circuit’s retention of the 3-day rule)

FRAP 26(c) provides that when a party may or must act within a specified time after being served, 3 days are added to the period unless the paper is actually delivered on the date stated in the proof of service.  Currently, a paper served electronically is not treated as having been delivered on the date stated in the proof of service.  Under revised FRAP 26(c), a paper served electronically is treated as having been delivered on the date stated in the proof of service.

However, practitioners should be aware that the Ninth Circuit’s Circuit Rule 26-2 (adopted in 2009) provides that “[t]he 3-day service allowance provided by FRAP 26(c) applies to documents served by the Appellate CM/ECF system pursuant to Circuit Rule 25-5.”  According to a recent Ninth Circuit notice, Circuit Rule 26-2 will remain in force notwithstanding revised FRAP 26(c).

Appellate Rules 28.1(e), 29, and 32(a)(7) – Reduction of word limits for briefs filed by parties and amici (and the Ninth Circuit’s retention of the existing word limits)

Current word limits are based on an estimate of 280 words per page.  Responding to concerns about the length of appellate briefs, the conversion ratio is being reduced to 260 words per page.  However, as noted below, the Ninth Circuit has adopted new local rules which maintain the current word limits.

Under revised FRAP 32(a)(7), in an appeal not involving cross-appeals, the appellant’s and appellee’s principal briefs must not exceed 13,000 words (down from 14,000), and the appellant’s reply brief must not exceed 6,500 words (down from 7,000).

Similarly, under revised FRAP 28.1(e), in an appeal involving cross-appeals, the appellant’s principal brief must not exceed 13,000 words (down from 14,000), the appellee’s principal and response brief must not exceed 15,300 words (down from 16,500), the appellant’s response and reply brief must not exceed 13,000 words (down from 14,000), and the appellee’s reply brief must not exceed 6,500 words (down from 7,000).

These changes also affect the word limits for amicus briefs addressing the merits of an appeal, which are limited to one half of the length set by the rules for a party’s principal brief.  Also, under new FRAP 29(b), which applies to amicus briefs addressing whether the court should grant a panel rehearing or rehearing en banc, such amicus briefs are limited to 2,600 words.

However, by local rule or order in a particular case, a court of appeals may accept documents that do not satisfy these length limits.  The Ninth Circuit has adopted new local rules, effective December 1, 2016, which “opt out” of the proposed reductions and maintain the existing word limits for briefs (http://bit.ly/2g3Ipnl).

Appellate Rules 27(d), 35(b) and 40(b) – Word limits for certain motions and petitions (and the Ninth Circuit’s retention of the existing page limits for motions)

These rules are revised to impose word limits instead of page limits when filers produce certain motions and petitions using a computer.  However, as noted below, the Ninth Circuit has adopted new local rules which effectively maintain some of the current page limits.

Current FRAP 27(d) generally provides that a motion or a response to a motion must not exceed 20 pages, and a reply must not exceed 10 pages.  Under revised FRAP 27(d), motions and responses to motions produced using a computer must not exceed 5,200 words, and replies produced using a computer must not exceed 2,600 words.

However, the Ninth Circuit’s local rules retain existing page limits.  New Circuit Rule 27-1(1)(d) reinstates the 20/10 page limits for motions, responses and replies.  In addition, revised Circuit Rule 32-3 provides that when “an order or rule of this Court” imposes a page limit for a brief or other document, a party may comply with the limit by filing a brief or document “in which the word count, divided by 280, does not exceed the designated page limit.”

Current FRAP 35(b) provides that a petition for an en banc hearing or rehearing must not exceed 15 pages.  Similarly, current FRAP 40(b) provides that a petition for a panel rehearing must not exceed 15 pages.  Under revised FRAP 35(b) and 40(b), such petitions produced using a computer must not exceed 3,900 words.

However, the Ninth Circuit’s revised Circuit Rule 40-1(a) provides that a petition for a panel rehearing or rehearing en banc, and any answer, may not exceed 15 pages unless it contains no more than 4,200 words.

Corresponding word limits in FRBP 8001 et seq. have NOT been reduced

In 2014, many rules in Part VIII of the FRBP were revised to mirror the FRAP.  For example, like current FRAP 32(a)(7), FRBP 8015(a)(7) provides for type-volume limitations of 14,000 words for principal briefs and 7,000 words for reply briefs.  When the Judicial Conference Committee on Rules of Practice and Procedure proposed to reduce the word limits in the FRAP, it did not propose reductions to the corresponding word limits in the FRBP.

The Advisory Committee on Bankruptcy Rules recently submitted proposed amendments to bring Part VIII of the FRBP into conformity with the pending amendments to the FRAP.  The public comment period for the proposed amendments to Part VIII started on August 15, 2016, and will end on February 15, 2017.  Assuming that these proposals follow the usual course, they are on track to become effective December 1, 2018.

Civil Rule 6(d) – Elimination of the 3-day rule when papers are served by electronic means

Like FRBP 9006(f) and FRAP 26(c), FRCP 6(d) is revised so that the 3-day rule does not apply when a party is served by electronic means under FRCP 5(b)(2)(E).

These materials were written by John N. Tedford, IV, of Danning, Gill, Diamond & Kollitz, LLP, in Los Angeles, California (jtedford@dgdk.com).  Editorial contributions were provided by Kyra E. Andrassy of Smiley Wang-Ekvall, LLP in Costa Mesa, California. 

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee

Co-Chair
Asa S. Hami
SulmeyerKupetz, A Professional Corporation
ahami@sulmeyerlaw.com

Co-Chair
Reno Fernandez
Macdonald Fernandez LLP
Reno@MacFern.com

Co-Vice Chair
Radmila A. Fulton
Law Offices Radmila A. Fulton
Radmila@RFultonLaw.com

Co-Vice Chair
John N. Tedford, IV
Danning, Gill, Diamond & Kollitz, LLP
JTedford@dgdk.com

SUMMARY

Last December, in United States v. Martin (In re Martin), 542 B.R. 479 (9th Cir. BAP 2015), the U.S. Bankruptcy Appellate Panel of the Ninth Circuit rejected recent circuit court decisions holding that an untimely Form 1040 is not, by definition, a “return” for purposes of determining whether a tax debt is dischargeable.  The BAP instead ruled that a court must examine the totality of the circumstances to determine whether the purported return was “an honest and reasonable attempt to satisfy the requirements of the tax law.”  To read the full published decision, click here:  http://1.usa.gov/1JziPUx.

When the BAP issued its ruling in December, this issue was already pending before the U.S. Court of Appeals for the Ninth Circuit.  On July 13, 2016, in Smith v. IRS (In re Smith), 828 F.3d 1094 (9th Cir. July 13, 2016), the Ninth Circuit declined to rule on the question of whether an untimely Form 1040 filed after an assessment can ever be a “return” for dischargeability purposes.  Instead, based on the facts of the case, the Ninth Circuit agreed with the lower court’s determination that the debtor had not made an honest and reasonable attempt to satisfy the requirements of the tax law.  To read the full published decision, click here: http://bit.ly/2bUkKrf.

BACKGROUND

Section 523(a)(1)(B) excepts from discharge a tax debt “with respect to which a [required] return . . . (i) was not filed or given; or (ii) was filed or given after the date on which such return . . . was last due . . . and after two years before the date of the filing of the petition.”  Also, section 523(a)(1)(C) excepts from discharge a tax debt “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”

Prior to BAPCPA, the term “return” was undefined in the Bankruptcy Code.  In determining whether a particular document qualified as a “return,” most courts adopted the following test developed by the Tax Court in Beard v. Commissioner of Internal Revenue, 82 T.C. 766, 777 (1984):

(1) there must be sufficient data to calculate tax liability;
(2) the document must purport to be a return;
(3) there must be an honest and reasonable attempt to satisfy the   requirements of the tax law; and
(4) the taxpayer must execute the return under penalty of perjury.

In 2005, BAPCPA added a “hanging paragraph” at the end of section 523(a).  For purposes of section 523(a), “the term ‘return’ means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements). Such term includes a return prepared pursuant to section 6020(a) of the Internal Revenue Code of 1986, or similar State or local law, or a written stipulation to a judgment or a final order entered by a nonbankruptcy tribunal, but does not include a return made pursuant to section 6020(b) of the Internal Revenue Code of 1986, or a similar State or local law.”  11 U.S.C. § 523(a) (emphasis added).

Particularly since BAPCPA was enacted, courts have struggled to determine when a filing constitutes a “return” for purposes of section 523(a)(1).  Four different approaches have been adopted:

(1) under the harsh “One-Day-Late Approach,” an untimely Form 1040 is not a return, even if it is filed only one day late;

(2) under the less harsh “Post-Assessment Approach,” a Form 1040 is not a return if it is filed after the IRS makes an assessment;

(3) under the “Totality-of-the-Circumstances Approach,” courts must take into account not just the timing of the tax filing, but also any evidence of the debtor’s good faith attempts to comply with the tax laws; and

(4) under the “No-Time-Limit Approach,” whether a document evinces an honest and genuine attempt to satisfy the tax laws depends on its form and content, not on when it is filed.

There is also a fifth approach – one favored by the IRS – which does not appear to have been adopted by any court.

IN RE MARTIN

In Martin, the debtors did not timely file Form 1040s for 2004, 2005 or 2006.  The IRS issued a notice of deficiency, at which point the debtors hired an accountant to prepare their tax forms.  The accountant completed and signed the Form 1040s in late 2008, but the debtors did not get around to signing and filing them until six months later.  Unfortunately for the debtors, the IRS made assessments, and started sending notices of the unpaid taxes, a few months before their Form 1040s were filed.  After the debtors filed their Form 1040s, the IRS accepted the Form 1040s and adjusted their tax liability based on the information set forth therein.

A few years later, the debtors filed for bankruptcy and filed a complaint seeking a determination that their tax debt was dischargeable.  The IRS argued that the debt was nondischargeable merely because the debt recorded by its assessment was not one with respect to which a return had been filed (this is the “IRS Approach”).

The bankruptcy court rejected the IRS Approach, adopted the No-Time-Limit Approach represented by the Eighth Circuit’s decision in In re Colsen, 446 F.3d 836 (8th Cir. 2006), and entered summary judgment in favor of the debtors.  The IRS appealed.

The BAP concluded that (at least as to federal tax returns) the hanging paragraph effectively codified the Beard test applied by courts prior to BAPCPA, except with certain enumerated exceptions not relevant to the appeal.  Therefore, the BAP examined the Ninth Circuit’s pre-BAPCPA adoption and application of the Beard test in In re Hatton, 220 F.3d 1057 (9th Cir. 2000).

According to the BAP, the Ninth Circuit held in Hatton “that we should use [the] version of the Beard test [adopted by the Sixth Circuit in In re Hindenlang, 164 F.3d 1029 (6th Cir. 1999)] . . . to determine whether the [debtors’] untimely tax returns qualify as tax returns for nondischargeability purposes.”  However, according to the BAP, the Ninth Circuit in Hatton did not actually adopt the Post-Assessment Approach adopted by the Sixth Circuit in that case.  Instead, based on how the Ninth Circuit analyzed the facts, the BAP concluded that the Ninth Circuit followed a Totality-of-the-Circumstances Approach.

Having concluded that the bankruptcy court incorrectly adopted the No-Time-Limit Approach, the BAP vacated the bankruptcy court’s judgment and remanded for further proceedings.  The BAP directed the bankruptcy court to consider “the number of missing returns, the length of the delay, the reasons for the delay, and any other circumstances reasonably pertaining to the honesty and reasonableness of the [debtors’] efforts.”

IN RE SMITH

In Smith, the debtor did not timely file a Form 1040 for 2001.  The IRS issued a notice of deficiency in 2006, which the debtor did not contest.  Instead, in 2009, the debtor filed a Form 1040 which purported to replace the “Substitute for Return” previously prepared by the IRS based on information it gathered from third parties.  The debtor’s Form 1040 actually reported a higher income than that previously calculated by the IRS, thereby increasing his tax liability.

After some time, the debtor filed for bankruptcy and sought to discharge his 2001 tax liability.  The question was whether the amount originally assessed by the IRS was dischargeable.  The bankruptcy court ruled that it was.  However, the district court reversed, adopting the Totality-of-the-Circumstances Approach.  In re Smith, 527 B.R. 14 (N.D. Cal. 2014).  The debtor appealed.

The Ninth Circuit did not expressly rule in favor of any one particular approach, but it acknowledged Hatton as binding precedent for these situations.  The panel expressly declined to decide whether a Form 1040 filed after the IRS makes an assessment can be a “return” for purposes of section 523(a) pursuant to the Post-Assessment Approach, and it passed on deciding the merits of the IRS Approach.  The court also did not consider, at least expressly, the One-Day-Late Approach or the No-Time-Limit Approach.  Instead, the court looked at the facts and determined that, in light of the amount of time the debtor waited to file his Form 1040, his “belated acceptance of responsibility” was not an honest and reasonable attempt to comply with the tax code, and therefore his Form 1040 did not qualify as a return for purposes of section 523(a)(1).

AUTHOR’S COMMENTARY

In light of Smith, courts in this circuit will likely follow either the Post-Assessment Approach (a Form 1040 is not a return if it is filed after the IRS makes an assessment) or the Totality-of-the-Circumstances Approach (courts must take into account not just the timing of the tax filing, but also any evidence of the debtor’s good faith attempts to comply with the tax laws).  Courts following the latter approach will examine the number of missing returns, the length of the delay, the reasons for the delay, and any other circumstances reasonably pertaining to the honesty and reasonableness of the debtor’s efforts.

However, in the author’s view, the No-Time-Limit approach is correct.  This is the approach adopted by the Eighth Circuit in Colson (a pre-BAPCPA case applying the Beard test) and by Judge Lee in Martin.  See In re Martin, 508 B.R. 717 (Bankr. E.D. Cal. 2014).  Based on the legislative history of the hanging paragraph, the origins of the Beard test, the Supreme Court’s decision in Badaracco v. Commissioner of Internal Revenue, 464 U.S. 386 (1984) (even if a Form 1040 is admittedly fraudulent, it is still a “return” unless the fraud is evident from the face of the document), and the existence of section 523(a)(1)(C), the author believes that whether a document evinces an honest and genuine attempt to satisfy the tax laws depends on its form and content, not on when it is filed.

This does not mean that dishonest debtors are off the hook.  Under section 523(a)(1)(C), a tax debt will not be discharged if the debtor filed a “fraudulent return,” or if the debtor “willfully attempted in any manner to evade or defeat such tax.”  The number of missing returns, the length of delay in filing returns, the reasons for such delay, and other circumstances pertaining to the honesty and reasonableness of the debtor’s efforts should be considered in connection with this inquiry under section 523(a)(1)(C).  But they should not be considered when determining whether a Form 1040 constitutes a “return” for purposes of section 523(a)(1).

Given the split among the circuits regarding the proper interpretation of the word “return” in section 523(a), this issue seems ripe for Supreme Court review.  The debtor in Smith filed a petition for certiorari on October 11, 2016, and responses to the petition are due in mid-November.  Martin actually would be a better vehicle for Supreme Court review, but since Martin was remanded for further fact-finding that case cannot reach the Supreme Court anytime soon.

These materials were written by John N. Tedford, IV, of Danning, Gill, Diamond & Kollitz, LLP, in Los Angeles, California (jtedford@dgdk.com).  Editorial contributions were provided by Michael T. O’Halloran of the Law Office of Michael T. O’Halloran in San Diego, California.

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee

Co-Chair
Asa S. Hami
SulmeyerKupetz, A Professional Corporation
Ahami@sulmeyerlaw.com

Co-Chair
Reno Fernandez
Macdonald Fernandez LLP
Reno@MacFern.com

Co-Vice Chair
Radmila A. Fulton
Law Offices Radmila A. Fulton
Radmila@RFultonLaw.com

Co-Vice Chair
John N. Tedford, IV
Danning, Gill, Diamond & Kollitz, LLP
JTedford@dgdk.com

This publication is in downloadable PDF form.

This publication is in downloadable PDF form.

SUMMARY
In Ly v. Che (In re Ly), 2015 WL 1787575 (9th Cir. Apr. 21, 2015), the U.S. Court of Appeals for the Ninth Circuit affirmed the BAP’s issuance of sanctions against an appellant and its attorney for filing a frivolous appeal, but declined to issue further sanctions because (a) the BAP cases that foreclosed the appellant’s arguments were not binding on the Ninth Circuit, and (b) a non-frivolous argument could be made that the reasoning of those BAP cases should not be adopted by the Ninth Circuit.

To read the full, unpublished decision, click here:  1.usa.gov/1T7Xqn6.

FACTUAL BACKGROUND[1]
In 2006, a forged deed was recorded with the L.A. County’s recorder’s office, purporting to transfer title of certain residential real property from Michelle Che (“Che”) to occupant Alen Ly (“Ly”).  When Che found out about it, she sued Ly and obtained a default judgment declaring the deed void and enjoining Ly from coming within 100 yards of the property.  Ly apparently refused to move out.

Ly filed for bankruptcy in April 2012; in his schedules he claimed to own the property.  A few months later, Che filed a motion for relief from stay to commence eviction proceedings.  Ly opposed the motion on the grounds that Che was not a real party in interest, and lacked standing to seek relief, because Ly had allegedly purchased the property from Che in July 2006.  Ly claimed that he had retained counsel to handle the state court litigation, and was shocked when he later received a 5-day notice to quit.

The bankruptcy court granted Che’s motion for relief from stay, and Ly appealed to the BAP.  Che responded by, among other things, filing a motion asking the BAP to sanction Ly and his counsel for filing a frivolous appeal.  Ly did not file any response to the motion.

In an unpublished decision, the BAP affirmed.  In doing so, the BAP referred to two cases it published in 2011 holding that a party moving for stay relief has a colorable claim sufficient to establish standing to prosecute the motion if it has an ownership interest in the subject property.  See Veal v. Am. Home Mortg. Servicing, Inc. (In re Veal), 450 B.R. 897, 913 (9th Cir. BAP 2011); Edwards v. Wells Fargo Bank, N.A. (In re Edwards), 454 B.R. 100, 105 (9th Cir. BAP 2011).

The BAP also sanctioned Ly and his counsel pursuant to FRBP 8020.  The BAP identified two reasons for its issuance of sanctions.  First,

Second, the BAP found it “particularly troubling” that when Ly’s counsel filed Ly’s original excerpts of the record, he omitted exhibits to declarations filed in support of Che’s motion for relief from stay (including the certified copy of the judgment), though he did include exhibits to his own declaration.  Ly’s counsel “had to be aware that the Judgment was a critical part of the evidentiary record before the bankruptcy court supporting its finding that Che had standing to seek stay relief.”  Ly’s counsel only supplemented the excerpts of the record to include the judgment after the BAP’s motions panel ordered Ly “to supplement the record with a complete copy, ‘including exhibits,’ of the Stay Motion.”

Ly appealed the BAP’s affirmance of the bankruptcy court’s order, and the BAP’s issuance of sanctions, to the Ninth Circuit.  Che responded by filing a motion with the Ninth Circuit requesting additional sanctions against Ly and his counsel.

NINTH CIRCUIT’S RULING AND REASONING
First, the Ninth Circuit easily affirmed the BAP’s affirmance of the bankruptcy court’s order granting relief from stay.

Second, the Ninth Circuit ruled that the BAP did not abuse its discretion in sanctioning Ly and his attorney for filing a frivolous appeal. “Given the case law directly contradicting [Ly’s] position [i.e., Veal and Edwards], the result of Ly’s appeal was obvious and his arguments were ‘wholly without merit.’”

However, applying the exact same standard that the BAP applied when it issued its sanctions, the Ninth Circuit declined to issue further sanctions against Ly and his attorney because “the cases that foreclosed Ly’s arguments before the BAP, [Veal] and [Edwards], are not binding on this court.  Accordingly, because a non-frivolous argument could be made that the reasoning of those cases should not be adopted by this Court, although no such argument was made, we decline to impose sanctions for a frivolous appeal in the exercise of our discretion.”

AUTHOR’S COMMENTARY
Based on the facts described in the BAP’s decision, Che clearly had standing to move for relief from stay and Ly’s appeal was frivolous.  But mixed signals from the Ninth Circuit make this decision notable.  While a circuit court can certainly exercise its own discretion in deciding whether to issue sanctions, how can the further appeal to the circuit court be considered non-frivolous where the circuit court affirms a lower court’s issuance of sanctions for filing a frivolous appeal?

In any event, litigants who intend to challenge a prior BAP ruling before the circuit court should elect to proceed before the district court or should be certain to make a non-frivolous argument that the prior BAP decision should be overruled.  Otherwise, even if a non-frivolous argument could be made that the BAP’s prior ruling should not be adopted by the circuit court, a party and counsel risk sanctions simply because the BAP considers its published rulings binding on subsequent panels.  See Ball v. Payco-Gen. Am. Credits, Inc. (In re Ball), 185 B.R. 595, 597 (9th Cir. BAP 1995) (“[w]e will not overrule our prior rulings unless a Ninth Circuit Court of Appeals decision, Supreme Court decision or subsequent legislation has undermined those rulings.”); Inst. of Imaginal Studies v. Christoff (In re Christoff), 527 B.R. 624, 634 (9th Cir. BAP 2015).

These materials were written by John N. Tedford, IV, of Danning, Gill, Diamond & Kollitz, LLP (jtedford@dgdk.com).  Editorial contributions were provided by Everett L. Green of the Insolvency Law Committee. 

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee

Return to  John N. Tedford, IV 

INTRODUCTION
A creditor with a lien against property subject to a sale under the Bankruptcy Code generally is entitled to bid the value of its claim. This avenue for lenders to recover on their collateral may also be an opportunity for distressed asset investors. Looking for a market advantage, investors may seek to acquire loans and the associated liens with an eye toward foreclosure or the acquisition of the property outright through a section 363 sale. The credit bid is an attractive option to the purchaser who may have acquired the underlying loan rights at a steep discount. However, such a venture will not always be welcome by the trustee or debtor seeking to maximize the recovery from the sale of an estate asset.

THE STATUTE
11 U.S.C. § 363(k) provides as follows:

At a sale under subsection (b) of this section of property that is subject to a lien that secures an allowed claim, unless the court for cause orders otherwise the holder of such claim may bid at such sale, and, if the holder of such claim purchases such property, such holder may offset such claim against the purchase price of such property.

This provision warrants some unpacking. While the right to credit bid is an important right to creditors, this right is by no means absolute, as the bankruptcy court may “for cause” deny the right to credit bid.

THRESHOLD ISSUES
As a threshold matter, a party seeking to credit bid must have a valid secured claim. If the secured claim is subject to dispute at the time of the sale under section 363, the bankruptcy court may not allow the creditor to credit bid, or may allow the creditor to credit bid provisionally, requiring the creditor to pay in cash if the claim is reduced or the lien is invalidated.[1]

Another barrier to credit bidding is lien seniority. A junior lienholder may be barred from credit bidding where the collateral is so far underwater that the lien itself has no value.[2]

When such issues are overcome, there are yet other reasons, having more to do with the equities and the economics of the particular sale and case, that may constitute cause to deny the right to credit bid.

RadLAX
There is a line of cases in which the trustee or debtor-in-possession seeks to sell property without credit bidding. The most recent Supreme Court decision on the issue is RadLAX Gateway Hotel, LLC v. Amalgamated Bank, 132 S. Ct. 2065 (2012). The debtors in RadLAX purchased the Radisson Hotel at the Los Angeles International Airport in 2007. The debtors owed the bank $120 million when they filed for chapter 11 protection in 2009. The debtors proposed a chapter 11 plan which contemplated sale of the property, and which would require the bank to bid in cash. The bank objected. Turning to the “cramdown” provisions of section 1129(b), under which a debtor may confirm a plan over creditors’ objections, the Court determined that the denial of the right to credit bid was impermissible under the circumstances. Section 1129(b)(2)(A)(ii) provides:

For the purpose of this subsection, the condition that a plan be fair and equitable with respect to a class includes the following requirements:

(A)With respect to a class of secured claims, the plan provides—…

(ii) for the sale, subject to section 363…(k) of this title, of any property that is subject to the liens securing such claims, free and clear of such liens, with such liens to attach to the proceeds of such sale, and the treatment of such liens on proceeds under clause (i) or (iii) of this subparagraph.

The debtors argued that they need not satisfy 1129(b)(2)(A)(ii) because they satisfied 1129(b)(2)(A)(iii), which provides:

    (A)With respect to a class of secured claims, the plan provides—…

(iii)for the realization by such holders of the indubitable equivalent of such claims.

The debtors reasoned that by paying the bank from sale proceeds, the debtors would be giving the bank the “indubitable equivalent” of its secured claim. The Court rejected this argument based on a basic canon of statutory interpretation—“that the specific governs the general.” Since (A)(ii) is specific to sales, it governs. In a footnote, the Court mentioned that that the bankruptcy court had found that there was no “cause” to deny credit bidding under section 363(k).[3]

“CAUSE” TO DENY THE RIGHT TO CREDIT BID
“Cause” to deny the right to credit bid is not defined in the Bankruptcy Code. Besides the circumstances concerning the validity or value of the lien addressed above, Courts have generally found “cause” to exist where denial is “in the interest of any policy advanced by the Code, such as to ensure the success of the reorganization or to foster a competitive bidding environment.”[4] A finding that a party has engaged in misconduct vis-à-vis the estate may be cause to deny the right to credit bid.[5] Beyond such examples, courts have found that the chilling of bidding can constitute cause.[6] The court in Fisker Automotive Holdings denied credit bidding because, under the circumstances, it determined that credit bidding would have made an auction essentially impossible.[7] These issues will be discussed at greater length in a future Inforuptcy blog post. It is sufficient for our purposes to conclude that, notwithstanding the generally accepted importance of the right to credit bid,[8] “cause” can be a fairly broad concept limiting, or eliminating, the right in many cases.

THE “FULL CREDIT BID”
As a final consideration in this overview, it must be noted that the concept of credit bidding is enshrined under nonbankruptcy law.[9] Under nonbankruptcy law, the “full credit bid” (that is an amount equal to the unpaid principal, interest and foreclosure expense) has the effect of extinguishing the creditor’s rights and remedies, including against guarantors and insurers. Thus, it should be exercised with caution.[10]

CONCLUSION
The credit bid in bankruptcy is a potentially powerful tool and valuable asset to creditors and distressed property investors. It must however be approached and exercised with knowledge of the potential pitfalls.

__________________________________

Return to Zev Shechtman, Partner

SUMMARY:

A Michigan bankruptcy court recently held that the doctrine of sovereign immunity is abrogated by 11 U.S.C. § 106(a)(1) with respect to a bankruptcy trustee’s action to avoid fraudulent transfers against a branch of the state under 11 U.S.C. § 544(b)(1). The court found that the requirement that an “actual creditor” be able to assert a fraudulent transfer action under applicable bankruptcy law did not make the doctrine of sovereign immunity applicable notwithstanding the express language of section 106(a)(1). Kohut v. Wayne Cnty. Treasurer (In re Lewiston), 528 B.R. 387 (Bankr. E.D. Mich. 2015).

FACTS:

The chapter 7 trustee filed a complaint against the county to avoid and recover $307,602.83 in fraudulent transfers pursuant to 11 U.S.C. §§ 544(b)(1) and 550. The individual debtor was a real estate developer. During the six years prior to his bankruptcy filing, the debtor personally made transfers to the county to pay taxes and fees owed by his real estate projects. The debtor had no legal obligation to personally pay the taxes; the debtor’s projects were insolvent when he made the transfers to the county; and the debtor received no benefit in exchange for his payments to the county. The county moved to dismiss the complaint based primarily on the doctrine of sovereign immunity.

The trustee brought the complaint under 11 U.S.C. § 544(b)(1) which allows a trustee to avoid transfers that an unsecured creditor of the debtor could avoid pursuant to applicable nonbankruptcy law. Pursuant to section 544(b)(1), the trustee brought the complaint under the Michigan Uniform Fraudulent Transfer Act (“MUFTA”). The court noted two significant differences between a cause of action brought under 11 U.S.C. § 548 (the Bankruptcy Code’s fraudulent transfer statute) and one brought under MUFTA pursuant to section 544(b)(1): (1) MUFTA allows the avoidance of fraudulent transfers made within six years before the filing of the complaint while section 548 has a shorter two year reach back period; and (2) section 544(b)(1) requires that an actual unsecured creditor could have brought the fraudulent transfer claim under applicable nonbankruptcy law.

In its motion to dismiss, the county contended that an actual unsecured creditor could not bring the MUFTA cause of action under applicable nonbankruptcy law because the doctrine of sovereign immunity bars causes of action against the county. The county argued that it is a political subdivision of the state and thus is immune from suit unless it consents under the 11th Amendment of the United States Constitution and Michigan state law. See Pohutski v. City of Allen Park, 641 N.W.2d 219 (Mich. 2002). The trustee generally did not dispute these claims, but argued that the county’s sovereign immunity was expressly waived under 11 U.S.C. § 106(a)(1), which provides that “[n]otwithstanding an assertion of sovereign immunity, sovereign immunity is abrogated as to a governmental unit to the extent set forth in this section with respect to” section 544, among various other specifically enumerated Bankruptcy Code sections.

The county conceded that section 106(a)(1) abrogates sovereign immunity with respect to section 544 and did not attempt to challenge the holding of the United States Supreme Court in Central Virginia Community College v. Katz, 546 U.S. 356 (2006), which upholds the power of Congress to abrogate states’ sovereign immunity in enacting bankruptcy laws pursuant to the Bankruptcy Clause (Art. I, § 8, cl. 4). Rather, the county’s argument was that since an “actual” creditor under nonbankruptcy law could not bring the cause of action because of sovereign immunity, neither could the trustee by virtue of section 544(b)(1).

REASONING:

The case law on this issue is split. The Seventh Circuit, the only circuit court to address the issue, found in In re Equipment Acquisition Resources, Inc. 742 F.3d 743 (7th Cir. 2014) that an action could not be brought against the I.R.S. under section 544(b)(1) because an actual creditor could not sue the Internal Revenue Service (“I.R.S.”) under the Illinois Uniform Fraudulent Transfer Act under the doctrine of sovereign immunity. Accord Dillworth v. Ginn (In re Ginn-La St. Lucie Ltd.), No. 10-2976-PGH, 2010 WL 8756757 (Bankr. S.D. Fla. Dec. 10, 2010); Pyfer v. Katzman (In re National Pool Construction, Inc.), no. 09-34394, 2015 WL 394507 (Bankr. D.N.J. Jan. 29, 2015).

On the other side, there are cases such as Zazzali v. Swenson (In re DBSI, Inc.), 463 B.R. 709 (Bankr. D. Del. 2012) which concluded, based on a textual analysis of section 106(a)(1), that the express abrogation of sovereign immunity with respect to section 544 was not consistent with the application of sovereign immunity under certain circumstances. Quoting another case, the court rhetorically inquired:

Why would Congress explicitly waive sovereign immunity for all other avoidance actions under the Bankruptcy Code, and include a waiver of sovereign immunity for actions under section 544 knowing that section 544 encompasses state law theories, but then require a separate waiver of sovereign immunity for the necessary state law component in actions under section 544? The argument offered by the United States defies logic.

In re DBSI, 463 B.R. at 717 (quoting Furr v. I.R.S. (In re Pharmacy Distributor Services, Inc., 455 B.R. 817, 821 (Bankr. S.D. Fla. 2011)). Accord VMI Liquidating Trust v. United States (In re Valley Mortgage Inc.), no. 12-01277-SBB, 2013 WL 5314369 (Bankr. D. Colo. Sept. 18, 2013).

Recognizing the split in the statutory interpretation, the Michigan bankruptcy court here concluded in favor of abrogation of sovereign immunity. The court reasoned:

The statute is susceptible to only one interpretation: it simply eliminates sovereign immunity however and whenever it applies “with respect to” the 59 sections of the Bankruptcy Code listed in § 106(a)(1). Section 544 is one of those sections. In this case, the Complaint is brought under § 544. That ends the inquiry. Wayne County cannot raise sovereign immunity as a defense to the Complaint under § 544 because sovereign immunity with respect to § 544 is unequivocally and unambiguously abrogated by § 106(a)(1).

The argument that the “actual creditor” requirement of section 544 cannot be met outside of bankruptcy because of sovereign immunity, the court concluded, did not pass logical muster. Indeed, an actual creditor could prevail, notwithstanding sovereign immunity, because section 106(a)(1) expressly abrogates sovereign immunity with respect to an action brought under section 544. Accordingly, the court denied the county’s motion to dismiss.

AUTHOR’S COMMENT:

The Insolvency Law Committee recently published an e-Bulletin regarding the above cited case of Pyfer v. Katzman (In re National Pool Construction, Inc.), no. 09-34394, 2015 WL 394507 (Bankr. D.N.J. Jan. 29, 2015), which came to the opposite result. As noted in the earlier e-Bulletin, the court in National Pool Construction did not provide a full discussion of case law coming out on the side of abrogation of sovereign immunity. Here, however, the court considered both sides of the argument and came out in favor of abrogation. What we are left with is a significant divide in the statutory interpretation, with one faction interpreting the “actual creditor” requirement in section 544 to come ahead of section 106(a)(1), and the other finding that the abrogation of sovereign immunity set forth in section 106(a)(1) as it applies to section 544 must be understood to apply to the underlying state law.

These materials were prepared by Zev Shechtman (zshechtman@dgdk.com) of Danning Gill Diamond & Kollitz LLP, Los Angeles, California. Editorial contributions were provided by ILC member Doris A. Kaelin, of Gordon & Rees LLP and Peter J. Gurfein (pgurfein@lgbfirm.com) ILC e-Bulletin co-editor-in-chief.

Return to Zev Shechtman, Partner