Sale of a Claim or Compromise of an Asset?

Bankruptcy trustees are authorized to use, sell or lease estate property.[1] Trustees are also authorized to enter into compromises or settlements on behalf of the estate.[2] Both sales outside of the ordinary course of business under section 363 of the Bankruptcy Code and compromises of disputes under rule 9019 of the Federal Rules of Bankruptcy Procedure require bankruptcy court approval after notice and a hearing. In general, sales, on one hand, and compromises, on the other, each require the satisfaction of different legal standards. When considering a sale under section 363, the court’s obligation is “to assure that optimal value is realized by the estate under the circumstances.”[3] When considering the approval of a compromise, the court must determine whether the proposed compromise is “fair and equitable,” which requires the consideration of four factors: (1) probability of success in litigation, (2) collectability; (3) complexity, expense, inconvenience and delay attendant to continued litigation; and (4) the “paramount” interest of the creditors.[4]

While settlements of disputes and sales of assets might generally seem like two clearly distinct and distinguishable events, there are circumstances, blurring the line between the two. For example, what happens if the trustee settles claims against a defendant for cash, but a creditor contends that the claims are worth more than what the trustee is getting for them? On the other hand, what if a trustee seeks to sell a property interest in the estate’s claims to a third party or even one of the litigants? What standard applies?

In the case of In re Mickey Thompson Enter. Grp., the trustee originally sought to compromise a dispute of potential fraudulent transfer claims. A creditor objected because a third party was willing to pay more than the settlement amount for the settled claims. Although the trustee first replied that he would set overbidding procedures in order to obtain the best sale price for the claims, at the hearing the trustee reversed course asserting that the original settlement was in the best interest of the estate “when he entered it” and that he was contractually bound by the agreement. Although the bankruptcy court decided that it could not substitute its judgment for the trustee’s, the Bankruptcy Appellate Panel for the Ninth Circuit Court of Appeals (“BAP”) reversed. The BAP found that both the standards for compromises and sales were implicated by the transaction. The BAP opined that any purported contractual obligation of the trustee was trumped by the duty to maximize estate assets.[5]

The case of In re Lahijani involved a trustee’s efforts to sell claims against the debtor and others to the highest bidder. The trustee sought from the sale an all-cash offer as opposed to a combination of cash and a percentage of the recovery from the lawsuit. The successful bidder was a company set up by the debtor’s co-defendant, who had no intention of actually prosecuting the claims. The unsuccessful bidder appealed. The BAP reversed because the bankruptcy court wrongly ruled solely based on the sale price, when it should have examined each factor of the fair and equitable test in order to approve what fundamentally was also a compromise.[6]

In In re Fitzgerald, the trustee sought to sell the estate’s interest in a certain company and litigation claims consisting of a pending cross-complaint in a pending action. The only bidders were the plaintiff/cross-defendant and the life partner of the debtor/defendant/cross-complainant. The bankruptcy court approved the sale based on a dollar-to-dollar comparison of the bids. However, in light of the relationships between the parties and the constrained competition due to the nature of the asset, the BAP found that the transaction required stricter scrutiny. Indeed, the BAP again found that the bankruptcy court should have applied the fair and equitable standard applicable to compromises.[7]

The lesson from this line of cases is that, when in doubt as to which standard applies in a contested transaction, a trustee or purchaser should ensure that both the “optimal value” standard for sales and the “fair and equitable” standard for compromises are fully satisfied.

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[1] 11 U.S.C § 363. With certain exceptions, chapter 11 debtors in possession are generally vested with the same rights and duties as trustees. See 11 U.S.C. § 1107.
[2] Fed. R. Bankr. P. 9019.
[3] In re Lahijani, 325 B.R. 282, 288 (B.A.P. 9th Cir. 2005).
[4] Id. at 290.
[5] In re Mickey Thompson Enter. Grp., 292 B.R. 415 (B.A.P. 9th Cir. 2003). The BAP suggested that the concern about a potential breach of contract by the trustee was misplaced since the agreement would only be enforceable after approval by the court. Id. at 421.
[6] Lahijani, 325 B.R. 282.
[7] In re Fitzgerald, 428 B.R. 872 (B.A.P. 9th Cir. 2010).

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Case Analysis: Elliott v. Weil (In re Elliott), ___ B.R. ___, 2014 WL 6972472 (9th Cir. BAP 2014), Insolvency Law e-Bulletin, Insol. L. Comm., Bus. L. Sec., Cal. State Bar (February 20, 2015).

SUMMARY

In Elliott v. Weil (In re Elliott), ___ B.R. ___, 2014 WL 6972472 (9th Cir. BAP 2014), the U.S. Bankruptcy Appellate Panel of the Ninth Circuit held that Law v. Siegel, ___ U.S. ___, 134 S.Ct. 1188 (2014), abrogated Ninth Circuit authority under which a debtor’s exemption could be denied, or under which a debtor could be denied the right to amend his or her exemptions, on the basis of bad faith or prejudice to creditors.

FACTUAL BACKGROUND

In an effort to conceal his Los Angeles home from judgment lien creditors, Edward Elliott (“Elliott”) transferred his residential real property to a business entity formed by the son of a former associate. The property was later transferred to another corporation formed and controlled by Elliott. Then, in December 2011, Elliott filed a chapter 7 petition. He failed to schedule any interest in the property or the corporation and he omitted certain judgment lien creditors. According to his schedules and testimony at his 341(a) meeting of creditors, he lived in Granada Hills and owned no real property. Relying on the schedules and Elliott’s testimony, the trustee filed a “no asset” report, Elliott was granted a discharge, and the case was closed.

A few weeks later, Elliott’s corporation quitclaimed the residence back to Elliott for no consideration. Elliott advised his judgment lien creditors that he acquired the property postpetition, and demanded that their judicial liens be removed. After an investigation, the judgment lien creditors successfully moved to reopen Elliott’s bankruptcy case.

In June 2013, the trustee filed a complaint for turnover of the property and revocation of Elliott’s discharge. In April 2014, the bankruptcy court granted summary judgment, revoked the discharge, vested title to the property in the trustee, and ordered that the property be turned over to the trustee. Elliott did not appeal the judgment.

While the adversary was pending, and almost one year after the case was reopened, Elliott amended his schedules to disclose an interest in the property and claim a $175,000 homestead exemption therein. The trustee objected to the claimed exemption due to Elliott’s bad faith concealment of the asset. The trustee also argued that Elliott could not claim a homestead exemption because he did not hold title to the property on the petition date. The bankruptcy court sustained the trustee’s objection on the basis that the debtor belatedly claimed the exemption in bad faith, but did not address the trustee’s alternative argument. Elliott appealed. Less than one month after the appeal was filed, the U.S. Supreme Court issued its decision in Law v. Siegel.

REASONING

The BAP first concluded that Law v. Siegel abrogated Ninth Circuit authority under which exemptions could be denied if a debtor acted in bad faith or creditors had been prejudiced. See Martinson v. Michael (In re Michael), 163 F.3d 526 (9th Cir. 1998); Arnold v. Gill (In re Arnold), 252 B.R. 778 (9th Cir. BAP 2000). Although the bankruptcy court’s ruling was supported by then-existing Ninth Circuit law, under Law v. Siegel, unless statutory power exists to do so, a bankruptcy court may not deny a debtor’s exemption claim – or bar a debtor from amending his or her exemptions – on the basis of bad faith or prejudice to creditors.

Second, the BAP addressed the trustee’s argument that Elliott could not claim a homestead exemption because he did not own the property on the petition date. The BAP held that for purposes of CCP § 704.730, continuous residency, not continuous ownership, controls the analysis. That exemption applies to any interest in the property so long as the debtor satisfies the continuous residency requirement set forth in CCP § 704.710(c). Because the bankruptcy court’s inquiry was confined to Elliott’s bad faith, the BAP remanded for the bankruptcy court to determine whether Elliott was, in fact, entitled to a homestead exemption under CCP § 704.730. Third, the BAP identified an alternative statutory basis for denying Elliott’s homestead exemption on remand. Section 522(g) provides that a debtor may claim an exemption in previously-transferred property that a trustee recovers under sections 510(c)(2), 542, 543, 550, 551 or 553 if “such transfer was not a voluntary transfer of such property by the debtor” and “the debtor did not conceal such property.” Since the trustee prevailed in her turnover action under section 542, Elliott’s right to claim an exemption is limited by section 522(g), and the BAP suggested that the limitation be considered on remand.

AUTHOR’S COMMENTARY

Some bankruptcy courts interpret Law v. Siegel narrowly, limiting its holding to cases in which trustees seek to surcharge exemptions after the objection period has expired. These courts continue to follow Michael and Arnold, sustaining timely filed objections when debtors conceal assets and then amend their schedules to claim exemptions after trustees discover and incur expenses administering those assets. The trustee in Elliott conceded the point in her brief, so the BAP’s decision was rendered without the benefit of a party advocating a contrary position. Before bankruptcy courts, this likely remains an open issue.

These materials were written by John N. Tedford, IV, of Danning, Gill, Diamond & Kollitz, LLP. Editorial contributions were provided by ILC member Doris A. Kaelin, of Gordon & Rees LLP.

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee

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Bankruptcy Decision Addressing Effective Service, Bankruptcy E-Bulletin, Insol. L. Comm., Bus. L. Sec., Cal. State Bar (Aug. 26, 2013).

Summary:

The U.S. Bankruptcy Appellate Panel of the Ninth Circuit (“BAP”) affirmed the Central District of California bankruptcy court’s denial of a bank’s motion for relief from stay in a single asset real estate chapter 11 case because the bank failed to serve parties on the list of 20 largest unsecured creditors to the attention of an “officer, a managing or general agent,” or other authorized agent, as required under the applicable rules. Bank of America, N.A. v. LSSR, LLC (In re LSSR, LLC), BAP No. CC-12-1636 (9th Cir. BAP May 29, 2013). To read the full decision, click http://cdn.ca9.uscourts.gov/datastore/bap/2013/05/29/LSSR,%20LLC%20Memo%2012-1636.pdf

Facts:

The chapter 11 debtor owned real property encumbered by a bank’s trust deed. The bank’s trust deed also encumbered real properties owned by affiliates of the debtor. The bank commenced a state court action against the debtor, its affiliates and other related entities (“Defendants”) for defaulting on their obligations under the trust deed. A resolution of that litigation required those Defendants to enter into a “Confession of Judgment” accepting joint and several liability to the bank for over $5,000,000, which the bank would file if the Defendants defaulted further.

The debtor filed a chapter 11 petition and the bankruptcy court determined it to be a single asset real estate debtor. Thereafter, the debtor’s manager paid the bank the monthly interest on the loan. The bank filed a motion for relief from stay claiming that the payment was both not enough and made by the debtor’s manager (rather than the debtor).

There were two unsecured creditors listed on the debtors’ schedules. The bank’s proof of service indicated service on the two unsecured creditors at their addresses but not to the attention of any officer or registered agent. The bankruptcy court denied the motion because: (1) the bank did not properly serve the 20 largest unsecured creditors; and (2) the debtor made the payment required in a single asset real estate case. See 11 U.S.C. § 362(d)(3). The bank appealed.

Reasoning:

The BAP affirmed the bankruptcy court’s decision. The BAP found that the bank did not serve the motion in compliance with the Federal Rules of Bankruptcy Procedure (“FRBP”) and the Local Bankruptcy Rules of the United States Bankruptcy Court for the Central District of California (“LBR”). In a chapter 11 case, the FRBP and LBR require a motion for relief from stay to be served on the unsecured creditors committee or, if none is appointed, on the 20 largest creditors. Further, in a contested matter, such as a motion for relief from stay, service on a corporation or partnership must be “to the attention of an officer, a managing or general agent” or to an authorized agent for service of process. FRBP 4001(a)(1), 7004(b), 9014(b). The proof of service must also “explicitly indicate how each person who is listed on the proof of service is related to the case.” LBR 9013-3(c).

The BAP determined that service of the motion was defective because the bank did not indicate on the proof of service that the motion was mailed to “an officer, a managing or general agent or any other authorized agent” of the two unsecured creditors.

Author’s Comment:

Although personal service is often not necessary in bankruptcy cases, this case is a reminder of the need to pay attention to detail, particularly the applicable federal and local rules, when executing service by United States mail.

These materials were prepared by Zev Shechtman (zshechtman@dgdk.com) of Danning, Gill, Diamond & Kollitz, LLP, in Los Angeles, California. Editorial contributions were provided by ILC member Asa S. Hami of SulmeyerKupetz, PC, in Los Angeles, California.

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