Category Archives: Debtors

March 15, 2016

Secured Creditors Beware: Ninth Circuit Holds a Chapter 13 Debtor may Avoid Liens Even if not Entitled to a Discharge

Congress enacted § 1328(f) of the Bankruptcy Code when its passed BAPCPA. This section prohibits the granting of a chapter 13 discharge if the debtor received a chapter 7 discharge within four years prior to the commencement of his chapter 13 case. The Ninth Circuit in In the Matter of Blendheim, 803 F.3d 477 (9th Cir. 2015) held a chapter 20 debtor may in his chapter 13 case avoid a lien under § 506(d) even if § 1328(f) precludes him from receiving a discharge.

The creditor in Blendheim was HSBC Bank, which held a deed of trust lien on the debtors’ home. The debtors filed a chapter 7 case and received a discharge. Soon thereafter, they filed a chapter 13 case, mainly to restructure debts relating to their primary residence. HSBC timely filed a secured proof of claim based on its deed of trust against the debtors’ residence. The debtors objected to the claim, substantively objecting on the grounds that the note which formed the basis for the claim bore a forged signature. For some unknown reason, HSBC never responded to the debtors’ objection, and the bankruptcy court entered an order disallowing HSBC’s secured claim. In fact, after receiving notice that its secured claim had been disallowed, HSBC withdrew its proof of claim and requested the court to no longer send it electronic notifications in the case.

Thereafter, the debtors filed an adversary proceeding against HSBC seeking to void HSBC’s lien under § 506(d) which provides “to the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void.” The debtors contended they were entitled to avoid the lien because the plain language of the statute says a lien securing a debt which is not an allowed secured claim is void. HSBC defended, asserting the debtors were not entitled to avoid the bank’s lien because the debtors were precluded from receiving a discharge by § 1328(f), which provides that a debtor may not receive chapter 13 discharge if he has received a chapter 7 discharge within four years prior to the commencement of his chapter 13 case.

The Ninth Circuit agreed the debtors could avoid HSBC’s liens even though they could not receive a chapter 13 discharge. First, the court concluded the plain language of § 506(d) entitled the debtors to avoid HSBC’s lien. Because this section provides that a lien is void if it secured a debt which is not an allowed secured claim, the court concluded that Congress’ intent was manifest, and held the purpose of § 506(d) was to nullify a creditor’s legal rights in a debtor’s property if the creditor’s claim is disallowed. The court stated its belief that the Supreme Court’s decision in Dewsnup v. Timm, 502 U.S. 410 (1992) confirmed its interpretation. In Dewsnup, the debtors argued that the creditor’s claim was not an allowed secured claim because it was undersecured, and therefore they could avoid it under § 506(d). The Supreme Court rejected this argument, holding “§ 506(d) did not void the lien on his property because the creditor’s claim has been fully ‘allowed.’”

HSBC argued that such a conclusion would be inconsistent with decisions from the Eighth,[1] Fourth[2] and Seventh[3] Circuits, all of which held that avoiding liens for claims which were disallowed because they were untimely filed violated the long-standing principle that valid liens pass through bankruptcy unaffected. Viewing these decisions as holding that filing an untimely claim is akin to not filing a claim at all, the court determined the reasoning of these cases to be inapplicable since HSBC’s claim was disallowed on the merits. The court also noted that the Eleventh[4] and Fourth[5] Circuits have held that a chapter 13 debtor who cannot receive a discharge because of § 1328(f) may still void liens under § 506(d).

Finally, the court rejected HSBC’s argument that allowing avoidance of its lien in these circumstances would effectively grant the debtors on a de facto basis, the discharge to which they were not entitled. The court stated this argument ignored the difference between in personam and in rem liability. By enacting § 1328(f), Congress affected only the debtor’s in personam liability: “We take Congress at its word when it said in § 1328(f) that Chapter 20 debtors are ineligible for a discharge, and only a discharge.” The court further noted there is no language in the Bankruptcy Code which prevents Chapter 20 debtors from receiving the other benefits chapter 13 has to offer, and had Congress intended to prevent these debtors from avoiding liens, it would have included specific language when it enacted BAPCPA.

 

[1] In re Shelton, 735 F.3d 747 (8th Cir. 2013)

[2] In re Hamlett, 322 F.3d 342 (4th Cir. 2003)

[3] In re Tarnow, 749 F.2d 464 (7th Cir. 1984)

[4] In re Scantling, 754 F.3d 1323 (11th Cir. 2014)

[5] In re Davis, 716 F.3d 331 (4th Cir. 2013)

January 12, 2016

Ninth Circuit BAP Holds That a Wholly Unsecured Junior Lien, Discharged in Chapter 7, is not Included in Calculating Chapter 13 Eligibility Under Sec. 109(e)

Section 109(e) of the Bankruptcy Code limits eligibility for chapter 13 relief to those individual debtors whose noncontingent, liquidated unsecured debts do not exceed statutory limits. In calculating eligibility to file chapter 13, should a court consider debts which have been discharged in a prior chapter 7 case and which are “out of the money” because, while secured by a trust deed against the debtor’s residence, the value of the debtor’s residence is insufficient to cover the debt relating to the first trust deed? The Ninth Circuit Bankruptcy Appellate Panel answered this question in the negative, holding in Free v. Malaier (In re Free), 2015 WL 9252592 (9th Cir. BAP 2015) that such debts are not to be included in determining eligibility for chapter 13 relief.

In Free the debtors owned a home which they valued in their chapter 7 schedules at $425,000. The home secured three debts totaling over $900,000, with the first lien holder owed more than the value of the home. The debtors received a chapter 7 discharge and shortly thereafter commenced a chapter 13 case in which they sought to strip off the two subordinate liens. The chapter 13 trustee filed a motion to dismiss the case, arguing that these two wholly unsecured subordinate liens should be included in determining eligibility, and doing so rendered the debtors ineligible for chapter 13 relief. While noting that there was no Ninth Circuit controlling case directly on point, the bankruptcy court relied on several opinions in the Ninth Circuit in chapter 12 cases to conclude the subordinate liens should be included in the calculation and finding the debtors were not eligible for chapter 13 relief.

The BAP reversed, concluding that the discharged debts reflected by the wholly unsecured subordinate liens, should not be considered in determining chapter 13 eligibility. The court began its analysis with the definitions of “debt” and “claim” in section 101 of the Code. Because “claim” is defined as a right to payment and “debt” is defined as liability on a claim, the court held “there is no ‘unsecured debt’ unless the creditor has a ‘right to payment’ on an unsecured basis.” The court next concluded that the result of the debtors’ chapter 7 discharge resulted in their having no personal liability to pay the debts relating to the subordinate liens.

Because the bankruptcy court based its ruling in part on the U.S. Supreme Court’s decision in Johnson v. Home State Bank, 501 U.S. 78 (1991), the BAP addressed its perceived distinctions between the facts in Johnson and the facts in the present case.   In Johnson, the debtor obtained a chapter 7 discharge of a judgment in a foreclosure action and then filed a chapter 13 case with the intent to pay the in rem judgment through his chapter 13 plan. In addressing the question of whether an in rem claim for which personal liability has been discharged can properly be included in a chapter 13 plan, the Supreme Court held that such a claim can be treated in a chapter 13 plan because the claim was enforceable against the debtor’s property even though it was not enforceable against the debtor himself.

The BAP also distinguished the decision of the Ninth Circuit in Quintana v. Commissioner, 915 F.2d 513 (9th Cir. 1990) and the Ninth Circuit BAP in Davis v. Bank of America (In re Davis), 2012 WL 3205431 (9th Cir. BAP 2012), both of which involved chapter 12 proceedings. In Quintana, a judgment creditor agreed to waive any deficiency judgment following the sale of the debtor’s real property securing the judgment. Because the real property had not yet been sold, making a determination of the relative amounts of the secured and unsecured debts uncertain, the Ninth Circuit held it appropriate to include the full amount of the judgment debt in determining the debtor’s eligibility for chapter 12 relief. The BAP also noted the differences between § 109(e), which segregates secured and unsecured debts in determining eligibility, and § 101(18), which determines who is a family farmer by looking to the individual’s aggregate debts. The BAP distinguished its prior decision in Davis on similar grounds.

The BAP then distinguished the Ninth Circuit’s decision in Scovis v. Henrichsen (In re Scovis), 249 F.3d 975 (9th Cir. 2001) and the Ninth Circuit BAP’s decision in Smith v. Rojas (In re Smith), 435 B.R. 637 (9th Cir. BAP 2010) both of which held that the unsecured portion of partially secured debts are to be included in determining chapter 13 eligibility on the grounds that both Scovis and Smith dealt with cases where the chapter 13 proceeding was not preceded by a chapter 7 discharge of the debtor’s personal liability on the debt in question.

Finally, the BAP addressed the U.S. Supreme Courts’ decisions in Dewsnup v. Timm, 502 U.S. 410 (1992) and Bank of America v. Caulkett, 135 S. Ct. 1995 (2015) in connection with lien stripping efforts by chapter 13 debtors. The Court in Dewsnup held that a chapter 7 debtor cannot strip down a partially unsecured lien under § 506(d) to the value of the collateral. Subsequently in Caulkett the Court extended its holding in Dewsnup to situations involving wholly unsecured junior liens. The BAP noted that, following Dewsnup and Caulkett, litigants have argued that debtors who first file a chapter 7 case and obtain a personal discharge and then file a chapter 13 case seeking to strip the remaining in rem claim are acting in bad faith. The BAP refused to reach this issue as it had not been brought forward in the appeal but did state that this argument must be raised by filing a motion to dismiss the chapter 13 case as a bad faith filing and not in the context of whether the debtor is eligible under § 109(e) to file a chapter 13 case.

December 26, 2015

Eleventh Circuit Holds That An Assignee for the Benefit of Creditors has no Authority to File a Bankruptcy Petition for the Assignor

In analyzing the parameters surrounding a state law assignment for benefit of creditors, as well as the extent and limits of the powers of the assignee, the Eleventh Circuit in Ullrich v. Welt (In re NICA Holdings, Inc.), 2015 WL 9241140 (11th Cir. 2015) held that an assignee for the benefit of creditors lacks the authority to file a bankruptcy petition on behalf of the assignee.

In NICA Holdings, the debtor owned stock in a company a company commonly called “Nicanor” which owned and operated a fish farm in Nicaragua. Peter Ullrich and a company called Biotec Holdings owned the remaining shares in Nicanor. When NICA Holdings experienced financial difficulties, it executed an Assignment for the Benefit of Creditors, pursuant to the applicable Florida statute. Under the Florida ABC statute, an assignment for the benefit of creditors serves as an alternative to bankruptcy, with the statute providing for the irrevocable assignment by the assignor of its assets to the assignee, with the assignee charged with disposing of the assets in accordance with state law. In this instance NICA Holdings assigned its assets to Kenneth Welt. When his efforts to sell NICA Holdings’ stock in Nicanor came to naught, Nicanor ceased business operations, and Ullrich instituted litigation against him, Welt filed a bankruptcy petition on behalf of NICA Holdings. Welt believed he had authority to cause NICA Holdings to file bankruptcy under the terms of the Assignment which NICA Holdings had signed in his favor. Ullrich disagreed and filed a motion to dismiss the bankruptcy case on the argument that Welt, as an assignee of NICA Holdings, lacked authority to file a bankruptcy petition on its behalf. The bankruptcy court denied Ullrich’s motion to dismiss, but the Eleventh Circuit agreed with Ullrich and reversed and remanded the case to the bankruptcy court with instructions to dismiss it.

The Eleventh Circuit began its analysis of the authority issue by notice that Florida’s Assignment for Benefit of Creditors (“ABC”) statute is designed to provide a simpler and cheaper process to the more complex procedures provided by the Bankruptcy Code. The ABC process may, in certain instances, be preferable because it is more flexible, faster, more private and less supervised than bankruptcy proceedings. In addition, the Eleventh Circuit noted that Florida courts had described the ABC statute as “an alternative to bankruptcy [that] allows a debtor to voluntarily assign its assets to a third party in order to liquidate the assets.” Hillsborough Cty. V. Lanier, 898 So. 2d 141, 143 (Fla. 2d DCA 2005). The Eleventh Circuit held that ABCs and bankruptcy proceedings are alternative proceedings—a debtor chooses to pursue one to the exclusion of the other. The ABC statute lacked any provision empowering an assignee to file a bankruptcy petition on behalf of the assignor, and the Eleventh Circuit refused to read any such power into the statute. Furthermore, the Assignment Agreement itself under which NICA Holdings assigned its assets to Welt did not contain any language specifically authorizing Welt to file a bankruptcy petition on NICA Holdings’ behalf. The court noted that the language of the agreement, while granting Welt broad powers, authorized him to exercise those powers only in furtherance of the ABC.

Could an assignee for the benefit of creditors file a bankruptcy on behalf of the assignor if the assignor grants specific authority to the assignee to do so? The Eleventh Circuit did not reach this question. I did note, however, that the Florida ABC statute requires all ABC agreements to “substantially” adopt the language in the proposed forms accompanying the statute, an indication that, in Florida at least, an assignee for the benefit of creditors could not be granted authority to file a bankruptcy petition on behalf of the assignor.

October 27, 2015

Creditors May Collect Debts From Funds Distributed to a Debtor From His/Her Exempt Retirement Account Under Tenth Circuit Ruling that Distributed Funds are not Exempt

In a case of first impression, the Tenth Circuit has held that a resident of Colorado may not assert an exemption under Colo. Rev. Stat. § 13-54-102(1)(s) for funds distributed from an exempt pension or retirement plan.  In re Gordon, 791 F.3d 1182 (10th Cir. 2015).  In Gordon the debtors received a lump sum distribution of $16,700 from an exempt 401(k) plan prior to filing bankruptcy.  They deposited the funds into a savings account, where the funds remained segregated from all other funds the debtors had received from other sources.  The debtors used these funds to pay their living expenses prior to filing bankruptcy, and on the petition date had $2,051 remaining.  They asserted an exemption in these remaining funds.  The trustee objected to the claim of exemption, contending the exemption does not apply to funds after their distribution from the exempt retirement account.  The bankruptcy denied the exemption, and the Tenth Circuit agreed with the bankruptcy court’s holding.

The court concluded the language of the statute was clear in allowing an exemption only for funds that are within the exempt retirement account, noting the statute provides an exemption for “property, including funds, held in or payable from any pension or retirement plan or deferred compensation plan.”  Colo. Rev. Stat. § 13-54-102(1)(s).  Noting that Colorado courts have not addressed the question whether the exemption applies to funds which have been distributed, the Tenth Circuit stated that it “must ascertain and give effect to the intent of the legislature, and that task begins with the language of the statute itself.”  The court concluded that the statutory exemption applies only to funds that are actually in the exempt plan.  Although the court agreed with the debtors that Colorado liberally interprets statutes granting exemptions, the court stated that “even a liberal construction must find support in the statutory text,” and determined that such support was lacking in the statute at hand.  The fact that the Colorado legislature had provided an exemption in other statutes for distributed funds but did not do so in the pension and retirement account statute also supported its reasoning.  For example, the court noted that Colorado law provides for an exemption for proceeds of life insurance policies, Colo. Rev. Stat. § 13-54-102(1)(l)(I)(B), as well as for all money received as a pension arising out of service as a member of the armed forces of the U.S., Colo. Rev. Stat. § 13-54-102(h). 

The court concluded that creditors are prohibited by the statute from going after the plan itself, but once the funds in the plan are distributed to the debtor, the creditor is free to execute. 

October 20, 2015

Ninth Circuit Holds That Debtor May Recover Attorneys’ Fees Incurred Prosecuting Action for Damages Relating to Violation of Automatic Stay

    The Ninth Circuit has overruled its own relatively recent decision and has held that a debtor who sues for damages to redress a violation of the automatic stay may recover the reasonable fees it incurs prosecuting the action, even after the stay violation is cured.

    The Bankruptcy Code’s automatic stay provision, section 362, includes this fee recovery clause: “[A]n individual injured by any willful violation of a stay provided by this section shall recover actual damages, including costs and attorneys’ fees . . . .”  11 U.S.C. § 362(k).  The Ninth Circuit, in contrast to every other court to consider the issue, held in 2010 that section 362(k) allows a debtor to recover only those fees incurred to end the stay violation itself, not the fees incurred to prosecute an action for damages.  See Sternberg v. Johnston, 595 F.3d 937 (9th Cir. 2010).  In a decision issued last week, the Ninth Circuit overruled its own Sternberg decision and held that a debtor may recover the reasonable fees it incurs prosecuting a damages action relating to a stay violation.  See In re Schwartz-Tallard, Case No. 12-60052 (9th Cir. Oct. 14, 2015).  (See opinion here.)

    In Schwartz-Tallard, a loan servicer foreclosed on the home of a chapter 13 debtor during the debtor’s bankruptcy, while the debtor was making its monthly payments.  The bankruptcy court found that the creditor had violated the automatic stay and ordered the creditor to reconvey the home to the debtor.  The creditor promptly complied.  The debtor also sought a damages award, and prevailed.  The creditor appealed the damages award, and the debtor prevailed on appeal.  The debtor then sought to require creditor to reimburse the attorney fees the debtor incurred defending its damages award on appeal.  The bankruptcy court denied the motion because under Sternberg, debtors could be reimbursed only for the fees they incurred to end the stay violation.  Here, the creditor had remedied the stay violation before the successful appeal, and thus no fees could be awarded in connection with the appeal. 

    The Bankruptcy Appellate Panel reversed on grounds not relevant here and held that the debtor could recover her fees relating to the appeal.  The Ninth Circuit, first as a three-judge panel and then sitting en banc, affirmed the BAP’s decision, but not on the same grounds.  The Ninth Circuit held that Stenberg was decided incorrectly and that the plain text of section 362(k) allows a debtor to collect attorney fees regardless of whether the fees were incurred to remedy the stay violation or to seek damages resulting from a stay violation.  Though it found the text of section 362(k) unambiguous, the Ninth Circuit went on to state that the policies presumably underlying section 362(k) would be advanced only if debtors had adequate “means or financial incentive (or both)” to “vindicate their statutory right to the automatic stay’s protection.”

    The most obvious practical impact of Schwartz-Tallard is identified in the decision itself: debtors who previously lacked the financial incentive to pursue damages for stay violations may now be more willing to bring those actions.  For creditors and their attorneys, Schwartz-Tallard is simply another reminder to scrupulously respect the automatic stay.

March 31, 2015

Ninth Circuit Holds Discharged Debts are Still Debts for Purposes of Determining Eligibility to File under Chapter 12

In a case of first impression, the Ninth Circuit held that the unsecured portion of a secured debt, for which the debtor’s liability has been discharged in a prior chapter 7 proceeding, is still a debt for determining the debtor’s eligibility to be a debtor under chapter 12 of the Bankruptcy Code.  Davis v. U.S. Bank (In re Carolyn Davis), 2015 WL 662001 (9th Cir. 2015).  Carolyn Davis owned three parcels of real property on which she created a vineyard.  The appraised value of the three parcels totaled $1,600,000, and Davis owed debts secured by the properties totaling $4,100,000.  When her vineyard venture failed, Davis filed a personal chapter 7 case and received a discharge of her liability on the three loans.  She then filed a chapter 12 petition seeking to restructure the secured debt.  At the time, the statutory limit for debt in order to be eligible to file a chapter 12 petition was $3,792,650.  Although the loans secured by her real property totaled $4,100,000, Davis contended she was eligible to file a chapter 12 petition because the value of the collateral securing these loans was below the statutory limit and she had received a discharge of her liability on these loans in her chapter 7 case.

The bankruptcy court dismissed her chapter 12 petition concluding her “aggregate debts” exceeded the statutory limit of $3,792,650 in effect at the time under 11 U.S.C. § 101(18)(A).  The Ninth Circuit BAP affirmed, holding that the term “aggregate debts” in § 101(18)(A) included the unsecured portion of the debts secured by her real property even though her personal liability for the debts had been discharged.  The Ninth Circuit affirmed.

In concluding the bankruptcy court and BAP had reached the correct conclusion, the Ninth Circuit began with viewing the plain language of the statute.  First it noted that a “debt” is a “liability on a claim.”  11 U.S.C. § 101(12).  Next, it noted that the Code defined the term “claim” as a “right to payment . . . or right to an equitable remedy for breach of performance.”  11 U.S.C. § 101(5).  Citing the U.S. Supreme Court’s opinion in Pa. Dept. of Pub. Welfare v. Davenport, 495 U.S. 552 (1990), the Ninth Circuit stated “the plain meaning of a ‘right to payment’ is nothing more nor less than an enforceable obligation, regardless of the objectives [sought] in imposing the obligation,” and that “the meanings of ‘debt’ and ‘claim’ [were intended by Congress to] be coextensive.”  Further, the Ninth Circuit noted the opinion of the U.S. Supreme Court in Johnson v. Home State Bank, 501 U.S. 78 (1991), where the Court held that a debtor must include a mortgage lien in a chapter 13 plan even though the obligation secured by the mortgage was discharged in an earlier chapter case.  As a result, the Ninth Circuit concluded that the word “claim” in § 101(5) is to be given the “broadest definition available.” 

The Ninth Circuit held that the creditors’ right to foreclose in rem against the debtor’s properties constituted a “debt” and a “claim” even though the debtor’s personal liability had been previously discharged.  As a result, the debtor’s “aggregate debts” for purposes of determining eligibility exceeded the statutory limit, and the dismissal of the debtor’s chapter 12 case was affirmed.

September 25, 2014

Nowhere to Turn for Insolvent Marijuana Businesses

Recreational marijuana is legal in two states—Washington and Colorado—and medical marijuana is legal in another twenty-one states.  Colorado alone has over 500 marijuana dispensaries and that number is on the rise.  However, as the marijuana industry continues to grow, federal law still prohibits the use of marijuana.  So what happens when a marijuana business becomes insolvent? Does it have the right to avail itself of the protections of the Bankruptcy Code?

The United States Bankruptcy Court for the District of Colorado (the “Court”) says no.  In In re Arenas, 2014 Bankr. LEXIS 3642 (Bankr. D. Colo. Aug. 28, 2014), a husband and wife filed for chapter 7 bankruptcy.  The husband engaged in the business of producing and distributing marijuana on the wholesale level in Colorado. The husband carried on his business operations in one unit of a commercial building owned by the debtors.  The debtors also leased another unit in the building to another marijuana dispensary.  The wife was not involved in the business and her income derived solely from disability payments. 

About one month after the debtors filed for bankruptcy, the United States Trustee (“Trustee”) moved to dismiss their case.  The Trustee argued that the Court should dismiss the case because it should not enforce the protections of the Bankruptcy Code to aid violations of the federal Controlled Substances Act (“CSA”).  Moreover, the Trustee argued that the Court should not place him in the position of administering assets used in connection with marijuana-related businesses.  The debtors filed a pro se opposition to the motion as their counsel previously withdrew from the case because it and the debtors disagreed as to whether bankruptcy relief was available to the debtors.

The Court agreed with the Trustee and debtors’ counsel and held that the debtors could not receive bankruptcy protection while operating the marijuana business.  Specifically, while the Court found that the husband’s activities were legal under Colorado law, they still violated the CSA.  These violations of federal law created significant impediments to the debtors’ ability to seek relief under the federal bankruptcy laws in a federal bankruptcy court. 

In its decision, the Court referred back to its prior ruling in In re Rent-Rite Super Kegs West Ltd., 484 B.R. 799  (Bankr. D. Colo. 2012).  In that case, the Court addressed issues concerning a chapter 11 debtor’s activities with respect to medical marijuana.  It held: “Unless and until Congress changes [federal drug] law, the Debtor’s operations constitute a continuing criminal violation of the CSA and a federal court cannot be asked to enforce the protections of the Bankruptcy Code in aid of a Debtor whose activities constitute a continuing federal crime.”  Id. at 805.

The debtors in Arenas invited the Court to reexamine its decision in the Rent-Rite case, but it declined to do so.  The Court explained that the “fundamental bargain underpinning a chapter 7 consumer liquidation case is that a debtor turns over his non-exempt assets to a chapter 7 trustee so those assets may be liquidated for the benefit of creditors….  Here, the…Trustee cannot take control of the Debtors’ property without himself violating…the CSA.  Nor can he liquidate the inventory of marijuana plants…because that would involve him in the distribution of a…controlled substance in violation…of the CSA.”  In re Arenas, 2014 Bankr. LEXIS 3642 at *10.  Therefore, the Court found that administration of the case under chapter 7 was impossible without involving the Court and the Trustee in ongoing criminal violations, and that impossibility constituted “cause” for dismissal under 11 U.S.C. § 707(a).

Moreover, the Court denied the debtors request to convert the case to a case under chapter 13 because any reorganization would be funded from ongoing criminal activity and would necessarily involve the chapter 13 trustee in administering and distributing funds derived from such activity.  The Court found that such circumstances would violate Section 1325(a)(3)’s requirement that a chapter 13 plan be “proposed in good faith and not by any means forbidden by law.”  Therefore, the Court denied the debtors’ request to convert and dismissed the case. 

In dismissing the debtors’ case, the Court noted that it recognized that dismissal would be devastating for the debtors, but that the legal analysis necessary for the resolution of the case was “relatively straight-forward.”  In re Arenas, 2014 Bankr. LEXIS 3642 at *19.  The debtors have appealed the decision to the United States Court of Appeals for the Tenth Circuit.

The marijuana industry continues to grow and legalization efforts are ongoing throughout the nation.  However, the Colorado cases make clear that unless federal law changes, there may be nowhere to turn for insolvent marijuana-related businesses.   

May 13, 2014

Oregon Bankruptcy Court Refuses to Enforce Bankruptcy Waiver in LLC Operating Agreement

The Bankruptcy Code impairs lenders’ rights in various ways.  Accordingly, lenders have long attempted to devise methods of preventing borrowers from filing for bankruptcy protection.  Such attempts generally have not been successful — courts hold that as a general matter, a borrower’s pre bankruptcy waiver of the right to file bankruptcy is against public policy and is void.  See, e.g., Klingman v. Levinson,831 F.2d 1292, 1296 n.3 (7th Cir. 1987) (“For public policy reasons, a debtor may not contract away the right to a discharge in bankruptcy.”).  Courts have rejected such waiver provisions in many forms.  See, e.g., In re Madison, 184 B.R. 686, 688 (Bankr. E.D. Pa. 1995) (refusing to enforce debtor’s oral bankruptcy waiver made on the record in prior bankruptcy case); In re Tru Block Concrete Prods. Inc., 27 B.R. 486, 492 (Bankr. S.D. Cal. 1983) (refusing to enforce bankruptcy waiver provision in forbearance agreement); In re Peli, 31 B.R. 952, 956 (Bankr. E.D.N.Y. 1983) (refusing to enforce bankruptcy waiver provision in personal injury settlement agreement).    

In light of these rulings, lenders began to look for other ways to prevent borrowers from filing bankruptcy cases.  Increasingly, they focused on borrowers’ corporate structure and organizational documents.  Prior to 2009, it was widely believed that an entity could be made “bankruptcy-remote” by creating a special purpose entity (“SPE”) whose organizational documents appoint a lender friendly director to vote against any bankruptcy filing.  The effectiveness of SPEs as bankruptcy-remote entities was called into question when the Bankruptcy Court for the Southern District of New York refused to dismiss bankruptcy petitions filed by several solvent, and supposedly bankruptcy-remote, SPEs.  See In re General Growth Properties Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009). 

In a similar vein, the Bankruptcy Court for the District of Oregon recently held that a bankruptcy waiver in a borrower’s LLC operating agreement is ineffective to prevent the borrower from filing for bankruptcy protection.  See In re Bay Club Partners-472, LLC, Case No. 14-30394, 2014 WL 1796688 (Bankr. D. Or. May 6, 2014).  In Bay Club, the debtor was a manager-managed LLC formed to acquire and operate a large apartment complex.  The LLC’s key formational document, the operating agreement, gave the LLC’s manager broad powers to direct and bind the LLC.  At the insistence of the borrower’s lender, however, the operating agreement included a separate provision purporting to bar the LLC from instituting or consenting to a bankruptcy proceeding.  Despite this provision, the LLC filed for bankruptcy protection, but did so with the consent of only 3 out of 4 of its members. 

The lender moved to dismiss the case under Bankruptcy Code § 1112(b) on the basis that the case was filed in bad faith and without necessary consent.  The Bankruptcy Court (Judge Dunn) denied the motion to dismiss.  It relied on prior cases in the Ninth Circuit, most notably In re Huang, 275 F.3d 1173 (9th Cir. 2002).  That case, like the others cited above, held that a debtor’s prepetition waiver of the right to file a bankruptcy case is unenforceable because it is a violation of public policy.  Id. at 1177. 

The Bay Club court explained that a bankruptcy waiver is unenforceable whether it is found in loan documents or in an entity’s organizational documents.  Nor did the court concern itself, in the opinion, with the intricacies of Oregon law — according to the court, federal law and public policy control the analysis.

In light of the Bay Club case and the Ninth Circuit cases it cites, lenders in the Ninth Circuit should approach each deal with a healthy skepticism that any borrower is truly bankruptcy-remote.

March 5, 2014

SCOTUS Tells the Ninth Circuit to Follow the Law: Section 105(a) Is Not a Means to Contravene Other Provisions of the Bankruptcy Code

Stephen Law filed a chapter 7 petition in California.  His only valuable asset was his home, which he scheduled at a value of $363,348.  Washington Mutual Bank held a lien against the home to secure a loan in the amount of $156,929.  Law asserted a homestead exemption under California law of $75,000.  In order to prevent the bankruptcy trustee from selling his home, Law fabricated a second lien against his home which consumed his entire equity, and obtained the cooperation of a Chinese national named Lili Lin to assert that she was actually owed money by the debtor.  The bankruptcy trustee brought an adversary proceeding to avoid the lien, an action which Law and Lin vigorously opposed.  In what some might call a poor financial decision, the bankruptcy trustee incurred $500,000 in legal fees overcoming Law’s fraudulent misrepresentations regarding his $363,000 home.  The bankruptcy court approved a surcharge of the debtor’s $75,000 homestead exemption to pay a portion of the trustee’s legal fees, a holding which was affirmed by the Ninth Circuit BAP and the Ninth Circuit.

The Supreme Court reversed in its opinion in Law v. Siegel, 2014 WL 813702 (March 4, 2014).  The Supreme Court held that neither 11 U.S.C. § 105(a) nor the bankruptcy court’s inherent powers provided a basis for a bankruptcy court to contravene the express language of § 522 of the Bankruptcy Code allowing debtors to claim exemptions in certain assets. In addressing § 105(a), the Court stated  “A bankruptcy court has statutory authority to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of” the Bankruptcy Code. . . But in exercising those statutory and inherent powers, a bankruptcy court may not contravene specific statutory provisions,” and that “It is hornbook law that § 105(a) ‘does not allow the bankruptcy court to override explicit mandates of other sections of the Bankruptcy Code.’” (citing 2 Collier on Bankruptcy ¶ 105.01[2], p. 105-6 (16th ed. 2013).  Consequently, because § 105(a) confers on bankruptcy courts the authority to “carry out” the provisions of the Bankruptcy Code, “it is quite impossible to do that by taking action that the Code prohibits.” 

The Court also rejected the trustee’s argument that the surcharge did not contravene § 522 of the Code.  The trustee argued that a bankruptcy court has equitable power to deny an exemption in response to a debtor’s misconduct.  The Court first held that the trustee’s failure to object to the debtor’s homestead objection within the time required by the Code prevented him from challenging the exemption through seeking a surcharge.  In addition, the Court held that the plain language of § 522 prevented the surcharge.  Section 522(b) provides that the debtor may exempt property, and the Court interpreted this provision as vesting the debtor, not the bankruptcy court, with the discretion on whether the exemption can be claimed.  Section 522 contains various bases on which an exemption can be limited or disallowed, some of which relate to misconduct by the debtor.  The Court held that § 522’s “meticulous—not to say mind-numbingly detailed” list of restrictions and limitations on a debtor’s right to assert an exemption “confirms that courts are not authorized to create additional exceptions.”  Consequently, the debtor’s misconduct in fabricating a lien was not grounds to deny his exemption.

Finally, the Court held that its prior decision in Marrama v. Citizens Bank, 549 U.S. 365 (2007) did not require a different result.  The Court explained its decision in Marrama as one where a chapter 7 debtor could be denied his statutory right to convert his bankruptcy case to a chapter 13 proceeding because his bad faith conduct prevented him from qualifying for relief under chapter 13, and should not be read as providing bankruptcy courts with an equitable right to take action which contravenes the express provisions of the Bankruptcy Code.