Tag Archives: bankruptcy

September 13, 2016

Delaware Bankruptcy Court Holds LLC Operating Agreement Provisions Placing Sole Power in the Company’s Lender to Prevent a Bankruptcy Filing are Void as Against Public Policy

In an important decision for debtors and creditors alike, the United States Bankruptcy Court for the District of Delaware has ruled that provisions in a limited liability company operating agreement, granting the company’s lender absolute power to prevent the company from filing a bankruptcy petition are unenforceable as against public policy. In re: Intervention Energy Holdings, LLC, 2016 WL 3185576 (Bankr. D. Del. 2016).

The facts involved in the case are straight-forward. The debtors—a parent limited liability company and its subsidiary—found themselves in financial straits compelling them to seek a forbearance agreement with their lender. The lender agreed to forbear, but only on the condition that the debtors amend their respective operating agreements to include a provision admitting the lender as a member of the parent and further requiring the unanimous consent of the members of the parent for any voluntary filing for bankruptcy by either the parent or the subsidiary. The debtors filed chapter 11 petitions without the consent of the lender, and the lender filed a motion to dismiss the petitions as filed without authority.

The bankruptcy court noted that the issue of whether debtors and creditors are free to contract away bankruptcy rights was one of first impression in Delaware. However, the court determined that it need not decide this issue, as it determined public policy considerations provided an alternate ground for its decision. The court concluded such a provision violates public policy and is unenforceable, stating its conclusion in the strongest of terms:

“A provision in a limited liability company governance document obtained by contract, the sole purpose and effect of which is to place into the hands of a single, minority equity holder the ultimate authority to eviscerate the right of that entity to seek federal bankruptcy relief, and the nature and substance of whose primary relationship with the debtor is that of creditor-not equity holder-and which owes no duty to anyone but itself in connection with an LLC’s decision to seek federal bankruptcy relief, is tantamount to an absolute waiver of that right, and, even if arguably permitted by state law, is void as contrary to federal public policy.”

The court relied on opinions from various courts to the effect that contractual provisions restricting the right to a bankruptcy discharge and the right to file bankruptcy are unenforceable as against public policy. Klingman v. Levinson, 831 F.2d 1291 (7th Cir. 1987) (“for public policy reasons, a debtor may not contract away the right to a discharge in bankruptcy.”). MBNA Am. Bank. N.A. v. Trans World Airlines, Inc. (In re Trans World Airlines, Inc.), 275 B.R. 712 (Bankr. D. Del. 2002) (“prepetition agreements purporting to interfere with a debtor’s rights under the Bankruptcy Code are not enforceable.”). In re Pease, 195 B.R. 431 (Bankr. D. Neb. 1996) (“the Bankruptcy Code pre-empts the private right to contract around its essential provision.”). The court believed such provisions would frustrate the object of the Bankruptcy Code and be repugnant to its purposes.

The concluded its opinion with the following strongly-worded language:

“Under the undisputed facts before me, to characterize the Consent Provision here as anything but an absolute waiver by the LLC of its right to seek federal bankruptcy relief would directly contradict the unequivocal intention of [the lender] to reserve for itself the decision of whether the LLC should seek federal bankruptcy relief. Federal courts have consistently refused to enforce waivers of federal bankruptcy rights.”

This decision, along with the recent decision of the U.S. Bankruptcy Court for the Northern District of Illinois in In re Lake Michigan Beach Pottawatamie Resort LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016), which found a similar provision violated applicable state corporate law, should be instructive to creditors’ counsel of the need to carefully craft these types of restrictive agreements in ways which comport with public policy and applicable state law.

June 7, 2016

Lenders Beware: Make Sure Your Borrower’s Organizational Documents’ Blocking Director Provisions Comply With State Law

Many lenders attempt to render their borrower bankruptcy remote by requiring the borrower to have on its board a director, known as a “blocking director,” whose consent is required for any bankruptcy filing. However, in doing so, the lender needs to make sure the organizational documents which impose this condition on the buyer comply with requirements of the law of the state in which the borrower is organized. If they don’t, a lack of the blocking director’s consent may not prevent the borrower from filing bankruptcy. This harsh lesson was learned by the lender in In re: Lake Michigan Beach Pottawattamie Resort, LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016).

In Lake Michigan Beach, the debtor was organized under the laws of the state of Michigan. It owed a loan to BCL-Bridge Funding, LLC secured by real property comprising a resort on Lake Michigan. When the borrower ran into financial trouble, the lender agreed to forbear, but required certain amendments to the borrower’s Operating Agreement under which the borrower added a fifth member (the “Special Member”). The amended Operating Agreement required the Special Member’s consent for the borrower to file bankruptcy. This Special Member had no right to distributions and was not required to make capital contributions. Essentially, the Special Member was kept separate from the borrower for all purposes other than to vote on filing bankruptcy. Further, the amended Operating Agreement provided that the Special Member, in voting on a bankruptcy filing, was not obligated to consider any interests or desires other than its own and had “no duty or obligation to give any consideration to any interest of or factors affecting the Company or the Members.”

After the borrower’s default and lender’s commencement of foreclosure proceedings, the borrower’s members—with the exception of the Special Member—voted to cause the borrower to file a chapter 11 petition. The lender filed a motion to dismiss, contending the filing was not authorized. The bankruptcy court denied the motion, finding the provisions in the amended Operating Agreement did not comply with applicable Michigan corporate governance law. The court stated that, under Michigan law, members of a limited liability company have a duty to consider the interests of the entity and only their own interests in the decisions they make for the company. Specifically, the Michigan statute relied on by the court stated: “A manager shall discharge the duties of manager in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and in a manner the manager reasonably believes to be in the best interests of the limited liability company.” As a result, the court held the Special Member provision unenforceable.

December 29, 2015

Tenth Circuit Refuses to Allow Guarantors to Shirk Their Guaranty Liability by Relying on Primary Obligor’s Confirmed Plan

May a chapter 11 debtor who is a guarantor require a creditor to look solely to the provisions of the primary obligor’s confirmed plan for repayment? The Tenth Circuit recently held that, in many cases, guarantors will not be able to restrict creditors’ rights in this fashion.

In FB Acquisition Property I, LLC v. Larry Gentry et al, 2015 WL 8117969 (10th Cir. 2015), Larry and Susan Gentry personally guaranteed a loan made by FirstTier Bank to their company, Ball Four, Inc. Their guaranty provided they would pay “all of the principal amount” of the “Indebtedness” of Ball Four to the bank, whether that amount was barred or unenforceable against Ball Four for any reason. In addition, their guaranty contained a waiver of any defenses arising because of the “cessation of Borrower’s liability from any cause whatsoever.” Third, the Genrtrys agreed not to assert “any deductions to the amount guaranteed under this Guaranty” through setoff, counterclaim, counter demand or other method.

Ball Four defaulted on the loan and filed a chapter 11 proceeding. Ball Four filed an adversary proceeding against FirstTier Bank, asserting various breaches of the loan agreement entitling Ball F our to setoffs and reductions of amounts it owed the bank. Ball Four obtained confirmation of a plan that provided payment of the bank’s claim at interest, amortized over twenty-five years with a five year call. During the course of Ball Four’s bankruptcy proceedings, the Colorado Division of Banking closed FirstTier Bank and the FDIC was appointed receiver. Eventually the Ball Four loan was transferred to FB Acquisition.

After Ball Four filed bankruptcy, FirstTier sued the Gentrys on their guaranties. The Gentrys filed a personal chapter 11 petition. The creditor filed a proof of claim in the Gentry bankruptcy case based on the guaranties of the loan, with the amount of the claim exceeding the amount of the proof of claim filed in the Ball Four bankruptcy case by the amount of default interest accruing on the debt between the two petition dates. The Gentrys took the position that their liability under their guaranties was co-extensive with Ball Four’s liability on the debt, and that they would enjoy any reduction of the debt through the adversary proceeding in the Ball Four bankruptcy case. The Gentrys proposed a plan which provided the debt owed on the FirstTier loan would be paid by Ball Four pursuant to its confirmed plan, with the Gentrys not paying any amounts to the creditor unless and until Ball Four defaulted on its plan obligations on the debt.

FB Acquisition appealed the confirmation of the Gentry plan, arguing the bankruptcy court erred in two regards: (1) basing its analysis of the feasibility of the Gentry plan on the feasibility of the Ball Four plan and (2) confirming the Gentry plan which treated the Gentrys’ liability under their personal guaranties as co-extensive with the liability of Ball Four under its confirmed plan.

The Tenth Circuit affirmed the feasibility findings. The court rejected FB Acquisition’s argument that the bankruptcy court relied solely on the Ball Four plan’s feasibility in determining the feasibility of the Gentry plan. The Tenth Circuit held that the bankruptcy court properly determined feasibility of the Gentry plan because the Gentrys had sufficient financial wherewithal to pay the debt if Ball Four defaulted under its plan and because the Gentrys would not receive a discharge in their case until the debt was paid in full.

However, the Tenth Circuit held that the bankruptcy court erred in confirming the Gentrys’ plan, which provided their guarantor liability on the debt was co-extensive with Ball Four’s liability. First, while Colorado law provides that a guarantor’s liability is co-extensive with that of the primary obligor, the Tenth Circuit held that “this rule of equivalent liability is inapplicable in the bankruptcy context. The court noted the majority rule that the Bankruptcy Code’s discharge provisions do not affect a guarantor’s liability. The court pointed to the specific language of § 524(e), which states the “discharge of a debt of the debtor does not affect the liability of any other entity on, or the property of any other entity for, such debt.” The Tenth Circuit stated that “Holding otherwise would impair a guaranty. Guaranties act as a safeguard, assuring performance of a guarantor even if the borrower defaults,” and further stated “Extending this rule of equivalent liability into the bankruptcy context would destroy the value of a guaranty.”

Second, the Tenth Circuit held that the specific terms of the guaranties themselves precluded the Gentrys from asserting their liability was co-extensive with Ball Four’s. The guaranties provided contained the Gentrys’ promise to pay “all of the principle amount outstanding” whether “barred or unenforceable against Borrower for any reason whatsoever.” The guaranties also contained waivers of defenses arising from the cessation of Ball Four’s liability from any cause whatsoever.” In addition, the Gentrys in their guaranties agreed not to assert any deductions to the amount guaranteed by way of setoff or counterclaim. The Gentrys contended that, since the guaranties provided they guaranteed the “Indebtedness” of Ball Four, they were entitled to any reductions in that indebtedness which might arise from a judgment in the adversary proceeding brought by Ball Four in its case. The Tenth Circuit disagreed, concluding that while a bankruptcy court may grant a discharge, “a discharge does not extinguish the underlying debt, rather it changes a debtor’s liability for that debt.” Therefore, although the confirmation of the Ball Four plan modified Ball Four’s liability for its debt, it did not modify the indebtedness itself. Because the indebtedness remained unchanged, the Gentrys’ liability also remained unchanged.

September 29, 2015

Another Marijuana Bankruptcy Case Bites the Dust as the Arizona Bankruptcy Court Dismisses an Involuntary Case Filed Against a Medical Marijuana Dispensary

Following its sister court in Colorado[1] the United States Bankruptcy Court for the District of Arizona recently held that the debtor’s operation of a business that it illegal under federal law mandates dismissal of an involuntary bankruptcy petition filed against the debtor.  In re Medpoint Management, LLC, 528 B.R. 178 (Bankr. D. Az. 2015).  Medpoint Management managed the operations of Arizona Nature’s Wellness (“ANW”), which held an Arizona Department of Health Services-issued Dispensary Certificate allowing it to operate a branded medical marijuana dispensary under the Arizona Medical Marijuana Act.  In its capacity as manager, Medpoint owned ANW’s name and trademark under which ANW sold its marijuana products.  When several of its creditors filed an involuntary bankruptcy petition against it Medpoint filed a motion to dismiss the petition.  In the context of the motion to dismiss, the court analyzed the issue as “whether [the court] can or should enter an involuntary order for relief against Medpoint despite the fact that Medpoint’s current and former business affairs are illegal under applicable federal criminal statutes.”

Medpoint argued that the case should be dismissed because the trustee could not lawfully administer the bankruptcy estate’s marijuana-related assets without violating the Controlled Substance Act, 21 U.S.C. § 801 et seq.  The petitioning creditors argued that an order for relief was not precluded under federal law because their claims against Medpoint were not related to it’s the actual proceeds of its marijuana sales, that Medpoint had received a federal tax identification number and maintained a bank account at an FDIC-insured bank, and that Consolidated and Further Continuing Appropriations Act (“Cromnibus Act”) prohibited the use of appropriated funds to “prevent Arizona from implementing its own law that authorizes the use, distribution, possession or cultivation of medical marijuana.”

The court decided to dismiss the case for cause.  It was persuaded by the opinions from the Colorado bankruptcy court dismisses two marijuana related cases.  The first, In re Arenas, held dismissal proper because the chapter 7 trustee could not take control of or administer the debtor’s assets without violating the Controlled Substance Act.  The court in In re Rent-Rite Super Kegs held that dismissal was proper in a case where the debtor owned real property that was rented to a marijuana entity and that the debtor’s continuing lease with that entity constituted gross mismanagement of the estate.  The Arizona court was persuaded by these decisions.  The court determined that the bankruptcy trustee would be placed in an untenable position, with the debtor’s assets subject to the prospect of possible forfeiture or seizure by the federal government under the Controlled Substance Act.  The fact that the Cromnibus Act prohibited the use of appropriations by the government under it to enforce the Controlled Substance Act did not persuade the court, as it noted the Department of Justice had other sources of funds from which it could prosecute violations of the Controlled Substance Act.  In short, the court held that entering an order for relief would result in the trustee necessarily violating federal law in carrying out his or her duties under the Code.  As a result, the court found cause existed to dismiss the involuntary petition.



[1] In re Arenas, 514 B.R. 887 (Bankr. D. Colo. 2014); In re Rent-Rite Super Kegs W. Ltd., 484 B.R. 799 (Bankr. D. Colo. 2012)

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.   

September 3, 2014

Ninth Circuit — Bank Did Not Violate Automatic Stay by Placing Administrative Hold on Chapter 7 Debtors’ Bank Accounts

On August 26, 2014, the Ninth Circuit Court of Appeals held that Wells Fargo (the “Bank”) did not violate the automatic stay by placing a temporary administrative hold on a chapter 7 debtor’s bank accounts.  See In re Mwangi, 2014 WL 4194057 (9th Cir. 2014).  Holland & Hart represented the Bank in this significant victory.

The United States Supreme Court long ago held that a bank may impose an administrative hold on a debtor’s bank account to preserve the bank’s setoff rights.  See Citizen’s Bank of Maryland v. Strumpf, 516 U.S. 16 (1995).  The Ninth Circuit’s Mwangi decision builds on the Strumpf holding and establishes that an administrative hold may be proper even if its purpose is not to preserve setoff rights.

Facts

The Mwangis, chapter 7 debtors, held four accounts at the Bank with an aggregate balance of $52,000.  When the Bank became aware of the Mwangis’ bankruptcy filing, it placed an administrative hold on all four accounts, and sent two letters: one to the chapter 7 trustee requesting instructions as to how to dispose of the account funds, and one to the Mwangis’ counsel informing him of the administrative hold that would last until the Bank received instructions from the Trustee or until 31 days after the meeting of creditors.

The Mwangis requested that the Bank lift the administrative hold.  The Bank refused to do so without the chapter 7 trustee’s consent.  The Mwangis then moved for sanctions, alleging that the Bank willfully violated the automatic stay, which motion the bankruptcy court denied.  The Mwangis then filed a class action adversary proceeding on the same basis.  The bankruptcy court dismissed the adversary action with prejudice, and the district court affirmed. 

Statutory Background

The filing of a bankruptcy petition gives rise to an automatic stay that prohibits, among other things, “any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate.”  See Bankruptcy Code § 362(a)(3).  It also automatically creates an estate that includes all legal or equitable interests of the debtor.  See Bankruptcy Code § 541(a).  On the petition date, a chapter 7 debtor is required to turn over to the chapter 7 trustee all of the debtor’s property.  See Bankruptcy Code § 521(a)(4).  Pursuant to Bankruptcy Code § 522, the Debtor may claim certain property as exempt from the estate, and if no party objects to the exemption, the property becomes exempt, in most cases, 30 days after the meeting of creditors.  See Fed. R. Bankr. P. 4003(b)(1).  A Nevada statute exempts from a debtor’s estate 75% of the debtor’s weekly disposable earnings.  See Nevada Revised Statutes § 21.090(1)(g). 

The Ninth Circuit’s Holding

The Mwangis argued that they were injured by the administrative hold during two periods: (1) after the Debtor claimed the property as exempt, but before the exemption became effective; and (2) after the exemption became effective. 

The Ninth Circuit held that the Mwangis could not allege a plausible injury relating to either period.  After a debtor claims property as exempt, but before the objection period expires, the allegedly exempt property remains property of the estate.  Mwangi at *7.  Thus, during that period, the Mwangis had no right to possess or control the accounts funds, and could allege no plausible injury.

When the objection period expires (typically 30 days after the meeting of creditors), exempt property revests in the debtor and ceases to be property of the estate.  The Mwangis alleged a violation of § 362(a)(4), which notably refers only to property of “the estate,” not property of the debtor.  Thus, once the exempt account funds revested in the Mwangis, the Bank’s administrative hold could not violate § 362(a)(4) because it did not affect estate property.  Id.

Conclusion

The Mwangi decision, like the Supreme Court’s 1995 Strumpf decision, should comfort banks that seek to impose administrative holds on debtors’ bank accounts.  This is particularly true where, as in Mwangi, the bank’s motivation for the administrative hold is to comply with the Bankruptcy Code and Rules.

March 14, 2014

Ninth Circuit B.A.P. Holds That Principal Can Discharge Debts Caused By His Agent’s Fraud

The BAP held that “more than a principal/agent relationship is required to establish a fraud exception to discharge . . . The creditor must show that the debtor knew, or should have known, of the agent’s fraud.”

A central purpose of bankruptcy is to grant debtors a fresh start – in bankruptcy terms, a “discharge” of existing debts.  But not all debts are dischargeable.  Bankruptcy Code § 523(a)(2)(A), for example, prevents the discharge of debts resulting from “false pretenses, a false representation, or actual fraud . . . .”  What if a principal incurs a large debt based not on his own fraud, but on the fraud of his agent?  Is that debt dischargeable?  That was the question addressed recently by the Ninth Circuit Bankruptcy Appellate Panel in In re Huh, BAP No. CC-12-1633, 2014 WL 936803 (9th Cir. B.A.P. March 11, 2014). Download In re Huh 2014 WL 936803 9th Cir BAP 2014.

Benjamin Huh was a real estate broker who ran a real estate and business brokerage business as a sole proprietor.  He hired an agent, Jay Kim, who did not hold a brokerage license of his own and so relied on Huh’s brokerage license.  Kim sold a shopping market (the “Market”) to an out-of-country investor looking for a profitable investment that required minimal personal involvement.  It turned out that the Market was quite unprofitable and required substantial personal involvement.  Its gross sales were significantly lower than Kim represented, and it was subject to so many code violations that its business license was revoked. 

The investor sued Kim for fraud in state court and prevailed.  The investor then successfully moved the state court to add Huh to the judgment.  Huh thereby became jointly and severally liable on the judgment of approximately $1 million, based upon his agent’s fraud.

Huh filed for chapter 7 bankruptcy relief.  The investor filed a complaint under Bankruptcy Code § 523(a)(2)(A), asking the court to except his state court judgment from discharge.  The investor argued that under basic agency principals, a principal is liable for the torts of his agents, and therefore Kim’s liability should be imputed to Huh for purpose of discharge.  Notably, the state court findings of fact were not binding on the bankruptcy court, which made its own findings.  It found that Huh had no involvement with Kim’s sale of the Market, and was totally unaware of the Market until after the sale closed.  In short, he had not personally engaged in any culpable conduct.  Thus, the judgment debt would be dischargeable in Huh’s bankruptcy unless Kim’s fraud was imputed to Huh for purposes of § 523(a)(2)(A). 

The bankruptcy court dismissed the investor’s nondischargeability complaint, and the BAP, sitting en banc, affirmed.  The BAP held that “more than a principal/agent relationship is required to establish a fraud exception to discharge . . .  The creditor must show that the debtor knew, or should have known, of the agent’s fraud.”  In reaching this result, the BAP examined various approaches taken by circuit courts, and a recent United States Supreme Court case that granted a discharge exception under another subsection only if the creditor could establish a debtor’s “culpable state of mind.”  See  Bullock v. BankChampaign, N.A., 133 S.Ct. 526 (2013). 

Because Huh was not aware of the Market sale or of his agent’s false representations until after the sale closed, Huh’s liability on the state court judgment was dischargeable in his chapter 7 case.

October 31, 2013

Ninth Circuit BAP Holds that Foreclosure Occurring After Abandonment May Violate the Automatic Stay

Under Section 554 of the Bankruptcy Code, the trustee may
abandon any property of the estate that is burdensome to the estate or that is
of inconsequential value and benefit to the estate.  Once the trustee abandons an asset that
serves as a secured lender’s collateral, the lender may assume that it may
proceed with foreclosure or repossession of the property since the asset has reverted
back to the debtor.  However, based on a
recent decision from the Bankruptcy Appellate Panel for the Ninth Circuit this
assumption is not only incorrect but may also give rise to a finding that the
lender violated the automatic stay.

In Gasprom, Inc. v.
Fateh
, BAP No. CC-12-1567-KuKiTa (B.A.P. 9th Cir. filed October 28, 2013), the
chapter 7 debtor had one asset of significance—a non-operational gas station
(the “Station”).  The chapter 7 trustee
decided to abandon the Station because she lacked the funds necessary to render
it operational and because the Station was fully encumbered.  The debtor objected to the abandonment claiming
that there was equity in the Station.  The
bankruptcy court overruled the debtor’s objection and authorized the
abandonment.  That same day, the secured
lender (whose interest encumbered the Station) proceeded with foreclosure.  Thereafter, the bankruptcy case was
closed.  Approximately one month after
the bankruptcy case’s closure, the debtor moved to reopen the case so that it
could seek to set aside the foreclosure sale and hold the secured lender in
contempt for violation of the automatic stay. 
The bankruptcy court agreed to reopen the bankruptcy case but held that
the foreclosure did not violate the automatic stay because upon entry of the
abandonment order, the automatic stay no longer enjoined the foreclosure sale
of the Station.  Therefore, the
bankruptcy court refused to set aside the foreclosure or hold the secured
lender in contempt for violating the automatic stay.

The debtor appealed the bankruptcy court’s order to the BAP
for the Ninth Circuit and the BAP held that the bankruptcy court erred when it
held that the foreclosure sale did not violate the automatic stay.  The BAP reached its holding by analyzing the
effect of abandonment on the debtor’s property and the various automatic stay
provisions under Section 362. 

Specifically, the court explained that upon abandonment, the
Station was no longer property of the estate and title to the Station reverted
back to the Debtor.  As a result, the
automatic stay provision that protects property of the estate no longer
applied.  See 11 U.S.C. § 362(c)(1).  However,
the abandonment did not terminate the aspect of the stay arising from Section
362(a)(5), which protects “property of the debtor.”  As a result, abandoned property continues to
be protected by the automatic stay to the extent it has reverted back to the
debtor, unless and until the case is closed or dismissed, or a discharge is
granted or denied. 

Based on the foregoing reasoning, the BAP held that the
bankruptcy court erred as a matter of law when it concluded that, immediately
upon abandonment, the automatic stay no longer enjoined the foreclosure.  Therefore, the BAP vacated the bankruptcy
court’s order and remanded for further proceedings consistent with its
decision.  

October 4, 2013

Creditors May be Able to Reduce Amounts Owed to Debtors Under Idaho Bankruptcy Court’s Broad Application of Recoupment

A recent Idaho Bankruptcy Court decision allowed a creditor to retain, under the doctrine of recoupment, a series of postpetition transfers of estate property. See In re Azevedo, 2013 WL 4463153 (Bankr. D. Idaho Aug. 19, 2013).  Recoupment is an equitable doctrine that allows a bankruptcy creditor to “net out” amounts it owes to the debtor against amounts the debtor owes the creditor, if those amounts arise from the same transaction.  Though recoupment is not codified in the Bankruptcy Code, the United States Supreme Court has acknowledged its validity: “It is well settled that a bankruptcy defendant can meet a plaintiff-debtor’s claim with a counterclaim arising out of the same transaction, at least to the extent that the defendant merely seeks recoupment.”  Reiter v. Cooper, 507 U.S. 258, 265 (1993).  This netting of claims between a creditor and debtor is appropriate where it is shown that “the parties’ agreement: (1) involved a netting out of debts, (2) based on a ‘single transaction’ between the parties, and (3) that it is equitable to apply the defense in this case.”  Azevedo, 2013 WL 4463153 at *6.  In In re Azevedo, the United States Bankruptcy Court for the District of Idaho adopted a broad application of the recoupment doctrine, thus allowing a party to deduct the amounts it was owed by the debtor from a series of postpetition payments it made to the debtor.  The decision is available here: Download In re Azevedo_2013_WL_4463153_Bankr Idaho_2013

In Azevedo, the debtor, Azevedo, was a dairy farmer.  He delivered milk every month to Davisco, a cheese producer.  In the industry, it is common for milk purchasers to pay for product the month after it is delivered.  As Azevedo’s funds became limited, however, he requested an advance from Davisco, and Davisco agreed.  Thus, in December 2010, Davisco paid in full for the milk before it was delivered.  Azevedo and Davisco agreed that Davisco could deduct the amount of the advance in monthly increments over the course of a year.  Accordingly, for the next year, each time Davisco purchased milk from Azevedo, it paid him slightly less than it otherwise would have, until it recouped its advance with interest.  These monthly deductions continued even after Azevedo filed for chapter 12 bankruptcy protection partway through the year.  Eventually, Azevedo’s case was converted to a chapter 7 case, and the chapter 7 trustee brought suit against Davisco to recover the monthly deductions as unauthorized postpetition transfers pursuant to Bankruptcy Code § 549(a).  That section allows a trustee to “avoid a transfer of property of the estate that occurs after the commencement of the case and . . . is not authorized under this title or by the court.”    

Davisco admitted that the reductions in its payments to the debtor during the bankruptcy case amounted to postpetition transfers of property of the estate.  It also admitted that the transfers were not approved by the court.  It argued, however, that the equitable doctrine of recoupment protected the transfers from avoidance.

The trustee argued that recoupment is not a defense to § 549.  He further argued that even if recoupment was available as a defense, the series of transfers in question didn’t qualify under the doctrine because they didn’t arise from a “single transaction.”  Finally, he argued that recoupment would be inequitable because it would allow Davisco to receive more than its pro rata share of the estate in relation to other unsecured creditors.

The court agreed with Davisco and held that the postpetition transfers were protected from avoidance under the doctrine of recoupment.  First, the court noted that even though recoupment is not codified in the Bankruptcy Code, the Supreme Court and the Ninth Circuit recognize its application, and the trustee cited no authority for the argument that it could not apply to a section 549 action.

Next, the court addressed the trustee’s argument that the doctrine didn’t apply because the series of postpetition transfers did not constitute a single transaction with the debtor.  In the Ninth Circuit, claims arise from the “same transaction” if they satisfy the “logical relationship” test, which “asks whether the defendant’s claim arises out of the same aggregate set of operative facts as the [plaintiff's] claim.” Aetna U.S. Healthcare v. Madigan (In re Madigan), 270 B.R. 749, 755 (B.A.P. 9th Cir. 2001) (quoting Pinkstaff v. United States (In re Pinkstaff), 974 F.2d 113, 115 (9th Cir.1992)).  The Azevedo court held that, although Davisco received transfers of estate property in multiple increments over time, those transfers arose from the “same transaction” as the original sale of milk in December 2010, because they were “a series of ongoing transactions and obligations created under a single agreement.”  Azevedo at *7. 

Finally, the court addressed the trustee’s argument that Davisco’s receipt of postpetition transfers – at more than 100 cents on the dollar – violated the Bankruptcy Code’s pro rata distribution paradigm.  The court noted that the Supreme Court and Ninth Circuit had already rejected such an argument.  See Newbery Corp. v. Fireman's Fund Ins. Co., 95 F.3d 1392, 1400 (9th Cir. 1996).  Those courts hold that “recoupment permits a determination of the just and proper liability on the main issue, and involves no element of preference.”  Reiter v. Cooper, 507 U.S. 258, 265 (1993).  In other words, in the Supreme Court’s view, recoupment does not alter the distribution made on a claim, it
determines the proper amount of a claim to begin with.

Azevedo may have strategic implications for creditors in Idaho cases who have offsetting obligations with a bankrupt debtor.  The court’s broad interpretation of recoupment may allow a creditor to avoid paying amounts owed to the debtor, to the extent that the creditor can argue that the offsetting amounts arise from the same transaction.  Under Azevedo, that may include a series of ongoing transaction and obligations relating to a single agreement.  Recoupment may be particularly attractive to a creditor who cannot achieve a similar result using the doctrine of setoff (see Bankruptcy Code § 553) because the debts do not arise between the exact same parties (mutuality) or the creditor does not have a valid set-off right under non-bankruptcy law.  A party contemplating applying recoupment should consult counsel to determine whether it has valid recoupment rights.

August 5, 2013

Supreme Court Holds that “Defalcation” for Purposes of Denial of a Discharge, Requires a Culpable State of Mind Involving Knowledge of, or Gross Recklessness in Respect to, the Improper Nature of the Fiduciary Behavior

The U.S. Supreme Court recently held that the term “defalcation” for purposes of denying a debtor a discharge under 11 U.S.C. § 523(a)(4) requires the showing of a culpable state of mind involving knowledge of, or gross recklessness in respect to, the improper nature of the fiduciary behavior involved, thereby resolving long-standing confusion over the required proof to establish defalcation and resolving a long-standing conflict among the lower courts.

In its decision in Bullock v. Banchampaign, N.A., 133 S. Ct. 1754, 2013 WL 1942393 (2013), the
rejected the notion that a debtors’ discharge on a debt may be denied if he engaged in conduct constituting a defalcation of his fiduciary duties but did so without acting in bad faith, with moral turpitude or other immoral conduct.  Justice Kennedy opened the Court’s opinion noting that § 523(a)(4) provides that an individual debtor may be denied a discharge on a debt for “fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.”  The Court discussed the historical
differences in the definition of the term “defalcation,” noting that various dictionaries, legislative reports and court opinion differed over whether the term carries an element of scienter, or whether a fiduciary can be liable for defalcation even in the absence of bad intent. 

The Court commenced its opinion by holding that the term “defalcation” “includes a culpable state of mind requirement akin to that which accompanies application of the other terms in the same statutory phrase”  and described the required state of mind as “one involving knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior.”

The Court based its conclusion on the following reasoning.  First, the Court adhered to the canon of
interpretation noscitur a sociis—that a word in a statute should be interpreted consistent with its companion words in the same statute.  Consequently, since the companions to “defalcation” in §
523(a)(4) are “fraud,” “embezzlement” and “larceny,” all of which require a scienter element, the Court held that the term “defalcation” should also.  Second, because the term “defalcation” does
not necessarily encompass conversion or the taking and carrying away of another’s property, nor does it necessarily involve false statements, holding that it requires an element of scienter does not render it superfluous to the other provisions of the statute.  Third, the Court believed its holding to be more consistent with the long-standing principle that exceptions to discharge should be confined to those plainly expressed. Fourth, application of a scienter standard has the virtue of ease of application, because of the existence of a robust body of securities law which analyzes and defines the term.