Tag Archives: Ninth Circuit

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)

July 6, 2015

Ninth Circuit Holds That Confirmed and Substantially Consummated Bankruptcy Plan is Appealable to District Court

The Equitable Mootness Doctrine

    The entry of an order confirming a plan of reorganization is probably the most significant event in a bankruptcy case.  Shortly after a confirmation order enters, parties to the case often invest funds, alter operations, sell assets, and otherwise implement the reorganization.  Accordingly, courts have developed a doctrine called “equitable mootness” to protect the finality of confirmation orders.  See, e.g., Rev. Op. Grp. v. ML Manager LLC (In re Mortgs. Ltd.), 771 F.3d 1211, 1215 (9th Cir. 2014) (“An appeal is equitably moot if the case presents transactions that are so complex or difficult to unwind that debtors, creditors, and third parties are entitled to rely on the final bankruptcy court order.”).

    The Ninth Circuit has developed four factors to determine whether an appeal is equitably moot.  They are: (1) whether the appealing party sought a stay of the confirmation order; (2) whether the plan has been substantially consummated; (3) whether the remedy sought will affect third parties unfairly; (4) whether the court can fashion effective and equitable relief without significantly upsetting the confirmed plan.  See In re Thorpe Insulation Co., 677 F.3d 869, 881 (9th Cir. 2012).

 The Transwest Decision

    The Ninth Circuit recently held that a confirmed bankruptcy plan could be reconsidered on appeal although the plan had been substantially consummated.  This was because, in the Court’s view,  the other three factors weighed in favor of appellate review and against application of the equitable mootness doctrine.  See In re Transwest Resort Props., Inc., 2015 WL 3972917 (9th Cir. July 1, 2015).  Link to Transwest Decision  The Transwest decision calls into question the finality of confirmation orders in the Ninth Circuit.  It should be of particular interest to third party investors in bankruptcy estate assets, as well as to parties seeking to appeal confirmation of a plan of reorganization.

    In Transwest, the debtors proposed a plan of reorganization by which a private equity fund (“Investor”) would invest at least $30 million and become the sole owner of two hotels.  The plan was opposed by the secured creditor (“Creditor”), who had purchased $260 million of secured claims before and during the bankruptcy.  The debtor’s plan was confirmed by the bankruptcy court.  Creditor appealed the confirmation and moved to stay the implementation of the plan.  Debtor and Investor successfully opposed the stay at the bankruptcy and district court levels and the plan was substantially consummated—the Investor assumed operating contracts and began running the hotels.

    Creditor appealed to the Ninth Circuit.  Despite substantial consummation of the plan, the Ninth Circuit held that the Creditor’s appeal was not equitably moot.  Id. at *1.  It noted that in other circuits, including the First and Second Circuits, substantial consummation creates a presumption of equitable mootness.  Id. at *5.  In the Ninth Circuit, however, substantial consummation is just one of four factors courts must consider.  Analyzing the other factors, the Court held that each one disfavored application of the equitable mootness doctrine. 

    The critical lynchpin of the Court’s analysis—and the portion that makes the case most notable—is the Court’s coinclusion that “[Investor’s] involvement in the reorganization process means it is not the type of innocent third party . . . equitable mootness . . . is intended to protect.”  Id. at *6.  After it became seriously engaged in the process of buying the hotels from the estate through the plan, Investor did what most investors in its position would do: it weighed in on the terms of the confirmation order, filed briefs supporting the plan and opposing Creditor’s attempts to defeat confirmation, and then opposed Creditor’s request for a stay.   Because Investor participated in the case in this manner, the Court held that Investor’s reliance interests could not be considered in the equitable mootness analysis.  In other words, to be equitably moot, the appeal would have to unfairly upset the interest of some otherthird partyBecause any amendment to the plan would impact only the monetary distribution between Investor and Lender, the appeal was not equitably moot.  Id. 

Conclusion

    As noted by the dissent, the Ninth Circuit’s Transwest holding may have the effect of discouraging parties from investing in bankruptcy estate assets.  Potential investors should be aware that even after they obtain a bankruptcy court order memorializing the terms of their transaction with the estate, that order could be subject to revision until all appeals are concluded.  Accordingly, investors may want to consider phasing their investments over time or eliminating their performance obligations (and unwinding prior investments) if the terms of the confirmed plan are amended on appeal. 

    On the other hand, the Transwest decision holds promise for parties who have unsuccessfully opposed confirmation of a reorganization plan.  The Ninth Circuit’s narrow construction of the equitable mootness doctrine means that parties enjoy a greater likelihood of having their confirmation objections heard on appeal.

February 3, 2015

Ninth Circuit Adopts a Strict “Dominion” Test for Purposes of Determining Initial Transferee Status under 11 U.S.C. sec. 550(a), With “Control” Playing No Part

In its opinion in Mano-Y&M, Ltd. V. Dane S. Field (In re The Mortgage Store, Inc.), 2014 WL 6844630 (9th Cir. 2014), the Ninth Circuit adopted a strict “dominion” test for purposes of determining who is the initial transferee of an avoidable transfer, clearly stating that equitable concepts of “control” play no part in determining initial transferee status.  In doing so, the court stated that the Ninth Circuit BAP’s decision in McCarty v. Richard James Enters., Inc. (In re Presidential Corp.), 180 B.R. 233 (9th Cir. BAP 1995) is no longer good law.

The facts of The Mortgage Store involved a sale of property, with the purchase price paid in part by a loan from The Mortgage Store to the purchaser.  The loan proceeds, along with the balance of the purchase funds, were deposited into a trust account held by the seller’s law firm, where they were held pursuant to an escrow agreement.  The attorney disbursed the funds pursuant to the purchase agreement.  It turned out that The Mortgage Store had been operating a Ponzi scheme, and the bankruptcy trustee brought an action against Mano-Y&M (“Mano”), as seller, to recover the loan proceeds it had been paid through the closing.  Mano contended the purchaser, for whose benefit the loan proceeds were transferred, was instead the initial transferee of the monies paid by The Mortgage Store in connection with the transaction.  The Ninth Circuit disagreed, held the seller was the initial transferee of the funds, and affirmed the judgment in favor of the bankruptcy trustee.

The court began its analysis with noting that § 550(a) does not define the term “initial transferee.”  The court referred to its prior adoption of the “dominion” test in Universal Serv. Admin. Co. v. Post-Confirmation Comm. Of Unsecured Creditors of Incomnet Commc’n Corp. (In re Incomnet), 463 F.3d 1064 (9th Cir. 2006) where it stated:  “Under the dominion test, a transferee is one who . . . has dominion over the money or other asset, the right to put the money to one’s own purposes.”  Id. at 1070. The court stated that a key factor in the dominion test is “whether the recipient of the funds has legal title to them” and whether the recipient has “the ability to use [the funds] as he sees fit.”  Id. at 1071.  The court cited to the Seventh Circuit’s opinion in Bonded Financial Services, Inc. v. European American Bank, 838 F.2d 890, 894 (7th Cir. 1988), where the Seventh Circuit held that a person will have dominion over a transfer if he is “free to invest the whole [amount] in lottery tickets or uranium stocks.” 

Following the Ninth Circuit’s decision in Incomnet, the Ninth Circuit BAP used a “dominion and control” test in In re Presidential, a test which arguably had been condoned by the Ninth Circuit.  See Schafer v. Las Vegas Hilton Corp. (In re Video Depot, Ltd.), 127 F.3d 1194 (9th Cir. 1997).  Elements of “control” for purposes of determining initial transferee status require courts to “step back and evaluate the transaction in its entirety to make sure that their conclusions are logical and equitable.”  The control test is a more flexible approach which empowers a court to utilize concepts of equity in determining who is an initial transferee. 

The Ninth Circuit in The Mortgage Store held that equitable concepts of “control” play no part in determining who is an initial transferee for purposes of § 550(a) and that the sole standard is one of “dominion.” 

Applying the strict dominion standard, the court affirmed the finding that the seller, whose legal title to the funds was unquestioned, and had the right to compel payment of the funds by the escrow agent to him following his execution of the documents conveying title to the property to the purchaser.  The purchaser had no ability to manipulate the funds on his own accord.  Mano had not argued that any other person, such as the attorney acting as the escrow agent, was the initial transferee.  Because the court found the purchaser was not the initial transferee, and because Mano had not argued that anyone else was, the court affirmed the judgment in favor of the bankruptcy trustee.

If Mano had argued that the attorney acting as escrow agent was the initial transferee, would the Ninth Circuit have agreed?  The opinion does not say, but the question is an open one. 

November 25, 2014

Ninth Circuit BAP Reluctantly Holds That a State Court Civil Contempt Proceeding is not Subject to the Automatic Stay, Following Ninth Circuit Court of Appeals Precedent under the Bankruptcy Act

Citing Ninth Circuit precedent from cases under the Bankruptcy Act, , the Ninth Circuit BAP reluctantly held that a pre-petition state court civil contempt proceeding is exempt from the automatic stay of sec. 362 of the Bankruptcy Code.  The decision of the BAP is Yellow Express, LLC v. Mark Dingley (In re: Dingley), 514 B.R. 591 (9th Cir. BAP 2014).

Pre-petition Yellow Express brought an action against the debtor and two LLCs he owned and controlled seeking judgment on various causes of action.  The debtor and his LLCs failed to appear for depositions, and the state court imposed sanctions against them.  When the debtor and his LLCs failed to pay the sanctions, Yellow Express filed an application for an order to show cause why the defendants should not be held in contempt for failure to pay the sanctions.  The state court entered an order requiring the defendants to appear in court to show cause why they should not be held in contempt for failing to pay the discovery sanctions.  Following the issuance of the Order to Show Cause and the date of the contempt hearing, Dingley filed a personal bankruptcy case, but neither of the LLCs filed bankruptcy.  The debtor’s state court and bankruptcy counsel notified Yellow Express’ attorney of the bankruptcy filing, asserting the contempt hearing could not proceed in light of the bankruptcy filing.  Yellow Express’ attorney replied that Ninth Circuit authority excepted a state court contempt proceeding from the automatic stay, relying on the David v. Hooker, Ltd., 560 F.2d 412 (9th Cir. 1977) and Dumas v. Atwood (In re Dumas), 19 B.R. 676 (9th Cir. BAP 1982).  The state court vacated the contempt hearing, but requested the parties submit briefing on the applicability of the stay to the contempt hearing.  Yellow Express’ attorney submitted its brief as ordered by the state court, with its brief arguing that the contempt proceeding could proceed against the debtor.

The debtor filed a motion in the bankruptcy court to enforce the automatic stay, contending the automatic stay prevented the state court from proceeding with the contempt action against the debtor and seeking sanctions against Yellow Express for willful violation of the stay for filing its state court brief asserting that the stay did not apply to the contempt proceeding.  Yellow Express responded, again contending the contempt action was excepted from the stay under prior Ninth Circuit precedent.  The bankruptcy court ruled that the contempt proceeding was stayed by the bankruptcy filing and further imposing sanctions against Yellow Express, finding it violated the stay by urging the state court to proceed with the contempt hearing, which was designed to force the debtor to pay the discovery sanctions which had been imposed pre-petition.

On appeal, the BAP reversed, albeit reluctantly.  The BAP noted that the Ninth Circuit has created a bright-line rule on whether the automatic stay applies to state court contempt proceedings:  if the sanction order “does not involve a determination [or collection] of the ultimate obligation of the bankrupt nor does it represent a ploy by a creditor to harass him” the automatic stay does not prevent the contempt proceeding from going forward.  Hooker, 560 F.2d at 418.  Hooker also involved a state court discovery sanction, directing the debtor to answer interrogatories and pay attorney’s fees.  The Ninth Circuit in Hooker held the automatic stay suspends, but does not dismiss, pre-petition state court actions, and that not every aspect of a pre-petition state court action is suspended by the stay. Specifically, the Ninth Circuit ruled that a proceeding addressing the debtor’s disobedience of a state court order issued prior to the automatic stay is not suspended by the stay, as such proceedings are not an “attempt in any way to interfere with the property which had passed to the control of the bankruptcy court; it sought merely to vindicate its dignity which had been affronted by the contumacious conduct of a person who ignored its order.”  Id.  Following enactment of the Bankruptcy Code, the Ninth Circuit BAP in Dumas, relying on Hooker,  held that a bankruptcy filing does not stay a sentencing hearing on a pre-petition state court contempt action for violating a subpoena.

The BAP also noted that other courts had interpreted Hooker as creating a judicially-crafted exception to the automatic stay of sec. 362(a).  KuKui Gardens Corp. v. Holco Capital Group, 675 F. Supp. 2nd 1016 (D. Haw. 2009); Lowery v. McIlroy & Millian (In re Lowery), 292 B.R. 645, (Bankr. E.D. Mo. 2003).  The BAP further noted that other courts have criticized Hooker  and Dumas, stating that there should be no judicially-created exceptions to the automatic stay.  In addition, the BAP referred in its opinion to other courts which had distinguished Hooker and Dumas, finding that a state court civil contempt proceeding can be justified if it is brought solely to deter wrongful conduct such as showing disrespect to the court, but is not justified if a creditor is using it merely to collect money due.  See In re Musaelian, 286 B.R. 781 (Bankr. N.D. Cal. 2002).  Finally, the BAP noted that two courts, including the Ninth Circuit, have excepted pre-petition contempt proceedings under one of the statutory exceptions found in sec. 362(b).  Alpern v. Lieb, 11 F.3d 689  (7th Cir. 1993); Berg V. Good Samaritan Hosp. (In re Berg), 230 F. 3d 1165 (9th Cir. 2000). 

The BAP ultimately reached its decision to reverse the bankruptcy court based on the precedent of Hooker and Dumas, ruling that a contempt action for nonpayment of court-ordered sanctions is not stayed by the automatic stay of sec. 362 unless the contempt proceeding turns on the determination or collection of the underlying debt.  The concurring opinion stated that, while Hooker is binding, its creation of the judicially-crafted exception to the automatic stay for state court contempt proceedings, is inconsistent with the modern breadth of the automatic stay and at odds with the plain language of the statute.  The majority opinion saw merit in the concurrence’s statement, but stated that it is up to the Ninth Circuit to determine whether Hooker remains valid law.

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.

June 6, 2013

Ninth Circuit BAP Holds that a Judgment Requiring Buyout of LLC Member Interest is Subject to Mandatory Subordination Under Section 510(b)

In a case of first impression in the Ninth Circuit, the Ninth Circuit BAP has held that a judgment setting the amount at which a limited liability company must repurchase a withdrawing member’s interest is subject to mandatory subordination under § 510(b).  O’Donnell v. Tristar Esperanza Properties, LLC (In re Tristar Esperanza Properties, LLC), 2013 WL 870238 (9th Cir. BAP 2013). 

The plaintiff O’Donnell purchased a member interest in Tristar in 2005.  Three years later, O’Donnell invoked the provisions of Tristar’s operating agreement to obtain a redemption of her member interest.  Pursuant to the operating agreement, Tristar paid O’Donnell $60,000 on account and the two jointly retained an appraiser to appraise O’Donnell’s interest.  The appraisal indicated a
value of $399,918, a value which Tristar considered to be “absurd” because it did not take into account secured debt owed by the company to a third party, which Tristar believed should have reduced the valuation to about $22,000.  O’Donnell thereafter initiated an arbitration
proceeding, which resulted in an arbitration award of $399,918.  The award was confirmed by a California superior court and reduced to judgment. 

Shortly after the judgment was entered, Tristar filed bankruptcy, and prosecuted an adversary proceeding seeking mandatory subordination of O’Donnell’s claim under § 510(b).  The bankruptcy court ruled in favor of Tristar, finding that the judgment constituted “damages” arising from the sale
of a security and, therefore, subject to mandatory subordination under § 510(b).  On appeal the BAP noted the following issues:  (1) whether a contractually-required buy-back of an LLC membership interest constitutes a “purchase or sale” of a “security” of the debtor within the meaning of § 510(b), (2) whether O’Donnell’s claim was for “damages” within the meaning of § 510(b), and (3) whether O’Donnell’s withdrawal as a member and obtaining her judgment before Tristar filed bankruptcy rendered § 510(b) inapplicable.

The court easily found that a contractually-required buy-back of an LLC membership interest constitutes a purchase or sale of a security within § 510(b).  Although member interests do not appear in the list of definitions of “securities” in § 101(49)(A), nor are they mentioned in the list of what are not securities in § 101(49)(B), the court found that the lists were not restrictive because they
stated that they “included” the interests listed.  Noting that a limited partner interest in a limited partnership is a security, and further noting that the interest of a member in a limited liability company is quite similar, the court found that a member’s interest in an limited liability company constitutes a security for purposes of § 510(b). 

The court then addressed whether the judgment on the arbitration award qualified as “damages” arising from the purchase or sale of a security within the statute.  The court determined that the “classic hornbook” on damages describes damages as “primarily how much can be recovered” on any basis for liability and as the preferred remedy over specific performance.  Charles T. McCormick, Handbook of the Law of Damages, § 1 (1935).  The court determined that it could find no basis for holding that “damages” under § 510(b) should be read more narrowly than the common concept of the term, rejecting O’Donnell’s argument that “damages” for purposes of § 510(b) requires actionable wrongdoing or malfeasance rather than merely enforcing a contract.

The court then addressed whether O’Donnell’s claim arose from the purchase or sale of the debtor’s securities.  First, the court noted that the term “arising from” as used in § 510(b) has been found ambiguous by several circuits, including the Ninth Circuit.  Because her claim had been reduced to judgment, O’Donnell argued that her claim should be characterized as an ordinary unsecured debt, to be treated on a par with Tristar’s other unsecured creditors.  In analyzing O’Donnell’s claim, the BAP noted that courts have developed narrow and broad readings of the term “arising from” as used in §
510(b).  The narrow view requires that the claim arise from the actual purchase or sale of a security, whereas the broad view requires that the purchase or sale be part of a causal link even though the injury may flow from a subsequent event.  The court then noted that the Ninth Circuit has adopted the broad view. In re Betacom of Phoenix, 240 F.3d 823, 828 (9th Cir. 2001).  The broad view is based on the differing expectations of owners and creditors. 

While both assume risk in their dealings with the debtor, an owner has an expectation of potential for an increase in the value of his ownership interest in the debtor but accepts that in the event of  nsolvency he will recover on his interest only after creditors are paid; whereas, the creditor expects not to share in the profits of the enterprise but does expect insolvency to receive payment ahead of returns to owners.  The Ninth Circuit BAP relied heavily on this view in agreeing that O’Donnell’s claim, although reduced to judgment before the debtor file bankruptcy, was still “so firmly rooted” to her equity claim that § 510(b) mandated its subordination to unsecured claims.

April 24, 2013

Ninth Circuit BAP Clarifies Standard of Review for Undue Hardship Determination

Under 11 U.S.C. § 523(a)(8), student loans are excepted from a debtor’s discharge unless paying those loans would “impose an undue hardship on the debtor and the debtor’s dependents.”  In the Ninth Circuit, a debtor must prove three elements to obtain a discharge of student loans—(1) that the debtor cannot maintain, based on current income and expenses, a minimal standard of living for him/herself and his/her dependents if forced to repay the loans; (2) that additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period of the student loans; and (3) that the debtor has made good faith efforts to repay the loans.  See United Student Aid Funds v. Pena (In re Pena), 155 F.3d 1108, 1111 (9th Cir. 1998).

In Roth v. Education Credit Management Corp., BAP No. AZ-11-1233-RnPaKi (B.A.P. 9th Cir. filed Apr. 16, 2013) the Bankruptcy Appellate Panel for the Ninth Circuit was faced with the determination of whether the bankruptcy court erred in concluding that the debtor failed to make a good faith effort to repay her student loans.  However, a threshold question the court had to resolve before deciding whether the bankruptcy court erred was what standard should be applied in reviewing that determination as Ninth Circuit precedent contains contradictory language regarding the appropriate standard of review.

First, the court found that it is clear from existing case law that the ultimate undue hardship determination is reviewed de novo even though the undue hardship determination is a mixed question of fact and law as it requires a determination of the legal effect of the bankruptcy court’s findings regarding the student’s circumstances.  The court explained that mixed questions of fact and law are reviewed de novo because they “require consideration of legal concepts and the exercise of judgment about the values that animate legal principals.”  Roth, 11:2-4.  De novo review is of course, independent and gives no deference to the bankruptcy court’s conclusion.

Second, the court went on to state that the bankruptcy court’s determinations of facts underlying its undue hardship determination are reviewed for clear error.  Review for clear error is significantly deferential to the bankruptcy court and an appellate court should not reverse a bankruptcy court’s factual findings unless it is left with a “definite and firm conviction that a mistake has been committed.”  Id. at 11:17-18.

However, what was not so clear is the standard of review to be applied to the three individual elements that a debtor must establish to obtain a discharge of student loans because Ninth Circuit case law at times acknowledges that the ultimate undue hardship determination is a question of law reviewed de novo but nevertheless, uses clear error language in its analysis.  The court held that the three hardship elements are subject to do novo review because they are stand-alone requirements and failure to prove any one precludes discharge.  The court reasoned that “if the ultimate undue hardship determination is reviewed de novo…, it must then follow that the three independent prongs are also mixed questions requiring de novo review.  If not, and they instead are simply factual determinations, the reviewing court, upon finding no clear error as to each prong, would be bound to uphold the bankruptcy court as to the ultimate hardship determination.  Such a mechanical application…would negate the reviewing court’s ability to ‘exercise judgment’.”  Id. at 14:4-14. 

Therefore, in sum, the court held that appellate courts in the Ninth Circuit should review: (1) the ultimate undue hardship determination de novo; (2) the bankruptcy court’s factual findings for clear error; and (3) the three hardship elements de novo.

February 25, 2013

Ninth Circuit BAP Addresses the Elements Required to Establish Substantial Justification Under Sec. 523(d)

Creditors who purchase consumer debt should be aware of a recent ruling by the Ninth Circuit BAP in considering whether to pursue a claim for non-dischargeability under section 523(a)(2).

In its decision in Heritage Pacific Financial, Inc. v. Raul Machuca, Jr. (In re Machuca), 2012 WL
652317 (9th BAP 2012), the Ninth Circuit BAP addressed the level of proof required for a creditor to establish that its losing pursuit of a non-dischargeable judgment under sec. 523(a)(2) was substantially justified.  In Machuca, Heritage Pacific Financial sued the debtor, Raul Machuca,
seeking a denial of the discharge of Machuca’s debt to Heritage under 11 U.S.C. sec. 523(a)(2).  Heritage had acquired the debt in question, a loan secured by a single family residence owned by the
debtor, from National City Bank.  Heritage asserted that Machuca committed fraud in connection with the loan application.  The loan in question was a “stated income” loan, and the loan application was taken over the phone by National City.  The evidence presented at trial on the dischargeability action established that National City approved the loan before Machuca signed the loan application, that various documents indicated substantially different incomes for Machuca, and that National City did not rely on the information provided by Machuca in approving the loan despite the fact that the loan
application contained a certification of the truth and correctness of the information in it. 

Furthermore, Heritage failed to present any evidence that it relied on the information when it
purchased the loan from National City. The bankruptcy court granted the debtor’s motion for summary judgment, finding that National City had not reasonably relied on the information contained in the loan application before it extended the loan, and that no reasonable lender could have relied on the information in the loan application and related documents, given the numerous red flags contained in them.  Heritage did not appeal the court’s judgment granting the debtor a discharge of the loan.

After the judgment was entered, the debtor then sought an
award of attorney’s fees under 11 U.S.C. sec. 523(d), which provides that, if a
creditor requests denial of the discharge of a debt under 523(a)(2) and loses,
the court shall award the debtor his or her reasonable attorney’s fees if the
court finds that the creditor’s position was not substantially justified.  In opposing the request for attorney’s fees, Heritage relied on the same evidence it presented in the original trial, that National City had reasonably relied on the information in the loan application.  The bankruptcy court entered an order granting attorney’s fees to the debtor, and the BAP affirmed. The BAP began its analysis by noting that section 523(d) required a bankruptcy court to award attorney’s fees to a prevailing debtor
unless such an award was “clearly inequitable.” 

However, finding that this standard discouraged the bringing of well-founded non-dischargeability actions, Congress amended 523(d) in 1984 to change the standard for awards from “clearly inequitable” to “substantial justification,” adopting the standard used in the Equal Access to Justice Act (“EAJA”).  The “substantial justification” standard provides that attorney’s fees shall be awarded to a prevailing debtor if the bankruptcy court finds that the creditor’s position in pursuing the
non-dischargeability action was not substantially justified.  The BAP then held that a debtor seeking an award of fees must establish three elements:  (1) that the creditor sought to except a debt from discharge under sec. 523(a)(2), (2) that the debt was a consumer debt and (3) that the debt was
ultimately discharged.  If the debtor proves these three elements, the BAP stated that the burden of proof then shifts to the creditor to establish that its position was substantially justified.

The BAP stated that, in order to prove substantial justification, the creditor must demonstrate that it had a reasonable factual and legal basis for its claim.  The claim may require reliance on a novel but reasonable legal theory, or an argument that the court should adopt one line of authority where courts are split.  However, a creditor cannot establish substantial justification by relying on the same facts on which it sought to obtain a denial of the discharge in the first instance, as such would be no
more than a collateral attack on the judgment allowing the discharge of the debt.  This was  articularly fatal to Heritage’s position, because it had not appealed the judgment allowing the discharge of the debt.  The BAP stated that Heritage’s failure to appeal the merits decision constituted a “waiver of any right to challenge the evidentiary rulings that led to it.” 

Consequently, in order to defeat an award of attorney’s fees, a creditor must do more than
argue that the bankruptcy court “got it wrong,”  and creditors who purchase consumer debt should carefully analyze the merits of non-dischargeability under section 523(a)(2) prior to bringing an
action.

January 21, 2013

Ninth Circuit BAP holds that a Debtor’s Income from Golf Course Driving Range and Greens Fees is not Cash Collateral

In its decision in In re Premier Golf Properties, LP, 477 B.R. 767 (9th Cir. BAP 2012), the Ninth Circuit BAP held that income from greens fees and driving range fees which a debtor enjoys from its ownership and operation of a golf course is not cash collateral.
In Premier Golf, the debtor financed its golf course property with Far East National Bank, obtaining a loan in the amount of $11,500,000 and securing it with a Deed of Trust, Security Agreement, Assignment of Leases and Rents and Fixture Filing (“Security Documents”) against the golf course property. The Security Documents granted broad rights to the bank against the real property and all of the income generated by it.

After the debtor filed bankruptcy, the bank sought to prohibit its use of the income it received from greens fees and driving range fees, asserting that such was the bank’s cash collateral. In focusing its analysis on sections 363 and 552 of the Bankruptcy Code, the BAP affirmed the bankruptcy court’s conclusion that the debtor’s driving range and greens fees were not cash collateral.
First, the court noted that “cash collateral” is defined in section 363(a) to consist of cash and cash equivalents in which the estate and an entity other than the estate have an interest. However, section 552(a) provides that, in general, a creditor’s pre-petition security interest does not extend to property acquired by the debtor after the filing of the case. The purpose of section 552(a) is to allow a debtor to “gather into the estate as much money as possible to satisfy the claims of all creditors.”

Second, the court reviewed and analyzed the provisions of section 552(b), which contains significant exceptions to section 552(a). Section 552(b)(1) allows a pre-petition security interest to extend to the post-petition proceeds, products, offspring, or profits of collateral, provided the security agreement expressly provides for such a lien and the security interest is properly perfected. In addition, section 552(b)(2) allows a pre-petition security interest to extend to rents or the fees, charges, accounts or other payments for the use or occupancy of rooms and other public facilities in hotels, motels or other lodging properties. The BAP stated that “read together, the provisions of section 363(c)(2) and section 552(b) protect a creditor’s collateral from being used by a debtor post-petition if the creditor’s security interest extends to one of the categories set out in section 552(b). Put another way, a creditor is not entitled to the protections of section 363(c)(2) unless its security interest satisfies section 552(b).”

The BAP agreed with the bankruptcy court that the driving range and greens fees did not constitute “rent” because the revenues were not generated by the use of the real property but instead from the labor and services the debtor performed in connection with operating the golf course. The BAP relied on its prior analysis in its decision in Zeeway Corp. v. Rio Salado Bank (In re Zeeway Corp.), 71 B.R. 210 (9th Cir. BAP 1987) in concluding that “rents” result from the occupancy of property, not from services provided in connection with a business operated on the property. In reaching its decision that driving range and greens fees are not cash collateral, the BAP agreed with the decision of the bankruptcy court for the District of Colorado in In re GGVXX, Ltd., 130 B.R. 322 (Bankr. D. Colo. 1991).

The BAP also concluded that the driving range and greens fees were not “proceeds” of the property. The court held that whether the revenues could be considered proceeds had to be determined by looking to section 9-102(a)(64) of the UCC, and determined that the revenues did not fall within that definition, because they derived from services performed by the debtor rather than being derived from the collateral itself.
In short, the BAP determined that the driving range and greens fees derived from the debtors’ post-petition labor and services, and not from the bank’s collateral. As a result, the court affirmed the bankruptcy court’s decision that the fees were not the bank’s cash collateral.