Successor Liability and Bankruptcy Sales: Can I Look to the Purchaser of My Customer’s Business for Payment of My Claim?

November 9 2023

Successor liability is a catchall term for a group of legal theories that, in certain circumstances, allow a creditor to recover amounts owed by its obligor from a person or entity who succeeds to the assets or business of that obligor. Typically, claimants cannot pursue successor liability against a purchaser in a bankruptcy sale because most sales are made “free and clear” of such claims under Section 363(f) of the Bankruptcy Code. However, there are some limited exceptions to this general rule.

Under Section 363(f) of the Bankruptcy Code, asset sales made in a bankruptcy case may be made “free and clear” of interests in the assets, including liens, claims, and encumbrances, under certain circumstances. The “free and clear” nature of these transactions is a defining feature of bankruptcy sales and a key motivator for buyers to purchase assets from a bankrupt company. Free and clear sales must meet at least one of the following conditions:

  1. Nonbankruptcy law permits the sale, “free and clear” of such interest;
  2. The holder(s) of such interest consent(s);
  3. The sale price exceeds the value of all liens on the property;
  4. Such interest is in bona fide dispute; and/or
  5. The holder(s) of such interest could be compelled to accept a money satisfaction of such interest.

Key Issues

  • Successor Liability. The majority of bankruptcy courts — although not all — have held that successor liability claims are “interests” of which assets can be sold “free and clear” under the Bankruptcy Code. Some courts have held that successor liability remains an issue determined by nonbankruptcy law and should not be impacted by the Bankruptcy Code, or have placed limits on the ability to sell assets “free and clear” of successor liability. Regardless of the approach a particular court takes, “free and clear” protection may not be effective against claimants who did not receive notice of the sale. Additionally, a purchaser may be unable to take assets “free and clear” of product liability claims and environmental claims that do not arise until after the sale closes.
  • Channeling Injunctions. In extreme circumstances, bankruptcy courts will issue a channeling injunction, whereby a claimant’s successor liability claims are channeled to a fund created, often from the proceeds of an asset sale, to satisfy such claims. In these cases, claimants can seek recourse from that recovery pool rather than attempt to bring a claim against a buyer.
  • Compliance With Bankruptcy Sale Orders. In courts that recognize the ability to sell assets “free and clear” of successor liability under the Bankruptcy Code, sale orders will often expressly enjoin the assertion of successor liability claims against the buyer or the assets being acquired. Even where a bankruptcy sale order is silent on the issue, though, a creditor contemplating pursuing a successor for the debts of a bankrupt obligor will want to ensure that its planned course of conduct does not violate the relevant sale order.

Takeaway

The intersection of bankruptcy law and successor liability is a complex issue, and the ability to seek recourse against a buyer who acquires assets pursuant to Section 363 will depend on the facts of the case and the precedent of the jurisdiction in which the bankruptcy is pending. In some cases, alternative recourse, such as a recovery pool created in relation to a bankruptcy court’s channeling injunction, may be available. If you have a potential successor liability claim against a buyer in a bankruptcy sale, it is important to have experienced bankruptcy counsel assess for the available recovery options.

Troutman Pepper – David M. Fournier, Evelyn J. Meltzer, Kenneth A. Listwak and Tori Lynn Remington
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Bankruptcy Trustees and Receivers Beware: The California Second District Court of Appeal Tests The Barton Doctrine’s Limits on Claims Against a Court-Appointed Officer Over a Distressed Commercial Real Estate Entity

October 26 2023

In Breanne Martin v. Leslie Gladstone, the Second District Court of Appeal recently decided a case that could reverberate throughout the receivership and bankruptcy industries. This case comes at a propitious moment as bankruptcy proceedings and receiverships – particularly for distressed commercial real estate entities – trend upward in California. Receivers and bankruptcy trustees alike should consider this case before operating a commercial real estate distressed entity.

The Doughertys’ Bankruptcy Proceeding

The case emerged from Christopher Dougherty and Nereida Dougherty’s Chapter 11 bankruptcy proceeding.[1]Their bankruptcy estate included their operating entity, JTA Real Estate Holdings, LLC (“JTA”), and JTA’s three properties, including one residential rental property located in Alpine, California (“Alpine Property”).[2] The bankruptcy court later converted the Doughertys’ bankruptcy case to Chapter 7 and appointed a Chapter 7 Trustee, Leslie Gladstone (“Trustee”).[3] Soon after her appointment, the Trustee sought the bankruptcy court’s consent to “Operate Business Pending Sale of Debtor’s Assets.”[4] Invoking its authority under 11 U.S.C. § 721, the bankruptcy court authorized the Trustee to operate JTA consistent with the orderly liquidation of the estate.[5] Under this authority, the Trustee could operate the Doughertys’ business assets, including the Alpine Property, until the Trustee liquidated the estate.[6] Three months after taking over the Doughertys’ business, the Trustee sought to abandon the Alpine Property because it was underwater and had “numerous” uncorrected code violations.[7] Shortly thereafter, the Trustee suffered a major setback: plaintiff Breanne Martin (“Martin”) sustained injuries at the Alpine Property before the Trustee abandoned it.[8]

Martin Sues the Trustee for Injuries She Incurred at the Alpine Property and the Trustee Seeks to Dismiss Martin’s Lawsuit

Martin sued the Trustee, asserting claims for negligence and premises liability.[9] The Trustee sought to dismiss Martin’s claims on two grounds. First, the Trustee argued that the Barton doctrine barred Martin’s claims because the bankruptcy court had not authorized her lawsuit.[10] Second, the Trustee contended that she was immune from Martin’s claims because she had abandoned the Alpine Property retroactively to the Doughterys’ bankruptcy filing date.[11] The trial court rejected the Trustee’s Barton doctrine defense but accepted the Trustee’s immunity defense from her abandonment of the Alpine Property.[12] The Martin Court reversed the trial court’s judgment.[13]

The Court of Appeal Reverses the Trial Court Judgment Against Martin

Considering the Trustee’s abandonment argument first, the Martin Court analyzed the transfers of a debtor’s property that occur during a debtor’s bankruptcy proceeding.[14] After a bankruptcy filing, the debtor’s legal and equitable interests in property become the property of the bankruptcy estate for creditors.[15] The debtor, however, may regain ownership and control over estate property during the bankruptcy case if the trustee abandons it.[16] After assessing these principles, the Martin Court focused on the impact of bankruptcy abandonment. As the Martin Court explained, “ownership and control of the asset is reinstated in the debtor with all rights and obligations before filing a petition in bankruptcy.”[17] Thus, the Martin Court conceived the key issue as the retroactive effect of the Trustee’s abandonment. The Trustee claimed the abandonment did more than just revert the Alpine Property to the Doughertys: It “operated as if the Doughertys retained … the Alpine Property, without interruption, throughout … the bankruptcy case.”[18] Although abandoned property reverts to the debtor from the petition date, the Martin Court refused to expand the bankruptcy abandonment rule as far as the Trustee urged.

The Martin Court recognized that retroactive abandonment is neither automatic nor absolute.[19] “Courts do not blindly give retroactive effective to a trustee’s abandonment of bankruptcy estate property in every situation.”[20]From this point, the Martin Court agreed with other bankruptcy courts that retroactive abandonment should occur only where justice requires it.[21] After searching nationwide, the Martin Court found no bankruptcy case where a court at the pleading stage applied abandonment retroactively to relieve a trustee of liability for injuries sustained on the bankruptcy estate property.[22] Comforted by this dearth of cases, the Martin Court declined to apply the legal fiction of relation back abandonment because it would have caused an unfair result – leaving Martin without a judicial remedy.[23] Retroactive abandonment also would have frustrated California’s policy of requiring those who exert control over property to ensure that such property remains reasonably safe.[24]Because Martin’s injuries occurred before the Trustee effectuated the abandonment, the Trustee was not absolved from liability for Martin’s injuries.

The Trustee implored the Martin Court to uphold the trial court’s dismissal anyway, citing the Supreme Court’s century-old Barton doctrine from Barton v. Barbour, 104 U.S. 126 (1881).[25] Under the Barton doctrine, an aggrieved party, before filing a lawsuit against a court-appointed officer, must obtain the appointing court’s consent.[26] The Barton doctrine safeguards trustees and receivers from “having to defend against suits by litigants disappointed by his actions on the court’s behalf, which would impede their work for the court.”[27] This vital protection for receivers and trustees is not limitless.[28] As the dissent in Barton acknowledged, the Bartondoctrine exceeds its purpose in cases where the court-appointed official does more than liquidate assets.[29]Congress, heeding this concern, precluded the Barton doctrine inqq situations where the court-appointed official continued the debtor’s business, rather than administered the estate.[30] Under 28 U.S.C. § 959(a), parties may sue “trustees, receivers, or managers of any property” for claims regarding “any of their acts or transactions in carrying on business connected with such property.”[31] Section 959 preserves the Barton doctrine for an aggrieved party’s claims against a trustee or receiver for actions consistent with preserving and liquidating the estate.[32] But if an aggrieved party challenges the trustee’s conduct in operating the debtor’s business, the aggrieved party need not obtain the appointing court’s consent to pursue such claims.[33]

Relying on bankruptcy cases nationwide limiting the Barton doctrine in similar scenarios, the Martin Court declined to apply it to Martin’s claims at the pleading stage.[34] Martin’s complaint alleged that the Trustee “owned, leased, occupied, maintained, or controlled” the Alpine Property as landlord during the relevant period.[35] The Trustee’s request to operate the Doughertys’ business and her monthly reports to the bankruptcy court supported this allegation.[36] Those documents showed that the Trustee was “carrying on an ongoing rental business connected with the premises” when Martin suffered her injuries.[37] Thus, the Martin Court concluded that Martin had sufficiently invoked § 959(a)’s exception to the Barton doctrine.[38]

Lessons from Martin

The Martin Court tried to protect Martin from a perceived Catch 22 – in which the debtor could not be liable because the accident happened post-petition and while the trustee owned and controlled the estate property, but the trustee could not be liable because she had “retroactively” abandoned the estate property. The Martin Court believed equity required it to apply § 959’s exception to the Barton doctrine and hold the Trustee responsible for Martin’s injuries. While Martin did not break new ground, it illuminates a risk that bankruptcy trustees and federal receivers take in operating a distressed commercial real estate entity. After Martin, an aggrieved party may now try to sue a court-appointed official (a bankruptcy trustee or a federal receiver) for injuries at a property owned and controlled by the court-appointed official. For the Martin Court’s attempts to protect the aggrieved party though, the opinion does not sweep as far as it may seem.

A bankruptcy trustee or a federal receiver faced with an aggrieved party’s lawsuit could try to distinguish Martinon its facts. The Martin Court seems to have overemphasized the effect of the Trustee’s decision to operate the Doughertys’ business. That decision, the Martin Court believed, unequivocally showed that the Trustee went beyond “the mere administration of property” and operated the Alpine Property like the Doughertys’ prebankruptcy. The decision though was consistent with the Trustee’s principal duty to “collect and reduce to money property of the estate ….”[39] The bankruptcy court authorized the Trustee to operate the Doughertys’ business for a limited time and consistent with an orderly liquidation. The Trustee undertook this task early to preserve the business assets while the Trustee sought to market them. That function should have been incidental to preserving the Doughterys’ business assets – a result that ordinarily should have triggered the Barton doctrine. The Martin Court did not hold that whenever a bankruptcy trustee seeks to temporarily operate a debtor’s business, the trustee automatically loses the Barton doctrine’s protection.

If the Barton doctrine does not apply when a bankruptcy trustee or a federal receiver operates a debtor’s business, both court-appointed officials still may be immune from an aggrieved party’s claims. The Martin Court did not address or purport to decide the Trustee’s potential immunity to Martin’s claims. Courts have long recognized that bankruptcy trustees enjoy immunity because they “perform an integral part of the judicial process.”[40] Federal receivers also have “absolute quasi-judicial immunity from damages.”[41] While judicial immunity does not encompass every kind of lawsuit that might be filed against a federal receiver or a bankruptcy trustee, judicial immunity should extend to damage claims, such as those in Martin, for acts within the court-appointed official’s duties.[42] Following Martin, federal receivers and bankruptcy trustees confronted with litigation for acts within the scope of their duties should raise the immunity protection “at the very earliest stage of the proceeding.”[43] As courts have acknowledged, for this protection “to be meaningful, it must be effective to prevent suits … from going beyond” the pleading stage.[44]

A California state court receiver, unlike a bankruptcy trustee or a federal receiver, might argue that Martinminimally impacts state court receiverships. Section 959’s exception to the Barton doctrine generally applies to bankruptcy trustees and federal receivers, not state court receivers.[45] California has no state corollary exception to § 959; in California, an aggrieved party must obtain the appointing trial court’s permission to sue a state court receiver in state court.[46] But a plaintiff’s failure to obtain leave is not jurisdictional and it may be cured at any stage of the proceedings.[47] Thus after Martin, a state court receiver that seeks to operate a debtor’s business should ensure that the appointing order acknowledges the receiver’s immunity for its work in operating the business and managing the debtor’s business assets. That language would bolster the receiver’s quasi-judicial immunity for acts within the receiver’s duties, and the receiver could use this immunity protection at the earliest stage of the aggrieved party’s action.[48]

To view all formatting for this article (eg, tables, footnotes), please access the original here.
Buchalter – Jarrett S. Osborne-Revis
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Did The Supreme Court Just Undermine Daimler? A Caution for Multistate Companies

USA June 28 2023

Hidden amidst the more high profile end of term decisions from the Supreme Court is a seemingly boring procedural decision that could have significant impact on businesses and expose them to litigation in a multiplicity of states where they never expected to be sued.

Nine years ago, in Daimler AG v. Bauman, 571 U.S. 117 (2014), the Court ruled that businesses are generally susceptible to suit only where they are incorporated and in their principal place of business. They are not subject to suit in a state on any matter merely because they happened to do some business there, including through a subsidiary. And businesses with a national distribution network therefore are not subject to suit anywhere their goods happen to end up. Id. 760-62.

In the new Mallory v. Norfolk Southern R. Co. decision, however, 600 U.S. ___ (Jun. 27, 2023), the Court dialed that back and held that Daimler should not be read so broadly. Instead, companies are also subject to suit in states where they are registered to do business if the registration statute of the particular state provides for a consent to jurisdiction. In that event, they are deemed present in the state just as a domestic company would be and can be sued for anything — contract, tort or otherwise — even if the lawsuit has no connection to any business the company transacted in the state.

Relying on the concept that consent has always been an exception to the old rule in International Shoe Co. v. Washington, 326 U.S. 210 (1945), that the Due Process clause protects against the unfairness of “haling” someone into court in another state with which it has few (if any) contacts, the Court held that the rule about personal jurisdiction being “specific” or “general” — which underpins Daimler — exists “side by side” a regime that continues to allow jurisdiction based on presence. And consent to jurisdiction under Pennsylvania’s registration to do business statute was held to be tantamount to physical presence since the statute says that an out of state business, once registered, is “deemed … located” in the state and treated the same as a local Pennsylvania business, and that once registered, state courts may “exercise general personal jurisdiction” over an out of state company. Norfolk Southern, slip op. at 10-11.

Of course, not all state foreign business registration statutes are written the same way, and Pennsylvania’s was particularly clear about registration constituting consent to jurisdiction. This made it easier for the Court to point to Norfolk Southern’s 20 years of registration-based consents and significant Pennsylvania operations as evidence that there was nothing unfair about making it litigate in Pennsylvania even in cases having no connection to the state. Id., slip op. at 17-20. But as the Court itself notes, some state business registration statutes are vaguer and just appoint the Secretary of State as agent for service of process, without saying for what types of cases they are appointed, or limit the jurisdictional consent to certain types of suits or certain types of companies. Id., slip op. at 6-7. The Court, relying on Pennsylvania Fire Inc. Co. v. Gold Issue Mining & Milling Co., 243 US. 93 (1917), nonetheless suggests that such a general appointment may well constitute a broad consent to jurisdiction. Norfolk Southern, slip op. at 8-9.

The Court’s decision in Norfolk Southern was limited to the question of whether holding an out of state company to jurisdiction in such circumstances violates the Due Process clause of the Constitution, and the Court held (5-4) that it does not. But the Court fractured — with four separate opinions — on what that means going forward.

Notably, Justice Alito’s concurrence highlights an argument not only for the Pennsylvania courts to consider on remand of Norfolk Southern, but also for businesses to use in other cases in an effort to narrow the impact of the Court’s ruling. Specifically, he noted that notwithstanding the purported consent, allowing states to mandate that companies must consent to all-purpose jurisdiction in their state as a condition of doing business may violate the Commerce Clause, either as discrimination against, or an undue burden on, interstate commerce. Concurring slip op. at 11-13. In that regard, he questioned what legitimate local purpose a state can have in seeking to exercise jurisdiction over companies based elsewhere when the claim has nothing to do with that forum state. And applied 50 times over, that would mean that every state can host litigation against companies that do business nationwide — the exact opposite of the result in Daimler — as long as their foreign business registration statute has some type of non-negotiable consent language, such that the commercial imperative of registering to do business in a state renders the company susceptible to all manner of lawsuits there.

As a practical matter, there is not much that many businesses can do about this conundrum. The commercial necessity of selling goods and services nationwide means that they may have no choice but to “consent” to broad jurisdiction in states that leave a company no option but to “consent” if they want to transact in the state. Whether a company with a sufficient appetite for litigation is willing to undertake a lengthy Commerce Clause challenge to such a regime in a later case has yet to be seen. For now, businesses need to be mindful that what was once perceived as a ministerial act of registering to do business in multiple states (and paying any required fees and taxes there) may now be a broad license to be sued in the courts of that state even in matters having nothing to do with the business transacted there.

Fried Frank Harris Shriver & Jacobson LLP – Peter L. Simmons, Michael C. Keats, Samuel P. Groner and Michael P. Sternheim

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In re Purdue Pharma L.P.: Second Circuit Reverses S.D.N.Y and Holds Bankruptcy Court Has Subject Matter Jurisdiction and Statutory Authority to Approve Sackler Family Releases

USA June 6 2023

On May 30, 2023, the United States Court of Appeals for the Second Circuit (the “Second Circuit” or the “Court”) rendered a much anticipated opinion (the “Opinion”),1 reversing the order of the United States District Court for the Southern District of New York (the “District Court”) that the Bankruptcy Code does not permit non-consensual third-party releases of direct claims and affirming the order of the United States Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”) confirming the chapter 11 plan (the “Purdue Plan”) of Purdue Pharma L.P. (“Purdue”), which approved non-consensual third-party releases of the owners of Purdue — members of the Sackler family.

The Opinion comes on the heels of a line of recent district court opinions upholding the propriety of non-consensual third-party releases in appropriate circumstances,2 a pending appeal before the Third Circuit Court of Appeals on the third-party releases approved in the Boy Scouts of America plan,3 and pending petitions for writ of certiorari in Highland Capital seeking review by the United States Supreme Court (the “Supreme Court”) of the scope of permissible plan exculpations, and whether Bankruptcy Code § 524(e) prohibits a chapter 11 plan from exculpating or releasing non-debtors for liability as held by the Fifth Circuit and consistent with rulings of the Ninth and Tenth Circuits.4

Background and Procedural History

On December 16, 2021, the District Court vacated the Bankruptcy Court’s order confirming the Purdue Plan, which had approved a mediated settlement that included non-debtor third-party releases for the Sacklers.5 For a detailed discussion on the background and procedural history of the Purdue bankruptcy case, see In re Purdue Pharma L.P.: S.D.N.Y. Holds Bankruptcy Court Lacks Statutory Authority to Approve Sackler Family Releases, VELaw.com (Dec. 28, 2021).

The Opinion

At issue before the Second Circuit was: (1) whether the Bankruptcy Court had the authority to approve the Purdue Plan’s non-consensual release of direct third-party claims against the non-debtor Sacklers; and (2) whether the Bankruptcy Code, the factual record, and equitable considerations supported the Bankruptcy Court’s approval of the Purdue Plan. The Second Circuit concluded that: (1) the Bankruptcy Court had “related-to” jurisdiction to approve the releases through submission of proposed findings of fact and conclusions of law to the District Court; (2) the Bankruptcy Court had the requisite statutory authority under §§ 105(a) and 1123(b)(6) to approve the releases; and (3) the factual record supported the Bankruptcy Court’s approval of the releases under a newly pronounced seven-factor test.

Subject Matter Jurisdiction: The Second Circuit first addressed whether the Bankruptcy Court had subject matter jurisdiction to approve the releases and found that it had “related-to” jurisdiction, but it lacked constitutional authority to approve the releases on a final basis. As such, the Second Circuit agreed with the District Court’s construction of the Bankruptcy Court decision as setting forth its proposed findings of fact and conclusions of law for the District Court’s de novo review.

Statutory Authority: Expressly joining the view of the majority of circuits, the Second Circuit explained that together, §§ 105(a)6 and 1123(b)(6)7 provide the statutory equitable authority necessary to permit the Bankruptcy Court’s approval of the Purdue Plan.8 The Second Circuit rejected the view of the minority of circuits that § 524(e)9 bars non-consensual third-party releases because they impermissibly discharge non-debtors.

The Second Circuit’s Test: The Second Circuit ruled that courts should consider the following seven factors:

whether there is an identity of interests between the debtors and released third parties, including indemnification relationships, such that a suit against the non-debtor is, in essence, a suit against the debtor or will deplete the assets of the estate;
whether claims against the debtor and non-debtor are factually and legally intertwined, including whether the debtors and released parties share common defenses, insurance coverage, or levels of culpability;
whether the breadth of the release is necessary to the plan;
whether the release is essential to the reorganization, in that the debtor needs the claims to be settled in order for the res to be allocated (and not because the released party is somehow manipulating the process to its own advantage10);
whether the non-debtor contributed substantial assets to the reorganization;
whether the impacted class of creditors “overwhelmingly” voted in support of the plan;11 and
whether the plan provides for fair payment of enjoined claims, with a focus on the fairness of the payment and not the final amount of the payment.
Significantly, the Court explained that “[a]lthough consideration of each factor is required, it is not necessarily sufficient — there may even be cases in which all factors are present, but the inclusion of third-party releases in a plan of reorganization should not be approved.” Moreover, “[f]or the bankruptcy court to make such findings, extensive discovery into the facts surrounding the claims against the released parties will most often be required.”

Ultimately, the Second Circuit concluded that the Bankruptcy Court did not err by approving the Purdue Plan, and the Court identified the following findings, supported “in tens of millions of documents produced in discovery,” as relevant to that approval:

the identity of interests between the Debtors and those Sacklers named as defendants in the litigations;
the factual and legal overlap between claims against Debtor and settled third-party claims;
the releases being required to ensure that the valuation of the res is settled;
the scope of the releases was limited so that the released claims related only to the Debtor’s conduct and the estate;
the res itself amounted to only approximately $1.8 billion and, without the Purdue Plan, the government would recover its $2 billion first, which would deplete the res completely and prevent any recovery by other creditors;
the impact of the financial contribution of $5.5–0 billion is one of the largest contributions to a bankruptcy anywhere in the country; and
the valuation of claims (estimated at $40 trillion) far exceeds the total funds available and the Sackler’s wealth, which created the need for the Purdue Plan’s “intricate settlements.”
Summary of Key Takeaways

The Second Circuit’s Opinion further demonstrates the split among circuits as to the validity and permissibility of third-party releases in plans of reorganization. Notably, the Court’s requirement that a bankruptcy court submit proposed findings of fact and conclusions of law to a district court for its approval where third-party releases are included may delay the plan confirmation process in certain cases. The new seven-factor test could also prove burdensome for some plan proponents seeking non-consensual third-party releases as part of a global compromise, particularly in light of the Court’s emphasis on the need for extensive discovery and particularized factual findings to support the inclusion of third-party releases in a plan. In light of the circuit split, including the different approval standards among the permissive circuits, parties may continue to experience uncertainty in seeking third-party releases in a package that otherwise delivers a complete resolution. These issues may well ultimately be addressed by the Supreme Court (as practically invited by Judge Wesley in his concurring opinion) to resolve the circuit split and adopt a uniform approach.

Vinson & Elkins LLP – Katherine Drell Grissel, Kristie Torkildsen Duchesne, David S. Meyer, Steven M. Abramowitz, Bradley Foxman, Paul E. Heath, George R. Howard, Lauren R. Kanzer, Jessica C. Peet, William L. Wallander and Steven Zundell

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Grammar Dooms Innocent Spouse in Non-Dischargeability Case

THURSDAY, FEBRUARY 23, 2023

While we often recite that bankruptcy is for the honest but unfortunate debtor, a new case from the Supreme Court shows that getting into bed or business with the wrong person can lead to a non-dischargeable debt for an innocent spouse. The case is No. 21-908, Bartenwerfer v. Buckley, which you can find here.

What Happened

The case involved David Bartenwerfer and his then-girlfriend, later wife, Kate. They jointly bought a house to remodel in San Francisco.

Posted by Stephen W. Sather

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While we often recite that bankruptcy is for the honest but unfortunate debtor, a new case from the Supreme Court shows that getting into bed or business with the wrong person can lead to a non-dischargeable debt for an innocent spouse. The case is No. 21-908, Bartenwerfer v. Buckley, which you can find here.

What Happened
The case involved David Bartenwerfer and his then-girlfriend, later wife, Kate. They jointly bought a house to remodel in San Francisco. Their first mistake was that they apparently formed a general partnership to buy the property. Kate’s second mistake was leaving the construction and sale of the property to David. David failed to disclose defects in the construction which led to both of them getting sued and being hit with a judgment for over $200,000. When they filed bankruptcy, the judgment creditor brought a non-dischargeability case against them. The Bankruptcy Court found that David had committed fraud and that Kate was liable for David’s fraud due to their partnership. The Bankruptcy Appellate Panel found that Kate could not be held liable based on imputed intent. On remand, the Bankruptcy Court found that Kate did not have fraudulent intent. Unfortunately the Ninth Circuit reversed and reinstated liability against Kate.

The Court’s Ruling

A unanimous court ruled that non-dischargeability under 11 U.S.C. Sec. 523(a)(2)(A) is based on the type of debt, not the actions of the debtor. Here, the exception to being dischargeable turned on whether there was a debt for money “obtained by . . . fraud.” Supreme Grammarian Justice Amy Coney Barrett decreed that because the exception was written in the passive voice rather than the active voice that the debt was non-dischargeable. She stated:

The provision obviously applies to a debtor who was the fraudster. But sometimes a debtor is liable for fraud that she did not personally commit—for example, deceit practiced by a partner or an agent. We must decide whether the bar extends to this situation too. It does. Written in the passive voice, §523(a)(2)(A) turns on how the money was obtained, not who committed fraud to obtain it.
Opinion, p. 1. While the opinion goes on for twelve pages, everything a practitioner needs to know is on page 1. If someone obtained money through fraud and that person is liable for the debt, then the liability will not be dischargeable in bankruptcy.

What Does It Mean?

I have two thoughts about this case. The first is that it is so typical of the types of bankruptcy cases that the Supreme Court hears. This was a narrow, technical issue. We just don’t see the Supreme Court taking up the big issues of bankruptcy practice, such as equitable mootness or third party releases Instead, they take up these smallish cases that can be decided by looking at a small amount of statutory text.

The other way this decision is similar to other Supreme Court decisions on bankruptcy is that we don’t know whether this will have a big impact or a teeny tiny one. Justices Sotomayor and Jackson wrote a concurrence stating that they joined the opinion because “(t)he court here does not confront a situation involving fraud by a person bearing no agency or partnership relation to the debtor.” If the decision is limited to those parameters it will have a small impact because most people are savvy enough not to enter into a general partnership when an LLC can be formed for a few hundred dollars.

However, the concurrence may be trying to impose a limitation not present in the majority opinion. Justice “passive voice” Barrett did not place any limits on how a person might be liable on a debt for fraud. Yes, partnership and agency ensure that the person being held liable has a legal relationship to the person committing the bad acts, but is not the only way someone can be held liable for the debts of another. What is the most common way that someone can be held liable for someone else’s debt? By signing a guaranty. Assume a company has a CEO actively involved in the business and a financial partner. The firm takes out a bank loan guaranteed by the financial partner. Under Bartenwerfer, if the CEO lied to get the loan and the bank justifiably relied on those misrepresentations, a debt for money obtained by fraud is created. The innocent guarantor could be held liable just as the innocent girlfriend was in this case. If that is how the cases develop, then Bartenwerfer will have dramatically expanded the universe of debts that can be excluded from discharge.

View Full Blog Article Here:
https://stevesathersbankruptcynews.blogspot.com/2023/02/grammar-dooms-innocent-spouse-in-non.html

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9th Cir. Affirms Bankruptcy Court Ruling Avoiding Judgment Lien on Calif. Homestead Property

December 26 2022
The U.S. Court of Appeals for the Ninth Circuit recently affirmed a bankruptcy court’s judgment in favor of a debtor who sought to avoid a judgment lien under California’s homestead exemption law.

In so ruling, the Ninth Circuit held that, when a judgment lien impairs a debtor’s state-law homestead exemption, the Bankruptcy Code requires courts to determine the exemption to which the debtor would have been entitled in the absence of the lien.

Here, Ninth Circuit held, the California exemption amount in effect at the time of the filing of the bankruptcy petition applied, even though the language of the California exemption for judgment liens would have required calculation of the amount of the exemption as of a different date.

A copy of the opinion in Christopher Barclay v. Dejan Boskoski is available at: Link to Opinion.

In 2014, a creditor filed a judgment lien for $256,075.95 against a debtor’s home in California (“judgment lien”). Seven years later, in 2021, the debtor filed a Chapter 7 bankruptcy petition. Before the debtor’s bankruptcy petition was filed, California amended its bankruptcy laws to substantially increase the homestead exemption to the greater of (1) the “median sale price for a single-family home” in the debtor’s county the year before the debtor claims the exemption, “not to exceed” $600,000; or (2) $300,000. See Cal. Civ. Proc. Code § 704.730(a) (2021).

California opted out of the default exemptions provided in the Bankruptcy Code, and California’s homestead exemption prescribes a set exemption amount based on the characteristics of the property and homeowner.

Based on the homestead exemption in effect at the time the debtor filed bankruptcy, the debtor claimed a $600,000 homestead exemption and sought to avoid the entire judgment lien. However, the trustee argued that California Code of Civil Procedure § 703.050(a) requires that “the amount of an exemption shall be made by application of the exemption statutes in effect . . . at the time the judgment creditor’s lien on the property was created.” Therefore, the trustee argued, the debtor was only entitled to the $100,000 homestead exemption available when the judgment lien was originally recorded in 2014.

The debtor’s calculation valued the homestead exemption at $600,000 which would result in the avoidance of the entire judgment lien. The trustee calculated the homestead exemption at $100,000, which would result in the creditor receiving $434,029.72.

The bankruptcy court held that 11 U.S.C. § 522(f) required application of the $600,000 homestead exemption in effect in 2021, when the bankruptcy petition was filed, and that the debtor could therefore avoid the entire judgment lien. The trustee appealed.

On appeal, the Ninth Circuit examined how the Bankruptcy Code’s lien avoidance procedure applies to liens that “impair an exemption to which the debtor would have been entitled” under 11 U.S.C. § 522(f)(1).

Under Section 522, a lien may be avoided when “the sum of (i) the lien; (ii) all other liens on the property; and (iii) the amount of the exemption that the debtor could claim if there were no liens on the property” is greater than “the value that the debtor’s interest in the property would have in the absence of any liens.” Id. § 522(f)(2)(A).

The Ninth Circuit held that the Supreme Court of the United States’ ruling in Owen v. Owen, 500 U.S. 305 (1991), controlled here. Relying on Owen, the Ninth Circuit held that Section 522(f) requires courts to determine the exemption to which the debtor would have been entitled but for the existence of the judicial lien at issue. The Court of Appeals noted the importance of the phrase “would have been” entitled to in the absence of any judgment liens.

Based on this language, Owen held that Section 522(f) “establishes as the baseline, against which impairment is to be measured, not an exemption to which the debtor ‘is entitled,’ but one to which he ‘would have been entitled.’” Id. at 311. Based on the holding in Owen, the Court of Appeals determined that at the time of the debtor’s bankruptcy filing, absent the judgment lien, the debtor could claim a $600,000 homestead exemption under Cal. Civ. Proc. Code § 704.730 (2021).

The trustee argued that under existing Ninth Circuit precedent the bankruptcy court had to apply the state exemption law with all its restrictions and limitations. Wolfe v. Jacobson (In re Jacobson), 676 F.3d 1193 (9th Cir. 2012). The Ninth Circuit in In re Jacobson held that “it is the entire state law applicable on the filing date that is determinative of whether an exemption applies.”

The Ninth Circuit disagreed because, under Owen, the Bankruptcy Code’s policy of permitting state-defined exemptions is not “absolute” and must be applied along with whatever competing or limiting policies are in the Bankruptcy Code.” 500 U.S. at 313. In addition, the Court of Appeals noted, In re Jacobson addressed “whether certain funds belonged to a Chapter 7 estate,” and “[n]othing in the case concerned the lien avoidance procedures at issue here.” Therefore, the Ninth Circuit held, Owen and not In re Jacobson was “the relevant precedent.”

Accordingly, the Ninth Circuit affirmed the bankruptcy court’s ruling.

Maurice Wutscher LLP – Jacob C. VanAusdall

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Reminder: New Disclosure Obligations for Lenders Go Into Effect in California on December 9, 2022

On June 9, 2022, California approved new commercial financing disclosure regulations proposed by the California Department of Financial Protection and Innovation (DFPI). Those regulations go into effect on December 9, 2022. The commercial financing disclosure regulations extend consumer style disclosure protections to California small businesses seeking commercial financing. The result is that providers of certain commercial financing products in California may need to provide borrowers with certain disclosures that comply with the new regulations at the time of making the offer on and after December 9, 2022.

Introduction

The DFPI regulations implement the financing disclosure requirements under California SB 1235, which California enacted on September 30, 2018, and is codified in the California Financial Code sections 228000–22805. The final regulations are posted to the DFPI website here. The purpose of the disclosure requirements is to ensure that small business owners have a complete understanding of the financing terms that are offered to them and to enable them to find the best terms for their business needs.

Parties and Transactions to Which the Regulations Apply

The disclosure regulations apply to “providers” making specific offers of commercial financing that is equal to or less than $500,000 to a recipient or a recipient’s agent or broker. Types of transactions that may be covered include (among others):

Accounts receivable financing transactions;
Factoring transactions;
Commercial loans;
Commercial open-end credit plans;
Lease financing transactions;
Asset-based lending transactions;
Merchant cash advances; and
The entry by a non-depository provider of a written agreement with a depository institution to arrange for the extension of commercial financing by the depository institution to a recipient via an online lending platform administered by the provider.
The requirements of the new law do not apply to any of the following:

(i) providers that are depository institutions;

(ii) providers that are lenders regulated under the federal Farm Credit Act;

(iii) a commercial financing transaction in which the recipient is a dealer (as defined by Section 285 of the Vehicle Code), or an affiliate of such a dealer, or a vehicle rental company, or an affiliate of such a company, pursuant to a specific commercial financing offer or commercial open-end credit plan of at least fifty thousand dollars ($50,000), including any commercial loan made pursuant to such a commercial financing transaction; and

(iv) any person who makes no more than one commercial financing transaction in California in a 12-month period or any person who makes five or fewer commercial financing transactions in California in a 12-month period that are incidental to the business of the person relying upon the exemption.

What Types of Disclosures Are Required?

The regulations are very detailed, covering everything from font size to economic content, and should be carefully reviewed if you think they may apply to you.

In general commercial financing providers can expect to have to disclose, among other things, the total amount of funds provided, the total dollar cost of the financing, the term or estimated term, the method, frequency, and amount of payments, a description of prepayment policies, and (until January 1, 2024) the total cost of financing expressed as an annualized rate.

It bears noting that different types transactions may have different disclosure and formatting requirements under the new law, and the specific provisions that are applicable should be consulted. In general, however, commercial financing providers should evaluate whether they undertake the following as party of their current processes:

Provide a copy of compliant disclosures to a recipient or a broker, whenever a financer provides a recipient or broker with a specific commercial financing offer.
Maintain a copy of the evidence of transmission of the disclosures provided for at least four years following the date that the disclosure is presented.
Obtain a copy of the disclosures signed by the recipient prior to consummating the commercial financing.
Ensure that any broker timely provides the disclosure transmissions to the financing recipient
Financiers subject to the DFPI regulations need to ensure that the disclosures that accompany their financing offers on and after December 9, 2022 are in compliance with the new regulations.

O’Melveny & Myers LLP – Jennifer Taylor, Danielle Oakley Morris and Kevin Loquaci

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Calif. App. Court (1st Dist) Holds Late Fee Was ‘Unlawful Penalty’ Under Calif. Law, Vacates Arbitration Award in Lender’s Favor

October 31 2022

The California Court of Appeal for the First Appellate District recently reversed a trial court’s decision to affirm an arbitration award that upheld the validity of a late payment fee assessed to borrowers in the event of a borrower’s default.

In so ruling, the Court held that: (1) Arbitration awards regarding liquidated damages provisions that allegedly violate California’s prohibition on unlawful penalties under California Civil Code § 1671 involve “well-defined and dominant” public policy and are therefore subject to de novo review; (2) “Liquidated damages in the form of a penalty assessed during the lifetime of a partially matured note against the entire outstanding loan amount are unlawful penalties”; and (3) The late fee at issue here was an unlawful penalty under § 1671.

A copy of the opinion in Honchariw v. FJM Private Mortgage Fund, LLC is available at: Link to Opinion.

Two borrowers took out a $5.6 million business loan with 8.5% interest assessed per annum. The loan was secured by a first lien deed of trust on commercial real property. The terms of the loan provided that, “based on even one missed monthly payment at any time during the life of the Loan”, the borrower would be charged “a one-time 10% fee of the overdue monthly payment” and “a default interest charge of 9.99% per annum assessed against the total amount of unpaid principal balance of the Loan.”

The borrowers defaulted when they missed one monthly payment. The default triggered the late fee provisions in the loan.

The borrowers filed a demand for arbitration challenging the validity of the late payment fee. The borrowers alleged the loan violated California Business and Professions Code § 10240 and California Civil Code § 1671 because the late fee was an unlawful penalty.

The arbitrator ruled against the borrowers and for the lender and upheld the validity of the late fee. The borrowers filed a petition to vacate the arbitration award with the trial court and argued that the arbitrator exceeded its authority by denying claims in violation of nonwaivable statutory rights and/or contravention of explicit legislative expressions of public policy under the Real Estate Loan Law which prohibits lenders from charging over 10% of the installment due and section 1671 which generally provides that contractual liquidated damages that constitute penalties are unenforceable.

The trial court disagreed with the borrowers and held that the borrowers did not meet their burden of proof to show that the default interest provision in the loan was invalid as a penalty. The trial court also concluded that the arbitrator did not exceed its powers by denying borrowers claims. The borrowers appealed.

ARBITRATION AWARDS INVOLVING § 1671 REVIEWABLE DE NOVO

In California, an arbitrator’s decision “is generally reviewable for errors of fact or law, whether or not such error appears on the face of the award and causes substantial injustice to the parties.” See Moncharsh v. Heily & Blasé, (1992) 3 Cal. 4th 1, 6. However, California Code of Civil Procedure § 1286.2 provides an exception to this rule when “[t]he arbitrators exceeded their powers and the award cannot be corrected without affecting the merits of the decision upon the controversy submitted.” In California, arbitrators are considered to exceed their power when they either (1) issue awards that violate a party’s unwaivable statutory right or (2) issue an award that contravenes an explicit legislative expression of public policy.

The Court held that California Civil Code § 1671 involves a “well-defined and dominant” public policy. Therefore, arbitration awards involving alleged violations of California’s prohibition on unlawful penalties under California Civil Code § 1671 are subject to de novo review.

Because the borrowers raised an issue on appeal that properly invoked the public policy considerations under section 1671 and argued that an arbitrator exceeded its powers by enforcing a contract in violation of public policy, the Court conducted a de novo review.

LATE FEE VIOLATED § 1671

The Court noted, in California, a liquidated damages provision is generally “presumed valid if it is in a non-consumer contract but presumed invalid if it is in a consumer contract.” The loan at issue here was a business loan, as it was “neither for the purchase of property for personal use nor does it involve a primary dwelling.”

Under § 1671, for business loans, “a provision in a contract liquidating the damages for the breach of the contract is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made.” In California, lawful liquidated damages provisions must bear a “reasonable relationship” to the “actual damages that the parties anticipate would flow from breach; conversely, if the liquidated damages clause fails to so conform, it will be construed as an unenforceable ‘penalty.’”

In Garrett v. Coast & Southern Fed. Sav. & Loan Assn, the California Supreme Court held that a charge for the late payment of a loan installment assessed against the unpaid balance of the loan must be deemed punitive in character.

Here, the lender argued that Garrett was not applicable because it was legislatively overruled when section 1671 was revised. The Court disagreed, holding that “[w]hile the current version of section 1671 declares all liquidated damages clauses presumptively invalid as to consumer contracts (as opposed to all contracts), Garrett remains good law for the proposition that a late fee assessed against the entire unpaid balance of a loan constitutes an unlawful penalty.”

Explaining its ruling, the Court discussed a California Supreme Court opinion rendered after the legislative amendment which upheld Garrett and held the late payment fees at issue there were disproportionate to the anticipated damages and as a result should be considered a penalty. Ridgley v. Topa Thrift & Loan Assn., (1998) 17 Cal. 4th 970, 977.

The lender further argued that the late fees represent the parties’ attempt to adequately calculate the lender’s damages in the event of a default and that the actual damages are not relevant because the parties agreed to the reasonableness of the liquidated damages in the loan.

The Court again disagreed because there was not sufficient evidence in the record to support the lender’s arguments. The Court held that the testimony proffered by a representative of the lender, without supporting documentation regarding the reasonableness of the late fees, was not sufficient or persuasive to support their arguments.

Therefore, the Court held that the 10% late fee provision here amounted to an unlawful penalty under California law and reversed the trial court’s order affirming the arbitration award.

Maurice Wutscher LLP – Jacob C. VanAusdall
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California Business Divorce: Reverse Veil Piercing: Permitting a Court to Hold a Company Liable for the Debt of an Individual Owner

You have likely heard the term “piercing the veil.” This legal doctrine permits a court to ignore corporate formalities and hold an individual owner liable for a company’s debt. But you may be less familiar with the doctrine of reverse veil piercing, which permits a court to hold a company liable for the debt of an individual owner.

Although courts in most states have eliminated any meaningful distinction between these related doctrines, which treat a company and its owner as alter egos, a recent decision by the California Court of Appeal in Blizzard Energy, Inc. v. Schaefers confirms that reverse veil piercing does not apply in certain situations in California.

Blizzard Energy is the latest in a trilogy of cases in California involving reverse veil piercing.

Back in 2008, the California Court of Appeal held, in Postal Instant Press, Inc. v. Kaswa Corp., 162 Cal.App.4th 1510, that reverse veil piercing does not apply to corporations. As that court noted, such a remedy is unnecessary because a creditor could simply levy and liquidate the individual owner’s interest in a judicial sale of the owner’s corporate shares. The court hypothesized, however, that reverse veil piercing may apply to a single-member limited liability company.

In 2017, in Curci Investments, LLC v. Baldwin, 14 Cal.App.5th 214, the California Court of Appeal expanded that hypothetical and held that reverse veil piercing permitted the trial court to add a limited liability company to a judgment against an individual judgment debtor who owned 99% of that LLC (his wife owned the other 1%). As the court explained, the first element of an alter ego analysis is a “substantial identity of ownership and control” between the debtor and the entity. That element was satisfied by the judgment debtor’s ownership of 99% of the LLC.

Most recently, in Blizzard Energy, the California Court of Appeal reversed the trial court’s order that used reverse veil piercing to add a limited liability company to a fraud judgment against an individual judgment debtor who owned only 50% of the LLC. The judgment debtor’s wife owned the other 50%, and they both acquired their ownership interest after they had legally separated more than 15 years ago. As the Court of Appeal explained, the trial court improperly assumed that the wife’s 50% ownership interest in the LLC was community property of the marriage, which called into question whether there was a “substantial identity of ownership” between the judgment debtor and the LLC necessary to apply reverse veil piercing. Because it was possible that the wife was an innocent member of the LLC, the Court of Appeal remanded the case to the trial court for further proceedings to determine whether it would be inequitable to use reverse veil piercing to add the LLC as an additional judgment debtor given that the wife owns half of that LLC.

Blizzard Energy teaches us that reverse veil piercing remains a restricted remedy in California. It is limited to LLCs and applies only when the plaintiff can demonstrate that there is a substantial identity of ownership and control between an individual judgment debtor and the LLC in question. And that is only the first element of the alter ego test. The plaintiff also must show that conduct amounting to bad faith makes it inequitable for the corporate owner to hide behind the corporate form. Mere difficulty in enforcing a judgment or collecting a debt does not satisfy this standard.

Stradling Yocca Carlson & Rauth – Jason Anderson and Jeremy G. Suiter
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Recent Ninth Circuit decision regarding interest on claims for unimpaired credit

On August 29, 2022, in the PG&E bankruptcy matter, the Court of Appeals for the Ninth Circuit became the first circuit-level court to address the question of what is the correct rate of interest to be applied to unimpaired unsecured claims against a fully solvent debtor.[2] In its decision, the Ninth Circuit reversed the bankruptcy court’s and district court’s rulings and held that such creditors are entitled to receive postpetition interest at the contractual rate or the state law default rate, which are almost always significantly higher than the federal judgment rate.

Outside of the Ninth Circuit, bankruptcy courts are divided on the issue. In recent decisions in the District of Delaware and the Southern District of New York, bankruptcy courts have applied the federal judgment rate in such situations, whereas in the Southern District of Texas, bankruptcy courts have ruled that the contractual rate of interest must be used.[3]

Over the next several years, it is a virtual certainty that other circuit-level courts will be asked to opine on the issue. In the meantime, solvent debtors or potentially solvent may choose to file bankruptcy cases outside the Ninth Circuit, if possible, to avoid paying unimpaired unsecured creditors the higher rate of interest. Additionally, both solvent debtors and unimpaired unsecured creditors to solvent debtors should be prepared to litigate the issue to the circuit level in cases maintained outside the Ninth Circuit.

Background

PG&E was solvent before and during its bankruptcy proceedings. Under the debtors’ proposed chapter 11 plan, members of an ad hoc committee of holders of trade claims were to be paid the full principal amount of their unsecured claims plus interest at the federal judgment rate, rendering such holders’ claims “unimpaired” under the plan. The federal judgment rate, however, was materially lower than what the committee members would have otherwise been entitled to under either state law or the interest rates set forth in their respective contracts. Specifically, the committee members alleged a $200 million discrepancy in their recoveries due to the lower rate of interest being applied.[4] Further, as unimpaired creditors, the committee members were not entitled to vote on the plan. The committee and other unsecured creditors objected to the plan on the basis that unsecured creditors to solvent debtors must be paid interest on their claims at the contractual or state law rate in order to be deemed unimpaired.[5] The bankruptcy court ruled against the committee, however, finding that the lower federal judgment rate applied to their claims.[6] The committee appealed the matter to the District Court for the Northern District of California, and the district court affirmed the bankruptcy court’s decision.[7]

The Ninth Circuit’s Decision

The Ninth Circuit began its analysis by reaffirming the common law solvent-debtor exception, which is that “a solvent debtor must generally pay postpetition interest accruing during bankruptcy at the contractual or state law rates before collecting surplus value from the bankruptcy estate.”[8] This exception was recognized under the former Bankruptcy Act (the predecessor statute to the Bankruptcy Reform Act of 1978). Because the Bankruptcy Code, as amended, lacked “any clear indication” that Congress intended to abrogate the solvent-debtor exception,[9] the appellate court held that unimpaired unsecured creditors retained an equitable right to postpetition interest pursuant to their contracts or state law, and that “failure to compensate creditors according to this equitable right as part of a bankruptcy plan results in impairment.”[10]

In reaching this conclusion, the Ninth Circuit relied on, among other reasons, the Bankruptcy Code’s structure. The court noted that the Bankruptcy Code provided impaired creditors with certain protections (e.g., the right to vote on a plan and the right of a dissenting impaired class to a plan that is “fair and equitable”).[11] Further, the court noted that by defining impairment broadly, Congress ensured these protections would be available “to creditors whose rights were altered in any way by a plan.”[12] The court reasoned that, without the solvent-debtor exception, PG&E would reap an improper windfall while steamrolling creditors’ statutory and equitable rights.[13]

In sum, the court’s decision in PG&E now leaves solvent debtors who file in the Ninth Circuit with two options: (1) use the contractual or state law rate in calculating interest on unsecured unimpaired claims, or (2) designate such claims as impaired.[14]

Conclusion

In its PG&E decision, the Ninth Circuit created the first circuit-level law on an issue that has bedeviled bankruptcy courts around the country. Going forward, parties in interest should expect significant litigation on the issue, and perhaps a circuit split that eventually finds its way to the United States Supreme Court.

To view all formatting for this article (eg, tables, footnotes), please access the original here.
Morrison & Foerster LLP – Seth J. Kleinman and Miranda K. Russell
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