Fifth Circuit: Preference Claims Are Property of the Bankruptcy Estate that Can Be Sold

May 30 2024

A debtor’s non-exempt assets (and even the debtor’s entire business) are commonly sold during the course of a bankruptcy case by the trustee or a chapter 11 debtor-in-possession (“DIP”) as a means of augmenting the bankruptcy estate for the benefit of stakeholders or to fund distributions under, or implement, a chapter 11, 12, or 13 plan. However, it is less well understood that causes of action that become part of the bankruptcy estate in connection with a bankruptcy case (e.g., fraudulent transfer, preference, or other litigation claims) may also be sold or assigned by a trustee or DIP during bankruptcy to generate value. The U.S. Court of Appeals for the Fifth Circuit considered this question in Matter of South Coast Supply Co., 91 F.4th 376 (5th Cir. 2024). The court of appeals joined the Eighth and Ninth Circuits in concluding that avoidance actions (in this case, a preference claim) are property of the estate that can be sold to creditors as a means of generating value.

Broad Scope of Property of the Estate

When a debtor files a bankruptcy petition, the filing creates an “estate” that consists of, among other things, “all legal or equitable interests of the debtor in property as of the commencement of the case” (with certain exceptions) as well as all property that the estate acquires “after the commencement of the case.” 11 U.S.C. § 541(a)(1) and (a)(7). Also included in “property of the estate” is “[a]ny interest in property that the trustee [or DIP] recovers” under various provisions of the Bankruptcy Code (see 11 U.S.C. § 541(a)(3)), including section 550, which authorizes the trustee or DIP to recover any property (or its value) that has been fraudulently or preferentially transferred by the debtor during a specified period prior to its bankruptcy filing. The estate also includes any property interest that a bankruptcy court orders to be transferred to the estate or preserved for the estate’s benefit because it is either a lien securing an equitably subordinated claim (see 11 U.S.C. § 510(c)) or an avoided transfer (see 11 U.S.C. § 551). In addition, under section 541(a)(6) of the Bankruptcy Code, estate property includes any “[p]roceeds, product, offspring, rents, or profits of or from property of the estate,” with certain exceptions.

Section 541 “is intended to include in the estate any property made available to the estate by other provisions of the Bankruptcy Code.” City of Chicago, Illinois v. Fulton, 141 S. Ct. 585, 589 (2021). Carefully defining the scope of estate property in a given case may be critical to the outcome of the bankruptcy. Property of the estate is protected (with certain exceptions) by the automatic stay under section 362; it may generally be sold, used, or leased under section 363, and, if unencumbered or non-exempt, it is generally available to stakeholders for distribution under a chapter 9, 11, 12, or 13 plan.

Given the importance of estate property, courts have found that a wide variety of interests of the debtor qualify as property of the estate. See United States v. Whiting Pools, Inc., 462 U.S. 198, 204 (1983) (“Both the congressional goal of encouraging reorganizations and Congress’ choice of methods to protect secured creditors suggest that Congress intended a broad range of property to be included in the estate.”); see, e.g., ACandS, Inc. v. Travelers Cas. & Sur. Co., 435 F.3d 252 (3d Cir. 2006) (insurance policies were estate property); Whetzal v. Alderson, 32 F.3d 1302 (8th Cir. 1994) (causes of action); Windstream Holdings, Inc. v. Charter Commc’ns Inc. (In re Windstream Holdings, Inc.), 634 F. Supp. 3d 99 (S.D.N.Y. Oct. 6, 2022) (customer contracts), appeal filed, No. 22-2891 (2d Cir. Nov. 3, 2022) (argument held on Sep. 7, 2023).

Avoidance Actions

An indispensable tool available to a bankruptcy trustee (or DIP, by operation of section 1107(a)) is the power to augment the estate by avoiding and recovering certain transfers or obligations incurred by the debtor prior to filing for bankruptcy that either are fraudulent or unfairly prefer certain creditors. With respect to the former of these categories, section 548 of the Bankruptcy Code provides in part that the trustee “may avoid any transfer … of an interest of the debtor in property, or any obligation … incurred by the debtor, that was made or incurred within 2 years before the date of the filing of the petition.” 11 U.S.C. § 548(a)(1).

Fraudulent transfers that can be avoided include both: (i) actual fraudulent transfers, which are transfers made with “actual intent to hinder, delay, or defraud” creditors (see 11 U.S.C. § 548(a)(1)(A)); and (ii) constructive fraudulent transfers, which are “transactions that may be free of actual fraud, but which are deemed to diminish unfairly a debtor’s assets in derogation of creditors.” Collier on Bankruptcy (“Collier”) ¶ 548.05 (16th ed. 2023); 11 U.S.C. § 548(a)(1)(B).

A transfer is constructively fraudulent if the debtor received “less than a reasonably equivalent value in exchange for such transfer or obligation” and was, among other things, insolvent, undercapitalized, or unable to pay its debts as such debts matured. See Collier at ¶ 548.05; 11 U.S.C. § 548(a)(1)(B).

Fraudulent transfers may also be avoided by a trustee or DIP under section 544(b) of the Bankruptcy Code, which provides that, with certain exceptions, “the trustee may avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim that is allowable under section 502 of [the Bankruptcy Code] or that is not allowable only under section 502(e) of [the Bankruptcy Code].” 11 U.S.C. § 544(b)(1). This provision permits a trustee to step into the shoes of a “triggering” unsecured creditor that could have sought avoidance of a transfer under applicable non-bankruptcy law (e.g., the Uniform Fraudulent Transfer Act or its successor, the Uniform Voidable Transactions Act, which has been enacted in many states). See generally Collier at ¶ 544.06. Section 544(b) is an important tool, principally because the reach-back period for avoidance of fraudulent transfers under state fraudulent transfer laws (or even non-bankruptcy federal laws, such as the Internal Revenue Code) is typically longer than the two-year period for avoidance under section 548. Id.

Section 547(b) of the Bankruptcy Code provides that, with certain exceptions, a trustee or DIP, “based on reasonable due diligence in the circumstances of the case and taking into account a party’s known or reasonably knowable affirmative defenses under subsection (c),” may avoid “any transfer” made by an insolvent debtor within 90 days of a bankruptcy petition filing (or up to one year, if the transferee is an insider) to a creditor for or on account of an antecedent debt, if the creditor, by reason of the transfer, receives more than it would have received in a chapter 7 liquidation and the transfer had not been made. 11 U.S.C. § 547(b).

Section 547(c) sets forth nine defenses or exceptions to avoidance. These include, among other things, contemporaneous exchanges for new value, ordinary course of business transfers, transfers involving purchase-money security interests, and transfers after which the transferor subsequently provides new value to the debtor.

Unauthorized postpetition transfers of estate property may be avoided under section 549, and other provisions of the Bankruptcy Code authorize the trustee or DIP to avoid certain other kinds of transfers. See 11 U.S.C. § 545 (certain statutory liens); 11 U.S.C. § 553(b) (certain setoffs); 11 U.S.C. § 724(a) (avoidance of liens securing certain claims for damages, fines, penalties, and forfeitures).

If a transfer is avoided under any of these provisions, section 550 of the Bankruptcy Code authorizes the trustee or DIP to recover the property transferred or its value from the initial or subsequent transferees, with certain exceptions.

South Coast Supply

South Coast Supply Co. (“South Coast) is an industrial products distributor that began experiencing financial troubles in 2016. Needing extra cash, South Coast borrowed $800,000 from its then-CFO. Under the loan agreement, South Coast made 47 separate payments to its CFO totaling approximately $321,000. After resigning, the former CFO demanded that South Coast pay $405,261.87 to satisfy the outstanding balance of the loan. Then, in October 2017, South Coast filed a chapter 11 petition in the Southern District of Texas. Five months later, South Coast brought an avoidance action under section 547 of the Bankruptcy Code to avoid as preferential the $321,000 in prepetition payments it made to the former CFO.

South Coast’s sole secured lender was Briar Capital Working Fund Capital, L.L.C. (“Briar Capital”). After objecting to South Coast’s first proposed chapter 11 plan, Briar Capital settled its issues with South Coast and agreed to a second, modified plan. Under the modified plan, Briar Capital would abandon a security interest it held in the proceeds of a sale of certain “intangible assets” valued at $700,000. South Coast would then distribute the proceeds to unsecured creditors. Briar Capital also agreed to waive a claim that it asserted against South Coast for administrative expenses. In exchange, Briar Capital would receive South Coast’s interest in the pending avoidance action against the former CFO. The bankruptcy court approved the sale of the preference claim and confirmed the modified plan.

Briar Capital was substituted for South Coast in the preference action. With Briar Capital as the plaintiff, the adversary proceeding was withdrawn to the district court. The former CFO filed a motion to dismiss the complaint, arguing that Briar Capital lacked standing to prosecute the preference action. The district court agreed, holding that Briar Capital lacked standing to bring the preference claim against the former CFO because: (i) a successful recovery would not benefit South Coast’s estate, and (ii) Briar Capital was not a “representative of the estate” under section 1123(b)(3)(B) of the Bankruptcy Code, which states that a chapter 11 plan may provide for the “retention and enforcement” of any claim belonging to the estate “by the debtor, by the trustee, or by a representative of the estate appointed for such purpose.” Central to its decision, the district court noted an absence of explicit authorization in the Fifth Circuit for the sale of avoidance actions under section 547, as distinguished from avoidance actions under section 548, which the Fifth Circuit previously held could be sold in In re Moore, 608 F.3d 253 (5th Cir. 2010). Briar Capital appealed to the Fifth Circuit.

The Fifth Circuit’s Decision

In a three-judge panel, with U.S. Circuit Court Judge James L. Dennis penning its opinion, the Fifth Circuit reversed the district court. South Coast’s appeal, Judge Dennis wrote, turned on “whether preference claims—a type of avoidance action—may validly be sold.” South Coast Supply, 91 F.4th at 382.

The Fifth Circuit panel first considered whether a preference action qualifies as “property of the estate” under the broad, general definition found in section 541(a)(1) of the Bankruptcy Code. Quoting the Supreme Court’s broad holding that property of the estate “is intended to include in the estate any property made available to the estate by other provisions of the Bankruptcy Code,” the Fifth Circuit found that avoidance actions must qualify. Id. at 381–382 (citing Whiting Pools, 462 U.S. at 205). “Preference actions,” Judge Dennis explained, “are a mechanism in the Bankruptcy Code by which additional property is made available to the estate, fitting squarely within the Whiting Pools definition.” Id. at 382.

Next, the Fifth Circuit considered whether preference actions qualify as estate property under section 541(a)(7), which provides that property of the estate includes “any interest in property that the estate acquires after the commencement of the estate.” Guided by a previous Fifth Circuit decision, the panel found that section 541 was intended by Congress to be an “all-embracing definition” of “property of the estate” and that all “property interests created with or by property of the estate are themselves property of the estate.” Id. (quoting In re TMT Procurement Corp., 764 F.3d 512, 525 (5th Cir. 2014)). Therefore, the Fifth Circuit panel concluded, preference actions “clearly qualify” as property of the estate under section 541(a)(7). Id.

The Fifth Circuit panel cited similar holdings by the Eighth and Ninth Circuits. Id. at 383 (citing Pitman Farms v. ARKK Food Co. LLC (In re Simply Essentials LLC), 78 F.4th 1006, 1011 (8th Cir. 2023) (“Chapter 5 avoidance actions are property of the estate”); In re P.R.T.C., Inc., 177 F.3d 774, 780-81 (9th Cir. 1999) (“Although no provision of the bankruptcy code similarly authorizes others to exercise [the trustee’s] powers, ‘[i]t is a well-settled principle that avoidance powers may be assigned to someone other than the debtor or trustee pursuant to a plan of reorganization’ under 11 U.S.C. § 1123(b)(3)(B)”) (citation omitted); In re Prof’l Inv. Props. of Am., 955 F.2d 623, 625–26 (9th Cir. 1992) (ruling that a trustee’s strong-arm powers were transferable to a purchaser of the estate’s claim to proceeds from sale of property and noting that “[i]f a creditor is pursuing interests common to all creditors or is appointed for the purpose of enforcement of the plan, he may exercise the trustee’s avoidance powers”); In re Lahijani, 325 B.R. 282, 288 (9th Cir. BAP 2005) (“While there is some disagreement among courts about the exercise by others of the trustee’s bankruptcy-specific avoiding power causes of action, the Ninth Circuit permits such actions to be sold or transferred.”).

Judge Dennis commented that broad interpretations of “property of the estate,” now endorsed by three Circuits, best serve both the estate itself and its creditors. In this case, while “Briar Capital does not owe any percentage of the possible recovery in this case to the estate, its waiver of the right to collect administrative expenses and its release of its claim to $700,000 are concrete benefits to the estate.” Id. at 383.

The Fifth Circuit panel rejected the former CEO’s argument that, because “Briar Capital would be pursuing claims only for itself,” it “would be potentially allowed to recover more than rightfully due to it.” According to Judge Dennis, the court previously addressed this policy concern in Moore. Although Moore addressed the sale of fraudulent transfer rather than preference claims, Judge Dennis explained, “its underlying policy arguments apply with equal force in this case”—namely, that the sale of avoidance claims “will not necessarily undermine core bankruptcy principles,” and in approving such sales, “bankruptcy courts must ensure that fundamental bankruptcy policies of asset value maximization and equitable distribution are satisfied.” South Coast Supply, 91 F.4th at 383-84 (citing Moore, 608 F.3d at 262 n. 18) (internal quotation marks omitted). Moreover, he wrote, “[a]llowing the sale of preference actions will grant bankruptcy courts more flexibility in distributing assets, maximize the value of the bankruptcy estate, and in turn, allow for more equitable distribution of assets.” Id. at 384.

Judge Dennis further noted that allowing for the sale of preference claims as property of the estate may be the “most equitable option.” Id. This rule, he explained, allows for increased flexibility in distributing remaining assets and allows a trustee or DIP to maximize the bankruptcy estate. Id.

Finally, the Fifth Circuit panel rejected the argument by the former CFO that a party must be a “representative of the estate” to pursue a validly purchased preference claim. Id. at 384–385. According to Judge Dennis, “[w]hether Briar Capital is a ‘representative of the estate’ is irrelevant to this appeal.” Id. at 385. He explained that this conclusion is supported by: (i) section 1123(b)(3), which, as noted previously, states that a chapter 11 plan may provide for the “settlement or adjustment of any claim or interest belonging to the debtor or the estate” or “the retention or enforcement by the debtor, by the trustee, or by a representative of the estate appointed for such purpose of any such claim”; and (ii) the fact that section 363(b) of the Bankruptcy Code, which authorizes the use, sale, or lease of estate property outside the ordinary course of a debtors’ business, does not expressly require that the purchaser of estate property also be a representative of the estate, but only that the trustee provides notice of the sale and an opportunity for a hearing before the court. Id.

Outlook

There are a few key takeaways from the Fifth Circuit’s decision in South Coast Supply, First, when lawmakers enacted the Bankruptcy Code in 1978, they intended that the scope of “property of the estate” would be quite broad to ensure that all of a debtor’s assets could be administered in a bankruptcy case. Second, the expansive definition of “estate property” in section 541 of the Bankruptcy Code encompasses pre-bankruptcy causes of action belonging to the debtor as well as causes of action or claims that spring into existence on the petition date (e.g., avoidance causes of action under the Bankruptcy Code, including claims that a trustee or DIP can assert on behalf of creditors). Third, under appropriate circumstances, where the estate lacks sufficient resources to prosecute colorable claims or causes of action, the trustee or DIP can sell such claims or causes of action to generate value for the estate. The Fifth Circuit’s decision in South Coast Supply is therefore a positive development for bankruptcy trustees, DIPs, or other stakeholders seeking to maximize estate value.

Finally, with South Coast Supply, the Fifth Circuit joins the Eighth and Ninth Circuits in applying a broad and flexible definition of “property of the estate” to encompass avoidance actions (which the Fifth Circuit had previously considered only in the context of fraudulent transfer claims in Moore).

Jones Day – Julian E.L. Gale

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Should I Care That the Debtor Has Filed a Motion to Sell Its Assets?

May 30 2024
Sales pursuant to Section 363 of the Bankruptcy Code have become commonplace in bankruptcy cases as a mechanism to liquidate a debtor’s assets and maximize value for creditors. Selling the debtor’s assets to a third party provides a new go-forward business partner for the debtor’s vendors and customers, and likely provides continuity of jobs for the debtor’s former employees. Due to the benefits associated with a sale of the debtor’s assets, creditors or parties-in-interest may be under the misconception that they need not pay attention to the sale process. Discussed below are several key reasons that a party should pay attention to the debtor’s sale process to ensure that its rights are protected, and its goals achieved.

Key Issues

Protecting Executory Contract Rights. As part of a going-concern sale, the debtor often seeks to assume and assign its executory contracts to the purchaser. An executory contract can only be assumed and assigned if all monetary and nonmonetary defaults are cured. Contract counterparties will want to carefully review the sale papers to determine if their executory contract will be assumed by the purchaser. This is to confirm that they agree with the proposed cure amount (which is the amount required to cure any monetary default) and to timely file an objection if they do not. Additionally, contract counterparties will want to review the sale papers to understand how to obtain adequate assurance of future performance information from the proposed purchaser, since sometimes the bid procedures require contract counterparties to formally request such information. This financial information is important to ensure that the proposed purchaser is ready, willing, able, and has the financial wherewithal to perform under the terms of the contract. For additional information regarding executory contracts, cure claims, and adequate assurance of future performance, please see the following toolkit articles: (i) What Is an Executory Contract and What Will Happen to My Executory Contract in Bankruptcy?1 and (ii) What Is a Cure Claim and What Does It Mean That the Buyer Has to Provide Adequate Assurance of Future Performance Under My Contract?

Sale of Preference Claims. Section 547 of the Bankruptcy Code allows the debtor, subject to applicable defenses, to claw back funds paid to creditors within 90 days of the bankruptcy being filed (and such lookback period is extended to one year for insiders), claims which are referred to as preference claims. See How Can You Protect and Defend Your Business From Preference Actions?3 Preference claims constitute property of the debtor’s estate and as such the debtor can sell preference claims as part of a Section 363 sale. Purchasers often want to purchase preference actions to keep the debtor from pursuing their claims, which could alienate parties the purchaser intends to do business with going forward. Even though the purchaser is not the same entity as the debtor, a creditor may not fully understand the legal distinction between the two entities and may take adverse action against the purchaser should it be sued for a preference claim. This could lead to go-forward problems for the new owner. By purchasing preference actions, the purchaser eliminates this potential pitfall. To the extent that a party received payments in the 90-day preference period, understanding the terms of the sale (and the benefit of continuing to do business with the purchaser), might shield a party from having to defend against a preference claim.

Sale of Non-Estate Property. To the extent that the debtor is holding property belonging to the creditor, the creditor will want to ensure that the sale does not seek to sell such property to the purchaser. Section 363(m) of the Bankruptcy Code limits attacks on a sale order after the sale closes provided the purchaser acted in good faith and without notice of any adverse claims with respect to the assets. To the extent that a creditor has notice of the sale and does not timely act, there is a risk that Section 363(m) will ensure that the purchaser is able to take ownership of the creditor’s property.

Sales Free and Clear of Setoff Rights. Setoff rights of nondebtors are treated as secured claims in a bankruptcy case, and a sale motion may propose to sell assets to a buyer, including accounts receivable, free and clear of such rights. If a creditor that holds such setoff rights does not timely object, it could find itself obligated to the buyer for accounts receivable or other claims purchased by the buyer, but unable to assert its setoff rights against the buyer to reduce the amount owed.

Objecting to the Sale to Gain Leverage. Creditors have the right to file an objection both to the bid procedures as well as the terms of any proposed sale. Sometimes a creditor will want to file an objection to try to gain leverage in the bankruptcy case. An example of this occurs where the creditor does or does not want its contract assumed and is using the objection to try to achieve its desired outcome in the case. A party may also object to the sale to put pressure on the debtor to address issues of particular concern to it. By becoming the squeaky wheel, the debtor/purchaser may have an incentive to resolve the party’s issues in advance of approval of the sale. Of course, any objection a creditor might file must have a sound legal basis. Whether or not a creditor files an objection, it is important to understand that a debtor need only provide a legitimate business justification for the bankruptcy court to approve its sale.

Takeaway

A bankruptcy sale can affect a party’s rights, so it is important to monitor what is happening in the case and timely respond. Additionally, sometimes a party may want to object to the bid procedures or the underlying sale as a way to get the debtors’ attention in a case. As always, it is important to have experienced bankruptcy counsel to help a party navigate the complex bankruptcy issues that can arise in connection with a sale.

https://www.troutman.com/a/web/6oYw925JzEy8PMS6heuzYc/tp_creditors-rights-toolkit_debtor-has-filed-a-motion.pdf

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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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