Bloomberg News

Revolt Weakens Jones’ Control of Fifth Circuit Law: Bankruptcy

August 29, 2011

(Bloomberg bankruptcy columnist Bill Rochelle regularly writes about important court opinions on bankruptcy law. The following items are a collection of cases handed down during his August vacation. The regular column can be found at NI ROCHELLE <GO>.)

Aug. 29 (Bloomberg) -- Sixteen judges on the U.S. Court of Appeals in New Orleans heard reargument in a bankruptcy case and thirteen voted to reverse the original opinion handed down in September by Chief Judge Edith H. Jones, who was writing for a three-judge panel.

Coupled with a ruling less than a week before where Jones had also written the original opinion, the two cases together could imply that a majority of the appeals court judges in the Fifth U.S. Circuit in New Orleans differ with the chief judge on the direction she was giving to bankruptcy law.

Jones, sitting on many three-judge panels involving key bankruptcy appeals, was moving Fifth Circuit law on corporate reorganizations and individual bankruptcies in directions that diverge from other U.S. courts of appeal. The Fifth Circuit, based in New Orleans, makes law binding on bankruptcy and district courts in Texas, Louisiana and Mississippi.

Reed v. City of Arlington, the case reheard by all the circuit judges and decided on Aug. 11, involved a fireman who filed for bankruptcy after he obtained judgment in excess of $1 million against the city that had been his employer. He repeatedly failed to disclose the judgment in his bankruptcy papers and was found out only after the appeals court affirmed the judgment.

The bankruptcy trustee sought to collect the judgment so the proceeds could be used to pay creditors in full. U.S. District Judge Terry R. Means crafted a resolution that would have allowed the trustee to collect enough to pay creditors fully while preventing the bankrupt from getting anything.

When the case returned to the circuit court, Jones oveturned Means, ruling that neither the trustee nor the bankrupt was entitled to collect anything.

Jones said it wasn’t proper to “distinguish the debtor’s conduct from the trustee in applying” a legal principle called judicial estoppel. Without citing case-law authority, Jones broadly stated that the trustee “succeeds to the debtor’s claim with all its attributes,” including the “potential for judicial estoppel.”

The bankruptcy trustee sought and was granted rehearing by 16 active Fifth Circuit judges. With 12 judges on her side, Circuit Judge Carolyn Dineen King reversed Jones, in the process saying that Means wrote a “very good opinion.”

King’s opinion laid down a “general rule that, absent unusual circumstances, an innocent trustee can pursue for the benefit of creditors a judgment or cause of action that the debtor fails to disclose.” King said the rule would deter a dishonest debtor while protecting the rights of creditors to a distribution from the bankrupt estate.

King said that the result was consistent with bankruptcy law by distinguishing between the bankrupt individual and the bankruptcy estate created when the petition was filed. The trustee, King said, isn’t affected by defenses the bankrupt’s own actions create after the bankruptcy began. She said that judicial estoppel must be applied “flexibly” to achieve “substantial justice.”

King noted that her opinion, unlike Jones’, is consistent with rulings by three other circuit courts discussing the issue.

Jones dissented along with the two other judges who signed the original opinion in September.

For a discussion of the other case where Jones in substance reversed her own opinion when a similar rehearing motion had been made, click here for the Aug. 5 Bloomberg bankruptcy report on the case regarding Scotia Pacific Co. and affiliate Pacific Lumber Co.

The case is Reed v. City of Arlington, 08-11098, U.S. Court of Appeals for the Fifth Circuit (New Orleans).

Jones Makes Circuit Conflict on Recharacterization

Debt held by a third party can be recharacterized as equity, Chief Judge Edith H. Jones ruled for the U.S. Court of Appeals in New Orleans on Aug. 9. Jones said there is no per se rule where only debt held by insiders may be recharacterized as equity.

Jones parted company with other circuit courts of appeal that allow debt to be recharacterized as equity using the equitable powers of a bankruptcy court under Section 105 of the U.S. Bankruptcy Code. She said the ability to recharacterize only exists under state law.

Although Jones’ opinion represents a conflict of circuits where a petition for review might be made to the Supreme Court, there isn’t likely to be further appeal because Jones upheld the lower court’s ruling.

The bankruptcy court had ruled that a claim held by a third party should be treated as equity. The district court reversed, saying only insiders’ claims could be recharacterized as stock. Jones said there is no per se rule saying that only claims of insiders are subject to recharacterization, so long as the 11- point test is satisfied under a 1981 5th Circuit decision called Jones v. U.S.

The case is Grossman v. Lothian Oil Inc. (In re Lothian Oil Inc.), 10-50683, U.S. Court of Appeals for the Fifth Circuit (New Orleans).

Discrimination Case May Affect Bankruptcy Fee Awards

Chief Judge Edith H. Jones for the U.S. Court of Appeals in New Orleans wrote an opinion this month on attorneys’ fees in employment discrimination cases that may eventually influence fee awards in bankruptcy cases.

The case involved allegations of racial discrimination in employment where the district judge awarded the plaintiff class $3.3 million in back pay. The district judge also awarded $7.7 million in counsel fees for the plaintiffs’ lawyers.

The plaintiffs originally were represented by a three- lawyer Texas firm. After the class was certified, there was no settlement, and a trial seemed possible. The small Texas firm handling the case alone then hired Goldstein Demchak Baller Borgen & Dardarian from Oakland, California. The record in the district court showed that no Texas firm experienced in similar cases would take the assignment. Jones said the Goldstein firm has a “nationwide reputation.”

In her opinion for two of the three circuit judges, Jones said it was error for the district court to limit the Goldstein firm to the $400 an hour rate prevalent in Texas. Jones said that the Goldstein firm’s $650 rate was the proper “starting point.”

Jones ruled that local rates are not “always required” in fee-shifting discrimination cases. Out-of-state lawyers, she said, can be hired in the “unusual case” where non-local lawyers are “necessary.”

Circuit Judge James L. Dennis agreed with the result although he did not agree with Jones’ opinion. In part, he said that rates charged by lawyers representing the defendant- employer are “relevant” in calculating the plaintiffs’ lawyers’ fees.

The case is unusual in that Jones, although she wrote the main opinion, wrote a separate concurring opinion where she explained why she believed Dennis was wrong.

If applied in bankruptcy cases, Jones’ opinion won’t be good news for lawyers representing creditors’ committees or companies in Chapter 11 reorganization. Although there were disputes years ago, most bankruptcy courts now allow out-of-town lawyers to charge rates prevalent in their hometowns. Jones’ opinion might also be used to support an argument that a reorganizing company can’t use a big-city firm if experienced Texas lawyers are available.

The case is McClain v. Lufkin Industries Inc., 10-40036, U.S. Court of Appeals for the Fifth Circuit (New Orleans).

Blind Reliance on Computer Brings Sanctions on Lawyer

Bankruptcy lawyers in a high-volume foreclosure practice run the risk of having sanctions imposed for blindly utilizing faulty computer-generated information provided by the bank client, the U.S. Court of Appeals in Philadelphia ruled on Aug. 24.

The circuit court upheld mild sanctions on a lawyer, the law firm, and the bank, saying that Bankruptcy Rule 9011 requires “more than a rubber-stamping of the results of an automated process.” The appeals court said that the lawyer filed papers in bankruptcy court after receiving “clear warning signs” that computer-generated information about the loan balance was inaccurate.

According to the Third U.S. Circuit in Philadelphia, a lawyer could not “abdicate her professional duty to a black box.” Rule 9011 requires any court filing be “well-grounded in law and fact.”

The case involved a couple in Chapter 13 bankruptcy who were current on their mortgage payments to the lender aside from a dispute over whether they were required to pay $180 a month for flood insurance. The lender was a subsidiary of HSBC Holdings Plc.

Lawyers for HSBC from the Urden Law Firm filed a motion to modify the so-called automatic stay and allow foreclosure of the mortgage. The filing incorrectly stated that the bankrupts made no payments on the mortgage after the Chapter 13 filing. The pleading also alleged the bankrupts had no equity in the home although the lawyer had no basis for making the allegation. The statements were based on limited information provided from a computer system operated by a third-party provider hired by the bank.

The bankruptcy judge imposed sanctions requiring the lawyer to take three hours of continuing legal education classes and conduct a training session at the firm on the use of the bank’s computerized data-retrieval system. HSBC was required to send the bankruptcy court’s opinion to every law firm performing foreclosure work for the bank.

Where outside lawyers previously were prohibited from contacting the bank, the bankruptcy court required HSBC to notify outside attorneys that they could contact the bank directly.

On appeal, the district court reversed and set aside the sanctions. The Court of Appeals, in an opinion by Circuit Judge Julio M. Fuentes, reversed the district court and reinstated the sanction.

The case is In re Taylor, 10-2154, U.S. Court of Appeals for the Third Circuit (Philadelphia).

Supreme Court to Decide on Hearing Split-Circuit Case

The U.S. Supreme Court is scheduled to decide in late September whether it will hear a bankruptcy appeal involving auto loans. The U.S. Courts of Appeal are divided on the issue.

The question is whether the so-called negative equity on a previously-owned auto must be paid in full as a condition to keeping the newer car after bankruptcy. The U.S. Court of Appeals in San Francisco, departing from the other eight circuits to consider the issue, ruled in July 2010 that negative equity is not part of a purchase money security interest and need not be paid to retain the newer auto.

Over a dissent by four circuit judges, the entire Court of Appeals for the Ninth U.S. Circuit in San Francisco decided earlier this year not to rehear the case. The dissenters argued that the majority on the circuit court interpreted the Bankruptcy Code “to mean the exact opposite of what the plain language says.”

The lender, who lost in the court of appeals, filed a petition in May for review by the Supreme Court. The high court often accepts appeals when the circuit courts are split.

The Supreme Court justices are currently scheduled to hold a conference on Sept. 26 to decide whether they will hear the appeal. For a discussion of the issue and the Ninth Circuit’s July 2010 opinion, click here for the July 19, 2010, Bloomberg bankruptcy report.

The Supreme Court already accepted a bankruptcy case for the term beginning in October. The case, called Hall v. U.S., involves the tax treatment of property sold after bankruptcy by so-called family farmers in Chapter 12. To read about the Chapter 12 case, click here for the June 14 Bloomberg bankruptcy report.

The auto-loan case in the Supreme Court is AmeriCredit Financial Services Inc. v. Penrod (In re Penrod), 10-1443, U.S. Supreme Court. The Circuit Court’s July 2010 opinion is AmeriCredit Financial Services Inc. v. Penrod (In re Penrod), 08-60037, U.S. Court of Appeals for the Ninth Circuit (San Francisco). To read the dissent on the motion for rehearing, click here.

Madoff Ruling Dooms Customers on False Profit Suits

Claims of customers of Bernard L. Madoff Investment Securities Inc. will be measured by the amount of cash put in less the amount taken out, as the result of the Aug. 16 opinion by three circuit judges on U.S. Court of Appeals for the Second Circuit in Manhattan.

Indirectly, the ruling means that customers may be left with no defenses against lawsuits by the Madoff trustee to recover so-called fictitious profits. The opinion appears to have few if any implications with regard to the outcome of other lawsuits where the trustee is attempting to recover repayments of principal from customers the trustee contends had reason to know Madoff was conducting a fraud.

Customers were appealing a ruling from March 2010 where U.S. Bankruptcy Judge Burton R. Lifland concluded that account statements showing customers’ stock holdings had to be ignored because they were wholly fictitious. Lifland authorized an appeal directly to the Court of Appeals, which heard argument in early March 2011.

The 34-page opinion by Chief Circuit Judge Dennis Jacobs upheld Lifland’s logic. Jacobs said that Lifland’s ruling was “legally sound” given the “statutory language” and the “extraordinary facts of this case,” since there was “no trading activity whatsoever” in the customers’ accounts.

Customers argued unsuccessfully that the Securities Investor Protection Act mandated that they have claims equal to the amounts shown on what Jacobs called “fictional account statements.”

Jacobs said that SIPA does not prescribe any single method for valuing customer claims. Using the last Madoff account statements, Jacobs said, “would have the absurd effect of treating fictitious profits and arbitrarily assigned paper profits as real and would give legal effect to Madoff’s machinations.”

Jacobs several times mentioned that slavishly adhering to account statements would result in injustice by affecting the limited amount available for distribution to creditors from the fund of customer property.

A trustee in a brokerage liquidation must be given discretion in selecting a method for calculating claims, Jacobs said, so long as it isn’t “clearly inferior” to other methods under consideration.

Jacobs backed off from a statement in a prior 2nd Circuit opinion saying that SIPA was a “form of public insurance.” Unlike ordinary insurance, SIPA does not insure against all types of losses, he said.

The opinion means that customers cannot claim ownership of fictitious profits shown in their account statements. Consequently, customers did not give consideration for payments of fictitious profits. As a result, the Madoff trustee would appear to have valid claims for recovery of fictitious profits received by customers within six years of the Madoff bankruptcy, regardless of whether customers knew about the fraud.

The Madoff trustee also has suits against customers for recovery of principal where he believes there was reason to suspect fraud. Jacobs’ opinion doesn’t give support either to the trustee or the customers in those situations.

Near the end of the opinion, Jacobs recognized the Madoff trustee’s right to sue. He said that the trustee’s method for pegging claims was “more harmonious” with provisions in SIPA and bankruptcy law giving the trustee the right “to avoid transactions made with intent to defraud.”

Jacobs noted that the bankruptcy judge is yet to rule on whether long-time customers are entitled to an increase in their claims based on the time-value of money. In that regard, he said that the opinion was part of an interlocutory appeal. As such, customers on the losing side may not be in a position as yet to ask for review by the U.S. Supreme Court.

The method of calculating claims has a major effect on the total value of claims. At oral argument in March, the lawyer for the Securities Investor Protection Corp. said that Lifland’s method meant that claims would total some $20 billion. If account statements governed, claims would have totaled $64 billion, the SIPC lawyer said.

Other judges on the panel were Circuit Judges Reena Raggi and Pierre N. Leval.

The Madoff firm began liquidating on December 11, 2008, with the appointment of the trustee under the Securities Investor Protection Act. Bernard Madoff individually went into an involuntary Chapter 7 liquidation in April 2009. His bankruptcy case was consolidated with the firm’s liquidation. Madoff is serving a 150-year prison sentence following a guilty plea.

The appeal is In re Bernard L. Madoff Investment Securities, 10-2378, U.S. Court of Appeals for the Second Circuit (Manhattan). The Madoff liquidation case is Securities Investor Protection Corp. v. Bernard L. Madoff Investment Securities Inc., 08-01789, also in Manhattan bankruptcy court. The criminal case is U.S. v. Madoff, 09-cr-00213, U.S. District Court for the Southern District of New York (Manhattan).

Expense Reimbursement Governed by 503(b), Not 363(b)

Whether a bankruptcy judge erred in approving expense reimbursement for potential bidders is governed by the more flexible business judgment test under Section 363(b) of the Bankruptcy Code, rather than the higher “benefit to the estate” test for administrative expenses under Section 503(b), the U.S. Court of Appeals in New Orleans ruled on Aug. 16.

The opinion by Circuit Judge Carl E. Stewart distinguished cases where a challenge was mounted to so-called breakup fees kicking in when the initial purchaser is outbid at auction. Expense reimbursement was designed to stimulate bidding where a breakup fee sometimes is alleged to have a chilling effect on bidding, he said. For expense reimbursement, Section 363(b) is the proper standard, Stewart said, because it was approved beforehand.

Stewart declined to resolve the difference of opinion between the Fifth Circuit in New Orleans and the Second Circuit in Manhattan over what is or isn’t an interlocutory appeal. Stewart stuck by the more flexible standard in the Fifth Circuit.

The case is Asarco Inc. v. Elliott Management, 10-40930, U.S. Court of Appeals for the Fifth Circuit (New Orleans).

Student Loan Discharge Complaint OK After Discharge

An individual was allowed three years after receiving a discharge in Chapter 7 to file papers seeking a ruling that student loans should be dischargeable as an undue hardship, the U.S. Court of Appeals for the Eighth Circuit in St. Louis ruled on Aug. 18. The circuit court upheld a ruling by the appellate panel reported on April 14, 2010.

Agreeing with the bankruptcy court and the appellate panel, the three judges on the circuit court concluded that bankruptcy law does not require filing a complaint to discharge student loans before the general discharge is granted. They also ruled that the bankruptcy judge properly considered the bankrupt’s financial condition at the time of the student loan discharge trial, not at discharge three years earlier.

The circuit court said it “would make little sense to require the court to ignore what actually occurred” in the three years after she received her Chapter 7 discharge and before she filed papers to wipe out the $300,000 in student loans.

On the merits, the appellate judges found that the bankruptcy judge did not commit error in finding that the student loans were an undue hardship. The woman had been unable to work, largely because she was caring for two autistic children. She had five children in total. The circuit court said that the evidence indicated that woman could not make payments on the student loans and at the same time maintain a “minimal standard of living.”

The case in the Circuit Court is Sallie Mae Servicing Corp. v. Walker (In re Walker), 10-2032, U.S. Court of Appeals for the Eighth Circuit (St. Louis). The opinion from the appellate panel is Educational Credit Management Corp. v. Walker (In re Walker), 09-06022, bankruptcy appellate panel for the Eighth Circuit.

New Resident May Use Old State’s Homestead Exemption

A U.S. district judge in Texas came down on the side of a majority of courts deciding an exemption question where federal bankruptcy law is ambiguous. In reversing the bankruptcy court, U.S. District Judge Kathleen Cardone said the result she reached was consistent with the intent of Congress.

Bankruptcy law now prohibits using state exemptions without having lived in the state for two years before bankruptcy. Someone who moved to the new state less than two years before bankruptcy must use exemptions provided by the former state of residence.

The case involved an individual who moved away from Texas in 2000 to seek employment in Nevada. He kept his home in Texas, intending it to be his residence. He returned to Texas in early 2009 and filed bankruptcy in late 2009.

Because the bankrupt wasn’t eligible for Texas exemptions, the bankruptcy judge forced him to use federal exemptions in the process of ruling that Nevada’s exemptions could never be used outside Nevada. Cardone reversed.

She noted that three of four circuit courts and appellate panels have ruled there is no prohibition against giving extraterritorial effect to a state’s exemptions. Consequently, the bankrupt was allowed to exempt the entire value of the house under Nevada law, even though the home was located in Texas.

Cardone said her decision is consistent with a ruling in January from the U.S. Court of Appeals in New Orleans, which controls lower courts in Texas. To read about the Fifth Circuit case, called Camp v. Ingalls, click here for the Jan. 11, 2011 Bloomberg bankruptcy report.

The case is Fernandez v. Miller (In re Fernandez), 11-123, U.S. District Court, Western District Texas (El Paso).

Order for Relief Improper after Transferring Venue

The bankruptcy court in Delaware committed error when it granted an involuntary bankruptcy petition by signing an order for relief after the same Delaware judge had already transferred the case to Colorado, the U.S. Court of Appeals in Denver ruled on Aug. 5. Nonetheless, an appeal to the Bankruptcy Appellate Panel in Denver was improper, the appeals court ruled.

When the Delaware bankruptcy judge signed an order transferring venue of an involuntary case to Colorado, the judge apparently had forgotten to sign another order granting the involuntary petition and putting the company into bankruptcy officially. The Delaware judge later signed the order for relief after the case was officially in Delaware.

On appeal, the appellate panel in the Tenth Circuit in Denver concluded that it was error for the bankruptcy judge in Delaware to grant the order for relief when the case was already transferred. Nevertheless, the appellate panel dismissed the appeal.

Circuit Judge Wade Brorby affirmed for the court of appeals, concluding that an appeal from the order for relief could only be taken to the district court in Delaware. Brorby said that the answer was not evident from the language of Section 158(a) of the Judiciary Code nor from legislative history. Consequently, he looked to similar federal laws for the answer.

The case is Healthtrio Inc. v. Centennial River Corp. (In re Healthtrio Inc.), 10-1351, U.S. Court of Appeals for the Tenth Circuit (Denver).

-- Editors: John Pickering

To contact the reporter on this story: Bill Rochelle in New York at wrochelle@bloomberg.net.

To contact the editor responsible for this story: John Pickering at jpickering@bloomberg.net.


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