SECOND CIRCUIT UPHOLDS $2.7 MILLION SANCTIONS AWARD OVER DISCOVERY VIOLATIONS

by Kristin Mayhew

In affirming a $2.7 million sanctions award for spoliation of evidence, the Second Circuit is sending a clear message to federal court practitioners (and bankruptcy litigants alike) that their clients must adhere to litigation hold instructions and comply with the discovery rules or suffer the consequences.

In Klipsch Group, Inc. v. ePRO E-Commerce Ltd., 880 F.3d 620 (2018), the plaintiff, a manufacturer of sound equipment, including headphones, sued a subsidiary of ePRO, a Chinese corporation, in the Southern District of New York for allegedly selling counterfeit Klipsch headphones.  According to ePRO, any potential damages to the Plaintiff resulting from the sales of counterfeit products amounted to no more than $20,000.  Despite the allegedly small amount at stake, ePRO went to great lengths to destroy potentially damaging evidence, resulting in a sanctions award more than 100 times ePRO’s exposure.

During the course of discovery, ePRO produced fewer than 500 documents, insisting it did not have any original sales data, and instead producing spreadsheets created for purposes of the litigation.  But during a deposition of ePRO’s CEO, it became clear that ePRO had not put an effective litigation hold on a substantial portion of its electronic data, including emails and faxes.  After hiring its own discovery vendor, ePRO produced an additional 40,000 documents, including over 1,200 original sales documents.

Klipsch moved for discovery sanctions, arguing that large quantities of documents had been lost as a result of ePRO’s failure to initiate a proper litigation hold.  Rather than then sanctioning ePRO, the magistrate judge authorized Klipsch to undertake an independent forensic examination of ePRO’s computer systems at its own cost (subject to potential reimbursement by ePRO).

Klipsch’s independent forensic examination revealed:

  • 4,596 responsive files or emails were manually deleted (although all of these documents were ultimately recovered);
  • Seven (7) employees used data-wiping programs shortly before the forensic examination began;
  • Eighteen (18) employees ran operating system upgrades during the litigation hold period resulting in the loss of their program usage data;
  • ePRO failed to provide access to email accounts of approximately nineteen (19) current and former employees who were custodians of discoverable data; and
  • Thirty-two (32) of thirty-six (36) custodians of discoverable data, including the CFO, refused to permit access to their accounts on a private messaging system.

As a result of ePRO’s spoliation of evidence, the District Court awarded Klipsch $2.68 million as compensation for the additional discovery efforts occasioned by ePRO’s misconduct.

On appeal, the Second Circuit affirmed the award, rejecting ePRO’s arguments that the award: (i) was so out of proportion to the value of the case or the evidence uncovered as to be impermissibly punitive and a violation of due process; (ii) failed to adhere to the limitations of Federal Rule of Civil Procedure 37(e); and (iii) lacked proportionality.

As to the sanctions amount, the Second Circuit pointed out that ePRO caused Klipsch to accrue the discovery costs by failing to comply with its own discovery obligations.  It stated, “[s]uch compliance is not optional or negotiable; rather, the integrity of our civil litigation process requires that the parties before us, although adversarial to one another, carry out their duties to maintain and disclose the relevant information in their possession in good faith.”

The Court went on to state, “[t]he extremely broad discovery permitted by the Federal Rules depends on the parties’ voluntary participation. The system functions because, in the vast majority of cases, we can rely on each side to preserve evidence and to disclose relevant information when asked (and sometimes even before then) without being forced to proceed at the point of a court order.”

This decision, while exceptional given the egregious conduct involved, is a cautionary tale to parties engaged in discovery battles.  All must adhere to their discovery obligations under the Federal Rules of Civil Procedure or risk severe sanctions for non-compliance.

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BANKRUPTCY COURT TAKES LIBERAL VIEW OF SECTION 327(C)’S “ACTUAL CONFLICT” PROVISION

by John P. Schneider

In re Relativity Media, LLC, 2018 Bankr. LEXIS 2037 (Bankr. S.D.N.Y. 2018) presents a very informative discussion of the ethical pitfalls which may arise when a law firm concurrently represents adverse parties. Prior to its bankruptcy filing, certain disputes arose between Relativity Media, LLC (the “Debtor”) and Netflix, Inc. (“Netflix”) relating to a distribution contract between the parties.  When the Debtor filed its Chapter 11 bankruptcy petition, it sought to retain Winston & Strawn, LLP (the “Law Firm”) as counsel.  In its retention application, the Law Firm disclosed that at the time of the petition, it represented Netflix in certain patent litigation in the United States District Court for the District of Delaware, and that this representation preceded the Debtor’s engagement of the Law Firm for the bankruptcy case.

Shortly thereafter, Netflix filed a complaint seeking to have the Bankruptcy Court declare that the Debtor had breached the parties’ distribution contract prior to commencement of the bankruptcy case.  In response, the Law Firm filed an answer on behalf of the Debtor, contending there was no default, and that the Debtor intended to assume, assign, and sell the Netflix contract to a third-party purchaser.

Two objections to the Debtor’s retention of the Law Firm were filed.  Netflix argued that the Law Firm’s representation of the Debtor in disputes with Netflix would violate the professional obligations owed to it by the Law Firm.  Netflix opposed the Law Firm’s retention, but only to the extent of the Debtor’s dispute with Netflix.  It urged that the Court require the Debtors to retain special counsel for matters involving Netflix.  The Office of the United States Trustee filed a much more general objection, arguing that the simultaneous representation of both the Debtor and Netflix created an actual conflict of interest which barred the Law Firm’s employment by the Debtor under section 327 of the Bankruptcy Code (the “Code”) entirely.

In response, the Law Firm argued that Netflix previously had agreed to waive conflicts to permit the Law Firm’s representation of other clients in unrelated matters which may be adverse to Netflix.  The Law Firm also noted that Netflix was no longer a client because the Law Firm had withdrawn from the patent litigation pending in the District of Delaware.  Netflix countered that it had never agreed to the advance waiver of conflicts and that even if it had, such an agreement would be unenforceable under relevant state law.  Netflix also cited the so-called “hot potato” rule in contending that the Law Firm’s subsequent withdrawal as counsel in the patent litigation did not cure the violations of its duty of loyalty to Netflix.  As the Court noted, the theory of the “hot potato” rule “is that a law firm owes a duty of loyalty to its client, and dropping the client so the law firm can be adverse to the client is just as much a breach of that duty of loyalty as if the law firm were to be adverse to a current client.”[1]

In its review of the Law Firm’s retention application, the Bankruptcy Court began with the relevant Code provisions.  Section 327(a) states that a debtor may employ attorneys who “do not hold or represent any interest adverse to the estate.”  Section 327(c) makes clear that in a Chapter 11 case, a law firm is not disqualified “solely because of such person’s employment by or representation of a creditor, unless there is objection by another creditor or the United States Trustee, in which case the court shall disapprove such employment if there is an actual conflict of interest.”[2]

The Court discussed that there are two schools of thought about the meaning of “actual conflict” under section 327(c).  The first employs an objective test that “excludes any interest or relationship, however slight, that would even faintly color the independence and impartial attitude required by the Code and Bankruptcy Rules.”[3]  But this test could “effectively negate the clear language of section 327(c),” which provides that the representation of a creditor is not inherently disabling, unless there is an actual conflict of interest.   A second school of thought, which the Court found more palatable, provides that no “actual conflict” exists under section 327(c) unless there is “an active competition between two interests, in which one interest can only be served at the expense of the other.”[4]

Whether the Law Firm’s representation of Netflix in the patent suit was continuing or not, the Court concluded that the Law Firm was not disqualified altogether because the duties associated with the representation of the Debtor in the bankruptcy case generally would not be adverse to Netflix and would not cloud its ability to remain independent and loyal to the Debtor.  So, the Court turned to the question of whether the Law Firm could represent the Debtor in matters adverse to Netflix, given its purported withdrawal from the patent suit.

The Court stated that Netflix had raised the Law Firm’s conflict from the very beginning of bankruptcy case.  And even if the Law Firm finalized its withdrawal from the patent suit, the “hot potato” rule prevented the firm from now asserting it had cured the breaches of its duty of loyalty to Netflix.  Moreover, upon review of certain engagement letters and emails between Netflix and the Law Firm, the Court determined that any advance waivers contained therein were only applicable in particular matters which had since ended, and were not a general waiver for any matter in which the Law Firm may be hired by Netflix in the future.  The fact that separate waivers were obtained in specific representations of Netflix only reinforced this notion.

Although the Court did not rule finally on whether the Law Firm would be disqualified from becoming adverse to Netflix, it stated that such an outcome was likely, but permitted the parties to further brief the issue.  As stated previously however, the Court did resolve the disputed retention application under section 327(c) by allowing the Law Firm to serve as Debtor’s general bankruptcy counsel so long as the Debtor engaged another firm to handle matters involving Netflix.

Hence, attorneys should be mindful to identify early the likely need for special counsel in these circumstances and confer with the prospective client about this issue as soon as possible.

[1] 2018 Bankr. LEXIS 2037, at *5 (internal citation omitted).

[2] Emphasis added.

[3] Id. at *6 (citing In re Granite Partners, 213 B.R. 22, 33 (Bankr. S.D.N.Y. 1998)).

[4] Id. at *7 (citing In re Empire State Conglomerates, Inc., 546 B.R. 306, 315 (Bankr. S.D.N.Y. 2016)).

A Single Statement about a Debtor’s Financial Condition Must be in Writing in order for a Creditor to Avoid Discharge

by Virginia Shea

In the recent Supreme Court decision Lamar, Archer & Cofrin, LLP v. Appling, 138 S. Ct. 1752 (2018), one can almost hear Justice Sotomayor belting out the lyrics to Aretha Franklin’s classic, “all I’m askin’ is for a little RESPECT . . . .”  Justice Sotomayor relies on the simple definition of “Respecting,” to settle a split in the circuits, resolutely determining that a debtor’s purported fraudulent statement about a single asset must be in writing to deny discharge under 11 U.S.C. § 523(a)(2).  At issue was whether a statement about a single asset could constitute a “statement … respecting the debtor’s … financial condition,” or, whether the statement, which must be in writing under 11 U.S.C. §523(a)(2)(B), had to be about the debtor’s overall financial status rather than about a single asset.  Justice Sotomayor, in no-nonsense fashion, looked to the clear language of the word “respecting” and ruled that a statement about a single asset could “relate” to a debtor’s financial condition, but that to avoid discharge, it must be in writing.

The underlying facts may resonate with everyone who has ever been promised payment from a client or customer.  Appling hired the Lamar law firm to represent him in litigation.  He eventually owed Lamar over $60,000, and after counsel threatened to withdraw from representation, he orally told his attorneys that he was expecting a tax refund of approximately $100,000.  When the tax refund arrived, it was under $60,000, and rather than paying Lamar, Appling spent it on his business.  A month later, Appling told his attorneys that he had not yet received the refund.  Lamar relied upon both misstatements in agreeing to complete the pending litigation.  Five years after Lamar sent its final invoice, the firm sued Appling for non-payment and obtained a judgment.  Appling filed for bankruptcy.  Lamar filed an adversary proceeding against Appling arguing, in part, that the debt was nondischargeable under § 523(a)(2)(A) as a debt arising from “false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor’s … financial condition.”  Appling argued that the law firm could not block discharge of the debt because the representations were statements about his financial condition, which had to have been in writing in order to be nondischargeable.

Justice Sotomayor linguistically explained that “the key word in the statutory phrase is the preposition ‘respecting,’ which joins together ‘statement’ and ‘financial condition.’”  Id. at 1759:

A statement is ‘respecting’ a debtor’s financial condition if it has a direct relation to or impact on the debtor’s overall financial status.  A single asset has a direct relation to and impact on aggregate financial condition, so a statement about a single asset bears on a debtor’s overall financial condition and can help indicate whether a debtor is solvent or insolvent, able to repay a given debt or not.

Id.at 1761.    Justice Sotomayor brushed aside concerns that this ruling could leave fraudsters free to swindle by lying about their finances orally, then discharging the resulting debt in bankruptcy.  The antidote, according to the Justice, is the good practice of memorializing promises in writing.  She explained that one reason that Congress  heightened the bar to discharge by imposing a writing requirement on statements respecting a debtor’s financial condition, was due to a historic practice of loan officers providing little space to list all debts on a loan application, followed by the preprinted phrase “I have no other debts.”  If the applicant later filed for bankruptcy, the creditor could contend that the debtor had made a misrepresentation in his loan application by failing to list all debts, and the creditor would threaten litigation over excepting the debt from discharge.  Justice Sotomayor explained that the new ruling does not leave creditors powerless – they need only “insist that representations respecting a debtor’s financial condition on which they rely in extending money, property, services, or credit are made in writing.”  Id. at 1764.   Thus, Justice Sotomayor’s ruling offers due “respect” to Congress’ effort to balance potential misuse of such statements vis-à-vis creditors and debtors, while providing creditors the ability to protect themselves from potential fraud by the good practice of memorializing representations of financial condition prior to extending credit.

Peculiar Parting from Protocol: U.S. Trustee’s Objection to Debtors’ Application to Retain Management Consultants under Section 363(b) Shot Down in SDNY

by Bradley Lehman

A recent decision from the United States Bankruptcy Court for the Southern District of New York ratifies a procedure often used for the employment of financial consultants by corporate debtors and the applicability of the “Jay Alix Protocol” in connection therewith.

In the Chapter 11 case of In re Nine West Holdings, Inc., et al., the debtors filed an application to retain Alvarez & Marsal North America, LLC (“A&M”) to provide an interim CEO and other management personnel to the debtors. The debtors sought the retention of A&M pursuant to Section 363(b) of the Bankruptcy Code, which applies a business judgment standard in evaluating a debtor’s proposed use of its money.

The Office of the United States Trustee (the “UST”) filed an objection to the application, arguing that A&M and the interim CEO are “professional persons” within the meaning of the Bankruptcy Code, such that their retention must be considered only under Section 327(a). Section 327(a) applies a more stringent standard than the relatively permissive business judgment rule applicable under Section 363(b). The UST argued that because the interim CEO had previously served on some of the debtors’ subsidiaries’ boards of directors, he and (by extension) A&M could not meet the disinterestedness requirement of Section 327(a).

The debtors and A&M, supported by other significant stakeholders in the case, vehemently disagreed with the UST’s objection. They pointed out that distressed management consultants have been retained under Section 363(b) in many bankruptcy cases. A&M cited to 37 other cases in which A&M itself had been retained under Section 363(b), noting that the UST objected to A&M’s retention in only one of those cases. The debtors and A&M also argued that the UST was ignoring the “Jay Alix Protocol,” the UST’s own national policy which has been in place for some fourteen years and directs debtors to seek retention of consultants like A&M under Section 363(b).

In her July 2 opinion, Judge Shelley Chapman noted that the UST was “seemingly ignoring this mountain of precedent,” and that the UST’s attempt to distinguish cases involving a consultant CEO rather than a CRO was “nonsensical.” With respect to the Jay Alix Protocol, the Court found that the UST’s surprising departure from the Protocol “lacks intellectual honesty and consistency.” The Court ultimately found that A&M’s retention would not violate the Protocol and granted the debtors’ application. Judge Chapman was sensitive to the economic and operational realities of the case.  She noted that removing A&M personnel from management positions they had held for the past four years, three of which were pre-bankruptcy, would likely have a disastrous effect on the debtors’ efforts to reorganize.

 

Second Circuit Holds Violation of Bankruptcy Discharge Injunction May Nullify Mandatory Arbitration Requirement Under Federal Arbitration Act

by John P. Schneider

In In re Anderson v. Credit One Bank, N.A., 884 F.3d 382 (2d Cir. 2018), the Second Circuit held that it is within a bankruptcy court’s discretion to deny arbitration of disputes involving a violation of the bankruptcy discharge injunction.  In doing so, it found that despite the strong congressional preference for arbitration generally, the importance of the Bankruptcy Code’s fresh start, and the bankruptcy court’s powers to enforce the discharge injunction, prevailed.

Orrin Anderson (the “Debtor”) was the holder of a consumer credit card account with Credit One Bank, N.A. (“Credit One”).   In March 2012, Credit One “charged off” the Debtor’s delinquent debt, sold it to a third-party purchaser, and reported these changes to each of the nation’s leading credit reporting agencies.  The Debtor subsequently filed a voluntary Chapter 7 bankruptcy petition and was granted a discharge in May 2014.

The Debtor’s claim arose after Credit One refused his request to remove the charge-off from his credit report.  The Debtor contended that Credit One’s refusal violated the discharge injunction by attempting to coerce him into paying a discharged debt, knowing that debtors would be more inclined to pay charged-off (rather than “discharged”) debt to clear their credit report.

In December 2014, the bankruptcy court permitted the Debtor to reopen the bankruptcy case to file a class action seeking damages against Credit One for violating Bankruptcy Code section 524’s discharge injunction.  In response, Credit One moved to stay the proceedings and to initiate arbitration of the dispute in accordance with an arbitration clause contained in the Debtor’s cardholder agreement.  The bankruptcy court denied Credit One’s motion and held that because the Debtor’s claim was a core bankruptcy proceeding which “went to the heart of the fresh start guaranteed to debtors” under the Bankruptcy Code, it was not subject to arbitration.[1]

As was its right under the Federal Arbitration Act (the “FAA”), Credit One filed an interlocutory appeal of the bankruptcy court’s denial of its motion to compel arbitration in June 2015.  The District Court for the Southern District of New York affirmed the bankruptcy court’s decision in June 2016.  Credit One then  appealed to the Second Circuit.

Reviewing the bankruptcy court’s decision under an abuse of discretion standard, the Second Circuit initially stated that although the FAA establishes a federal policy favoring arbitration, “[t]his preference . . . is not absolute[]” and its mandates may be overridden by a contrary congressional command.  Therefore, given the presence of the Bankruptcy Code’s discharge provisions, the ultimate issue was whether Congress intended those provisions to preclude enforcement of arbitration agreements under the FAA.

Keenly aware that the discharge is the foundation upon which the Bankruptcy Code is built and of Congressional intent to afford the “honest but unfortunate debtors an opportunity to reorder their financial affairs and get a fresh start,” the Second Circuit recognized that this would only be possible if discharge injunctions were fully heeded by creditors.  Violations of the discharge order “damage the foundation on which the debtor’s fresh start is built.”[2]  Not surprisingly, the court determined that requiring arbitration to enforce the bankruptcy court’s discharge injunction would seriously jeopardize the effectiveness of the discharge, because: (i) the discharge injunction is integral to the bankruptcy court’s ability to provide debtors with the fresh start at the very foundation of the Bankruptcy Code; (ii) the Debtor’s claim against Credit One related to an ongoing bankruptcy matter requiring bankruptcy court supervision; and (iii) the equitable powers of the bankruptcy court to enforce its own injunctions are central to the structure of the Bankruptcy Code.[3]

Moreover, because the power to enforce a bankruptcy discharge injunction complements the duty to obey the injunction, only the bankruptcy court would have the power to enforce the injunction under section 524 of the Bankruptcy Code.  Arbitration of the claim, the Second Circuit found, would present an inherent conflict with the Bankruptcy Code.

Because the Second Circuit determined that there was an inherent conflict between arbitration of the Debtor’s claim against Credit One and the Bankruptcy Code, the court concluded that the bankruptcy court “properly considered the conflicting policies in accordance with the law” and acted within its discretion to deny Credit One’s motion to compel arbitration.[4]

 

[1] Id. at 385.

[2] Id.

[3] Id. at 389-90 (internal citation omitted).

[4] Id. at 392 (internal citation omitted).

Please Release Me? Colorado Bankruptcy Court Answers “Perhaps” in Midway Gold Case

by Nicole Leonard and Jeffrey Bernstein

This article is  reprinted with the permission of the American Bankruptcy Institute. It originally appeared in Volume 17, Number 1 of the ABI Business Reorganization Committee Newsletter, May 2018.

The permanent release of a nondebtor from a debt owed to a third party in a chapter 11 plan is barred per se in some courts and must meet a high standard to be allowed in others. The U.S. Bankruptcy Court for the District of Colorado in In re Midway Gold US Inc. addressed this issue in connection with confirmation of the joint chapter 11 plan of 14 debtor entities in the gold mining and exploration business.[1]

As a threshold issue, the Midway court looked to whether third-party releases are ever allowed in the Tenth Circuit or whether they are barred per se as had been argued and applied in other cases. The court analyzed the Western Real Estate case and concluded a chapter 11 plan could not “bar litigation against nondebtors for the remainder of the discharged debt” and that the court’s authority under § 105(a) could not be used in a manner inconsistent with § 524(e). However, such finding did not translate into an absolute bar of all nondebtor releases in all circumstances.[2]

In connection with its analysis of the nondebtor release, the Midway court reviewed the treatment of nondebtor releases in other circuits and found that while the “Fifth and Ninth Circuits have held a bankruptcy court does not have authority to issue and enforce third-party non-debtor releases in a Chapter 11 plan,” these circuits are in the minority.[3] Rather, the Midway court sided with the majority, represented by the First, Second, Third, Fourth, Sixth, Seventh, Eighth and Eleventh Circuits, permitting third-party releases under certain narrow circumstances.

Section 524(e) of the Bankruptcy Code provides in pertinent part that “discharge of a debt of the debtor does not affect the liability of any other entity on, or the property of any other entity for, such debt.” The majority of the circuits view this language as a “savings clause” that preserves post-confirmation rights (e.g., the right to pursue a nondebtor for a debt) rather than “an absolute bar to third-party releases.”[1]

Further, the court observed that, read together, §§ 105(a),[2] 1123(b)(3)(A)[3] and 1123(b)(6)[4] indicate that “enjoining a creditor’s claims against a nondebtor may be necessary, and within the bankruptcy court’s authority, to achieve a successful reorganization.”[5]

Before forging its own path, the court examined the standards used by the other circuits in determining whether nondebtor releases are acceptable, some of which overlap. The First and Eighth Circuits look generally to the following nonexclusive list of factors outlined in the case In re Master Mortg. Fund (the “Master Mortgage Factors”), including whether:

(1) there is an identity of interest between the debtor and the third party, usually an indemnity relationship, such that a suit against the nondebtor is, in essence, a suit against the debtor or will deplete assets of the estate;

(2) the nondebtor has contributed substantial assets to the reorganization;

(3) the injunction is essential to reorganization (i.e., without it, there is little likelihood of success);

(4) a substantial majority of the creditors agree to such injunction; specifically, the impacted class (or classes) has “overwhelmingly” voted to accept the proposed plan treatment; and

(5) the plan provides a mechanism for the payment of all, or substantially all, of the claims of the class or classes affected by the injunction.[6]

The Midway court found that courts in the Third Circuit do not have a specific test, although a Delaware bankruptcy court has looked to the Master Mortgage Factors as a foundation along with “other relevant factors.”[7] Third-party nondebtor releases are allowed in the Second and Seventh Circuit only “when truly ‘unusual circumstances’ exist.”[8] The Sixth Circuit also restricts allowing such releases to “unusual circumstances” and further looks to a set of seven factors, certain of which are identical or substantially similar to the Master Mortgage Factors referred to as the “Dow Corning Factors.” The Midway court found that the U.S. Courts of Appeals for the Fourth and Eleventh Circuits have also looked to the Dow Corning Factors.[1]

After analyzing Western Real Estate and the other circuits, the Midway court determined that “while § 524(e) does not expressly provide for the release of a third party’s claims against a nondebtor, § 524(e) does not expressly preclude such releases.” However, such releases are not given “carte blanche” and are acceptable only “in certain, and very limited, circumstances if the release is “appropriate” and not inconsistent with any other provision of the Bankruptcy Code, including § 524(e).”[2]

For its own approach, the Midway court found that “the Court must parse out exactly who is releasing whom from what.”[3] In other words, the court stressed the importance of distinguishing “between the Debtors’ release of nondebtors and third parties’ release of nondebtors” and to “find the release to be necessary for the reorganization and appropriately tailored to apply only to claims arising out of or in connection with the reorganization itself, and not to matters which would have no effect upon the estate.”[4] If not, there is potential for a jurisdictional issue that would preclude the authority of the bankruptcy court to enter a final order.

The court further warned against the releases providing “nondebtors with ‘blanket immunity’ for all times, transgressions and omissions and may not include immunity from gross negligence or willful misconduct.”[5] As the Midway court summarized it, “[i]t is not the intention of the Court to permit nondebtors to purchase immunity from unrelated torts, no matter how substantial their contribution to a debtor’s reorganization.”[6]

In summary, most jurisdictions will allow third party releases of nondebtors — but only in certain narrow circumstances. Courts will determine the issue based on the facts and dynamics of each case and will require that such releases be fully justified. Plan proponents must walk the tightrope of providing for the releases necessary to have a plan accepted while avoiding overbroad language and staying within the lines of bankruptcy jurisdiction.

 

CAN SPOUSES NOW SAVE MARITAL PROPERTY BY FILING SEPARATE BANKRUPTCIES?

by Virginia Shea

The New Jersey Appellate Division has crafted a potential new avenue for debtor spouses to protect marital property.  The Appellate Division recently clarified that a creditor of one spouse cannot execute on marital real or personal property held by the spouses as tenants by the entirety, absent consent of both spouses.  Bankruptcy law holds that property held as tenants by the entirety is exempt property, unless state law holds to the contrary, which New Jersey law, now, clearly does not.  Accordingly, spouses may be able to protect marital property by filing separate bankruptcies, whereby consent may be denied by the respective non-debtor spouse.

The New Jersey Appellate Division recently ruled that a New Jersey Statute enacted in 1988 supersedes prior case law, such that there is no question that an unsecured creditor of one spouse cannot seek partition of property held by spouses as tenants by the entirety.  In Jimenez v. Jimenez, __A.3d __, 2018 WL 2106639 (App. Div. 2018), Raul and his wife Gwyn[1] owned undeveloped land in Mansfield, NJ (the “Mansfield Property”), as tenants by the entirety.  Plaintiffs, relatives of Raul, sought to enforce a consent judgment entered against Raul only, which judgment had been recorded as a lien.  Plaintiffs tried to enforce the judgment by way of other collection efforts but were unsuccessful.  Plaintiffs then moved under R. 4:59-1(d) to compel the partition and sale of the Mansfield Property.  Raul opposed the motion arguing that a forced sale and partition is prohibited by N.J.S.A. 46:3-17.4.  The motion judge agreed with Raul and denied the partition application.  The Appellate Division affirmed stating that N.J.S.A. 46:3-17.4 precluded one spouse’s unsecured creditor from obtaining a forced partition of property owned by both spouses as tenants by the entirety.

In 1988, new statutes were enacted in New Jersey, N.J.S.A. 46:3-17.2 to -17.4, pertaining to tenancies created on or after the 1988 enactment date.  Section 17.2 provides that a tenancy by the entirety is created when a husband and wife take title to “real or personal property under a written instrument designating both of their names as husband and wife.”  A tenancy by the entirety is a form of joint ownership of property only available to spouses, whereby each co-tenant is the owner of the entire property and each co-tenant has the right of survivorship after the death of the other.  Jimenez, 2018 WL 2106639 at *2.  A spouse can alienate his or her right of survivorship,[2]  but a spouse cannot force the partition of the property during the marriage.  Id.

Section 17.4 of N.J.S.A. 4:3 statute states, “[n]either spouse may sever, alienate, or otherwise affect their interest in the tenancy by entirety during the marriage or upon separation without the written consent of both spouses.”  Prior to the adoption of the 1988 statute, case law authorized courts to compel the partition and sale of a spouse’s interest in property held in a tenancy by the entirety, in the court’s discretion, where it would be equitable to do so.  Id. at *3.  In Jimenez, equity otherwise would have warranted partition as the Mansfield Property, because it was not used as the marital residence, some of the funds loaned to Raul by the plaintiffs related to development of the Mansfield Property, and plaintiffs had expended significant effort trying to execute from other sources, to no avail.  Id.  Nevertheless, the Appellate Division was constrained by the language of the 1988 statute to preclude partition since Raul and Gwyn owned the Mansfield Property as tenants by the entirety.  “Otherwise, a free-wheeling spouse, by amassing such individual debt, could detrimentally ‘affect’ the other spouse’s interest in their co-owned property.” Id. Moreover, “[t]here would have been little point for the Legislature to have enacted Section 17.4 if it only intended to continue established principles of case law regarding tenancies by the entirety ….”  Id.  The Appellate Division reached this conclusion in part, after reviewing In re Wanish, 555 B.R. 596 (Bankr. E.D. Pa. 2016).

In In re Wanish, a chapter 7 trustee in a Pennsylvania bankruptcy case, objected to a debtor’s claimed exemption in a mobile home owned with his non-debtor wife, which was located in New Jersey.  The Trustee conceded that New Jersey law applied in order to determine the exemption issue.  The bankruptcy court determined that based upon New Jersey’s 1988 statute, it was clear that creditors of one spouse could not levy or sell personal property held by a debtor as a tenant by the entirety, without the non-debtor spouse’s consent.  Id. 555 B.R. at 498.  Since it was clear under New Jersey law that creditors of the debtor were prohibited from levying on the mobile home without the consent of the non-debtor spouse, the debtor’s interest in the mobile home was exempt under 11 U.S.C. § 522(b)(3)(B).   Section 522(b)(3)(B) provides that a debtor may exempt as property “any interest in property in which the debtor had, immediately before the commencement of the case, an interest as a tenant by the entirety … to the extent that such interest as a tenant by the entirety … is exempt from process under applicable non-bankruptcy law.”  Here, New Jersey law no longer provides such “exempt[ion] from process,” such that property held as tenants by the entirety, is now clearly exempt under 11 U.S.C. § 522(b)(3)(B).

Along these lines, in 2012, the Bankruptcy Court for the Middle District of Florida, applied New Jersey law and determined that a trustee could not reach the sales proceeds generated by the sale of a debtor’s marital property.   In In re Montemoino, 491 B.R. 580 (2012), a married debtor, together with her non-debtor husband, sold real property held as tenants by the entirety, and deposited the net proceeds into a bank account titled solely in the non-debtor spouse’s name.   The trustee alleged that half the proceeds from the sale were property of the debtor and could be avoided as fraudulent, because the debtor transferred the proceeds to the non-debtor spouse for no consideration causing her to become insolvent as a result.  Id. at 583.  The debtor argued that the proceeds had originated from property held as tenants by the entirety,  and, as such, the proceeds maintained their tenant by entirety status, such that the proceeds were exempt.  The Florida bankruptcy agreed that New Jersey recognizes that personal property could be held as tenants by the entirety, and since the proceeds from the sale went to both spouses, the proceeds were presumed to be, under New Jersey law, held by the spouses as tenants by the entirety.  Id. at 586.  The bankruptcy court then held that although New Jersey common law prior to 1988 permitted creditors of a single spouse to execute on tenancy by the entireties property, “with the enactment of the tenancy by the entireties statutes, this Court concludes that creditors of just one spouse can no longer execute on entireties property.”  Id. at 588.  The court noted that the statute prevented a spouse from granting a mortgage on real property without the consent of the other spouse.  Id. at 589.  The court also pointed to a Third Circuit ruling that held “filing a bankruptcy petition does not sever a tenancy by the entirety and thus an individual spouse may be able to exempt the whole of entireties property from the bankruptcy estate in some circumstances.”  Id. (quoting In re O’Lexa, 476 F.3d 177 (3d Cir. 2007)).

Accordingly, Jimenez clarifies that with respect to creditors of a debtor who owns New Jersey property with a non-debtor spouse as tenants by the entirety, the entireties property is exempt under 11 U.S.C. § 522(b)(3)(B) because it is exempt from process under applicable non-bankruptcy law (absent a fraudulent conveyance).   A debtor may thus be able to protect marital property by filing for bankruptcy without his or her spouse, or by each spouse filing an indivi

[1] As plaintiffs and defendants surnames are “Jimenez,” all references will be to their first names.

[2] Presumably, by stepping into the debtor’s survivorship shoes, an unsecured creditor could acquire survivorship rights only such that the unsecured creditor could become owner of the entire property to the extent the debtor survives his or her non-debtor spouse after the marriage ends, whether by way of divorce or death.

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The Supreme Court Sets the Limits of Fee-Shifting for Bad Faith Conduct in Goodyear Tire & Rubber Co. v. Haeger

by Nicole Leonard and Jeffrey Bernstein

This article is  reprinted with the permission of the American Bankruptcy Institute. It originally appeared in Volume 15, Number 2 of the ABI Business Reorganization Committee’s Ethics & Professional Compensation Newsletter, June 2017.

[1]In a recent unanimous decision delivered by Justice Kagan,[2] the Supreme Court has made clear that federal courts, when awarding sanctions for bad faith conduct through the use of their inherent powers (not derived from rule or statute), must limit such sanctions to only compensatory damages that have a causal connection to the misconduct.

The underlying lawsuit involved a products liability action against Goodyear Tire & Rubber Co. (“Goodyear”) in which customers alleged a Goodyear G159 tire failed and caused their motor home to swerve off the road and flip over. The plaintiffs (the “Haegers”) theorized that the tire design could not withstand the level of heat generated by driving at highway speeds.

The Haegers repeatedly requested that Goodyear provide them with Goodyear’s internal test results regarding the tire. Goodyear’s responses to these requests were slow and less than forthcoming. Additional discovery battles ensued but the case eventually settled just before trial.

Months later, the plaintiff’s counsel became aware of a pertinent piece of information from an article in a newspaper on another lawsuit involving the exact same Goodyear tire. Apparently, Goodyear had supplied additional internal test results in the other matter that were not supplied to the Haegers despite the Haegers’ repeated requests. The test results, unsurprisingly, revealed that the tire became unusually hot at highway speeds. Goodyear later conceded that it withheld this information. The Haegers in turn requested sanctions against Goodyear which included attorneys’ fees and costs for Goodyear’s discovery fraud.

The District Court for the District of Arizona (the “District Court”) found that the conduct of Goodyear spanned years and was egregious. Based on the severity of the misconduct, the District Court determined that it was not confined to award only the legal fees incurred as a result of the conduct but, rather, could award all the legal fees incurred by the Haegers from the moment the misconduct occurred. The District Court recognized that typically it would have to establish a causal connection between the misconduct and the fee award but determined this case was not typical based on the pattern of abuse. However, as an apparent hedge, the District Court also entered a contingent award in a lower amount in the event the inclusion of legal fees lacking a causal connection in the award was rejected on appeal.

The Ninth Circuit Court of Appeals, in a departure from rulings in other Circuits, affirmed the District Court, though not without dissent.[3] The majority found that it was appropriate to award legal fees incurred by the Haegers during the period of time that Goodyear was misbehaving — as opposed to the legal fees incurred as a result of the misconduct. The Supreme Court disagreed.

First, the Supreme Court (the “Court”) recognized that apart from the authority derived from rule or statute, federal courts have inherent power to “manage their own affairs so as to achieve the orderly and expeditious disposition of cases” and “fashion an appropriate sanction for conduct which abuses the judicial process.”[4] However, if the sanction is awarded under civil, as opposed to criminal, procedures, the sanction is limited to compensating the aggrieved party for the loss and cannot contain a component based on punishment for the bad acts. Thus an award compensating an aggrieved party for legal bills caused by the misconduct would be appropriate, but including legal bills that would have been incurred regardless of the misconduct would not be appropriate. In other words, a “but for” test is used to determine the appropriate sanction.

Thus, it is clear that sanctions awarded through a federal court’s inherent power based on civil procedures may only compensate an aggrieved party and may not contain a punitive component. But how does the trial court determine what compensatory sanction is appropriate? The direction here is less precise. The Court acknowledged that ‘“[t]he essential goal” in shifting fees is “to do rough justice, not to achieve auditing perfection” and “[a]ccordingly, a district court “may take into account [its] overall sense of a suit, and may use estimates in calculating and allocating an attorney’s time.”’[5] Further, in certain circumstances, requiring a causal connection does not preclude an award of all of an aggrieved party’s fees if such fees would not have been incurred but for the misconduct. But, in the absence of that unusual circumstance, the trial court is tasked with scrutinizing fees and segregating “individual expense items.” However, substantial deference is afforded to the trial court to determine what fees were caused by the misconduct given the trial court’s “superior understanding of the litigation.”[6]

The Court found that the District Court’s award of all the fees incurred by the Haegers from the moment of the misconduct by Goodyear was not appropriate because the Haegers could not show that the litigation would have settled but for the bad faith withholding of discovery. In other words, if Goodyear had supplied all the requested internal test results, the case may not have settled as Goodyear had other defenses (which the Court noted Goodyear used in other litigation which proceeded to trial) that might have precluded settlement at that time. Thus, it is possible the fees would have been incurred even in the absence of the bad faith withholding of discovery by Goodyear.

The Haegers argued that Goodyear waived the ability to challenge the District Court’s contingent award which purportedly excluded the punitive component because the amount of such award was based on Goodyear’s own submission. The Court acknowledged that the District Court should address the waiver issue on an initial basis as it would end the matter if it found in favor of the Haegers. Otherwise, the analysis of the appropriate amount of the sanction would have to start anew under the correct standard.

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Texas District Court Finds Unclaimed Oil and Gas Royalties Are Not Property of the Estate

by Bradley Lehman

By: Bradley Lehman, Esquire

McElroy, Deutsch, Mulvaney & Carpenter, LLP

A recent opinion from the U.S. District Court for the Southern District of Texas, on appeal from the bankruptcy court in the District, is likely to have broad applicability in pending and future energy producer bankruptcy cases. In Oklahoma State Treasurer v. Linn Operating, Inc., 6:17-CV-0066, 2018 WL 1535354 (S.D. Tex., March 29, 2018), the Chapter 11 plan filed by Linn Operating LLC, an Oklahoma-based oil and gas producer, provided that the claims of owners of the approximately $1 million in unclaimed royalties held by the debtor would be discharged upon confirmation of the plan and the debtor would retain the funds. The bankruptcy court confirmed the plan, and the State of Oklahoma filed an adversary action against the debtor seeking turnover of the unclaimed royalties to the state. The bankruptcy court dismissed the complaint, finding that the adversary case was merely a post-confirmation collateral attack on the debtor’s plan.

Oklahoma appealed the dismissal of its adversary case to the Southern District of Texas, and Judge Kenneth M. Hoyt entered an opinion reversing the bankruptcy court’s decision. The District Court found that, as a matter of state law, unclaimed oil and gas royalties are held in trust by the producer for the owners of the royalties. Therefore, the unclaimed royalties were never property of the debtor’s bankruptcy and were not subject to the bankruptcy court’s jurisdiction or to confirmation of the debtor’s Chapter 11 plan.

Supreme Court Finds Determination of Insider Status Rests with the Bankruptcy Court and “Clear Error” is the Appropriate Standard of Review

by Bradley Lehman

By: Bradley P. Lehman, Esquire

McElroy, Deutsch, Mulvaney & Carpenter, LLP

A recent decision by the United States Supreme Court in U. S. Bank N. A., Trustee, by and through CWCapital Asset Management LLC v. Village at Lakeridge, LLC, 138 S.Ct. 960  (2018) clarified the standard of review to be applied to bankruptcy court determinations of who counts as an “insider” of the debtor under the Bankruptcy Code.

When Village at Lakeridge declared bankruptcy, it had two primary creditors: U.S. Bank and MBP Equity Partners (“MBP”). MBP also owned Village at Lakeridge. Village at Lakeridge proposed a Chapter 11 plan pursuant to which both of its creditors were in separate impaired classes. U.S. Bank would not consent to the proposed plan, and MBP’s vote could not be counted because, being the owner of the debtor, it was the classic insider. MBP devised a plan to bypass this inconvenience by selling its claim to someone else who would vote in favor of the plan. Thus, an MBP board member approached the doctor whom she was dating about buying MBP’s claim, and he agreed to purchase the $2.76 million claim for $5,000.

U.S. Bank argued that the purchaser of MBP’s claim was still an insider, albeit a non-statutory insider, and therefore could not be counted as an affirmative vote in favor of the debtor’s plan. The bankruptcy court disagreed and found that he was not an insider because he purchased the claim as a speculative investment and did so in the context of an arms-length transaction. U.S. Bank appealed, and the Ninth Circuit held that there was no clear error in the lower court’s determination that the transaction was at arm’s length. U.S. Bank appealed to the United States Supreme Court, arguing that the Ninth Circuit should have reviewed the lower court’s determination de novo.

The Supreme Court disagreed in its unanimous opinion finding that the clear error standard utilized by the Ninth Circuit was appropriate because the answer to the mixed question of law and fact involved more factual work than legal work.   Thus, deference to the bankruptcy court on the appeal through use of the clear error, rather than de novo, standard of review was appropriate.