by Jason Angelo

In re WCI Communities, Inc., 2015 WL 4477696 (D. Del. July 22, 2015)
In the Third Circuit, the answer to when a claim “arises” for purposes of the discharge depends upon what law applied at the time of the discharge.
The Court in the WCI case looked at three Third Circuit Court of Appeals decisions that addressed when a claim “arises”: In re M. Frenville Co., Inc., 744 F.2d 332 (3d Cir. 1984), which used the widely criticized accrual test based on whether an entity has a right to payment and when such right arose under state law; In re Grossman’s Inc., 607 F.3d 114 (3d Cir. 2010), which overruled the accrual test and used a test based on when the claimant was exposed to the product or conduct that led to the injury and formed the basis for the claim to payment; and Wright v. Owens Corning, 679 F.3d 101 (3d Cir. 2012), which addressed the due process issues raised when a person who did not have a “claim” under the Frenville test applicable at the time of plan confirmation would have had a claim under the subsequent Grossman’s test, thereby retroactively denying due process. The result as set forth in WCI following the opinion in Wright is an approach that permits Frenville to apply in narrow circumstances when to do otherwise would deny due process.

In WCI, following the entry of the confirmation order and the discharge, a condominium association sought inter alia to pursue claims in state court against the reorganized debtor/builder for construction defects and past due amounts owed to the condominium association. As discussed below, the District Court for the District of Delaware, following the Third Circuit Court of Appeals decision in Wright, affirmed the Bankruptcy Court decision that the claims in question did not “arise” until after the discharge and therefore were not barred by it.

WCI Communities, Inc., along with its 126 subsidiaries (the “Debtor”), filed a voluntary Chapter 11 petition on August 4, 2008. Prior to filing its petition, the Debtor constructed homes and operated residential communities throughout the country, including the Lesina at Hammock Bay Condominium in Florida. Debtor filed a Condominium Declaration in 2007, which included Articles of Incorporation and the By-Laws for the community’s Condominium Association (the “Association”), which administers and manages the property. The Articles of Incorporation provided that the Association would be managed by a three-person board of directors appointed by the Debtor until an event known as “Turnover” under Florida law, at which point the control of the Association would be ceded to a five-member board elected by the Condominium owners.

The Bankruptcy Court set the bar date for filing claims against the estate as February 2, 2009, and thereafter approved the restructuring plan in August 2009. The Bankruptcy Court’s confirmation order contained a general discharge of all claims against the Debtor and permanently enjoined any holders of claims from asserting their claims against the Debtor. Following entry of the confirmation order, “Turnover” occurred on December 4, 2009. After the “Turnover,” an independent audit revealed that Debtor owed the Association over $80,000 in payments pursuant to the Condominium Declaration. An inspection by an engineering firm also revealed construction defects at the property with a repair cost of approximately $500,000.

The Association, when it was still under Debtor control prior to the “Turnover,” had timely filed a broad proof of claim that included any claims for “any defect in workmanship” and “assessment funding of association dues for unsold units.” However, post-Turnover, the Association contended that the confirmation order did not discharge its claims and filed a motion for declaratory relief pursuant to 11 U.S.C. §105(a) seeking a determination that the Debtor’s obligations to it were not discharged through the Plan and that Debtor was unjustified in threatening sanctions if the Association commenced a state court action.

Before the Bankruptcy Court ruled on the motion, the Third Circuit issued its opinion in Wright and utilized the standard for determining when a claim arises that was set forth in Frenville rather than the standard articulated in the en banc decision in Grossman’s. Thus, in WCI Judge Kevin Carey of the Bankruptcy Court for the District of Delaware held that Wright compelled the determination that the Third Circuit’s Frenville test applied to the Association’s claims and, under that test, the claims did not “arise” until after the “Turnover” date. Since the “Turnover” date was after the confirmation of the Plan, the Association’s claims were not subject to discharge under the Bankruptcy Code. Judge Gregory Sleet of the District Court upheld the Bankruptcy Court decision.

As the District Court noted, when determining when the claims arose, the “dispute hinges upon whether the Association’s asserted statutory claims ‘arose’ prior to the date of the debtor’s plan confirmation.” In re WCI Communities, Inc., 2015 WL 4477696 at *3. The standard in the Third Circuit has been particularly fluid in recent years following the overruling of the widely-criticized Frenville “accrual” test. Under Frenville, a claim did not ripen until a right to payment arises, which in turn was decided by reference to state law. In re M. Frenville, 744 F.2d at 337. The Third Circuit further expounded on this in In re Remington Rand Corp., 836 F.2d 825, 830 (3d Cir. 1988), holding that “the existence of a valid claim depends on: (1) whether the claimant possessed a right to payment; and (2) when that right arose” as determined by reference to relevant non-bankruptcy law.” The Third Circuit’s 2010 Grossman’s decision abrogated the Frenville test. There, the Court held that a “claim” arises when an individual is exposed pre-petition to a product or other conduct giving rise to an injury, which underlies a “right to payment.” In re Grossman’s, 607 F.3d at 125. According to the Grossman’s Court, Frenville’s emphasis on a “right to payment” failed to give sufficient weight to other words in the statutory definition that modified the term “claim,” such as “contingent,” “unmatured,” and “unliquidated.” Id. at 121.

Wright addressed the retroactive effect of the Grossman’s decision, carving out specific exceptions where a claimant’s due process rights would be affected by its application. Specifically, claimants operating under the Frenville test would not have realized that they held “claims” and would not have taken action to protect their interests prior to the bar date and plan confirmation. To ensure that such claimants were afforded due process, instead of allowing claimants operating under the Frenville test to have their claims discharged in an earlier bankruptcy without notice or an opportunity to be heard, the Third Circuit in Wright held that the Frenville test applies to plans proposed and confirmed prior to the Grossman’s decision on June 2, 2010. So those who all of the sudden had “claims” under Grossman’s were exempt from the new test.

Since the WCI Debtor’s plan was confirmed prior to the Grossman’s decision, the Bankruptcy Court applied the Frenville accrual test and determined that the Association’s right to payment did not accrue under Florida law until the “Turnover,” which occurred after confirmation, and thus that the claims did not fall within the scope of the discharge. In upholding the decision, the District Court recognized that Grossman’s is not retroactively applicable in all situations, but only when a claimant’s due process rights would not be violated as per Wright.

The Debtor in WCI argued that the Association had been permitted due process because the Association (prior to the “Turnover”) had actually filed a proof of claim and thus had the opportunity to participate in the bankruptcy proceedings. In Debtor’s view, the filing of a proof of claim alone, even if a claimant did not yet hold a “claim,” would allow such a claim to be discharged upon confirmation of a plan.

The District Court refused to adopt such a bright line rule and countered that the mere filing of a proof of claim does not, in and of itself, mean that a claimant was afforded full due process. The District Court stated that “[w]hether a party receives proper due process depends on the circumstances of a particular case.” In re WCI Communities, Inc., 2015 WL 4477696 at *6 (citing In re Grossman’s, 607 F.3d at 127). Here, the Association could not have asserted the claims against Debtor until “Turnover,” since its cause of action under Florida law did not accrue until the condo owners acquired control of the Association. Further, since it was controlled by a Board hand-picked by the Debtor itself up to that point, the Association was not independent from the Debtor, and under Florida law, its actions were attributable to the Debtor rather than the condo owners until post-“Turnover.”

Key Takeaways
While Grossman’s and Wright have complicated the ever-evolving issue of when a “claim” arises in the Third Circuit, the District of Delaware recognized that due process concerns override the formalistic approach advocated by the Debtor. Additionally, the court made clear that the mere filing of a proof of claim would not per se meet the standard for due process under Third Circuit precedent.

Jason D. Angelo is an Associate in MCELROY, DEUTSCH, MULVANEY & CARPENTER, LLP.’s Bankruptcy Practice Group and is admitted to practice in Delaware and New Jersey.