Month: July, 2018

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).