Landlords Are Entitled To Priority Treatment of Lease Payments Which First Come Due During the Gap Period of an Involuntary Bankruptcy

In a case of first impression, Judge Montali had to decide whether a landlord’s claim for payment of rent during the gap period of an involuntary bankruptcy is entitled to priority.

Before delving into the facts of the case, a quick primer is appropriate. The treatment of a commercial landlord’s claims in bankruptcy is too complicated and will be discussed in more depth in a future article so this “quick primer” is very limited.

When a company files for bankruptcy, the landlord in a nonresidential context is usually the most powerful player in the scene. The landlord is entitled to be paid contract rate lease payments until the Debtor decides to either reject or assume the lease. This is provided for under § 365(d)(3) which states that “The trustee shall timely perform all the obligations of the debtor … arising from and after the order for relief under any unexpired lease of nonresidential real property … until such lease is assumed or rejected, notwithstanding section 503 (b)(1) of this title….”

That last bit, the “notwithstanding section 503 (b)(1)” portion means that the landlord is entitled to payment until the lease is rejected; even if it is not an actual, necessary cost or expenses of preserving the estate. Not only is the landlord entitled to an administrative claim, but the payments must commence immediately (for the most part).

Howrey LLP was a global law firm that practiced antitrust, global litigation and intellectual property law. At its peak Howrey had more than 700 attorneys in 17 locations worldwide. In early 2011, Howrey began to wind down its business and was hit with a petition for an involuntary Chapter 7 petition. For simplicity, we are going to assume the case was never a Chapter 7 case; meaning it went from an involuntary Chapter 7 to a voluntary Chapter 11.

 

Section 502(f) states that “In an involuntary case, a claim arising in the ordinary course of the debtor’s business or financial affairs after the commencement of the case but before the earlier of the appointment of a trustee and the order for relief shall be determined as of the date such claim arises, and shall be allowed … the same as if such claim had arisen before the date of the filing of the petition.”

Furthermore, even though the claim is an unsecured prepetition claim, it is entitled to priority under § 507(a)(3): “(3) Third, unsecured claims allowed under section 502 (f) of this title.”

The creditors’ committee and Chapter 11 Trustee argued that the landlord’s claims did not fall under § 502(f) because § 502(f) “only applies to claims arising in the ordinary course of a debtor’s business or financial affairs after the commencement of the case.” The court rejected this argument for several reasons including that the code was designed to protect landlords and that the landlord’s claim arose during the gap period and not when the lease was signed.

The creditors’ committee also argued that § 502(g)(1) applied to this situation. That argument was summarily dismissed because § 502(g)(1) applies to rejected leases; the leases were not rejected during the gap period.

Most surprising was the Court’s relatively short discussion on whether the landlord’s claims were incurred during the ordinary course of Debtor’s business.  The creditors’ committee argued that since the Debtor was winding down its business, the rents were no longer in the ordinary course of the Debtor’s business. In rejecting that argument, the Court took the position that “the focus is on the circumstances under which the right to payment of current rent “arises”, which is when the occupancy continues, when the status quo vis-a-vis the Landlords continues.”

The result is fair but I am not sure whether it is technically correct. I would have expected a more detailed vertical and horizontal dimension analysis. Assuming no bankruptcy, would creditors or even the landlord expect the Debtor to stay current on rent? If not, why is this payment ordinary course?

You can find the case here.

There Is No Limit to the Number of Times a Chapter 11 Debtor Can Receive a Discharge within a Certain Time Frame!

I have spoken with quite a few practitioners and surprisingly, all of them have said the same thing: an individual Debtor in Chapter 11 Bankruptcy can only receive a discharge once every 8 years.

Then a good friend of mine and told me about his magic bullet: he would vacate the prior discharge to make his clients eligible for the Chapter 11 discharge. It is quite brilliant actually but it turns out not to be necessary.

First, let’s discuss the code section which seems to have caused all the confusion:

Under § 1141(d)(3),

(3) The confirmation of a plan does not discharge a debtor if—
(A) the plan provides for the liquidation of all or substantially all of the property of the estate;
(B) the debtor does not engage in business after consummation of the plan; and
(C) the debtor would be denied a discharge under section 727 (a) of this title if the case were a case under chapter 7 of this title.

Furthermore, § 727 (a)(8) provides, in pertinent part, there will be no discharge if:

(8) the debtor has been granted a discharge under this section, under section 1141 of this title … in a case commenced within 8 years before the date of the filing of the petition;

When read together, § 1141(d)(3)(c) coupled with § 727 (a)(8) state that if the Debtor has received a discharge in a case that began within the last 8 years, then there will be no discharge. This seems pretty straight forward.

The problem with this reading is that it ignored the “and” at the end of subsection (B) which turns this rule into a conjunctive test. For § 1141(d)(3) to be applicable to a case, all three tests (A), (B) and (C) must be satisfied. The purpose behind § 1141(d)(3) is not to prevent multiple bankruptcy discharges but to prevent an individual from obtaining multiple Chapter 7 discharges within an 8 year span through constantly filing liquidating Chapter 11 plans.

After I told my friend the analysis, he opened his copy of the code and could not believe his eyes. Unfortunately, there does not seem to be a lot of case law on the subject, but my friend was able to find this gem: In re Berg, 423 BR 671 (10th Cir. BAP 2010). You can find the case here.

I am trying to keep my friend anonymous but he immediately had good luck with this reading of the code as he convinced Judge Neiter and that furthermore, § 1141(d)(3) does not automatically trigger but requires an adversary proceeding!

Author’s comments. I have heard some people say that a second Chapter 11 bankruptcy is an impermissible end-run around § 1127 which governs modification of a plan. There has also been some talk that multiple Chapter 11 bankruptcies are somehow “bad faith” filings. I do not see how either of this could be true when Congress contemplated multiple filings and addressed that specific issue by limiting discharge when the filings are liquidating plans. It is noteworthy that companies may receiving multiple Chapter 11 discharges within a short period of time, even if the plans are liquidating plans, because this is a three part test that also requires the Debtor to not engage in business after consummation of the plan.

Is It Community Property Or Separate Property?

The 9th Circuit really confused a lot of people in 2003 when it incorrectly interpreted California community property laws. The confusion spread to California courts of appeal until finally corrected by the California Supreme Court in 2014!

In Hanf v. Summers (In re Summers), 332 F.3d 1240 (9th Cir.2003), the pertinent facts are as follows: Husband, Wife and Daughter bought real property and titled it as joint tenants. The bankruptcy court held that the property was held in a joint tenancy! The BAP affirmed, and the 9th Circuit affirmed the BAP.

The basic idea was since the property was titled as joint tenants, the property was owned as a joint tenancy. The problem with this is that Cal. Fam.Code § 852(a) provides that “[a] transmutation of real or personal property is not valid unless made in writing by an express declaration that is made, joined in, consented to, or accepted by the spouse whose interest in the property is adversely affected.”

So there you have it, the property is community property because the parties did not have an express declaration otherwise. But that is not how the Circuit Court decided this case. It held that § 852 has historically only been applied to inter-spousal transactions and so it did not apply to the facts of this case due to the parties having bought the property from a third party.

Since most spouses purchase their first home after marriage, this holding had the practical effect of making virtually all post-marriage purchases of real property a joint tenancy instead of community property. It is difficult to understand why the Circuit court would believe this was something the legislature would have intended particularly when the 1984 amendments were made to prevent exactly that!

Now the law as it stands today, according to In re Marriage of Valli (2014) 58 Cal.4th 1396, 1400:

Property that a spouse acquired before the marriage is that spouse’s separate property.

Property that a spouse acquired during the marriage is community property unless it is:

traceable to a separate property source;
acquired by gift or bequest; or
earned or accumulated while the spouses are living separate and apart.
Finally, spouses may change the character of property during the marriage by what is called a “transmutation.” To do so, they need to comply with § 852 even if the property is purchased from a third party.

The Valli Court was critical of the 9th Circuits holding, stating that “There, the federal appellate court was attempting to construe and apply California law ‘to determine whether the requirements of California’s transmutation statute . . . must be met when realty is transferred from a third party to spouses as joint tenants.’”

It further criticized the Court’s holding as “not persuasive insofar as [it] purport[s] to exempt from the transmutation requirements purchases made by one or both spouses from a third party during the marriage.” The California Supreme Court did not think the 9th Circuit’s rationale reconciled the exemption with the state legislatures purpose in enacting § 852.

The court went one step further and said that in so far as Evidence Code section 662, which states that “[t]he owner of the legal title to property is presumed to be the owner of the full beneficial title,” applies to a situation, it does not apply when it conflicts with transmutation statutes.

The Court left open whether § 662 can ever apply to marital dissolution proceedings.

The concurring opinion is a work of art but too long for me to go over. I highly recommend it to anyone who would like a deeper understanding of the subject matter. You can find it here.

Note: This is important, not only in bankruptcy proceedings and marital dissolution proceedings but also for tax purposes. If the tenancy is a joint tenancy, then upon death, only the deceased spouses “share” of the property will have a step up in basis. If held as community property, then the whole property receives the benefit of a step up in basis.

Not All Expenses Of A Professional May Be Compensable By The Estate, Even In The Face Of A Clear Retainer Agreement And An Approved Employment Application!

The facts of the situation are not in dispute. The Debtor in a Chapter 11 case needed to hire a forensic accountant. The Debtor applied for permission to hire the accountant under § 327(a) of the Bankruptcy Code. The employment application did not contain any special provisions but the engagement letter contained the following clause:

In the event we are requested or authorized by Debtor or are required by government regulation, subpoena, court order, or other legal process to produce our documents or our personnel as witnesses with respect to our engagements for Debtor, Debtor will, so long as we are not a party to the proceeding in which the information is sought, reimburse us for our professional time and expenses, as well as the fees and expenses of our counsel, incurred in responding to such requests.

No objection to employment was filed and the Court entered an order approving the application.

Flash forward and after the forensic accountant had finished preparing its report, the Bank decided to subpoena and depose the accountant.  Debtor’s counsel refused to defend the accountant so the accountant was forced to hire an attorney for the deposition. The attorney cost the accountant about $8,000.

The Court did not allow the expense. It reasoned that under § 330(a)(1)(B) only reimbursement of actual, necessary expenses would be allowed. Under the standard articulated by the court, only those expenses necessary to accomplish the task the professional is hired to accomplish are compensable. The Court’s reason was that Without such a limitation, potentially, whenever a bankruptcy court-approved professional deems it necessary to employ another professional to protect its interests in the bankruptcy case, that cost would be taxed to the bankruptcy estate, effectively negating the Code’s regimen requiring prior notice to other interested parties, and the necessary scrutiny by the court, before committing the limited resources of the bankruptcy estate to the payment of professional compensation.

Author’s comments: The case noted a split of authority in the Southern District of New York and no binding law in the 9th Circuit which necessarily means there is a lot more room to litigate this matter.

The Court focused on the fact that the retainer agreement contained a clause which would allow the accountant to be paid by the debtor but focused on the fact that the employment application itself did not contain the language or allude to it. One workaround for this rule may be to clearly articulate any special clauses for attorney fees inside the application to employ the professional.

In my experience as debtor’s counsel, most professionals rely on me to obtain court approval of their employment. At the same time, my duty is to the Estate. So what am I supposed to do?

You can find the full case here.

Bankruptcy Judges Might Not Be Able to Remand Removed Cases!

This is a dangerous article to write but I am hoping the comments will be worth it.

So the Wellness case came out and the Supreme Court seems to have taken a pragmatic view by allowing parties to consent (implied or explicit) to the jurisdiction of bankruptcy courts. Fine. But is there more to this story?

The Court believed the central question that must be answered was “whether allowing bankruptcy courts to decide Stern claims by consent would ‘impermissibly threate[n] the institutional integrity of the Judicial Branch.’ Schor, 478 U. S., at 851.”

The court then concluded that allowing parties to consent to adjudication of Stern claims does not usurp the constitutional prerogatives of Article III courts for several reasons:

  1. Bankruptcy judges, like magistrate judges, “are appointed and subject to removal by Article III judges;”
  2. They “serve as judicial officers of the United States district court;” and
  3. collectively “constitute a unit of the district court” for that district.

But I wanted to quote this language in particular:

“Furthermore, like the CFTC in Schor, bankruptcy courts possess no free-floating authority to decide claims traditionally heard by Article III courts. Their ability to resolve such matters is limited to “a narrow class of common law claims as an incident to the [bankruptcy courts’] primary, and unchallenged, adjudicative function.” Id., at 854. “In such circumstances, the magnitude of any intrusion on the Judicial Branch can only be termed de minimis.” Id., at 856.”

It seems to indicate that since the magnitude of the intrusion is de minimis, waiver is okay.

But what if the Bankruptcy Court enters an order divesting the District Court of jurisdiction? Can it do that?

On June 8, 2015, in Flam v. Flam, the US Court of Appeals for the Ninth Circuit joined other sister circuits in holding that a motion to remand is a dispositive motion and that it is beyond the scope of a magistrate judge’s authority to issue a remand order under 28 U.S.C. § 1447(c) . You can find the case here.

In Flam, the Court focused on the fact that an order granting remand is final and not subject to review by the District Court. 28 U.S.C. § 1447(d). It conclusively takes away the litigant’s right to federal courts, as was previously held, the effect of a remand order is to end all federal proceedings.

A Bankruptcy Court’s order granting remand is also final and not subject to review by the District Court. 28 U.S.C. § 1334(d). It conclusively takes away the litigant’s right to federal courts. In effect, a Bankruptcy Court’s order has the effect of ending all federal proceedings. This is certainly not de minimis.

So why can a bankruptcy judge do it when a magistrate can’t?

Lawyers Cannot Be Held Liable For Malpractice If The Bad Advice They Give Leads To A Result That Was Not Foreseeable

For those of you who do not like analysis: lawyers cannot be held liable for malpractice if the bad advice they give leads to a result that was not foreseeable. In the case summary below, the client was given bad advice which led to her being prosecuted for forgery. Under the particular facts of the case, forgery was a legal impossibility, so the court found that the lawyer’s bad advice (to forge a signature) did not have a causal connection to the crime the client was charged with.

Those of us who are lawyers remember the Palsgraf case written by Cardozo. Guard pushes man onto train. Fireworks drop from man’s hands. The fireworks cause commotion. The commotion causes a scale on the other side of the train station to fall onto a lady. Lady sues train station. Result: lady loses lawsuit!

I did not understand it back then but I do now. There is “causation” and there is “legal causation.” In other words, almost any bad act can be traced to a series of events. But for any of those events, the bad act would not have happened. So are all those people responsible?

For example: A stranger is born. Twenty years later, I see him on the highway and give him a ride to your house, just in time, because you were just about to leave the city. The guy stabs you. Now, you can sue the guy for the harm he caused but can you sue me? But for me, he would not have made it in time. What about the stranger’s mom? But for her giving birth to him, this would not have happened! So the law has to put a stop somewhere and that is the root of “legal causation.”

The details.

To sue an attorney for legal malpractice, you have to show four things:

(1) the duty of the attorney to use such skill, prudence, and diligence as members of his or her profession commonly possess and exercise;
(2) a breach of that duty;
(3) a proximate causal connection between the breach and the resulting injury; and
(4) actual loss or damage resulting from the attorney’s negligence.

This article/case brief is about the 3rd element: proximate causal connection between the breach and the resulting injury.

When poor legal advice results in litigation that could have been avoided, that is surprisingly not enough to sue your lawyer. That’s just “but for” causation. You need to show that the advice was the proximate cause of the litigation! This means you have to find a causal connection between your lawyer’s breach of his duty and the injury you’ve suffered.

The fact pattern is as follows: A client comes into your office with a problem. The problem is she is the true owner of a bank account which hasn’t been used in ages. The account is in the name of her now dead husband and two former partners who disclaim any interest in the account. Your client accidentally deposited $36,000 into the account and needs the money ASAP!

The proper advice would be to update the account card so your client would be the proper signatory, but that slipped your mind. Instead, you told her to forge a check in her own name as if one of the named account holders had signed it. Malpractice? What is she is later prosecuted for forgery!?

First, we have to know more about writing checks (my apologies). The negotiation of a check is a matter of private contract between a financial institution and a depositor. A check is a signed instrument by which the depositor (the drawer) instructs the financial institution (the drawee) to transfer the depositor’s funds to a check bearer in accordance with the account agreement.

In summary, an instrument is a “note” if it is a promise to pay and a “draft” if it is an order to pay. A check then, is a draft payable on demand and drawn on a bank. The purpose of a signature on a check is to authorize and obligate the financial institution to pay out the funds in accordance with the depositor’s prior instructions.

Here is the catch, even though the prior instructions state which signatures must be accepted, under the California Commercial Code, a valid signature may be made by penning “any name, including a trade or assumed name, or by a word mark, or symbol” so long as the signer intends to effectuate a transaction.

So when your client signed the check, she impersonated the named owners. This is not a crime but a breach of the agreement with the bank! To make “imposter” a crime, there must be an intent to defraud. Since your client owns the account, it’s impossible for her to defraud anyone with the transaction just described!

Consequently, there is no way you could have predicted she would be charged for forgery.

California has adopted the substantial factor test set forth in the Restatement Second of Torts, section 431. This means the conduct is a legal cause of harm if it is a substantial factor in bringing about the harm. This happens when the conduct is recognizable as having an appreciable effect in bringing about the harm.

Courts have found that the link between the conduct and harm suffered is closely related to foreseeability in the inquiry because a defendant owes no duty to prevent a harm that was not a reasonably foreseeable result of his negligent conduct.

A key element to the crime of forgery is intent to defraud, and a depositor cannot intend to defraud herself. Therefore it was legally impossible to foresee a district attorney trying to prosecute forgery as a crime under these facts.

Therefore, the Court found no causation between the crime charged and the advice given.

The full case can be found here.

Lawyers Are Not Allowed to Speak with Their Clients about the Client’s Intention to File a State Bar Complaint!

Business and Professions Code § 6090.5 prohibits an attorney from seeking a client’s written or oral agreement not to file a State Bar complaint against that attorney. The reason for this is the discussion could produce an impermissible chilling effect on the client’s future filing of a State Bar complaint.

Even worse, if you have already done this, you can’t take it back! Withdrawal of your request does not reverse the ethical violation.

“Seeking” an agreement includes any attorney communication to a client proposing or suggesting a prohibited agreement. “Seeking” also may encompass factual recitations in the settlement agreement that the client has not filed a State Bar complaint, or concerning the client’s future intentions regarding filing a State Bar complaint.

The long version (which is a summary of the actual advisory opinion, link at the bottom):

California Business and Professions Code § 6090.5 provides, in relevant part:

(a) It is cause for suspension, disbarment, or other discipline for any member, whether as a party or as an attorney for a party, to agree or seek agreement, that

(1) The professional misconduct or the terms of a settlement of a claim for professional misconduct shall not be reported to the disciplinary agency.

This section applies to all settlements, whether made before or after the commencement of a civil action.

In re McCarthy (Review Dept. 2002) 4 Cal. State Bar Ct. Rptr. 364 involved an attorney who committed defalcation against a business partner while acting as a fiduciary. While attempting to settle the dispute, the attorney offered a settlement term that would have the complaining witness “contact the State Bar to withdraw any claims.” The complaining witness refused, and settlement was never consummated. In disciplinary proceedings, the court held that the attorney’s intent to agree to withdrawal of the State Bar complaint in the civil settlement agreement was itself a violation of section 6090.5. In In re Brockway (Review Dept. 2006) 4 Cal. State Bar Ct. Rptr. 944, an attorney violated section 6090.5(a)(2) when he entered into a settlement agreement resolving a fee dispute in that the client “agreed to settle [the fee] dispute and to withdraw the complaint pending before the State Bar, all in accordance with the terms of this Agreement.”

Business and Professions Code section 6090.5 bars an attorney’s attempt, in settling a dispute with his or her client, to seek or obtain a client’s oral or written agreement not to make a State Bar complaint. Section 6090.5 may also prohibit a lawyer from seeking representations of the client’s intentions or actions regarding filing a complaint with the State Bar. Even a simple contractual factual recitation that the client has not yet made a State Bar complaint in the past may be an ethical violation since it could produce a chilling effect on the client’s future actions. Once a lawyer seeks such an oral or written agreement, the withdrawal of that request will not cure the ethical violation.

The full ethics opinion can be found here.

Judge Bauer Reversed, Trustee Clawback Power Strengthened

In this case, the sole shareholder, director and president of a company (all the same Individual) transferred about $8,000,000 into a secret bank account which he then used to pay personal debts. The question before the Court was whether the transfers to the bank account made the Individual, in his personal capacity, an initial transferee within the meaning of § 550.

The surprising answer (although not stated in this way) is that it depends on whether the secret bank account was opened in the name of the company or individual. In this case, the secret account was completely under the dominion and control of the Individual; the Individual’s wife was a signatory on the account and the only purpose it served was to pay personal expenses. None of that mattered. The account was opened under the company’s name. The District Court held that the Individual was not an initial transferee since the account was a company account.

This is a big deal because it meant that 3rd parties who were paid from that account could not raise certain defenses, discussed below.

Under § 550(a) of the Bankruptcy Code, a trustee of the debtor may recover a fraudulent transfer of estate property from either “(1) the initial transferee of such transfer or the entity for whose benefit such transfer was made; or (2) any immediate or mediate transferee of such initial transferee.”

The distinction between an “initial transferee” and a subsequent transferee is critical because the trustee’s right to recover from an initial transferee is absolute. A subsequent transferee, on the other hand, has a defense. A trustee may not recover from a subsequent transferee if “the subsequent transferee accepted the transfer for value, in good faith, and without knowledge of the transfer’s voidability.” 11 U.S.C. § 550(b)(1).

Since initial transferee is not defined by the code, Courts have created their own definitions. The major tests are the “dominion” test and the “control test.” According to the district court, the 9th Circuit has explicitly adopted the dominion test to the exclusion of the control test.

Under the dominion test, a transferee is one who has dominion over the money or other asset, i.e. the right to put the money to one’s own purposes. The test focuses on whether someone had legal authority over the money and the right to use the money however desired. The control test, on the other hand, takes a more gestalt view of the entire transaction to determine who, in reality, controlled the funds in question.

According to the district court, the control test shifts the risk too far towards creditors of the debtor because an unscrupulous insider could make an “initial transfer” to himself insolating any subsequent transfers. After analysis of 9th Circuit law, the court concluded: “As these cases demonstrate, a corporation’s principal who effects a transfer from the corporation in his representative capacity does not have dominion over those funds in his personal capacity, and therefore does not constitute an initial transferee of those funds under the Bankruptcy Code.”

Author’s comments: The analysis should turn on whether the transfer is to an intermediary/conduit to facilitate the transfer. Conduit / intermediary transfers should not be designated as “initial transferees” thereby shielding a subsequent transfer to the actual “initial transferee.” That is a fair reading of the code.

I do not think the analysis should be limited to either the “dominion” test, the “control test” or as some courts have applied it, the “dominion and control” test because if we assume clawback actions are fair, then why hinge the entire analysis on how title to the bank account was held? If the president of the company had transferred the funds from the initial, secret, company account to his own personal account and paid the defendant from that personal account, then the defendant here would have been shielded. That is too trivial of a distinction for me to be happy with.

Query: Should you advise your client, who is about to sell something to a wholly owned company, to have the company first transfer its funds into the company’s owner’s account before paying your client? The committee notes seem to indicate that this type of “washing” is not prohibited by the good faith requirement.

You can find the district court opinion here.

Employers Must Accommodate Pregnant Workers!

The Pregnancy Discrimination Act added new language to the definitions subsection of Title VII of the Civil Rights Act of 1964. The first clause of the Pregnancy Discrimination Act specifies that Title VII’s prohibition against sex discrimination applies to discrimination “because of or on the basis of pregnancy, childbirth, or related medical conditions.”

The Act’s second clause says that employers must treat “women affected by pregnancy . . . the same for all employment-related purposes . . . as other persons not so affected but similar in their ability or inability to work.”

Read more

9th Circuit BAP Opinion Allows For Stripping Wholly Unsecured Junior Liens in a Chapter 20

On June 9, 2015, the 9th Circuit Bankruptcy Appellate Panel held that a Debtor not eligible for a Chapter 13 discharge may strip off a wholly unsecured lien through a Chapter 13 Plan. You can find the case here.

This is common practice in the Central District and I am happy the BAP went the right way. I was a little worried after reading their Wages where the Court held that the anti-modification provision under §1123(b)(5) applies to any loan secured only by real property that the debtor uses as a principal residence. When the law is ambiguous, why rule in favor of the bank! You can find that case here.

Questions the author has yet to consider:

So what happens in a Chapter 11? 1111(b)(1) says nonrecourse debts become recourse debts but it starts out with “A claim secured by a lien on property of the estate…”