CD Case Summary: Judge Maureen A. Tighe on Contempt for Violation of Discharge Injunction and Automatic Stay

The creditor here had three excuses. First, they did not have actual notice of the bankruptcy (so there was no willful violation of the stay); second, that the statute of limitations for violating the automatic stay had run; and third, that it was the former attorney’s fault.

A violation of the automatic stay is willful if a party knew of the automatic stay, and its actions in violation of the stay were intentional. Note, it is not the intent to violate the stay that is at issue; it is having knowledge of the bankruptcy and voluntarily doing something that violates the stay! Even worse, once a creditor has knowledge of the bankruptcy, it is deemed to have knowledge of the automatic stay!

The Court did not buy the creditor’s argument that the notice of the bk was sent to “Creditors Specialty Service” instead of “Creditors Specialty Services.” The Court did not allow the creditor to blame its attorney but suggested that if the creditor though its attorney was to blame, it could pursue that claim. The conduct of an attorney is attributable to the client. See Seacall Development v. Santa Monica Rent Control Bd., 86 Cal. App. 4th 201, 204-205 (Cal.Ct.App. 1999) (citing Carroll v. Abbott Labroatories, 32 Cal. 3d 892, 895, 898 (1982)).

Finally, the Court reiterated the concept that Congress did not establish any limitations period for damage claims under § 362(k).

Full opinion here.

Chapter 11 Debtors Are Prohibited From Paying Taxes… Without a Notice and Hearing!

Before people worry too much, this is not as bad as it sounds but it is still pretty awful.

Under Bankruptcy Code section 102, “notice and hearing” is a due process safeguard: “after such notice as is appropriate in the particular circumstances, and such opportunity for a hearing as is appropriate in the particular circumstances.” In other words, there are circumstances where notice and hearing means just notice or notice and an opportunity to object. Hopefully local bankruptcy rules are modified to make these notice only requests.

This article is going to discuss IN THE MATTER OF CLOOBECK which is a 9th Circuit Court of Appeals decision decided on June 12, 2015 and its impact on Chapter 11 Bankruptcy practice. You can find a copy of the decisionhere.

Cloobeck is a case where the Chapter 7 Trustee paid the Bankruptcy Estate’s $340,000 tax liability. This is a no brainer right? Just look at all the authority for doing so:

Under IRC § 6012(b)(4), taxes returns must be filed by the Trustee:

 “[r]eturns of an estate, a trust, or an estate of an individual under chapter 7 or 11 of Title 11 of the United States Code shall be made by the fiduciary thereof.”

28 U.S.C. § 960(a) makes it clear that taxes will continue to accrue, even with a Trustee appointed and § 960(b) requires payment to be made.

Furthermore, the Trustee is authorized to make the payment via § 726 which states in pertinent part:

(a) Except as provided in section 510 of this title, property of the estate shall be distributed—

(1) first, in payment of claims of the kind specified in, and in the order specified in, section 507 of this title, proof of which is timely filed under section 501 of this title

Following Section 507 leads us to:

“(2) Second, administrative expenses allowed under section 503 (b) of this title”

Following Section 503(b), we get to this gem:

“(1)(B) any tax— (i) incurred by the estate, whether secured or unsecured, including…”

Not only that, but the code goes even further; the taxing agency does not even have to file a proof of claim!

“(1)(D) notwithstanding the requirements of subsection (a), a governmental unit shall not be required to file a request for the payment of an expense described in subparagraph (B) or (C), as a condition of its being an allowed administrative expense;”

For those of us paying attention, the Trustee has to file returns on time. The taxes found to be incurred are then administrative expenses that must be paid by the Trustee even if the IRS does not file a proof of claim. WRONG.

I forgot something. Section 503(b) starts out like this, “After notice and a hearing,…”

According to the 9th Circuit Court of Appeals, the taxes are not administrative expenses until notice and a hearing. So the Chapter 7 Trustee, despite all the authority in the world to file and pay taxes, must also give creditors an opportunity to object before making those payments.

Chapter 7 Trustees are now on notice and will go this extra step. But wait, this was about Chapter 11 Debtors.

A Chapter 11 Bankruptcy case may be converted or dismissed if the Debtor does not timely pay postpetition taxes. See § 1112(b)(4)(I):

(I) failure timely to pay taxes owed after the date of the order for relief or to file tax returns due after the date of the order for relief;

The same analysis above applies to these taxes. They are potentially administrative claims, but only after notice and hearing. So before the tax may be paid, there must be notice and a hearing. Until local rules provide otherwise, a Debtor must notify all parties that it intends to pay taxes, wait the requisite 17 days to lapse, then file a declaration of non-opposition and lodge an order. That is a lot of work just to pay taxes as they come due.

Some other thoughts…

What if your client has already paid those taxes without notice and hearing? Will the DOJ require the Debtor to file a turnover action against the IRS? Should we go back and notice all prior paid taxes to see if anyone objects? There are more problems for individual debtors as well. Unless and until an individual filing Chapter 11 is considered as “operating a business (the business of living?),” an individual cannot technically buy food without a motion. This is the rationale behind having to file budget motions. If this is how it is, then how can taxes be paid without a § 363(b) motion — or quarterly fees for that matter?

Despite Lis Pendens, Subsequent Purchaser with Notice Prevails!

This is relevant to bankruptcy practitioners because before we can do anything, we need to know who owns what!

Short version: In California, a notice of lis pendens gives constructive notice that an action has been filed affecting title or right to possession of the real property described in the notice. Any taker of a subsequently created interest in that property takes his interest subject to the outcome of that litigation.

In 1981, the Legislature amended section 409 so as to provide for the first time that the lis pendens must be [1] mailed to “to all known addresses of the adverse parties AND [2] to all owners of record as shown by the latest county assessment roll,”

In this case, the owner’s lawyer’s address was listed on the county assessor’s roll. When contacted, the lawyer said he would refuse the lis pendens and that he did not know where the owners resided. The Court held that despite the lawyer’s statement, the lis pendens should have been mailed to the lawyer because this is a strict requirement of section 409.

Long version: As of March 8, 2001, the owner of record of the property in question was a decedent’s estate in probate. About two years later, title of this property was transferred to parties Ortiz and Colon (presumably as tenants in common). Colon then sold her half to a third party “Lopez.” Lopez did not record the grant deed.

A few years went by and Squatter filed a lawsuit against Ortiz and Colon. In connection with the lawsuit, he recorded a Lis Pendens. The Lis Pendens was not mailed to anyone but instead, Carr’s attorney attached a declaration which stated that Ortiz and Colon had no known address. The problem with this is that on the latest country roll, Ortiz and Colon were listed as the owners of the property with an address of attorney Gaitan. Squatter’s attorney contacted Gaitan and Gaitan said he would not accept service at his address and that he did not know the location of either Ortiz or Colon.

After the lawsuit was filed, Lopez sold his share of the property to a company.

The critical fact here is that the squatter’s attorney contacted Gaitan and, based on his representation that the owner’s address was not known, filed a declaration to that effect. As far as the statute is concerned, the owner’s address is whatever is listed on the assessor’s roll. Consequently, not mailing the lis pendens to the address listed was fatal!

Author’s comments: At first blush this seems very unfair. However, the Plaintiff might be in the business of moving into dead people’s houses, adversely possessing the property and filing a quiet title action once the probate process is finished with. That should be a crime! I get this sense because the facts in the case start out with, “Carr claims to have been in adverse possession of lot 122 since March 8, 2001. As of March 8, 2001, the owner of record of lot 122 was a decedent’s estate in probate.” It is not clear from the opinion but it seems like the squatter moved in THE DAY title changed to the probate estate.

You can find the full case here.

A New Wrinkle in Negligent Infliction of Emotional Distress

In Thing v. La Chusa (1989) 48 Cal.3d 644, 667–68 (Thing), the California Supreme Court established three requirements that a plaintiff must satisfy to recover on a claim for negligent infliction of emotional distress to a bystander: (1) the plaintiff must be closely related to the injury victim; (2) the plaintiff must have been present at the scene of the injury-producing event at the time it occurred and then aware that it was causing injury to the victim; and (3) as a result, the plaintiff must have suffered serious emotional distress.

In a recent case, two sisters watched as their mom, after surgery was completed, choked to death due to the surgery. The hospital argued that the sisters did not know that their mom was choking because of the doctor’s malpractice. Since they didn’t know the cause of the choking, they shouldn’t be able to recover for negligent infliction of emotional distress. In California, this is a valid defense because it’s true, the sisters did not, and could not know about the negligence that caused their mom to pass away.

That’s not where the analysis stops. In this case, the evidence showed that the plaintiffs were present when Knox, their mother, had difficulty breathing following thyroid surgery. They observed inadequate efforts to assist her breathing, and called for help from the respiratory therapist, directing him at one point to suction her throat. They also directed hospital staff to call for the surgeon to return to Knox’s bedside to treat her breathing problems. These facts could be properly considered by the jury to demonstrate that the plaintiffs were contemporaneously aware of Knox’s injury and the inadequate treatment provided her by defendants.

The slow response time is key here, that’s the negligence the sisters were aware of which allowed them to sue and win against the hospital. This case was affirmed by the California Court of Appeals. You can read more about it here.

How Does the Sham Guarantor Defense Work?

Under California law, a lender may not pursue a deficiency judgment against a borrower where the sale of property securing a debt produces proceeds insufficient to cover the amount of the debt. Lenders may pursue deficiency judgments against guarantors, but only true guarantors. Where the borrower and the guarantor are the same, however, the guaranty is considered an unenforceable sham.

The first set of antideficiency laws were enacted during the Great Depression. They prohibited lenders from obtaining personal judgments against borrowers where the lender’s sale of real property security produces proceeds insufficient to cover the amount of the debt. These laws were expanded beginning on January 1, 2013 in response to the bursting of the housing market bubble.

Of course, the antideficiency statutes do not affect the liability a guarantor might otherwise have with respect to a deficiency. (§ 580d, subd. (b).) A lender may recover a deficiency judgment from a guarantor who waives his or her antideficiency protections, even though the antideficiency statutes would bar the lender from recovering that same deficiency from the primary borrower. However, to collect a deficiency from a guarantor, he must be a true guarantor and not merely the principal debtor under a different name also known as “sham guarantors.” The following is a summary of the legal framework for sham guarantor analysis. Detailed case law is available in the decision found here.

From the cases cited in the decision above, the following principles may be derived:

A guaranty is an unenforceable sham where the guarantor is the principal obligor on the debt. This is the case where either (1) the guarantor personally executes underlying loan agreements or a deed of trust, or (2) the guarantor is, in reality, the principal obligor under a different name by operation of trust or corporate law or some other applicable legal principle.

The legislative purpose against deficiency judgments may not be subverted by use of a borrowing entity with the true principal obligor relegated to the position of guarantor. Thus, courts may find a sham guaranty where a lender structures a transaction to avoid antideficiency protections, even though the borrowing entity is a properly formed corporation that observes the necessary formalities. However, a sham guaranty defense generally will not lie where there is adequate legal separation between the borrower and the guarantor, e.g., through the appropriate use of the corporate form.

This last tidbit, that “a sham guaranty defense generally will not lie where there is adequate legal separation between the borrower and the guarantor” means the guarantor has to try and pierce the corporate veil for a company he has setup to protect himself from corporate liability! Thus invoking alter ego liability onto himself.

Secured Creditors Who Do Not File Continuation Statements Will Lose Their Secured Status, Despite a Bankruptcy

UCC-1 financing statements are effective for five years.  Before the five years has run, the creditor must renew the financing statement by filing what’s called a continuation statement.  This is essentially a UCC-1 with a check next to the box labeled “continuation statement.”  The only caveat is any continuation statement must be filed no sooner than six months before the five year period has expired.  Assuming a continuation statement is filed, the five year period is expanded by five years from when the original would have expired.  This can be done indefinitely.

What if the Debtor filed bankruptcy?

The automatic stay will apply as this is an act to perfect a lien. See § 362(a)(4).

Old school practitioners will turn to the Uniform Commercial Code (“UCC”) § 9-403(2) which states, in pertinent part:

“… If a security interest perfected by filing exists at the time insolvency proceedings are commenced by or against the debtor, the security interest remains perfected until termination of the insolvency proceedings and thereafter for a period of sixty days or until expiration of the five year period, whichever occurs later.”

Mystery solved.  A continuation statement is unnecessary as the creditor’s interest will be perfected until the bankruptcy is over and for at least 60 days thereafter.

The problem is the UCC was revised and the insolvency language was removed. See e.g. California Commercial Code (“CCC”) § 9515:

“(c) The effectiveness of a filed financing statement lapses on the expiration of the period of its effectiveness unless before the lapse a continuation statement is filed …. Upon lapse, a financing statement ceases to be effective…. If the security interest … becomes unperfected upon lapse, it is deemed never to have been perfected as against a purchaser of the collateral for value.”

One may be tempted to conclude that creditors must seek relief from the stay to file a continuation statement.  However, this is unnecessary as Congress has added an exception to the automatic stay in § 362(b)(3):

“(3) [the automatic stay does not apply to] any act to perfect, or to maintain or continue the perfection of, an interest in property …”

In summary, a continuation statement is mandatory for a creditor to preserve its lien.  The filing of a continuation statement is not prohibited or stayed by the filing of a bankruptcy petition; consequently, it must be filed.

Author’s final words:

There are important issues that remain. For example, what about language under 9515(3) which states: “If the security interest … becomes unperfected upon lapse, it is deemed never to have been perfected as against a purchaser of the collateral for value.” Is a Trustee a purchaser for value or just a lien creditor? So what happens when the lien lapses? Most courts find that a lost lien is just that, gone so the creditor becomes unsecured. There are some courts that fix a creditor’s rights as of the petition date. What happens to a lien which is “fixed” but then lapses? The trend seems to be a lapsed lien makes the creditor an unsecured creditor…

California One-Action Rule Preempted by Federal Debt Collection Improvement Act

Cal. Code Civ. P. § 726, often referred to as the one-action rule, has many facets. Relevant to this article is the “security-first” rule which requires “a secured creditor to proceed against the security before enforcing the underlying debt”; the penalty for failing to do so is waiver of the security.

In practical terms, this means a creditor secured by property has to either pursue foreclosure or file a lawsuit on the debt. The aforementioned ‘or’ is an exclusive ‘or’ meaning the lender has to pick one or the other and cannot pick both options. Consequently, this is what’s typically referred to as an “election of remedies.”

Federal agencies like the Small Business Administration (“SBA”) are allowed to offset debts owed to them by directing the U.S. Treasury Department to pay them monies that would otherwise be paid to a debtor.

So what happens when the SBA is owed money secured by property in California and obtains an offset from the treasury department?  Application of § 726 would mean the SBA would have to waive its security interest. The Debtor would own the property free and clear of SBA’s lien. (Practically speaking, the SBA could then obtain a judgment, an abstract of judgment and record a new lien, but this new lien would be in last place.)

This issue was before the bankruptcy court in case no. Case 9:13-ap-01143-PC (the decision was actually made by Judge Riblet and recently assigned to Judge Caroll). While the bankruptcy court wasn’t clear as to its exact rationale for granting the SBA’s motion to dismiss the action seeking to remove its lien (which left open several basis for affirming the decision), the District Court, acting as an appellate court, didn’t mince words.

Preemption occurs in one of three ways: “(1) Congress enacts a statute that explicitly pre-empts state law; (2) state law actually conflicts with federal law; or (3) federal law occupies a legislative field to such an extent that it is reasonable to conclude that Congress left no room for state regulation in that field.” Chae v. SLM Corp., 593 F.3d 936, 941 (9th Cir. 2010). This is a disjunctive test meaning any of the clauses above, by themselves, are sufficient for the court to apply preemption.

The court found that § 726 is a consumer protection law that implicates contract law and is therefore of the kind typically regulated under state law. Consequently, the only way to preempt it would be through application of the second prong above, which requires a finding that (1) § 726 presents an obstacle to the accomplishment of the purpose of a federal statute and (2) the statute presents a “clear and manifest purpose of Congress” to preempt state law. This is a conjunctive test which requires both prongs to be satisfied.

The offset described above is authorized by the Debt Collection Improvement Act (“DCIA”). Through analysis of the statement of purpose in enacting the DCIA, the court found that Congress intended to regulate the debt collection of federal agencies under a single scheme, which necessarily carries with it the purpose of preempting state law to the degree that it presents an obstacle to the operation of such a federal scheme.

The court found that the purposes of the statute would be thwarted if its mandatory debt collection procedures resulted in the loss of an agency’s security interest under state election-of-remedies rules.

Therefore, therefore, Cal. Code Civ. P. § 726 is preempted.

A copy of the decision may be found on Google Scholar here.

Proposed Changes to the California Homestead Exemption

SB 308 is a new bill introduced by Senator Bob Wieckowski in the California State Senate that provides significant improvements to California’s current exemptions including:

  • increasing the homestead to $300,000 for all individuals;
  • removing the 6 month reinvestment requirement;
  • increasing the exemption for vehicles to $6,000;
  • establishing that bankruptcy alone is not an event of default; and
  • creating a grubstake of $5,000 for self-employed individuals.

The complete text of the amendment can be found here.

Note: the link above is to the original proposal and is easy to read. The original proposal provided for a $700,000 exemption which was amended down to $300,000. A more difficult to read, updated version can be found here.

Can I Reaffirm a Non-Recourse Debt?

This question was posed to a listserv in the Central District of California: “If  a debtor reaffirms an otherwise non-recourse mortgage, does the reaffirmation convert that into a recourse loan?”

This question made me consider what reaffirmation really meant because, in the fact pattern above, reaffirmation could potentially put the creditor in a better position than before the bankruptcy, and that can’t be!

Reaffirmation is invoked through section 524(c) of the Bankruptcy Code which provides in pertinent part:

(c) An agreement between a holder of a claim and the debtor … which is based on a debt that is dischargeable in a case under [bankruptcy] is enforceable only to any extent enforceable under applicable nonbankruptcy law … only if (it is reaffirmed per the code’s requirements).

So the effect of a reaffirmation is to make something just as enforceable as it was before the bankruptcy was filed. In the case of a non-recourse loan which is only enforceable against property to begin with, nothing happens as it was only against property to begin with!

Upon further inquiry, I found a case that agreed but in a much more bold way:

“The court disapproves the reaffirmation agreement between the debtors and JP Morgan Chase Bank, N.A., because the debt in question is a home equity loan, which is, under Texas law, a nonrecourse obligation. Thus, there is nothing to “discharge” and so nothing to reaffirm. Reaffirmation agreements of such loans are inappropriate … so as to impose a liability on the debtor, a liability for which the debtor, under nonbankruptcy law, clearly has no liability.”

The case can be found here.

What’s Not a Claim In Bankruptcy?

Before joining his firm, I visited Professor Hayes’ Bankruptcy class which he teaches at the University of West Los Angeles. The topic of the day was “claims.”  As we parsed through the case law, I gave the students a hint, if there is any question whether something is a claim, it’s a claim! In fact, I couldn’t think of something that wasn’t a claim!

The reason is claims are BROADLY defined. Under 11 U.S.C. 101(5), a claim is defined as:

“(5) The term “claim” means—

(A) right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured; or

(B) right to an equitable remedy for breach of performance if such breach gives rise to a right to payment, whether or not such right to an equitable remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed, undisputed, secured, or unsecured.”

A typical bankruptcy puts a stop to virtually all claims, and so if you’re paying attention, it puts a stop to virtually every adverse action against the bankrupt.

But that’s not what this article is about. It’s about how Leslie Cohen Law, with their combined horsepower of three attorneys fought against the juggernaut that is Pachulski Stang Ziehl & Jones LLP and came out on top by discovering, finally, something that is not a claim!

This is important because a creditor is defined as “(A) entity that has a claim against the debtor that arose at the time of or before the order for relief concerning the debtor; (B) entity that has a claim against the estate ….”

At this point, most people would be thinking, well, why wouldn’t I want to have a claim? Why wouldn’t I want to be a creditor? How could this be useful?

I am not going to go into the history of it all, as exciting as it may be, but Congress decided that it wouldn’t be fair for some creditors to receive money before a company filed for bankruptcy – to the exclusion of other creditors. It came up with a rule where, but for a few exceptions, creditors paid by a bankrupt company/individual, would have to pay back whatever they were paid within ninety days of the bankruptcy. If those creditors had inside knowledge of the company, they had to pay back whatever they were paid within one year of the bankruptcy. This is done through what’s commonly referred to as a preference action under 11 U.S.C. 547; one of the Trustee’s “clawback” powers.

The key here is, CREDITORS who receive payments are the only people subject to preference actions. If you’re not a creditor – that is, you don’t have a claim, you’re not worried about a preference action! This element is hard coded into Section 547(b) which allows trustees to avoid transfers “(1) to or for the benefit of a creditor;”

In the particular case at issue, Leslie Cohen’s client was the President of a company. He guaranteed debt of about $8.5 million. The company paid off about $5 million of the debt nine months before filing for bankruptcy. This meant that the President had received a $5 million dollar benefit by this payment because he had to pay the bank $5 million less on the guarantee that he made. But wait, was he a creditor?

He is clearly a creditor because any payment he would have to make to the bank would be indemnified by the company and so he had a contingent, unliquidated right to payment against the company. There is one fact I left out though. The bankruptcy court found that the President had waived, unequivocally, any of his right to repayment by the bankrupt company.

So to answer the question, what is not a claim? A claim that is unequivocally waived is not a claim! On April 6, 2015, the 9th Circuit Court of appeals agreed, meaning this client saved $5,000,000.  You can find the case here.

Author’s commentary: This is clearly an incorrect decision. As the dissent pointed out, every other bankruptcy court to address this issue has gone the other way. It’s simple, you shouldn’t be able to contract around a preference. Furthermore, as the judge pointed out, this unequivocal waiver is actually a sham because “such a waiver has no economic impact. —if the principal debtor pays the note, the insider guarantor would escape preference liability, but if the principal debtor does not pay the note, the insider could still obtain a claim against the debtor, simply by purchasing the lender’s note rather than paying on the guarantee. Thus, the [waiver] could only be seen as an effort to eliminate, by contract, a provision of the Bankruptcy Code. The attempted waiver of subordination rights was thus held to be a sham provision, unenforceable as a matter of public policy.”