Winter 2008 • Issue 31, page 7

Bay Area Bankruptcy Forum and San Francisco Bar Assn. Review 2008's Key Business Bankruptcy Case Decisions

By Montali, Honorable Dennis, Dumas, Cecily & Oliner, Ron*

Recent Developments in Business Bankruptcy” was the subject of a panel presentation by the Bay Area Bankruptcy Forum and the San Francisco Bar Association Commercial Law and Business Section for attorneys from throughout the greater Bay Area and San Jose on November 6, 2008.

The authors, panelists and presenters at the annual evening programs – The Honorable Dennis Montali, United States Bankruptcy Judge; Cecily A. Dumas, Esq., (a partner in the firm Friedman Dumas & Springwater LLP); and Ron Mark Oliner, Esq. (a partner in the firm Duane Morris LLP) – have excerpted the facts and law from some of the most important cases reported on for readers of the Receivership News.

The authors’ written materials illuminated more than 70 published opinions. This article (and a second part to appear in the next issue of Receivership News) set forth some of the more interesting and important decisions. Some materials have been edited because of space limitations.
The authors give special thanks for the assistance of Peggy Brister and Valerie Grubich, Law Clerks to the Hon. Dennis Montali, and Robert E. Clark, Friedman Dumas & Springwater LLP, in the preparation of these materials.

Filing An Involuntary Petition Solely To Gain Leverage Against Other Creditors Is Bad Faith
An unusual series of involuntary and voluntary petitions caught the attention of the judges of the Central District. All of the cases involved companies with a common ownership or an affiliation with each other. The companies would make small loans to owners of properties facing foreclosure, who would in turn transfer the property to a trust in which the transferor was a partial owner. A representative of the companies would then begin negotiations with lienholders, seeking to pay off the secured loans at a discount in order to create equity where there was none. If the lienholders balked, the companies would file an involuntary petition against one of the trust owners (or have the owner file a voluntary petition), thereby staying foreclosure and gaining time and leverage in the negotiations. If more time was needed, the companies would file a petition against another of the trust owners. Three of the judges of the Central District joined in a decision finding that the involuntary petitions were filed in bad faith and subject to dismissal under 11 U.S.C. § 303. The judges applied a “totality of the circumstances” test to determine that the petitioning creditor was using the petitions to gain an unfair advantage over other creditors. In re Mi La Sul, 380 B.R. 546 (Bankr. C.D. Cal. 2007).

A Debtor’s Transfer Of Estate Property Does Not Violate The Automatic Stay
The automatic stay of 11 U.S.C. § 362 prohibits “all entities” from exercising control over property of the estate. In this case, the debtors exercised such control by selling their home, in which the estate retained an interest, to a bona fide purchaser (no record of the bankruptcy having been filed at the recorder’s office). The trustee successfully sued for quiet title, with the bankruptcy court finding the sale void from the outset as a violation of the automatic stay. See Schwartz v. U.S. (In re Schwartz), 954 F.2d 569 (9th Cir. 1992) (acts taken in violation of the stay are not merely voidable, but are void). The Bankruptcy Appellate Panel and the Ninth Circuit both disagreed. Schwartz itself observed that section 549 allows a trustee to avoid a debtor’s transfer of estate property, implying that such transfers are not automatically void. Even if that observation was dictum in Schwartz, the Ninth Circuit has now pronounced it officially the law of the circuit. In addition, the court held that the protections afforded the bona fide purchaser of the property under California law, Cal. Civ. Code § 1214, are consistent with the purpose and structure of the Bankruptcy Code, and so are not preempted by the Code’s provisions governing title transfers by debtors. Burkart v. Coleman (In re Tippett), —- F.3d —-, 2008 WL 4070690 (9th Cir. Sept. 4, 2008).

Relief From Stay Applies To Property, Not Creditors
Washington Mutual Bank obtained relief from the automatic stay under 11 U.S.C. § 362(d) after the debtors defaulted on the home loan for which Washington Mutual was the serving agent. The trust deed was actually held by Wachovia Bank, which was not a party to the stay-relief motion and was not named in the order granting that relief. After Wachovia foreclosed on the property, the debtors sued it for violating the automatic stay, arguing that the stay-relief order applied only to Washington Mutual. The district court dismissed the suit, and the Ninth Circuit affirmed. Because bankruptcy jurisdiction is at its core in rem, a final order lifting the automatic stay is binding as to the property at issue, and its scope is not limited to the parties before the court. It was therefore immaterial that the order did not name Wachovia. (The debtors also argued that Washington Mutual did not have standing to move for the stay to be lifted, but the Ninth Circuit deemed the issue waived for not having been raised when that motion was being decided.). Reusser v. Wachovia Bank, N.A., 525 F.3d 855 (9th Cir. 2008).

“Opt-Out” State May Not Provide Special Wild-Card Exemption For Debtors In Bankruptcy
Section 522 of the Bankruptcy Code allows individual debtors to exempt from their estate certain property as listed in subsection (d). Many states have their own lists of property that is exempt from creditors’ claims outside of bankruptcy. Those states may, if they wish, “opt out” of the Code’s exemption list, giving bankruptcy debtors the same exemptions they would have in a non-bankruptcy situation. California’s list includes several exemptions available only to individuals who have filed for bankruptcy, which mostly follow the federal exemptions of 11 U.S.C. § 522(d).

But one of them, the “wild card” exemption, Cal. Code Civ. Proc. § 703.140(b)(5), can end up being twice the size of the comparable exemption provided under the Code (depending on the amount of “spillover” from the debtor’s homestead exemption). Many years ago, the Ninth Circuit held (in a case under the Bankruptcy Act) that bankruptcy-specific state exemption laws violate the Supremacy Clause. See Kanter v. Moneymaker (In re Kanter), 505 F.2d 228 (9th Cir. 1974).

The bankruptcy court in this case (involving an Arizona debtor who had previously lived in California, see § 522(b)(3)(A)) considered the principle still valid: California’s bankruptcy-specific exemption concerns a field already occupied by the Bankruptcy Code and effectively discriminates against trustees in bankruptcy, who unlike creditors don’t have the option of pursuing debtors outside of bankruptcy. The debtor asked the court to reconsider its decision, arguing that the field of bankruptcy exemptions is not fully occupied by federal law because the Code allows states to make their own exemption rules effective in bankruptcy cases.

But the court upheld its original decision, explaining that the Code’s opt-out mechanism is not an invitation to the states to come up with their own bankruptcy-specific exemptions, but only to keep a debtor’s exemptions in line with those generally available against creditors. In re Regevig, 389 B.R. 736 (Bankr. D. Ariz. 2008), reconsideration denied, 2008 WL 3992250 (Bankr. D. Ariz. Aug. 21, 2008).

Investors’ Investment Not Invested
In this Nevada bankruptcy case, the debtor’s apparent purpose was to provide a vehicle for investors to invest in loans originated by USA Commercial Mortgage Company. Investors purchased membership interests, which then invested in various loans.

Certain investors thought they were purchasing membership interests in the debtor. However, the insiders of the debtor failed to invest the money. These investors filed both proofs of claim and proofs of interest as equity holders. The bankruptcy court disallowed the proofs of claim, characterizing these investors’ positions as equity. Obviously, the issue of priority comes into play, as well as potential subordination issues under 11 U.S.C. § 510.

During the bankruptcy, and after a change of management, the debtor’s insiders’ wrongs became apparent. The debtor’s portfolio was ultimately determined to be part of a scheme to fund the insiders’ speculative real estate activities. There were approximately 1,300 “members” or investors on the petition date. One hundred and thirty-seven of these investors filed proofs of claim. The bankruptcy court sustained the equity committee’s objection to these claims, reclassifying the claims as equity interests. The BAP reversed, finding that the reclassification of these claims to equity interests was unfounded on the record before it. Margaret B. McGimsey Trust v. USA Capital Diversified Trust Deed Fund (In re USA Commercial Mortgage Co.), 377 B.R. 608 (9th Cir. BAP 2007).

Investing In Malaysian Latex Gloves Probably Not A Good Idea
Mr. Kowell unknowingly participated in a Ponzi scheme as an investor. The corporation in which he invested promised investors a 20% return in 90 days by using their money to provide working capital to a Malaysian latex glove manufacturer. Later, predictably, there was an SEC investigation and an action brought against the corporation.

A court appointed receiver determined that Kowell had received a substantial profit on his investment and brought suit under the Uniform Fraudulent Transfer Act. Noting that Ponzi schemes leaves no true winners once the scheme collapses, and that even winners are defrauded because their returns are often illusory, the court determined that even an innocent participant in the scheme may be required to disgorge amounts long after the money has been spent. The Ninth Circuit ruled that Kowell had to share some of the hardship with others who lost their entire initial investment and directed that he return substantially all of his profits but allowing him to retain his initial investment. Donell v. Kowell, 533 F.3d 762 (9th Cir. 2008).

What Is It About “NO” You Don’t Understand?
A lender engaged in unauthorized postpetition transactions with a chapter 11 debtor; in particular, the lender purchased the debtor’s accounts receivable at a discount under a factoring agreement. Ultimately, the lender collected less than he paid for the accounts receivable. Following conversion, the chapter 7 trustee sought to recover all amounts collected by the lender under 11 U.S.C. § 549 because the factoring arrangement was an unauthorized postpetition transfer. The lender argued that he had already paid more than full value for the accounts and the estate should not be allowed a double recovery (i.e., the amount he initially paid plus the amounts he recovered). The Ninth Circuit disagreed.

Resolving an issue of first impression, the Ninth Circuit held that depletion or diminution of the estate is not a requirement for finding a transfer avoidable as an unauthorized postpetition transfer. Because the lender had known about the bankruptcy (and had entered into the unauthorized factoring agreement with debtor only after the bankruptcy court had refused to authorize his proposed loan to debtor secured by the accounts receivable), his inequitable conduct rendered the doctrine of recoupment inapplicable. The factoring arrangement did not fall within the “ordinary course of business” exception to avoidable postpetition transfers, and the defense of earmarking did not apply. Consequently, the Ninth Circuit concluded that the bankruptcy court did not abuse its discretion in ordering the lender to turn over the amounts collected plus all remaining uncollected accounts. Aalfs v. Wirum (In re Straightline Inv., Inc.), 525 F.3d 870 (9th Cir. 2008).

Mr. Ponzi Just Won’t Go Away
In addressing an issue of apparent first impression, the Ninth Circuit held that once the existence of a Ponzi scheme is established, payments received by investors as purported profits are deemed fraudulent transfers as a matter of law.

A debtor admitted through guilty pleas and a plea agreement that he operated a Ponzi scheme with the actual intent to defraud his creditors. The chapter 11 trustee filed an action against investors in the scheme, seeking to avoid as fraudulent the profits transferred to them by debtor. The Ninth Circuit held that “the mere existence of a Ponzi scheme [is] sufficient to establish intent” to defraud for the purposes of 11 U.S.C. § 548(a) and state fraudulent transfer statutes. The debtor’s guilty pleas and plea agreement “conclusively establishe[d] the debtor’s fraudulent intent under [those fraudulent transfer statutes] and preclude[d] relitigation of that issue.” Because the source of any profits received by the investors was a theft from other investors, those payments received as profits are fraudulent transfers as a matter of law. Johnson v. Neilson (In re Slatkin), 525 F.3d 805 (9th Cir. 2008).

This Ponzi Victim Dodged The Bullet
The defendant invested $73,400 in a Ponzi operation (the debtor) as a purported limited partner. Before the operation filed for bankruptcy, the investor/defendant ended his participation in it and recovered $89,824.18 (representing his initial investment of $73,400 plus a $16,424 fictitious gain on the investment). The chapter 11 trustee filed an action under 11 U.S.C. §§ 544(b) and 550 and the California Civil Code to avoid the transfer of $89,824.18 to the investor.

The bankruptcy court granted summary judgment in favor of the trustee. The district court reversed, and the Ninth Circuit affirmed, holding that even though the transfer from the operation to the investor was made with fraudulent intent, the investor exchanged reasonably equivalent value (the release or reduction of his restitution claim) for his recovery of $73,4000 (his initial investment). Therefore, the good faith exception to fraudulent transfers set forth in California Civil Code § 3439.08(a) (equivalent to 11 U.S.C. § 548(c)) was not barred as a matter of law.

In its decision, the Ninth Circuit noted that it had twice addressed the application of the phrase “reasonably equivalent value” in the context of a fraudulent transfer action relating to a Ponzi scheme. In Hayes v. Palm Seedlings Partners-A (In re Agri. Research & Tech. Group, Inc.) (“Agretech”), 916 F.2d 528 (9th Cir. 1990), the court held that a distribution on account of a partnership interest relative to an investor’s capital contribution was not “reasonably equivalent value.” In contrast, in Wyle v. C.H. Rider & Family (In re United Energy Corp.), 944 F.2d 589 (9th Cir. 1991), the court held that a transfer in exchange for a proportionally reduced restitution claim was “reasonably equivalent value.” It then held that the United Energy analysis applied here. Barclay v. Mackenzie (In re AFI Holding, Inc.), 525 F.3d 700 (9th Cir. 2008).

To Pursue Recovery Against A Subsequent Transferee, Trustee Does Not Have To Avoid Initial Transfer To Initial Transferee
On a matter of first impression in the Ninth Circuit, the BAP held that a trustee is not required to avoid the initial transfer from the debtor to the initial transferee before pursuing recovery against a subsequent transferee. Noting the split in authority among other circuits, the BAP stated that “Congress intended avoidance as one remedy and recovery as another” and that recovery did not require avoidance. The BAP therefore affirmed the bankruptcy court’s judgment requiring the law firm defendant to turn over fees it received from the proceeds of an unauthorized postpetition sale. Woods & Erickson, LLP v. Leonard (In re AVI, Inc.), 389 B.R. 721 (9th Cir. BAP 2008).

Bankruptcy Code Section 363: Not A Panacea
In this case, the BAP was faced with a simple issue: outside a plan of reorganization, does section 363(f) of the Bankruptcy Code permit a senior secured creditor to credit bid its debt and purchase estate property, taking title free and clear of valid, nonconsenting junior liens? In a case already generating much commentary, the BAP said no.

The facts of the case are relatively simple. The debtor owned prime real estate in Burbank, California and owed $40 million to the senior lender on a secured basis. There was a $2.5 million junior lien in favor of Clear Channel Outdoor, Inc. (“Clear Channel”). The liquidating trustee filed a motion to sell the real estate and, with court supervision, the senior secured creditor was the highest bidder, paying its consideration by credit bidding the entire amount of its debt. The bankruptcy court approved the sale free and clear of liens, relying on section 363(f)(5) (“such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.”). The junior lienholder appealed.

BAP reversed the bankruptcy court solely with respect to stripping the junior lienholder’s lien; the sale itself was not reversed. Before reaching the merits, the BAP observed that section 363(m) (which provides that the reversal or modification of a sale order does not affect the validity of a sale to a good faith purchaser) applies to the sale itself, not necessarily to the lien-stripping terms of an order.

With respect to the merits, the BAP held that neither subsection (f)(3) or (f)(5) applied. In doing so, it broke subsection (f)(5) into three elements: (1) a proceeding exists or could be brought, in which (2) the non-debtor could be compelled to accept a money satisfaction of (3) its interest. In a thoughtful opinion, the BAP ruled that the bankruptcy court did not apply the correct legal standard under (f)(5), and therefore it did not make the appropriate findings required under the paragraph. Clear Channel Outdoor, Inc. v. Knupfer (In re PW, LLC), 391 B.R. 25 (9th Cir. BAP 2008).

Form (B22C) Over Substance
A chapter 13 debtor’s Schedules I and J reflected $1,523.89 in monthly income available to pay creditors, while the above-median income debtor’s Form B22C reflected -$4.04 in disposable income. Because her B22C reflected a negative number, the debtor asserted that she was not subject to the “applicable commitment period” of five years called for by section 1325(b)(4)(A)(ii), and instead proposed a three-year plan paying $1,000.00 per month, despite her ability to pay more. The Arizona bankruptcy court confirmed debtor’s plan in spite of an objection lodged by the chapter 13 trustee, who argued that as an above-median debtor she was subject to a five-year plan.

In a split opinion, the Ninth Circuit, the first circuit to address this issue post-BAPCPA, affirmed the bankruptcy court, holding that an above-median debtor’s “projected disposable income” is calculated using the debtor’s “disposable income” figure, as calculated in the B22C, and multiplying that figure by 3 or 5. The court agreed with debtor’s argument that “projected disposable income” means the numbers as calculated by section 1325(b)(2) projected over the applicable commitment period, and rejected the trustee’s argument that projected disposable income as calculated is only a starting point, as held by the BAP in Pak v. eCast Settlement Corp. (In re Pak), 378 B.R. 257 (9th Cir. BAP 2007)(historic definition of “disposable income” is merely a “starting point” to determine “projected disposable income” that a debtor can devote to payment under BAPCPA).

Therefore, if a debtor’s B22C reflects a $0.00 or negative dollar figure, the “applicable commitment period” is inapplicable. As such, the “applicable commitment period” can apply only to plans that have “projected disposable income.” The court did note, however, that nothing in its opinion prevents the debtor, trustee, or unsecured creditor from requesting modification of the plan after confirmation pursuant to section 1329.

The dissent disagreed with the majority’s determination that the “applicable commitment period” is mandatory only when the debtor has “projected disposable income” at the time of confirmation, and would hold that an above-median debtor must propose a five-year plan, regardless of whether his or her “projected disposable income” is zero (or less), unless the plan proposes to pay unsecured creditors in full in a shorter period of time. Maney v. Kagenveama (In re Kagenveama), 541 F.3d 868 (9th Cir. 2008). Note: In light of Kagenveama, the Ninth Circuit has essentially overruled Pak.

A Cautionary Tale For Trustees And Creditors: Section 521(I)’S “Draconian” Dismissal Provisions Are Mandatory
A chapter 7 debtor did not obtain prepetition credit counseling as required by 11 U.S.C. § 109(h) and did not file his “payment advices (i.e., pay stubs) within 45 days of his petition date as required by 11 U.S.C. § 521. After the chapter 7 trustee discovered potential nonexempt assets, the debtor moved to dismiss his case voluntarily because of his failure to comply with sections 109(h) and 521. The bankruptcy court denied the motion to dismiss, and District Judge Breyer reversed, holding that because the debtor had not timely filed the requisite documents, section 521(i) mandated automatic dismissal effective on the 46th day following the petition date.

Judge Breyer observed that section 521(i)’s “draconian result can only be avoided in two circumstances.” First, a debtor may request an extension within the 45-day period. 11 U.S.C. § 521(i)(3). Second, a trustee may file a motion within that 45-day period requesting the court to retain the case or waive the filing requirements, but the court may decline to dismiss only if it “finds that the debtor attempted in good faith” to file the documents and “that the best interests of creditors would be served by administration of the estate.” 11 U.S.C. § 521(i)(4). Because the trustee could not demonstrate that the debtor had attempted in good faith to file all payment advices, the bankruptcy court erred in retaining the case, even though such retention was in the best interests of creditors.

Judge Breyer also held that the credit counseling requirement of section 109(h) is not jurisdictional and that strict compliance can be waived by a debtor. Consequently, debtors cannot force dismissal of their cases simply because they did not attend credit counseling. Warren v. Wirum, 378 B.R. 640 (N.D. Cal. 2007).

BAPCPA Eliminates “Ride-Through” Option For Chapter 7 Debtors
Section 521(a)(2)(A) requires an individual chapter 7 debtor to file a statement of intention with respect to any estate property that secures a scheduled liability, indicating whether the debtor intends to surrender the property, claim it as exempt, redeem it, or reaffirm the debt it secures. In 1998, the Ninth Circuit held that the debtor has another option: retain the property, keep making payments on the debt, and let the obligation “ride through” the bankruptcy. See McClellan Fed. Credit Union v. Parker (In re Parker), 139 F.3d 668 (9th Cir. 1998).

In 2005, the BAPCPA amended section 521(a)(2) to include a cross-reference to section 362(h), which lifts the automatic stay with respect to any collateral for which the debtor does not file a statement of intention (or does not act on that intention). Another BAPCPA amendment allows ipso facto clauses to be enforced under the same circumstances. Analyzing these provisions, the BAP has concluded that Parker’s “ride-through” option is no longer available. A debtor consequently needs to file and follow through on a statement of intention in order to protect against repossession of collateral. Dumont v. Ford Motor Credit Co. (In re Dumont), 383 B.R. 481 (9th Cir. BAP 2008).

Intentional Breach Of Contract, Without More, Is Not A “Willful And Malicious” Injury
Prior to bankruptcy, debtor intentionally breached a settlement agreement. Finding the debtor’s conduct constituted intentional harm “without any legitimate cause, the bankruptcy court entered a judgment declaring the debt arising from the deliberate breach nondischargeable as a “willful and malicious” injury under 11 U.S.C. § 523(a)(6). The district court affirmed, and the Ninth Circuit reversed, holding that the intentional breach of contract was not a tort under Arizona law and thus could not constitute a willful and malicious injury under section 523(a)(6).

The Ninth Circuit held that tortious conduct is a required element for a finding of nondischargeability under section 523(a)(6). “Something more than a knowing breach of contract is required before conduct comes within the ambit of § 523(a)(6), and . . . that ‘something more’ [is] tortious conduct.” Because Arizona law does not recognize a tort for intentional breach of contract, even when the breach is unjustified, the Ninth Circuit reversed the nondischargeability judgment. Lockerby v. Sierra, 535 F.3d 1038 (9th Cir. 2008).

If You Want To Pursue A Claim Against One Spouse, Be Sure To Assert It In The Other Spouse’s Bankruptcy Case
Under Section 524(a)(3) of the Bankruptcy Code, a discharge protects not only a debtor’s separate property but also a couple’s community property from any attempts to collect on a prepetition community claim. In this case, the claimant had sued both the husband and the wife. The wife filed for bankruptcy and obtained a discharge. The claimant then obtained a judgment against the husband individually, following which the couple executed a postnuptial agreement converting the wife’s future wages to her separate property.

The claimant eventually complained that this was a fraudulent transfer under state law. The Ninth Circuit BAP held that it didn’t matter: the claimant had his opportunity to present the claim in the wife’s bankruptcy or to object to the discharge, but failed to take advantage of it. Thanks to the all-encompassing discharge, the claimant could not seek satisfaction against any of the couple’s community property regardless of the postnuptial wage partition. Rooz v. Kimmel (In re Kimmel), 378 B.R. 630 (9th Cir. BAP 2007).

Coin Collection Is “Numismatic Property,” Not “Money”
An interpleader action was filed by an auction house to determine entitlement to the proceeds from the sale of the debtor’s rare coin collection. One creditor had been promised title to the collection, but a different creditor had previously obtained and recorded a security interest in “all personal property and other assets” of the debtor. The later creditor argued that the earlier creditor’s financing statement didn’t cover the coin collection because under the Uniform Commercial Code as adopted in Hawaii, “a security interest in money may be perfected only by the secured party’s taking possession.” Haw. Rev. Stat. § 490:9-312(b)(3).

The bankruptcy court adopted the “commonsense” principle that collectible coins worth more than their face value are not really “money” anymore, but instead are “numismatic property” qualifying as “goods” under the U.C.C., and therefore the first creditor’s security interest was perfected by the filing of the financing statement. (The court also considered whether the transfer to the first creditor was part of a Ponzi scheme and, if so, whether the creditor had a good-faith-value defense under 11 U.S.C. § 548(c), but found the evidence on both points inconclusive.) Bowers & Merena Auctions, LLC v. Lull (In re Lull), 386 B.R. 261 (Bankr. D. Haw. 2008).

*The Hon. Dennis Montali is a United States Bankruptcy Judge sitting in the San Francisco Division of the Northern District of California.

*Cecily A. Dumas, Esq. is a partner in the firm Friedman Dumas & Springwater LLP.

*Ron Mark Oliner, Esq. is a partner in the firm Duane Morris LLP.

The authors gratefully acknowledge the assistance of Peggy Brister and Valarie Grubich, Law Clerks to the Hon. Dennis Montali; Robert E. Clark, Friedman Dumas & Springwater LLP in the preparation of this recap/analysis of key bankruptcy cases.