Spring 2018 • Issue 63, page 1

Excerpts from Recent Developments in Business Bankruptcy 2017

By Johnson, Honorable Stephen & Hayes, Jennifer & Katz, Ori*

The panelists gratefully acknowledge the assistance of Ryan Witthans and Laurent Chen, Law Clerks to the Honorable Stephen Johnson, Stephen Finestone of Finestone Hayes LLP, and Robert Sahyan, Jamee Lewis, Matt Klinger, and Shadi Mahmoudi of Sheppard, Mullin, Richter & Hampton LLP, in the preparation of these materials.

Egregious nature of stay violations warranted $45 million punitive damages award, subject to channeling condition.
Sundquist v. Bank of Am., N.A., 566 B.R. 563 (Bankr. E.D. Cal. 2017)

Debtors brought an adversary proceeding to recover for Bank of America’s allegedly willful violations of the automatic stay. Debtors were current on their home loan prior to bankruptcy, though struggling financially. They defaulted only after Bank of America told them that the only way to get a loan modification would be if they were in default. Thereafter, the parties began a series of modification attempts during which Bank of America consistently lost paperwork and denied modification without explanation, while at the same time going forward then retreating on foreclosure actions.

Debtors filed for Chapter 13 bankruptcy under threat of imminent foreclosure. After knowingly foreclosing in violation of the automatic stay, Bank of America sent people to stake out the residence and intimidate the family and gave the family a three-day notice of eviction causing the debtors and their children to find temporary housing. Upon learning that they were no longer the owners of the home, Debtors voluntarily dismissed their bankruptcy case. Meanwhile, and without Debtors’ knowledge, Bank of America rescinded the foreclosure and returned title of the home to them. When they later returned to the house, they found that major appliances had been removed and that the homeowner’s association had assessed large sums against the property. Bank of America then attempted to collect mortgage payments for the months Debtors had been without their home.

The bankruptcy court held that Bank of America willfully violated the automatic stay by, among other things, (1) foreclosing on Debtors’ residence, (2) prosecuting an unlawful detainer action, (3) forcing Debtors to move, (4) secretly rescinding the foreclosure, (5) failing to protect the residence from looting, (6) refusing to pay for property lost, and (7) subjecting debtors to a mortgage modification charade. The court also held that as actual damages, Debtors’ were entitled to (1) moving expenses and costs of alternate housing, (2) reimbursement for their legal expenses in both state and federal bankruptcy court, (3) award for lost income through date of trial, (4) reimbursement for damage to property while it was under Bank of America’s control, (5) reimbursement of medical expenses and emotional distress damages, and (6) award of punitive damages. Finally, the court held that it had authority to channel a portion of the punitive damages award to ensure that it was sufficient to deter Bank of America’s misconduct without resulting in windfall for Debtors. To that end, the court ordered a portion of the award payable to organizations devoted to the public purposes of education and consumer protection.

Dismissals that are structured to avoid the priority scheme that otherwise applies in bankruptcy are prohibited.
Czyzewski v. Jevic Holding Corp.
, 137 S. Ct. 973 (2017)

Debtor sought dismissal of its Chapter 11 case but wanted an order indicating that funds would be distributed to certain creditors in a manner that was inconsistent with the ordinary priority scheme. In particular, Debtor sought to bar payment to Worker Adjustment and Retraining Notification (“WARN”) Act claimants of any money received from a settlement with certain lenders. The bankruptcy court approved the “structured dismissal” and the Third Circuit affirmed.

The Supreme Court reversed. The traditional means of resolving a Chapter 11 case are confirmation of a plan, conversion to Chapter 7, or dismissal pursuant to §§ 1112 and 349. Section 349(b)(1) restores the parties to the status quo ante unless the bankruptcy court, “for cause, orders otherwise.” The Supreme Court concluded that while § 349 authorizes the bankruptcy court to “make appropriate orders to protect rights acquired in reliance on the bankruptcy case,” nothing in the Code authorizes a court to “make general end-of-case distributions of estate assets to creditors . . . that would be flatly impermissible in a Chapter 7 liquidation or Chapter 11 plan because they violate priority without the impaired creditors’ consent.” Addressing the apparently common practice of structured dismissals, the court held “the distributions at issue here more closely resemble proposed transactions that lower courts have refused to allow on the ground that they circumvent the Code’s procedural safeguards.”

Barton doctrine applies to members of unsecured creditors’ committee.
Blixseth v. Brown (In re Yellowstone Mountain Club, LLC),
841 F.3d 1090 (9th Cir. 2016)

Blixseth borrowed money on behalf of the Yellowstone entities but used some of the proceeds to pay off personal debts. Blixseth claimed he relied on the advice of his attorney, Brown, who assured him that his actions were lawful. The Yellowstone entities later filed bankruptcy. Brown was appointed to the Unsecured Creditors Committee (“UCC”).

Blixseth sued Brown in district court, alleging that Brown used confidential information to Blixseth’s detriment in the bankruptcy case. The district court held that it lacked jurisdiction because Blixseth did not first obtain permission to sue, as required by the Barton doctrine, which requires a plaintiff to obtain authorization from the bankruptcy court before initiating an action in another forum against certain court-appointed officers for actions taken in their official capacities. See Barton v. Barbour, 104 U.S. 126 (1881). The bankruptcy court denied Blixseth’s subsequent request to sue, finding it impossible to isolate Brown’s prepetition alleged misfeasance from his activities as a member of the UCC. The district court affirmed.

The Ninth Circuit held that the Barton doctrine extends to UCC members who are sued for acts performed in their professional capacities. The Ninth Circuit then distinguished between Blixseth’s claims related to Brown’s prepetition conduct, which could proceed in district court, and those that related to Brown’s activities on the UCC, which could not. The Ninth Circuit remanded for the bankruptcy court to determine whether the chair of the official committee acted in its official capacity and is therefore entitled to derived judicial immunity.

The Ninth Circuit rejected Blixseth’s argument that the bankruptcy court lacked authority to decide his claims against Brown. Because Barton claims could not exist outside of bankruptcy, Stern does not preclude a bankruptcy court from adjudicating Barton claims. Stern v. Marshall, 564 U.S. 462 (2011).

The case applies the Barton doctrine to official committee members on the basis that allowing suits outside bankruptcy court would undermine reorganization efforts and the system of the code. It also, notes that district court is treated as “another forum” for the purposes of the statute. The bankruptcy court had power to enter final orders on these Barton claims because they arise as an incident to the bankruptcy case and in fact could not exist without it.

A contractual choice of law provision does not usually control which state’s statutes of limitation will be applied. Instead, the forum state’s statute of limitations is used unless “exceptional circumstances” compel a different result.
In re Sterba
, 852 F.3d 1175 (9th Cir. 2017)

Debtor and Bank agreed in a promissory note that Ohio law would control. Later, Debtor defaulted on promissory note and filed bankruptcy in California. Bank filed a proof of claim to which the Debtor objected on statute of limitations grounds. Under the law of California, where the bankruptcy case was filed, the statute of limitations was four years and the claim was time-barred. However, under Ohio law, the statute of limitations was six years and the claim was still collectible.

Generally, the Ninth Circuit applies contractual choice of law provisions. Precedent holds that if a contract choice of law term does not explicitly refer to the statute of limitations, a generic choice of law provision addressing substantive law is not controlling on statute of limitations questions. Statutes of limitations are considered procedural rather than substantive. Here, the provision was general. The court analyzed the situation using conflict of law rules, including the Restatement (Second) of Conflict of Laws § 142. Under that provision, the law of the district where a case is pending (here, California) is normally applied absent “exceptional circumstances.” The court found the facts of this case were exceptional and applied Ohio’s longer six year statute of limitations. Otherwise, the court found, Bank’s claim would be rendered unenforceable simply because it had to file its claim in California, which would apply the forum state’s shorter limitations period.

Filing a proof of claim for a debt that is barred by state statute of limitations does not violate the Fair Debt Collection Practices Act.
Midland Funding, LLC v. Johnson
, 137 S. Ct. 1407 (2017)

Creditor filed proof of claim in Chapter 13 case, noting that the last payment was more than ten years before the bankruptcy filing. The applicable statute of limitations was six years. Debtor brought a lawsuit for violation of Fair Debt Collection Practices Act (“FDCPA”), 15 U.S.C. § 1692k, contending that filing the time-barred proof of claim was false, deceptive, misleading, unconscionable, and unfair. The Supreme Court held the filing was not a violation of the FDCPA. The Bankruptcy Code’s definition of claim can be seen to include even claims that are time-barred because the Code authorizes a court to disallow claims that are not “enforceable.” The Supreme Court distinguished nonbankruptcy court decisions which generally find that the filing of a time-barred claim is an unfair practice. Bankruptcy cases are different from state court proceedings because of the involvement of a trustee, who is a knowledgeable participant that would seek to disallow unenforceable claims. Moreover, the process of objecting to claims in a Chapter 13 case is more streamlined than equivalent procedures in state courts. Finally, the Supreme Court declined to create a rule authorizing recovery in bankruptcy cases. It suggested that such a rule would upset a delicate balance in bankruptcy between a debtor’s protections and obligations. It held that the remedy for filing a claim on a time-barred debt was best vindicated through an affirmative defense to a collection action.

Trustee was entitled to share of spendthrift trust distributions payable as of petition date and future payments.
Frealy v. Reynolds (In re Reynolds),
867 F.3d 1119 (9th Cir. 2017)

Debtor was beneficiary of trust with a spendthrift provision. He was entitled to principal distribution under the terms of the trust at the time he filed a personal Chapter 7 case. Trustee moved for an order turning over the funds that had not been distributed directly to the estate, which Debtor opposed. The Ninth Circuit determined that California’s Probate Code § 15302 governed the bankruptcy estate’s right to the trust funds and referred the question of statutory interpretation to the Supreme Court of California. The Supreme Court found a creditor can reach all principal funds that are due and payable to the beneficiary, unless the trust includes the “education and support” limitation, in which case the funds are not reachable until actually paid to the beneficiary. The creditor can receive 25% of the payment that would be paid to the beneficiary, provided however, that the 25% limitation is not applied to any amount the court decides is necessary for the support of the beneficiary and those relying upon him/her.

The community property presumption trumped the presumption that the legal title holder of real property is the beneficial owner.
In re Brace
, 566 B.R. 13 (B.A.P. 9th Cir. 2017)

During their marriage, Debtor and his wife acquired three real properties, taking title to each as “husband and wife as joint tenants.” Pre-bankruptcy, Debtor transferred his interest in two of the properties to an irrevocable trust for which he was the trustee and his wife was the sole beneficiary. The court determined the transfers were an intentional fraudulent conveyance and entered judgment in favor of the trustee. The issue on appeal was limited to the characterization of the properties: were they joint tenancy as a matter of title or were they community property under California law and thus property of the bankruptcy estate?

The BAP analyzed various California statutes, including Evidence Code § 662 (presumption that the legal title holder is the beneficial owner) and Family Code § 760 (presumption that property acquired during marriage community property except as otherwise provided by statute). The community property presumption may be rebutted by evidence that the spouses agreed to transmute the property from the community, but a transmutation must be made in writing by an express declaration and signed by the adversely affected spouse. The BAP relied on Valli v. Valli (In re Marriage of Valli), 58 Cal. 4th 1396 (2014), in holding that the title presumption provision does not apply to the characterization of property acquired during marriage when it conflicts with the transmutation statute, regardless of whether the property transfer was between spouses or acquired from a third party. The BAP relied on Family Code §§ 851 and 852 to determine that the same Valli analysis should apply in disputes outside of marital dissolution or separation proceedings, such as bankruptcy proceedings. To effectively transmute the property from community property to separate property, a transmutation must be “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,” such as taking title as one spouse’s “sole and separate property” and the other spouse executing and recording a document relinquishing her or his interest in the property. Merely taking title as “husband and wife joint tenants” does not satisfy the transmutation statute.

Contingent right to real estate commission is estate property, even if transaction closes after the petition date.
Anderson v. Rainsdon (In re Anderson), 572 B.R. 743 (B.A.P. 9th Cir. 2017)

Real estate agent Debtors claimed that commissions paid after the bankruptcy case began were not property of the bankruptcy estate because they were postpetition earnings under § 541(a)(6). The BAP rejected this argument based on the Ninth Circuit’s ruling in In re Jess, 169 F.3d 1204 (9th Cir. 1999). In Jess, the Ninth Circuit held that the formal closing of the transaction is not required for a party to have some right to the commission. That right is cognizable under state law, and therefore is property of the bankruptcy estate under § 541(a)(1) because the commissions are “sufficiently rooted” in a debtor’s prepetition work.

The BAP held that Debtors’ real estate commissions paid after commencement of the case were estate property. Under Idaho law, a real estate agent has a right to the commission if she has produced a buyer, a contract has been signed, and the agreement is later completed. Here, there was no evidence of any postpetition work. The BAP acknowledged that earnings paid after bankruptcy by an individual can be excluded from the bankruptcy estate under § 541(a)(6), but held that exception cannot apply if all the obligations for the commission were fulfilled before the bankruptcy case was filed. Fact finding would be necessary to determine whether commissions were earned due to work performed after the bankruptcy filing.

Sale free and clear under § 363 could be used to cut off Attorney General’s authority to review.
In re Gardens Reg’l Hosp. & Med. Ctr., Inc.
, 567 B.R. 820 (Bankr. C.D. Cal. 2017)

The court held that because a closed hospital does not qualify as a “health facility” under California law, Debtor was not required to obtain the California Attorney General’s consent prior to selling a material amount of its assets. Debtor was a nonprofit hospital that ran out of funds during its Chapter 11 case and closed. It proposed to sell the closed facility and its suspended state hospital license to a for-profit buyer under § 363 without compliance with state law that permits the Attorney General to impose conditions on a sale of a nonprofit hospital to a for-profit buyer. Section 363(d)(1) permits sale of a nonprofit debtor’s assets “only in accordance with nonbankruptcy law applicable to the transfer of property” by such debtor. Section 363(f) permits a sale of property of the estate free and clear of an interest in that property.

The court found that the Attorney General’s authority to impose monetary conditions upon a sale, such as a requirement that the buyer provide a specified amount of charitable care, constituted an interest in the hospital property for the purpose of § 363(f). However, the court held that, because Debtor was no longer operating a hospital, it was not a “health facility” within the meaning of the applicable nonbankruptcy law and, therefore, the Attorney General’s consent rights did not apply.

Trustee recovers fraudulent prepetition tax payments, prevailing over IRS’s contention that sovereign immunity barred recovery of tax payments.
In re DBSI, Inc.
, 869 F.3d 1004 (9th Cir. 2017)

Trustee sought to avoid debtor’s allegedly fraudulent federal tax payment to the IRS. The IRS argued that the bankruptcy court could not order return of the payments because the United States had not waived sovereign immunity. The Ninth Circuit disagreed based on §§ 106(a)(1) and 544(b). It found that Congress abrogated sovereign immunity with respect to § 544(b), meaning that a trustee may avoid fraudulent transfers if an actual unsecured creditor could avoid the same transfer under applicable law outside of bankruptcy (the “actual creditor” or “triggering creditor” requirement). This requires the existence of an actual creditor in whose shoes the trustee can stand.

In this case, the § 544(b)(1) adversary action brought under Idaho’s Uniform Fraudulent Transfer Act (“UFTA”) was the applicable law. While an unsecured creditor seeking to avoid such tax payment under Idaho law outside bankruptcy would be precluded because of sovereign immunity, the court reasoned that § 106(a)(1)’s abrogation of sovereign immunity applied not only to § 544(b)(1), but also extended to the underlying applicable law (i.e., UFTA).

28 U.S.C. § 1927 allows an award of sanctions encompassing all fees caused by the sanctionable conduct, including fees incurred in prosecuting the sanctions motion. Appellate Rule 38 does not allow for an award of “fees on fees.”
Blixseth v. Yellowstone Mountain Club, LLC
, 854 F.3d 626 (9th Cir. 2017)

28 U.S.C. § 1927 allows for sanctions against an attorney for “unreasonably and vexatiously” multiplying proceedings. The Ninth Circuit held that 28 U.S.C. § 1927 is a “fee-shifting provision,” despite its sanctions trigger, because it expressly provides for “excess costs, expenses, and attorneys’ fees reasonably incurred because of [the sanctionable] conduct.” “Fee-shifting provisions” allow for an award of all fees incurred due to the sanctionable conduct, such as fees incurred in prosecuting the sanctions motion. By contrast, “fees on fees” are not allowed under Appellate Rule 38, which authorizes an award of “just damages” if a court determines an appeal is frivolous. Appellate Rule 38 limits awardable sanctions to the appellee’s direct fees and costs for defending against the frivolous appeal, but does not include fees and costs incurred in obtaining the sanctions. Absent specific language in the statute or rule, or indication to the contrary, a statute or rule permitting an award of “damages” is not a fee-shifting statute and does not permit an award of fees for obtaining the “damages.”

Automatic stay did not prevent government from collecting criminal restitution under the Mandatory Victims Restitution Act.
Partida v. United States DOJ (In re Partida)
, 862 F.3d 909 (9th Cir. 2017)

The Ninth Circuit decided an issue of first impression in determining that the federal Mandatory Victims Restitution Act (“MVRA”) allows the government to collect criminal restitution despite the automatic stay. The Second and the Sixth Circuits have reached the same result. The MVRA provides the government with broad powers to enforce a civil judgment “[n]otwithstanding any other federal law.” The MVRA was enacted after § 362 and the Ninth Circuit has recognized “a general proposition that statutory ‘notwithstanding’ clauses broadly sweep aside potentially conflicting laws.” Also, the legislative history for the MVRA shows that Congress envisioned that the MVRA would “ensure that criminals pay full restitution to their victims for all damages caused as a result of the crime.” The Ninth Circuit did not rest its holding on the exception to the automatic stay for ongoing criminal actions or proceedings.

Special Thanks: The panel gratefully acknowledges the invaluable assistance of Ryan Witthans and Laurent Chen, Law Clerks to Judge Johnson; Stephen D. Finestone, Finestone Hayes LLP; and Sheppard Mullin senior associate Robert Sahayan and junior associates Shadi Farzan, Matt Klinger, and Jamee Lewis.

*Judge Stephen L. Johnson was appointed to the bench in the Northern District of California by the Ninth Circuit Court of Appeals in 2010.

*Jennifer C. Hayes is a partner of Finestone Hayes LLP, a San Francisco law firm specializing in insolvency law, bankruptcy law, and business disputes. Prior to her current firm, Ms. Hayes was a partner at the international law firm, Dentons.

*Ori Katz is a partner in the Finance and Bankruptcy practice group in the San Francisco office of Sheppard, Mullin, Richter & Hampton LLP, where he is also the Co-Office Managing Partner. He specializes in business bankruptcies and other aspects of insolvency law.