The South Bay Law Firm Law Blog highlights developing trends in bankruptcy law and practice. Our aim is to provide general commentary on this evolving practice specialty.
 





 
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    Getting Stuck With the Tab
    Back to School in the Ninth Circuit
    An Unexpected Tribute to mile Zola
       

    Getting Stuck With the Tab

    Monday, March 17th, 2014

    It often happens that, upon commencement of a bankruptcy case, property which is part of the debtor’s bankruptcy estate is not held or controlled by the trustee (or debtor-in-possession).  To recover that property, Bankruptcy Code section 542 permits the trustee to seek its turnover from the party holding it.

    Bankruptcy

    Until very recently, Ninth Circuit law left unanswered the question of whether a party who at one point may have held estate property could remain liable for its turnover even after that property had been transferred elsewhere.  Shapiro v. Henson answers that question in the affirmative.

    In a case of first impression, the Ninth Circuit Court of Appeals expanded the trustee’s ability to seek turnover of estate property.  In its analysis, the Court took cues from Section 542′s language which suggests that possession of property may not necessarily be mandatory for turnover.  To support its interpretation of S. 542(a), the Court also reviewed turnover practices before the Bankruptcy Code was promulgated.  Among these, the Court noted that ‘plenary proceedings’ did not require the present possession of property.  The pre-Code possibility of a turnover of property of the bankruptcy estate without possession strengthened the Court’s similar reading of the present statute.

    The Ninth Circuit Court also examined Section 550(a), which empowers trustees to recover from initial and intermediate transferees.  Under the Ninth Circuit’s analysis, this section would be redundant if “present possession” was always a requirement for such recovery.  Further, if possession or property was a must for seeking the property’s turnover, merely transferring the property in question would be an easy way to avoid the trustee’s reach.  Finally, the Court considered (but rejected) the analysis behind Eighth Circuit rulings, which designate possession as a pre-requisite to turnover recovery.

    In a nutshell Shapiro v. Henson‘s result means:

    • A party holding “property of the estate” may be liable at any time for its turnover, regardless of whether or not those parties remain in possession of it at the time the turnover motion is filed.
    • The trustee’s ability to seek turnover of estate property is protected in a manner consistent with the trustee’s power to avoid pre- and post-petition transfers – the trustee need not immediately “use” the turnover, or forever “lose” it.
    • Out-of-possession debtors and other custodians may be at risk, essentially through no fault of their own.  It is easy, for example, to imagine facts different than those reviewed in this case, where an innocent debtor or receiver finds a bank account balance reduced by virtue of pre-petition checks negotiated post-petition (or by virtue of post-petition levies) effectively beyond the debtor’s control.  Alternatively, a receiver obligated to surrender estate property despite the provisions of Section 543(d) may find him- or herself liable for post-petition funds disbursed prior to the time that turnover is sought.

    Shapiro v. Henson protects bankruptcy trustees from having to “chase” estate property through multiple transferees.  But it does so at the cost of an added level of risk imposed on those initial holders of estate property who may not have notice of the debtor’s bankruptcy – or may be unable to prevent transfer of the property.

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    An Unexpected Tribute to Émile Zola

    Wednesday, July 10th, 2013
    Portrait of Émile Zola (1848), by Édouard Manet

    Portrait of Émile Zola (1848), by Édouard Manet (Photo credit: Wikipedia)

    “The humorist Douglas Adams was fond of saying, ‘I love deadlines. I love the whooshing sound they make as they fly by.’ But the law more often follows Benjamin Franklin’s stern admonition: ‘You may delay, but time will not.’ To paraphrase Émile Zola, deadlines are often the terrible anvil on which a legal result is forged.”

    With these words, Ninth Circuit Court of Appeals last week declined to retroactively extend Federal Rule of Bankruptcy Procedure 4007(c)’s deadline to file a non-dischargeability complaint.  That deadline permits creditors only 60 days following an individual debtor’s initial meeting of creditors (otherwise known as the debtor’s “section 341(a) meeting”) to file a complaint to have certain types of debt determined non-dischargeable, unless a request for extension of the deadline is filed within the same, initial 60-day period.

    The case before the 3-judge panel involved a creditor who had, in fact, previously obtained an extension to file a non-dischargeability complaint – but who, due to internal word-processing difficulties with conversion to the “Portable Document Format” (*.pdf) format now required for electronic filings with federal bankruptcy courts, missed the extended deadline by less than an hour.

    The brief, 14-page decision (available here) upheld prior rulings in the same matter by both the Bankruptcy Court and the District Court.  It raised, but did not answer, the question of what happens when a missed deadline is due to external problems (e.g., technical difficulties with the Bankruptcy Court’s filing system), rather than problems with counsel’s IT configuration or office procedures.  But it also declined to recognize an “equitable exception” to the rule in the absence of a Supreme Court directive to the contrary:

    We acknowledge that the U.S. Supreme Court has not expressly addressed whether FRBP 4007(c)’s filing deadline admits of any equitable exceptions and that lower courts are divided on the issue. See Kontrick v. Ryan, 540 U.S. 443, 457 & nn.11–12 (2004) (declining to decide question and noting circuit split).  We need not, and do not, reach the question of whether external forces that prevented any filings—such as emergency situations, the loss of the court’s own electronic filing capacity, or the court’s affirmative misleading of a party—would warrant such an exception.  See, e.g., In re Kennerley, 995 F.2d at 147–48; see also Ticknor v. Choice Hotels Intern., Inc., 275 F.3d 1164, 1165 (9th Cir. 2002). . . .  In short, absent unique and exceptional circumstances not present here, we do not inquire into the reason a party failed to file on time in assessing whether she is entitled to an equitable exception from FRBP 4007(c)’s filing deadline; under the plain language of the rules and our controlling precedent, there is no such exception.

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    When a Good Deal . . . Isn’t.

    Monday, July 1st, 2013

    A very recent decision out of California’s Central District Bankruptcy Court highlights the boundaries of “commercial reason” and “diligence” where distressed asset sales are concerned.

    In re 1617 Westcliff, LLC (Case No. 8:12-bk-19326-MW) involved the court-approved sale of the debtor’s real property under a purchase agreement in which the debtor and the purchaser agreed to use their “commercially reasonable and diligent efforts” to obtain the approval of the debtor’s mortgage lender for the assumption of the mortgage debt by the buyer.  If the approval was not obtainable, the buyer had the right to terminate the transaction.  The buyer also had the right to terminate the deal if the assumption required payment of more than a 1% assumption fee.

    As is sometimes the case where due diligence remains while a deal is approved, things didn’t quite work out as planned.  Unfortunately, the bank proved less cooperative than the parties had anticipated.  More importantly, however, the buyer notified the debtor-seller 4 days prior to closing that it would not proceed with the transaction as structured, but might be willing to proceed if the transaction was framed as a tax deferred exchange.

    The debtor was, understandably, somewhat less than receptive to restructuring the deal at the 11th hour.  It insisted that the buyer proceed with the transaction as originally agreed and as approved by the court.  In response, the buyer effectively walked away.  The parties then made competing demands on the escrow company regarding the buyer’s $200,000 deposit, and filed cross-motions with Bankruptcy Judge Mark Wallace to enforce them.

    In a brief, 11-page decision, Judge Wallace found that the buyer’s renunciation of the deal 4 days before closing was a material breach of the buyer’s obligation to use “commercially reasonable and diligent efforts” to obtain assumption consent:

    The Purchase Agreement required [the buyer] to keep working in good faith for an assumption until the close of business on May 10, 2013, not to throw up its hands and to propose – at the eleventh hour – a wholesale restructuring of the purchase transaction in a manner completely foreign to the Purchase Agreement.  On [the date of the proposal] there were still four days left to reach agreement with the Bank, but [the buyer] chose (five months into the deal) to abandon the assumption.  It was not commercially reasonable nor was it diligent for [the buyer] to cease negotiations with the Bank relating to the assumption of the loan under these circumstances.
    Judge Wallace found that due to this breach the debtor was entitled to retain the $200,000 deposit.  He found further that the buyer, by offering to purchase the property in a restructured transaction, had failed to effectively terminate the deal.  Instead, the buyer had indicated that it was “eager to keep the Purchase Agreement in force (on terms other than those agreed to).”  Since the deal had not terminated, the buyer remained under a duty to continue to use reasonable efforts to obtain the bank’s consent.  Its failure to do so caused the loss of its deposit.

    Bill of sale sedan 1927

    Bill of sale sedan 1927 (Photo credit: dlofink)

    The 1617 Westcliff decision (the unpublished slip copy is available here) serves as a reminder to buyer’s counsel of the unique nature of distressed asset purchases.  The Bankruptcy Court which originally approved the purchase remains available and prepared to resolve any issues which may arise prior to closing, often at a fraction of what it would cost to get a Superior Court involved in connection with an unraveled private sale.  And conditions and contingencies to the sale must be carefully drafted and observed.  This applies even to common asset-purchase “boilerplate” such as “commercial reasonableness” and “diligence.”

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    Cherry Picking.

    Friday, June 14th, 2013

    In a 23-page memorandum decision issued yesterday, New York Bankruptcy Judge Stewart Bernstein ruled that the debtor and a third party were parties to a master agreement that allowed the debtor to issue purchase orders that the counter-party was required to fill.  Judge Bernstein held that the debtor could assume the master agreement but could reject individual purchase orders.  The purchase orders were divisible from the master agreement.

    English: Sketch of Richard Mentor Johnson free...

    English: Sketch of Richard Mentor Johnson freeing a man from debtors' prison. Johnson was an advocate of ending the practice of debt imprisonment throughout his political career. (Photo credit: Wikipedia)

    The decision (available here) provides a thorough analysis of when – and under what circumstances – an executory agreement may be “divisible” into separate, individual agreements . . . which can then be selectively assumed or rejected by a debtor or trustee.

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    “Debtquity.”

    Tuesday, June 4th, 2013

    A recently-issued Ninth Circuit decision creates potentially new avenues of recovery for creditors of an insolvent debtor.

    Fitness Holdings International, Inc. (FHI), a home fitness corporation, had received significant funding between 2003 and 2006 from two entities: Hancock Park, its sole shareholder, and Pacific Western Bank.  FHI’s unsecured obligations to Hancock Park, totaling $24 million, were subordinated to $12 million in secured financing by Pacific Western Bank in the form of a $5 million term loan and a $7 million line of credit (all guaranteed by Hancock Park).

    In 2007, after numerous amendments, FHI re-financed its remaining obligations to Pacific Western Bank and to Hancock Park with a new $17 million term loan and an $8 million line of credit.  The payoff of Pacific Western Bank’s prior secured loan had the effect of releasing Hancock Park from its guarantee.  FHI’s efforts to restructure were ultimately not successful, however, and in 2008, the company sought protection under Chapter 11.
    A Committee of Unsecured Creditors in FHI’s case sued Hancock Park, seeking to recover the earlier pay-off of Hancock Park’s debt and alleging that the debt ought, in fact, to be re-characterized as “equity” (and that the “repayment” of the “debt” ought therefore to be avoided as a constructively fraudulent transfer, since FHI allegedly received “less than equivalent value” in exchange for the payments).
    The Committee’s complaint was dismissed; however, FHI’s case was subsequently converted from one under Chapter 11 to one under Chapter 7, and the trustee appealed the dismissal to the US District Court.  The District Court affirmed the dismissal, finding that under longstanding precedent of the Ninth Circuit Bankruptcy Appellate Panel, Hancock Park’s advances to Fitness Holdings were loans and, as a matter of law, it was barred from re-characterizing such loans as equity investments.
    The trustee appealed to the Ninth Circuit, which vacated the District Court’s decision and remanded for further findings.  In doing so, the Ninth Circuit held that in an action to avoid a transfer as constructively fraudulent under § 548(a)(1)(B), if any party claims that the transfer constituted the repayment of a debt (and thus was a transfer for “reasonably equivalent value”), the court must determine whether the purported “debt” constituted a right to payment under state law.  If it did not, the court may re-characterize the debtor’s obligation to the transferee under state law principles.
    The decision is worth noting because:
    Prior case law in the Ninth Circuit held that re-characterization of “debt” as “equity” was impermissible (see In re Pacific Express, 69 B.R. 112 (B.A.P. 9th Cir. 1986)).  This decision overrules that earlier precedent.
    The Ninth Circuit joined the Fifth Circuit (In re Lothian Oil, 650 F.3d 539, 542–43 (5th Cir. 2011)) in holding that state law – and state law alone – controls in determining when, and whether, alleged “debt” ought to be re-characterized as “equity.”
    The 3-judge panel’s ruling suggests that it is “substance” – and not “form” – which ultimately determines whether an obligation is an equity investment (rather than debt) under applicable state law.  The crucial question is “whether that obligation gives the holder of the obligation a ‘right to payment’ under state law.”
    A copy of the decision is attached.
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    A Formula for Confusion

    Monday, January 23rd, 2012
    Inc

    Image by Guudmorning! via Flickr

    Thanks to an active lobby in Congress, commercial landlords have historically enjoyed a number of lease protections under the Bankruptcy Code.  Even so, those same landlords nevertheless face limits on the damages they can assert whenever a tenant elects to reject a commercial lease.

    Section 502(b)(6) limits landlords’ lease rejection claims pursuant to a statutory formula, calculated as “the [non-accelerated] rent reserved by [the] lease . . . for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease . . . .”

    This complicated and somewhat ambiguous language leaves some question as to whether or not the phrase “rent reserved for . . . 15 percent . . . of the remaining term of such lease” is a reference to time or to money:  That is, does the specified 15 percent refer to the “rent reserved?”  Or to the “remaining term?”

    Many courts apply the formula with respect to the “rent reserved.”   See. e.g., In re USinternetworking, Inc., 291 B.R. 378, 380 (Bankr.D.Md.2003) (citing In re Today’s Woman of Florida, Inc., 195 B.R. 506 (Bankr.M.D.Fl.1996); In re Gantos, 176 B.R. 793 (Bankr.W.D.Mich.1995); In re Financial News Network, Inc., 149 B.R. 348 (Bankr.S.D.N.Y.1993); In re Communicall Cent., Inc., 106 B.R. 540 (Bankr.N.D.Ill.1989); In re McLean Enter., Inc., 105 B.R. 928 (Bank.W.D.Mo.1989)).  These courts calculate the amount of rent due over the remaining term of the lease and multiply that amount times 15%.

    Other courts calculate lease rejection damages based on 15% of the “remaining term” of the lease.  See, e.g., In re Iron–Oak Supply Corp., 169 B.R. 414, 419 n. 8 (Bankr.E.D.Cal.1994); In re Allegheny Intern., Inc., 145 B.R. 823 (W.D.Pa.1992); In re PPI Enterprises, Inc., 324 F.3d 197, 207 (3rd Cir.2003).

    For more mathematically-minded readers, the differently-applied formulas appear as follows:

    Rent-Based Formula: Maximum Rejection Damages = (Rent x Remaining Term) x 0.15
       
    Term-Based Formula: Maximum Rejection Damages = Rent x (Remaining Term x 0.15)

    Earlier this month, a Colorado bankruptcy judge, addressing the issue for the first time in that state, sided with those courts who read the statutory 15% in terms of time:

    “In practice, by reading the 15% limitation consistently with the remainder of § 502(b)(6)(A) as a reference to a period of time, any lease with a remaining term of 80 months or less is subject to a cap of one year of rent [i.e.,15% of 80 months equals 12 months] and any lease with a remaining term of 240 months or more will be subject to a cap of three years rent [i.e., 15% of 240 months equals 36 months].  Those in between are capped at the rent due for 15% of the remaining lease term.”

    In re Shane Co., 2012 WL 12700 (Bkrtcy. D.Colo., January 4, 2012).

    The decision also addresses a related question:  To what “rent” should the formula apply – the contractual rent applicable for the term?  Or the unpaid rent remaining after the landlord has mitigated its damages?  Under the statute, “rents reserved” refers to contractual rents, and not to those remaining unpaid after the landlord has found a new tenant or otherwise mitigated.

    Colorado Bankruptcy Judge Tallman’s decision, which cites a number of earlier cases on both sides of the formula, is available here.

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    “Collateral Damage”? Or “Credit to Whom Credit is Due”?

    Monday, December 19th, 2011
    Collateral Damage (film)

    Image via Wikipedia

    Outside of bankruptcy, a creditor whose loan is secured by collateral typically has the right to payment in full when that collateral is sold – or, if the collateral is sold at an auction, to “credit bid” the face amount of the debt against the auction price of the collateral.

    Inside bankruptcy, however, the right to “credit bid” is not always guaranteed.

    In July, this blog predicted Supreme Court review of a Seventh Circuit case addressing the question of whether a bankruptcy court may confirm a plan of reorganization that proposes to sell substantially all of the debtor’s assets without permitting secured creditors to bid with credit.  The courts of appeals are divided two to one over the question, with the Third and Fifth Circuits holding that creditors are not entitled to credit bid and the Seventh Circuit holding to the contrary (for a review of the more recent, Seventh Circuit decision, click here).

    The question is one of great significance for commercial restructuring practice, with several bankruptcy law scholars suggesting the answer “holds billions of dollars in the balance.”

    Apparently, the Supreme Court agrees.  Last week, the justices granted review of the Seventh Circuit decision.  For the petitioners’ brief, respondent’s opposition, and amicus briefs, click here.

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    A Chip Too Far

    Thursday, December 15th, 2011
    Chip

    Image via Wikipedia

    Nearly 16 months ago, this blog covered the story of Qimonda AG – a German chip manufacturer whose cross-border liquidation created waves on both sides of the Atlantic.  As noted in that prior post, Qimonda’s insolvency proceeding illustrates what can happen when one country’s rules governing the treatment of an insolvent firm’s intellectual property assets collide with those of another.

    But what can happen is not always what does happen.

    As a liquidating entity, Qimonda’s primary assets were its portfolio of patents, licensed to other firms under a series of cross-licensing agreements.  Though not completely settled law in Germany, patent cross-licenses are widely viewed by German practitioners as executory agreements.  Such agreements are automatically unenforceable unless the insolvency administrator (the functional equivalent of a trustee under US bankruptcy law) affirmatively elects to perform the contracts.  In practice, to avoid any implied election of performance, an insolvency administrator will usually send a letter of non-performance to the counter-party.  Consistent with this practice, Qimonda’s administrator had issued non-performance letters to a number of licensees in connection with his proposed disposition with Qimonda’s patents, which were the company’s most valuable remaining asset following a decision to liquidate.  The business strategy was to maximize the value of Qimonda’s patents by canceling, then re-negotiating, the company’s patent licenses with Qimonda’s original licensees.

    In response, the licensees asserted rights with respect to Qimonda’s US patents under Bankruptcy Code section 365(n), which – contrary to German law – specifically protects the rights of patent licensees in the event of a licensor’s bankruptcy.  Qimonda’s recognition under Chapter 15 of the Bankruptcy Code had made Section 365 “applicable” to the company’s ancillary proceedings in the US.

    Qimonda’s administrator sought the Bankruptcy Court’s elimination or restriction of Section 365′s applicability to the company’s US patents, in light of his proposed disposition of the patents under conflicting German insolvency law.  The Bankruptcy Court restricted 365(n)’s applicability, but the District Court remanded on appeal for a determination of whether doing so was “manifestly contrary to the public policy of the United States” and whether the licensees would be “sufficiently protected” if Section 365(n) did not apply.

    After four days of evidentiary hearings and one day of argument, the Bankruptcy Court concluded that:

    - Chapter 15 of the US Bankruptcy Code, which is rooted in considerations of comity and deference to the decisions of foreign tribunals, is nevertheless limited by the “sufficient[] protect[ion] of creditors’ interests.”  Moreover, any relief requested by a foreign representative seeking recognition and relief in the US under this statute is further limited when granting such relief “would be manifestly contrary to the public policy of the United States.”

    - The protections afforded patent licensees by Section 365(n) have their origins in Congressional reaction to the Fourth Circuit’s decision in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985), a decision involving the debtor’s rejection of a fully paid-up license to a non-bankrupt licensee for use of the debtor’s metal coating technology.  Most disturbingly for Congress, the Lubrizol court found that rejection under Section 365(a) effectively prohibited the licensee’s continued receipt of specific performance under the agreement, even if that remedy would otherwise be available under a  breach of this type of contract.  Congress’ answer to the Lubrizol decision was to pass the “Intellectual Property Licenses Act of 1987,” which included the licensee protections of Section 365(n).  According to the Congressional history behind the statute, adoption of the legislation was intended to “immediately remove [the threat of license rejection] and its attendant threat to American [t]echnology and will further clarify that Congress never intended for Section 365 to be so applied.”

    - Though the nature of patent cross-licensing made it difficult – if not impossible – for the parties to establish whether the cancellation of licenses for specific patents would put at risk the licensees’ investment in manufacturing or sales facilities in the US for products covered by US patents, the administrator’s threat of infringement litigation following cancellation of Qimonda’s patent licenses was as damaging to licensees as an actual finding of infringement of specific patents.  This risk, balanced against the loss in value to Qimonda’s patent portfolio, warranted the application of Section 365(n) to the administrators disposition of the company’s US patents.

    - Application of the German insolvency law as an exercise of comity would “severely impinge[] . . . a U.S. statutory . . . right such that deferring to German law would defeat ‘the most fundamental policies and purposes’ of such right[].’”  For the Bankruptcy Court, the question of whether or not Section 365(n) was intended to protect a “fundamental” US policy was an extremely close one.  But “[a]lthough [technological] innovation [in the US] would obviously not come to a grinding halt if licenses to U.S. patents could e cancelled in a foreign insolvency proceeding, . . . the resulting uncertainty would nevertheless slow the pace of innovation, to the detriment of the U.S. economy.”  As a result, the failure to apply Section 365(n) to Qimonda’s US patent portfolio “would ‘severely impinge’ an important statutory protection accorded licensees of U.S. patents and thereby undermine a fundamental U.S. public policy promoting technological innovation” – and as such, deferring to German law would be “manifestly contrary to U.S. public policy.”

    The Bankruptcy Court’s most recent decision is available here.

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    Stern v. Marshall – What a Long, Strange Trip It’s Been

    Saturday, June 25th, 2011

    On Thursday, the US Supreme Court released its second decision in the long-runing battle between the estate of Vickie Lynn Marshall (aka Anna Nicole Smith) and her erstwhile son-in-law, Pierce Marshall.

    American actreess Anna Nicole Smith in the red...

    Image via Wikipedia

     

    The 63-page slip opinion, available here, illustrates how the result of a high-profile celebrity bankruptcy can ultimately turn on arcane, esoteric matters of jurisdiction – and how such esoterica can be potentially ground-shifting for the US Bankruptcy Court system which has been in effect since its first constitutional challenge in 1984.

    A small portion of the already considerable commentary evolving in conventional media and in the blogosphere appears below.

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    Flushed Away

    Sunday, June 12th, 2011

    Personal liability for corporate debt has been all the rage in the Ninth Circuit.  Within the last year, at least two appellate decisions (discussed here and here) have clarified the doctrine of alter ego liability – the idea that a corporate entity and its principals ought to be treated as one and the same, and therefore equally liable for corporate obligations.

    It is easy to see why interest in alter ego liability has become so fashionable: When a business slips into insolvency and cannot pay its creditors in full, those creditors naturally go looking for other pockets from which to satisfy their claims.

    Cover of

    Cover of Flushed Away (Widescreen Edition)

     

    If creditors can show that the business’ officers effectively ran the business for personal economic purposes rather than as a separate and distinct corporate entity, the doctrine of alter ego permits creditors to hold the officers responsible for the business’ obligations.  This is especially the case where it appears the officers used the business to perpetrate a fraud or some other inequity on creditors.  One California court noted that “[t]he general purpose of the doctrine of alter ego is to look through the fiction of the corporation and to hold the individuals doing business in the name of the corporation liable for its debts in those cases where it should be so held in order to avoid fraud or injustice.”

    Earlier this year, Judge Clarkson of California’s Central District followed this fashion trend by offering his view on a non-dischargeability claim based on alter ego liability.

    The facts of In re Munson are relatively straightforward.  Robert and Kimberly Munson were the owners – and corporate officers – of Munson Plumbing, Inc. (“MPI”), a plumbing subcontractor on several public works projects in the Los Angeles metropolitan area.  As is typically required of public works contractors, MPI’s work was backed by surety bonds issued by SureTec Insurance Company (“SureTec”).  As part of the consideration for the issuance of the surety bonds, the Munsons and MPI signed a General Agreement of Indemnity (“SureTec Indemnity Agreement”), in which the Munsons agreed to jointly and severally indemnify SureTec and to deposit collateral with SureTec upon its demand.  The SureTec Indemnity Agreement contained language that all project funds received by MPI would be held in trust for the benefit of SureTec.

    Eventually, MPI encountered financial difficulties and could not pay its own subcontractors – thereby requiring SureTec to make payments under the bonds and finish MPI’s work.

    Concurrent with MPI’s demise, the Munsons commenced individual Chapter 7 proceedings.  SureTec, which had been left with over $436,000 in losses related to various MPI projects, asserted claims against the Munsons individually.  It also sought to have at least a portion of those losses deemed non-dischargeable in the Munsons’ Chapter 7 case.  Specifically, it claimed:

    - The SureTec Indemnity Agreement created an express trust which placed fiduciary duties upon the Munsons.

    - Further, because the Munsons had allegedly defrauded SureTec by diverting at least $95,000 in progress payments on the projects to non-bonded expenses, including their own personal expenses, applicable fiduciary duties upon the Munsons arose by California statutes (including Business & Professions Code §7108 and Penal Code §§§ 484b, 484c and 506.)

    - The Munsons were alter egos of MPI, and therefore were liable for MPI’s obligations under the surety bonds.

    - The Munsons’ obligations were non-dischargeable because they arose as a result of the Munsons’ breach of their fiduciary duties.

    The Debtors sought dismissal of SureTec’s lawsuit.  In a brief, 9-page decision, Judge Clarkson found that:

    -  The SureTec Indemnity Agreement did not impose fiduciary duties upon the Munsons.  “If a trust was created, it imposed the fiduciary duty obligations on the corporation, the receiver and disburser of the project funds. The [Munsons,] [in] signing the [SureTec Indemnity Agreement] were creating only a creditor-debtor relationship (and a contingent one at that) between SureTec and the [Munsons]. They were “indemnifying” SureTec, as SureTec accurately indicates  . . . .”

    - Any alleged trust relationship created on a constructive, resulting, or implied basis (i.e., arising legally as a result of the Munsons’ allegedly bad acts) is not the sort of trust relationship which gives rise to a non-dischargeable debt.  “The core requirements [for asserting non-dischargeability based on breach of a fiduciary duty] are that the [fiduciary] relationship exhibit characteristics of the traditional trust relationship, and that the fiduciary duties be created before the act of wrongdoing and not as a result of the act of wrongdoing.”

    - SureTec’s allegations of alter ego liability were likewise insufficient to tag the Munsons with the sort of fiduciary obligations that would give rise to a non-dischargeable claim.  “If a finding of alter ego were to be considered as imposing fiduciary duties, any such imposition would be ex maleficio, i.e., trusts that arose by operation of law upon a wrongful act.”

    Judge Clarkson also found that SureTec’s separate non-dischargeability claim for fraud had not been pleaded with the requisite particularity, and dismissed it with leave to amend.

    The Munson decision is important in several respects:

    - It emphasizes the relatively narrow scope of non-dischargeability claims based on breaches of fiduciary duty in the Ninth Circuit.

    - It also emphasizes the similarly narrow scope of liability derived from alter ego status.

    - It highlights the importance of the alter ego doctrine as a strategic tool for both creditors and trustees in bankruptcy litigation – as well as litigants’ varying success in using it.  As detailed in other posts, alter ego liability has been employed (i) unsuccessfully as a “blocking device” in an attempt to capture recoveries for the corporation’s bankruptcy estate; and (ii) successfully to preserve recoveries from self-settled trusts to which the debtors attempted to convey assets out of the reach of creditors.  Here, alter ego was employed (again, without success) to “bootstrap” a creditor’s claim into “non-dischargeable” status.

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