Today, President Biden signed into law the Bankruptcy Threshold Adjustment and Technical Corrections Act, S. 3823, 117th Cong. (the “Act”), which, among other things, continues the temporary expansion of subchapter V eligibility.  Section 1182(i)(B)(1) of the Bankruptcy Code originally limited the term “debtor,” for subchapter V purposes, to a person engaged in commercial or business activities with aggregate noncontingent, liquidated debts not exceeding $2,725,625.  The Act extends the temporary increase of the debt limit to $7.5 million that was first enacted at the outset of the COVID-19 pandemic.  The new extension lasts for a two-year period from the Act’s enactment, and also applies retroactively to cases filed on or after March 27, 2022.

The Act represents another patch in ongoing efforts to permanently increase subchapter V eligibility that started shortly after the Small Business Reorganization Act (the “SBRA”) introduced subchapter V of the Bankruptcy Code in February 2020.  As we have discussed in our previous post on the subject, the SBRA’s original $2,725,625 debt limit was first increased to $7.5 million on March 27, 2020 with the enactment of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act).  This original expansion of subchapter V eligibility was only intended to last for one year—to March 27, 2021—but was extended another year by the COVID-19 Bankruptcy Relief Extension Act.  The Act now further extends the temporary increase by two years from enactment and provides for the retroactive debt limit increase necessary to cover the gap between the March 27, 2022 sunset of the COVID-19 Bankruptcy Relief Extension Act and the enactment of the Act.

The further extension under the Act—while not permanent—will grant a broader swath of small business debtors renewed access to the streamlined provisions of subchapter V.  In his comments in support of the legislation, Representative Cliff Bentz (R-OR) observed that “[a]n additional 2 years of normal post-pandemic bankruptcy activity will give us a better understanding of the underlying policy issues and will help guide the future design of our bankruptcy system.”  We will have to wait until the sunset of the provisions of the Act approach to see whether the legislature will consider either a further or permanent expansion of the eligibility criteria. 

By:   Keith C. Owens

While it is becoming increasingly rare for the Supreme Court to speak with a singular voice on virtually anything these days, bankruptcy provides a rare exception.

On June 6, 2022, the Supreme Court unanimously held in Siegel v. Fitzgerald, 596 U.S. ___ , 2022 WL 1914098 (Jun. 6, 2022), that Congress’s enactment of a temporary increase in the fee rates applicable to large Chapter 11 cases in 2017 to address a shortfall in the United States Trustee System Fund (Pub. L. 115-72, Div. B, 131 Stat. 1229) (the “2017 Act”), violated the uniformity requirement of the Bankruptcy Clause set forth in Article I, § 7, cl. 4 of the United States Constitution, which empowers Congress to establish “uniform Laws on the subject of Bankruptcies throughout the United States.”   This decision affects United States Trustee quarterly fees paid by Chapter 11 debtors between January 1, 2018 and January 1, 2021, and opens the door to refund actions across the country, potentially resulting in the evaporation of millions of dollars from the coffers of the Office of the United States Trustee (the “U.S. Trustee”).  

The United States Trustee Program

A little background.  In 1978, Congress piloted the United States Trustee Program in 17 of the 94 federal judicial districts.  Siegel, 596 U.S. ___, 2022 WL 1914098, at *3 (citing Bankruptcy Reform Act of 1979, 92 Stat. 2549).  The purpose of the pilot program was to relieve bankruptcy judges from overseeing the growing administrative tasks by delegating such tasks to newly-created United States Trustees administered by the Department of Justice.  Id.  Congress made the U.S. Trustee Program permanent in 1986 by expanding the program to virtually all federal judicial districts.  However, due to resistance from stakeholders in North Carolina and Alabama, Congress permitted six judicial districts in those states to continue judicial appointment of bankruptcy administrators.  Id. (citations omitted).  Ultimately, these districts were preeminently exempted from the Trustee Program unless they elected to participate.  Id.

Creation of the UST Fund

A unique feature of the U.S. Trustee Program is that the UST Fund is entirely funded by user fees, the bulk of which are paid by Chapter 11 debtors, based on quarterly disbursements to creditors from the bankruptcy estate.  Id. at *4 (citing 28 U.S.C. § 1930(a)). 

Due to a shortfall in the UST Fund, “Congress enacted a temporary, but significant, increase in the fee rates applicable to large Chapter 11 cases.” Id. (citing 2017 Act).  The 2017 Act increased quarterly fees for disbursements of $1 million or more during any one quarter from a maximum of $30,000 to $250,000, “regardless of whether the debtor’s case was newly filed or already pending when the increase too effect.” Id. In contrast to the U.S. Trustee Program which applied to all pending and newly filed cases, the “Administrator Program” administered in six districts in North Carolina and Alabama applied the fee increase only to newly filed cases. In 2021, Congress amended Section 1930(a)(7) to require the “imposition of fees in Administrator Program districts that are equal to those imposed in Trustee Program Districts.” Id. at * 5 (citing 28 U.S.C. § 1930(a)(7)).

The Circuit City Chapter 11 and Post-Confirmation U.S. Trustee Fee Increase

The constitutionality of the UST fee hike was called into question after the one-time electronics store behemoth, Circuit City, confirmed its Chapter 11 liquidating plan.  In 2008, Circuit City Stores, Inc. filed Chapter 11 bankruptcy in the Eastern District of Virgina, and confirmed its Chapter 11 liquidating plan in 2010.  Like all liquidating plans, the Circuit City plan required the liquidating trustee to pay U.S. Trustee fees until the bankruptcy cases were closed or converted.  At the time the plan was confirmed, the maximum quarterly fee was $30,000.  Id.  However, after the fee increase took effect under the 2017 Act, the liquidating trust paid nearly $600,000 in increased UST fees than it would have had to pay had the fee increase taken effect prospectively for cases filed after January 1, 2018.  Id. at *5.

The liquidating trustee objected to the fee increase under the 2017 Act, asserting that it violated the Bankruptcy Clause of the U.S. Constitution because the fee increase was non-uniform across the Trustee Program districts and the Administrator Program districts.  The Bankruptcy Court sustained the objection, and directed the liquidating trustee to pay the rate in effect prior to the effective date of the 2017 Act, reversing the question of whether the trustee could recover any overpayments made under the 2017 Act.  The Fourth Circuit reversed, concluding that while it agreed that the uniformity requirement of the Bankruptcy Clause applied to the 2017 Act, the Clause only forbid “’arbitrary’ geographic differences.”  Id. (quoting In re Circuit City Stores, 996 F.3d 156, 166 (4th Cir. 2021)). 

Circuit Split Regarding Constitutionality of 2017 Act

A divided panel of the Fourth Circuit concluded that the “fee increase permissibly applied only to Trustee Program districts because the UST Fund, which funded that program alone, was dwindling.” Thus, “Congress’ effort to remedy that problem was not arbitrary.”  Id.  The Fourth Circuit’s decision was consistent with the Fifth and Eleventh Circuits, which found the fee hike did not violate the U.S. Constitution. See, e.g.., United States Tr. Region 21 v. Bast Amron LLP (In re Mosaic Mgmt. Grp.), 22 F.4th 1291, 1327 (11th Cir. 2022); In re Buffets, LLC, 979 F.3d 366 (5th Cir. 2020).  The Fourth Circuit’sdecision further highlighted a circuit split with the Second and Tenth Circuits holding that the 2017 Act violated the Constitutional uniformity requirement.  See, e.g. In re Clinton Nurseries, Inc., 998 F.3d 56 (2d Cir. 2021); In re John Q. Hammons Fall 2006, LLC, 15 F.4th 1011, 1016 (10th Cir. 2021). 

Supreme Court Strikes Down 2017 Act as Violating the Bankruptcy Clause of the U.S. Constitution

The Supreme Court granted certiorari to resolve the circuit split.  See Siegel v. Fitzgerald, No. 21-441 (U.S. 2021).  Justice Sotomayor, writing an opinion for a unanimous Court, held that the different fee systems applicable to the Trustee Program Districts and the Administrative Program Districts, was unconstitutional.  The Court rejected the U.S. Trustee’s arguments that (1) the uniformity requirement of the Bankruptcy Clause did not apply because the statute in question was an “administrative law” rather than a “substantive law”, and (2) even if the Bankruptcy Clause applied, the Bankruptcy Clause only prohibited arbitrary differences and not all dis-uniform bankruptcy laws based on geographical differences.  Specifically, the Court held that the 2017 Act fell within the Bankruptcy Clause’s uniformity requirement. 

The Court analyzed three prior cases interpreting the Bankruptcy Clause to come to this conclusion.  In Hanover Nat. Bank v. Moyses, 186 U.S. 181, 187, 22 S.Ct. 857, 46 L.Ed. 1113 (1902), the Court held that it was not a violation of uniformity to have state exemption laws incorporated into Bankruptcy Code.  Id. at *7.  The Court noted “that the ‘general operation of the law is uniform although it may result in certain particulars differently in different States.’” Id. (quoting Moyses, 186 U.S. 190). In the Regional Real Reorganization Act Cases, 419 U.S. 102 (1974), the Court held that the Regional Rail Reorganization Act of 1973, which only applied to rail carriers operating within a defined region of the country, did not violate uniformity because the Act “”’operate[d] uniformly upon all bankrupt railroads then operating in the United States’ . . . .”  Id. (alteration in original).  The Court noted that the Bankruptcy Clause is inherently flexible, and that “Congress may enact geographically limited bankruptcy laws consistent with the uniformity requirement if it is responding to a geographically limited problem.”  Id.  Finally, the Court relied on Railway Labor Executives’ Assn. v. Gibbons, 455 U.S. 457, 468–469, 102 S.Ct. 1169, 71 L.Ed.2d 335 (1982), which rejected the contention that Congress could “enact nonuniform bankruptcy laws pursuant to the Commerce Clause,” because doing so “would eradicate from the Constitution a limitation on the power of Congress to enact bankruptcy laws.”  In Gibbons, the Court struck down the Rock Island Railroad Transition and Employee Assistance Act which altered the priority scheme in a single railroad’s bankruptcy proceedings.  Id. at *8. The Court held that “’[t]o survive scrutiny under the Bankruptcy Clause, a law must at least apply to a defined class of debtors.’”  Id. (quoting Gibbons, at 473).

After analyzing the foregoing precedent, the Supreme Court concluded that “[n]othing in the language of the Bankruptcy Clause itself . . . suggests a distinction between substantive and administrative laws . . . .”  Indeed, the Supreme Court noted that it had never distinguished between substantive and administrative bankruptcy laws.  Next, the Supreme Court found the 2017 Act violated the uniformity requirement.  The Court noted that the Bankruptcy Clause “does not deny Congress power to take into account differences that exist between different parts of the country, and to fashion legislation to resolve geographically isolated problems.”  Id. (quoting Regional Rail Reorganization Act Cases, 419 U.S. at 159. Indeed, “Congress may enact geographically limited bankruptcy laws consistent with the uniformity requirement if it is responding to a geographically limited problem.” Id. at *7.  However, there are limits. While “the Bankruptcy Clause offers Congress flexibility, [it] “does not permit the arbitrary, disparate treatment of similarly situated debtors based on geography.” Id. at *8. 

In Siegel, the Court concluded that while “Congress’ stated goal in raising fees in Trustee Program districts was to address this budgetary shortfall . . .[,] [t]hat shortfall . . . existed only because Congress itself had arbitrarily separated the districts into two different systems with different cost funding mechanisms . . . .”  Id. 

Significance of Siegel

Siegel is notable for a variety of reasons. Setting aside the Constitutional implications, this decision will undoubtedly have an impact on the coffers of the Trustee Program.  The 2017 Act was intended to remedy the budget shortfall by making large Chapter 11 debtors fund the Trustee Program.  However, debtors are certain to move to recoup fees paid into the Trustee Program under the 2017 Act now that the Supreme Court has ruled that the Act is unconstitutional.  Indeed, the Court did not decide the appropriate remedy for affected debtors.  In Siegel, the liquidating trustee sought a full refund of fees paid during the nonuniform period while the U.S. Government argued that any remedy should apply prospectively “or should result in a fee increase for debtors who paid less in the Administrator Program districts.”  Id. at *9.  Rather than address the “practicality, feasibility, and equities of each proposal; their costs; and potential waivers by nonobjecting debtors . . .”, the Court remanded the case for further proceedings, noting that the Bankruptcy Court “has not yet had an opportunity to address these issues or their relevancy to the proper remedy.”  Id.  Indeed, the Court did not opine on the vitality or rationale of the holdings in the Second and Tenth Circuits, which ordered refunds for overpayment of excess fees imposed under the 2017 Act.  See In re John Q. Hammons Fall 2006, LLC, 15 F.4th at 1026; In re Clinton Nurseries, Inc., 998 F.3d at 70. Therefore, these decisions are still good law in these circuits.

 In light of the Court’s ruling, it is certain that bankruptcy courts across the country will be asked to determine the appropriate remedy for debtors who have paid unconstitutionally excessive fees under the 2017 Act.  While the potential dollar amounts at issue are large, the decision will likely impact only a small percentage of Chapter 11 cases pending during this narrow window under the 2017 Act.  As a practical matter, many of those cases will likely have been impacted for only one quarter due to sales that may have resulted in distributions of more than $1 million. 

Similarly, the Supreme Court expressly declined to rule on the “potential waivers by nonobjecting debtors.”  Siegel, 596 U.S. ____; 2002 WL 1914098, at *9.  If a debtor paid and did not timely object to the fee increases imposed under the 2017 Act, bankruptcy courts may conclude that such objections have been waived.  Assuming that those waivers are enforceable, the fiscal impact on the Trustee Program may be less catastrophic than one might imagine.  On the other hand, if such waivers are found to be unenforceable, the Trustee Program may have a funding shortfall, and it is unclear whether such a shortfall could impact excess funds that might otherwise flow to Chapter 7 trustees.

On a wider scale, the Siegel decision might be interpreted liberally to cast doubt on the validity of Congress’s implementation of a dual program for administering bankruptcy cases in different parts of the country, which may prompt further litigation. To be clear, the Court took pains to state in no uncertain terms that the decision is intended to be narrow in effect, holding only “that the uniformity requirement of the Bankruptcy Clause prohibits Congress from arbitrarily burdening only one set of debtors with a more onerous funding mechanism than that which applies to debtors in other States.”  Id. As the Court noted, the Court “does not today address the constitutionality of the dual scheme of the bankruptcy system itself, only Congress’ decision to impose different fee arrangements in those two systems. The Court’s holding today also should not be understood to impair Congress’ authority to structure relief differently for different classes of debtors or to respond to geographically isolated problems.”  Id.

Setting aside the impact of orders requiring the Trustee Program to potentially disgorge hundreds of millions of dollars in the aggregate, it is not difficult to imagine challenges to the constitutionality of the dual programs themselves. Indeed, prior to the Court’s ruling in Siegel, certain debtors filed a class action complaint requesting such relief in the United States Court of Federal Claims. See Acandiana Mgm’t Group, LLC, et al. v. United States, Case No. 1:10-cv—00496-PEC (Apr. 3, 2019), which case is currently on appeal before the United Stated Court of Appeals for the Federal Circuit, Case No. 21-1941 (Fed. Cir. May 11, 2021).  Oral argument was stayed pending the outcome of the Supreme Court’s ruling in Siegel.

In addition to greenlighting litigation to recoup excessive fees paid under the 2017 Act, the Court’s rationale in Siegel may open up additional constitutional challenges to the dual scheme itself.  For example, while the Office of the United States Trustee has the right to appoint official committees and administrators in Trustee Program Districts, bankruptcy judges have the power to do so in Administrative Program Districts. Are the disparate powers of bankruptcy judges in Trustee Program Districts and Administrative Program Districts simply a question of “administrative law” or do they raise a fundamental question regarding the uniformity of federal “bankruptcy law,” and does this distinction matter given the Supreme Court’s admonition that “[n]othing in the language of the Bankruptcy Clause itself . . . suggests a distinction between substantive and administrative laws”? Might professionals challenge the legitimacy of the Trustee Program itself when confronted with an objection to a fee application?

Similarly, the “Tax and Spending Clause” set forth in Article I, Section 8, Clause 1 of the U.S. Constitution, like the Bankruptcy Clause, requires uniformity.  It is certainly foreseeable that similar challenges could be made to the extent that Congress enacts dual systems that undermine uniformity. 

And what about the effect of legislation like the Puerto Rico Oversight, Management and Economic Stability Act (“PROMESA”), which was enacted in 2016 to make bankruptcy available to Puerto Rico – a U.S. territory – even though Puerto Rico was excluded from the U.S. Bankruptcy Code?  The Supreme Court concluded in a unanimous decision written by Justice Breyer, that the appointment of the members of the Financial Oversight and Management Board, which served as the debtors’ statutory representative under PROMESA, was constitutional because the selection of the board’s members was “not subject to the constraints of the Appointments Clause” set forth in U.S. Const. art. 2, § 2, cl. 2; U.S. Const. art. 4, § 3, cl. 2.  See Financial Oversight & Mgm’t Bd. For Puerto Rico v. Aurelius Invs., LLC, 140 S.Ct. 1649, 1663 (U.S. Jun. 1, 2020).  To be clear, this decision does not address whether such a statutory scheme falls within the ambit of the Bankruptcy Clause’s uniformity requirement, and any future challenges may be moot in any event. As discussed above, the Supreme Court in Gibbons, supra, rejected Congress’ attempt to “enact nonuniform bankruptcy laws pursuant to the Commerce Clause,” because doing so “would eradicate from the Constitution a limitation on the power of Congress to enact bankruptcy laws.” 

The Court’s focus on the arbitrariness of the 2017 Act is potentially instructive as it suggests that nonuniform bankruptcy legislation may be permissible so long as it is not based on the Commerce Clause or other pretext to circumvent the Bankruptcy Clause, and is not otherwise arbitrary. As the Court noted, “our precedent provides that the Bankruptcy Clause offers Congress flexibility, but does not permit the arbitrary, disparate treatment of similarly situated debtors based on geography.” Siegel, 596 U.S. ____; 2022 WL 1914098, at *8.  Of course, the question of what is arbitrary and what is not is left undefined.

In the meantime, in light of Siegel, creative bankruptcy lawyers will undoubtedly look for ways to advocate for their clients both for and against the dual bankruptcy programs.

By: Zach Williams, Associate, Fox Rothschild LLP (Las Vegas, NV)

 

On April 5, 2022, the Ninth Circuit Bankruptcy Appellate Panel (the “BAP”) published an opinion, Censo, LLC v. Newrez, LLC, BAP No. NV-21-1125-LTF (Apr. 5, 2022), which provides a framework for addressing whether a non-bankruptcy court’s postpetition order on a pending matter violates the automatic stay.

In Censo, the former owner of a mortgaged condominium unit (the “Property”) defaulted on his homeowner’s association (“HOA”) assessments, and the HOA foreclosed on the Property. A predecessor entity to the debtor purchased the Property from the 2013 foreclosure proceedings, subject to the mortgage, and transferred the Property to the debtor entity in 2019.

In 2014, the foreclosed former owner sued the purchaser, HOA, mortgagee, and various other entities in federal district court, seeking a declaration that the foreclosure was invalid because of certain alleged defects in the mortgage. Various claims and counterclaims were filed by the purchaser, arguing that the HOA’s foreclosure effectively extinguished the mortgage.

Ultimately, the mortgagee filed a motion for summary judgement, seeking declaratory relief that the purchaser bought the Property subject to the mortgage. The purchaser turned debtor subsequently filed a chapter 11 petition. Neither the debtor nor the mortgagee filed a notice of automatic stay notifying the district court of the bankruptcy case. Shortly thereafter, the district court entered an order granting the motion for summary judgment and declaring that the debtor took the Property subject to the mortgage.

In the bankruptcy proceeding, the debtor filed an adversary complaint against the mortgagee, again arguing that the mortgage was defective due to, among other things, an incorrect description of the Property. The mortgagee filed a motion to dismiss the adversary complaint, which was granted by the bankruptcy court primarily based on issue preclusion as a result of the district court’s postpetition ruling on the summary judgment motion.

The debtor appealed, and ultimately only raised the issue of whether the district court’s postpetition order was a violation of the automatic stay.

The BAP analyzed each applicable subsection of Section 362(a) of the Bankruptcy Code, beginning with Section 362(a)(1), of which he noted that the plain language of the provision indicated that the automatic stay applied only to actions against the debtor. Accordingly, the BAP described the distinction between “offensive” and “defensive” creditor claims as follows:

The cases holding that a creditor’s defense of claims brought by a debtor do not violate the automatic stay typically involve facially defensive actions such as moving for summary judgment requesting dismissal of a complaint filed by a debtor. On the other hand, the commencement or continuation of a creditor’s counterclaim for affirmative relief will generally be construed as a stay violation. Id. (citations omitted).

Ultimately, the BAP determined that the debtor initiated the fight against the mortgagee by attempting to invalidate the mortgage, and that the mortgagee was merely “defending its lien against [the debtor’s’] attack.”

The BAP then analyzed Section 362(a)(3), which prohibits any act to take possession or exercise control over property of the estate. The BAP, citing the Supreme Court’s decision in City of Chicago v. Fulton, reasoned that “acts that simply maintain the status quo do not violate the automatic stay.”

Accordingly, because the mortgage existed as of the petition date, the district court order was held to have “simply affirmed the validity of the existing lien” and did not affect possession or control of the property of the debtor’s estate.

Finally, in addressing Sections 362(a)(4) and (a)(5), the BAP emphasized that “not every post-petition act or omission that could conceivably affect property of the debtor or the estate is a stay violation.” For this unfortunate debtor, no violations of Sections 362(a)(4) or (a)(5) were found because the district court’s order did not try to create, perfect, or enforce a lien against property of the estate.

The BAP upheld the bankruptcy court’s decision to dismiss the adversary complaint and provided the framework for determining whether a non-bankruptcy court’s postpetition order should be considered a violation of the automatic stay.

Going forward, the framework outlined by the BAP in the Censo decision may empower non-bankruptcy courts to enter postpetition orders on defensive creditor claims that may have been previously considered violations of the automatic stay. However, on April 27, 2022, Censo filed a notice of appeal to the Ninth Circuit.  It remains to be seen if the Ninth Circuit will adopt the framework set forth by the BAP, or apply another standard. Should the Ninth Circuit adopt the framework, courts in the Ninth Circuit should cautiously and carefully distinguish between offensive and defensive creditor claims to ensure proper enforcement of the automatic stay.

On March 14, 2022, Senator Chuck Grassley (R-IA) introduced proposed legislation that—if enacted—would make permanent the $7.5 million debt limit applicable to debtors under subchapter V of chapter 11 of the Bankruptcy Code that has enjoyed only temporary status under the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) for the prior two years.  Of course, as bankruptcy practitioners may expect, the Bankruptcy Threshold Adjustment and Technical Corrections Act, S. 3823, 117th Cong. (as introduced to the S. Comm. on the Judiciary, Mar. 14, 2022) (the “Act”) substantially and permanently expands the scope of Subchapter V relief through an inconspicuous cross-reference to previously enacted legislation (the progeny of which is discussed below).  Despite the Act’s humble language, the proposed change promises a wider swath of small businesses and business owners a faster and more affordable pathway to reorganization in bankruptcy.

On February 19, 2020, the Small Business Reorganization Act (the “SBRA”) became effective.  The brainchild of the American Bankruptcy Institute’s (the “ABI”) Commission to Study the Reform of Chapter 11, the SBRA established subchapter V of the Bankruptcy Code to address the increasingly prohibitive time and cost reorganizations posed to “Main Street” mom and pop businesses.  However, to ensure only small businesses and business operators accessed the truncated procedures of subchapter V, Section 1182(i)(B)(1) of the Bankruptcy Code limited the term “debtor” for subchapter V purposes to a person engaged in commercial or business activities with aggregate debts not exceeding $2,725,625.

And then—as with any contemporary story—came the COVID chapter.  The CARES Act, which was signed into law by President Trump on March 27, 2020, offered sweeping legislative responses to the predicted economic toll the coronavirus pandemic would wreak upon the United States economy.  In connection with this focus, the CARES Act provided for a temporary increase in the subchapter V debt limit from $2,725,625 to $7.5 million.  The CARES Act debt limit increase was scheduled to sunset one year later, on March 27, 2021, but was extended to March 27, 2022 by the COVID-19 Bankruptcy Relief Extension Act.

The Act simply refers to the Section 1113(a)(5) of the CARES Act—the sunset provision—and provides simply that it “is amended by striking paragraph (5).”  However, this simple legislative modification would nearly triple the debt limit permanently.  In a press release, the ABI “applauded” the Act for increasing the debt limit and noted that, since the enactment of the SBRA, “more than 3,000 debtors have elected to file under subchapter V of chapter 11.”  The Act likewise has found bipartisan support—having been introduced with co-sponsorship from Sen. Richard J. Durbin (D-IL), Sen. Sheldon Whitehouse (D-RI), and Sen. John Coryn (R.-TX).

Yet, the timing could have been better.  As of the date of this post, the debt limit has reverted to its original limits under the SBRA due to the sunset provisions in the CARES Act and COVID-19 Bankruptcy Relief Extension Act.  As the Act winds its way through Congress, the subchapter V practitioners and potential debtors affected by the debt limit reduction will need to watch with bated breath for a permanent solution.  Until then, small business debtors whose debt exceeds the $2,725,625 debt limit but is less than the $7.5 million under the Act have a difficult decision to make: whether to wait until the Act passes and is signed into law before commencing a case under subchapter V, or commencing a case under chapter 11 and then seek to convert the case to subchapter V after the Act passes or dismiss the case and refile under subchapter V.  This post will be updated if and when the Act is passed by the Senate and signed into law.

The City of Chicago impounded vehicles for nonpayment of fines.  When the owners filed chapter 13 cases and requested that the city return their vehicles, the city refused. The bankruptcy court held that the city’s refusal violated § 362(a)(3) because it had acted to “exercise control over” the debtors’ vehicles.  The Supreme Court reversed. City of Chicago v. Fulton, 141 S. Ct. 585 (2021).

The Court held that merely retaining possession of estate property does not violate the automatic stay.  Section 362(a)(3) prohibits affirmative acts that would disturb the status quo of estate property as of the time when the bankruptcy petition was filed.  In Stuart v. City of Scottsdale (In re Stuart), 632 B.R. 531 (B.A.P. 9th Cir. Nov. 10, 2021), the court applied the teaching of Fulton to a prepetition bank account garnishment.

The City of Scottsdale was awarded $30,000 in sanctions and costs against Stuart.  They served a writ of garnishment on Bank of America (BOA) where Stuart had three accounts.  BOA froze the accounts.  Stuart filed a chapter 33 petition and argued that the automatic stay required the City to lift the garnishment immediately.  The city filed a motion to stay litigation in the state court action.  The city did not oppose release of the funds by the bank, and they were released.

Stuart filed a motion for sanctions for violation of the stay.  The bankruptcy court decided that the city violated the automatic stay and allowed Stuart to proceed with an evidentiary hearing for a determination of damages against the city and its attorneys.  On reconsideration the bankruptcy court examined subsections (a)(1), (2), (3), and (6) and declined to find any stay violation.  Stuart appealed to the BAP. which affirmed the bankruptcy court.

Based on Fulton, the BAP held that the city did not violate § 362(a)(3) by its inaction.

Where a creditor has executed a prepetition writ of garnishment against a debtor’s bank account, it is under no affirmative obligation to release the funds and need only maintain the status quo. 632 B.R. 531, 540.

The BAP then reviewed the other subsections of § 362 relied on by Stuart.

Section 362(a)(1) prohibits the “continuation . . . of a judicial, administrative, or other action or proceeding against the debtor . . .” The city did not have to quash the garnishment to avoid a “continuation.”  Leaving the action and the garnishment in place did not disturb the status quo.

Section 362(a)(2) prohibits “the enforcement against the debtor or against property of the estate, of a judgment obtained before the commencement of a case under this title.” The city took no position on whether the state should order the release of the account funds.  The city did not do anything to enforce the state court judgment.

Section 362(a)(6) prohibits “any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case under this title.”  The mere retention of a valid prepetition state court attachment or lien without more, is not a violation of§ 363(a)(4)-(6).

Conclusion

Doing nothing is not an “act.”

The Bankruptcy Code contemplates the valuation of a secured creditor’s collateral for a variety of purposes at different stages of a bankruptcy case. While title 11 of the United States Code (the “Bankruptcy Code”) does not define “value” or determine precisely when to value a secured creditor’s collateral, section 506(a) of the Bankruptcy Code provides some guidance:  “Such value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor’s interest.”

Indeed, the notion that value of a debtor’s interest in property becomes fixed at any given time including on the date that the bankruptcy case is filed is too narrow of a reading of the Bankruptcy Code.  As section 506(a) provides, bankruptcy courts must look to the purpose the valuation and the proposed disposition or use of the property to be valued.  For example, if a debtor desires to use the secured creditor’s cash collateral over the creditor’s objection, the debtor must provide the secured creditor with “adequate protection” to protect the secured creditor from diminution in the value of its collateral during the course of the bankruptcy case.  Determinations of adequate protection in the context of cash collateral fights usually occur early in the bankruptcy case.  Courts look at a variety of factors including whether the debtor has a sufficient “equity cushion” in the collateral to protect the secured creditor from diminution in the value of the collateral during the pendency of the bankruptcy case.  Similarly, a secured creditor may file a motion for relief from stay on the grounds that there is no equity in the property and that the property is not necessary for an effective reorganization.  The secured creditor has the burden of proof on the issue of value and whether the debtor lacks equity in the property.  Motions for relief from stay and adequate protection can occur at any stage of the bankruptcy case.  Bankruptcy Courts may also be called upon to determine the value of an interest of the debtor in property in the context of a sale of assets free and clear of liens, claims and interests under section 363 of the Bankruptcy Code.  Valuation may also arise in the context of fraudulent transfer litigation where the debtor is alleged to have been insolvent or received less than a reasonably equivalent value in exchange for such transfer.  Finally, a debtor may seek to establish the value of a secured creditor’s collateral for both voting purposes and treatment under a Chapter 11 plan of reorganization.

Indeed, it is not unusual for a debtor and the secured creditor to stipulate to value to resolve disputes concerning adequate protection and classification and treatment of a secured creditor’s claim.   To complicate matters, different methods of valuation may be employed depending on the purpose of the valuation and circumstances of the case.  For example, bankruptcy courts may be asked to apply a “going-concern” value to an operating company, which may take into consideration goodwill.  Liquidation value may be more appropriately assigned to the value of assets of failed businesses. Oftentimes, the parties present expert witness testimony to determine valuation of the debtor’s interest in property and whether a creditor is over secured, undersecured or unsecured.

However, what happens when the value of a secured creditor’s collateral increases or decreases during the course of a bankruptcy case?  What if the value of collateral differs at the time of the plan confirmation hearing from the value previously determined by the bankruptcy court by agreement or after an evidentiary hearing?  The answers to these questions depend in large part on the purpose for which the valuation was previously determined and the jurisdiction of the bankruptcy court.

For example, the author of this blog post represented a secured creditor in a single asset real estate case in Reno, Nevada.  At the time the case was filed, the value of the secured creditor’s real estate collateral was indisputably less than the full amount of the secured creditor’s claim.  The parties stipulated to value “for plan confirmation purposes” based on the value of the real estate collateral at the time.  The secured creditor made an election to have the entirety of its secured claim treated as a fully secured claim under the debtor’s chapter 11 plan of reorganization as authorized by section 1111(b) of the Bankruptcy Code.  Ultimately, the Bankruptcy Court denied plan confirmation on the grounds that no plan could be confirmed because the debtor only had two creditors, a secured creditor that would not vote in favor of the plan, and an assignee of an insider claim whose vote could not be counted.  The Bankruptcy Court’s ruling was appealed – first to the Ninth Circuit Bankruptcy Appellate Panel, and then to the Ninth Circuit Court of Appeals, and was ultimately decided by the United States Supreme Court on a discreet legal issue concerning the appropriate standard of review unrelated to the value of the property.  The case was thereafter remanded back to the Bankruptcy Court.

Approximately seven years after plan confirmation was denied, the debtor sought to rely on the same plan that was previously denied with the same valuation that was agreed upon seven years earlier.  The plan projections and values had become stale, and that the secured creditor had since become oversecured due to rising real estate values, entitling the secured creditor to recover post-petition interest and attorney’s fees and costs.  Ultimately, the debtor and secured creditor entered into a settlement agreement under which the property was sold and the secured creditor was paid from the proceeds of sale.  The key issue that was avoided was whether an agreed upon valuation for plan confirmation purposes seven years earlier was binding on the secured creditor.

As discussed below, the answer depends in large part on where the bankruptcy case is pending.  However, the majority view is that valuation of collateral for purposes of plan confirmation must be made at or near the time of plan confirmation.

As a preliminary matter, section 506(a) of the Bankruptcy Code provides that the undersecured creditor’s claim must be bifurcated into a secured claim to the extent of the value of the collateral and an unsecured deficiency claim for the balance of the claim that exceeds the value of the collateral. As noted above, the value of a secured creditor’s collateral “shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor’s interest.”  The Bankruptcy Code permits undersecured creditors in a chapter 11 case to bypass the effects of section 506 by making an election to have their entire claim treated as secured under Section 1111(b) of the Bankruptcy Code. This is known as an “1111(b) election” and was employed by the secured creditor in the above example.  However, because Section 1111(b) is silent with respect to how to value the secured creditor’s collateral, bankruptcy courts generally look to sections 506(a) and 1129(b)(2)(A) for guidance. Although Section 1129(b)(2)(A) requires the discounting of the value of a secured creditor’s collateral to present value when determining whether a chapter 11 plan provides for adequate payments to creditors, section 506 governs when determining initial valuation.  However, section 506 does not specify the date on which collateral should be valued.

The date of valuation for plan confirmation purposes was recently addressed in In re S-Tek 1, LLC, Case No. 20-12241-j11 (Bankr. D.N.M. Dec. 9, 2021).  In S-Tek, the secured creditor, Surv-Tek, Inc., filed a motion requesting the Bankruptcy Court to value its collateral comprised of various business assets, including accounts receivable, equipment, general intangibles, and other commercial assets (the “Collateral”) as of the date of the bankruptcy petition. S-Tek filed a Subchapter V plan and a plan modification separately classifying Surv-Tek’s secured claim. The Plan proposed that S-Tek retain the Collateral and use it in the operation of its post-confirmation business. Under the plan, S-Tek proposed to pay Surv-Tek’s claim, if and to the extent the claim is allowed as a secured claim, in deferred cash payments. The valuation motion requested that the Bankruptcy Court value the Collateral pursuant to section 506(a)(1) for purposes of plan confirmation.

Valuation Date for the Purpose of Plan Confirmation

 To confirm its subchapter V Plan, and in the event that Surv-Tek did not consent to the proposed treatment under the Plan, S-Tek was required to satisfy the “fair and equitable requirement” set forth in section § 1129(b)(2)(A) with respect to Surv-Tek’s secured claim. See 11 U.S.C. § 1191(b) and (c). Section 1191(b) requires that if all applicable requirements of section 1129(a) are satisfied (other than paragraphs (8), (10) and (15)), the court shall confirm the plan notwithstanding those requirements if “the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.” Section 1191(c) provides that for a plan to be fair and equitable with respect to a class of secured claims, the plan must meet the requirements of section 1129(b)(2)(A).

S-Tek’s Plan provided that if Surv-Tek did not make the section 1111(b) election, its claim would be treated as unimpaired under the Plan, and that if Surv-Tek made the section 1111(b) election, Surv-Tek would not be entitled to vote to accept or reject the plan. If Surv-Tek did not make the § 1111(b) election and voted to reject the plan,   S-Tek must meet the requirements of section 1129(b)(2)(A)(i)(II), which requires that “each holder of a claim of such class [must] receive on account of such claim deferred cash payments totaling at least the allowed amount of such claim, of a value, as of the effective date of the plan, of at least the value of such holder’s interest in the estate’s interest in such property[.]”

As the S-Tek court noted, “Section 1129(b)(2)(A)(i)(II) does not give any guidance regarding the applicable valuation date—whether collateral should be valued, for plan confirmation purposes, as of the petition date, the confirmation date, or at some other time.” All that is required is that “the plan must provide for payments totaling at least the allowed amount of the secured claim and the deferred cash payments must have a present value at least equal to the value of the creditor’s  interest in the collateral. For a debtor to achieve the required value of the deferred cash payments, typically the debtor pays the allowed secured claim with interest to account for the time-value of money.”

The S-Tek court recognized that a “large majority of courts that have addressed the issue have held that under § 506(a)(1), for plan confirmation purposes, collateral the debtor will retain for its post-confirmation business operations should be valued as of or near the date of the confirmation hearing S-Tek” rather than the petition date.  (Citations omitted).  The S-Tek court sided with the majority, concluding that “[j]ustifying a per se petition date valuation for confirmation purposes, on the theory that claims are allowed as of the petition date under § 502(b), ‘conflates the amount of the claim and the value of the collateral securing the claim[.]’” Id. (quoting In re Cahill, 503 B.R. 535, 541 (Bankr. D.N.H. 2013)).  As the court noted:  “The amount of the allowed claim determined under § 502(b) is fixed as of the petition date, whereas the value of the collateral securing the claim determined under § 506(a) can vary over the life of the case depending on the purpose of the valuation and the proposed use or disposition  of the collateral.” Id. (citations omitted).

The S-Tek court followed the Fifth Circuit’s rationale in Houston Reg’l Sports, 886 F.3d 523, 532 (5th Cir. 2018), which “adopted a ‘flexible approach to valuation timing that allows the bankruptcy court to take into account the development of the proceedings, as the value of the collateral may vary dramatically based on its proposed use under any given plan.’”  See also In re Dheming, No. 11-56798, 2013 WL 1195652, at *3 (Bankr. N.D. Cal. Mar. 22, 2013) (holding that “the appropriate date for valuing collateral for purposes of fixing a secured creditor’s claim is the confirmation date, or a date close to confirmation”, but leaving open the possibility of using some other date in unusual circumstances).  The S-Tek court concluded that “for plan confirmation purposes, collateral the debtor or other plan proponent will retain for its post-confirmation business operations should be valued as of or near the date of the confirmation hearing.”  Id.  However, the S-Tek court did not “rule out the possibility that a different date might be appropriate in unusual circumstances based on developments during the bankruptcy case.”  Id.

Conclusion

While the majority of courts apply a flexible approach to valuation that fixes a secured creditor’s claim at or near the date of plan confirmation, some courts take a more rigid approach to valuation that limits the secured creditor’s claim to the value of its collateral as of the petition date.  Parties should carefully consider not only the purpose for which valuation is sought, but whether the bankruptcy court follows the majority or minority rule for determining when a secured creditor’s collateral should be valued for purposes of confirming a chapter 11 plan.

The United States Supreme Court ruled that 11 U.S.C. § 330(a)(1) does not authorize compensation to debtors’ attorneys from estate funds.  Lamie v. U.S. Trustee, 540 U.S. 1023 (2004).  A chapter 7 lawyer cannot look to the estate or to the debtor postpetition for payment of fees for services rendered or to be rendered if the obligation to pay the fee arose prepetition.  That leaves four payment options:

(1) delay filing the case until all the fees are paid;

(2) file the chapter 7 case without getting paid and hope that the debtor will voluntarily pay additional fees postpetition;

(3) the attorney can bifurcate the legal services; or

(4) the debtor can file a chapter 13 case so that the fees can be paid post- petition.

In an opinion that represents the legal conclusions of all the judges of the Bankruptcy Court of the Southern District of Florida, Judge Isicoff held that

so long as attorneys offering a bifurcated fee arrangement comply with the terms of this Order, those arrangements do not violate the Bankruptcy Code or Bankruptcy Rules, this Court’s Local Rules, or the Florida Bar Rules. In re Brown, 631 B.R. 77, 105 (Bankr. S.D. Fla. 2021).

In an opinion that represents the the legal conclusions of all the judges of the Bankruptcy Court for the Western District of Kentucky, Judge Lloyd held that

the bifurcated fee agreements entered . . .in each of the eleven cases herein violate the United States Bankruptcy Code, the Federal Rules of Bankruptcy Procedure, and the Kentucky Rules of Professional Conduct.  Such contracts are not to be used by any attorney practicing bankruptcy law in the United States Bankruptcy Courts for the West District of Kentucky.  In re Balwin, 2021 Bankr. LEXIS 2753 at *50 (Bankr. W.D.Ky. 2021).

What made the difference?

Local Rules?

Local Rule 2091-1 of the Bankruptcy Court for the Southern District of Florida provides:

(D) Attendance at Hearings Required for Debtor’s Counsel. An attorney who makes an appearance on behalf of a debtor must attend all hearings scheduled in the debtor’s case that the debtor is required to attend under any provision of the Bankruptcy Code, the Bankruptcy Rules, the Local Rules, or order of the court, unless the court has granted a motion to withdraw pursuant to Local Rule 2091-1.

(E) Duties of Debtor’s Counsel. Unless the attorney has withdrawn as attorney for the debtor pursuant to Local Rule 2091-1, an attorney who files a petition on behalf of a debtor must advise the debtor of, and assist the debtor in complying with, all duties of a debtor under 11 U.S.C. §521.

Local Rule 9011-1 of Local Rules of United States Bankruptcy Court of the Western District of Kentucky provides:

Attorneys–Duties

(a) Extent of an Attorney’s Duty to Represent.

(1) An attorney who files a bankruptcy petition for or on behalf of a debtor will remain the responsible attorney of record for all purposes including the representation of the debtor in all proceedings that arise in conjunction with the case.

(2) An attorney is relieved of his duties when the debtor’s case is closed, or when the attorney is specifically relieved after notice and a hearing upon motion and order of this court.

Courts’ Mindsets

The Florida court looked for a way to authorize bifurcated fee arrangements.

These three cases present this Court with the opportunity to provide a framework for when and under what circumstances bifurcation of chapter 7 fees is allowable. 631 B.R. 77, 85.

The Kentucky court was satisfied that it could not be done.

The attorney cannot bifurcate his or her representation of the debtor. 2021 Bankr. LEXIS 2753 at *35.

With BAPCPA, Congress greatly encouraged debtors to file chapter 13.  In the Western District of Kentucky debtors must only tender a filing fee or a motion to pay the filing fee in installments to get the Chapter 13 case  filed, as counsel are paid over time through a plan administered by a standing Chapter 13 trustee.  While Chapter 13 is not necessarily available to all debtors, it’s (sic) flexibility is well-known in the district and is used quite often when debtors cannot pay their lawyers the full Chapter 7 fee up front on a pre-petition basis. 2021 Bankr. LEXIS 2753 at *51.

The two courts agree on some issues.

The filing fee is a prepetition charge

Both courts agree that a law firm’s payment of the filing fee with post-petition repayment by the debtor violates Bankruptcy Code §§ 526(a)(4)(a debt relief agency shall not advise any assisted person or prospective assisted person to incur more debt in contemplation of such person filing a case under this title), 362 and 524 (effect of discharge), and Rule of Professional Conduct 4-1.8(a)(prohibiting financial assistance to a client).

Required disclosure 

Both courts agree that adequate disclosure to the debtors and the court is required.

The Florida court held that the disclosures to a potential client are adequate so long as

  1. The potential client receives the separate disclosure form;
  2. b) The prepetition agreement and the postpetition agreement are provided at the same time for the potential debtor’s review;
  3. c) The prepetition agreement clearly describes the services that must be performed prepetition as well as other services that may be provided; and
  4. The postpetition agreement clearly describes the included services (delineated, where appropriate as “if necessary”) and specifically describes the excluded services, and any additional or flat fee or hourly charge associated with those excluded services.
  5. There must be a “cooling off” period of 14 days, whether after the prepetition is signed, or until the postpetition agreement must be signed, to permit recission.  Brown, 631 B.R. 77,100.

The Kentucky court seems satisfied with this list.  2021 Bankr. LEXIS 2753 at *38.

Factoring of fee agreements is prohibited.

The Florida court determined that it will not allow any attorney to factor its legal fees. This creates an inherent conflict of interest between the attorney and the debtor, and violates R. Regulating Fla. Bar 4-5.4, 4-1.8, and 4-1.7. 631 B.R. 77,99 n. 34.

The Kentucky court held that the factoring of fees violates the United States Bankruptcy Code, the Federal Rules of Bankruptcy Procedure, the Local Rules of the United States Bankruptcy Court for the Western District of Kentucky and the Kentucky Rules of Professional Conduct. 2021 Bankr. LEXIS 2753 at *25.

Fees must be reasonable.

Both courts specify that fees must be reasonable, but they interpret this statement differently.

For the Florida court reasonableness is not measured by a comparison between the prepetition charges and the postpetition charges. The court  will review the reasonableness of the postpetition flat fee charged  taking into account not only the work that was done but also the services that might have been required in the case for which there would have been no additional charge. The court holds fees of $1262 and $1362 for postpetition services was reasonable. 631 B.R. 77, 104.

The Kentucky court found that a fee of $2,500 for postpetition services was unreasonable by comparing it to the fees charged by that attorney in other chapter 7 cases of $1,250.

Conclusion

Know your local courts.

Section 11 of Official Bankruptcy Form 105, Involuntary Petition Against an Individual, provides:

Allegation

Each petitioner is eligible to file this petition under 11 U.S.C. § 303(b).

The debtor may be the subject to an involuntary case under 11 U.S.C. § 303(a).

At least one box must be checked:

[  ] The debtor is generally not paying such debtor’s debts as they become due, unless they are the subject of a bona fide dispute as to liability or amount.

[  ] Within 120 days before the filing of this petition, a custodian, other than a trustee, receiver, or agent appointed or authorized to take charge of less than substantially all of the property of the debtor for the purpose of enforcing a lien against such property, was appointed or took possession.

Two recent cases have held that an involuntary petition which used Official Bankruptcy Form 105 was legally sufficient to state a claim and, thereby, defeat a  motion to dismiss. In re Hammond, 2021 Bankr. LEXIS 2651 (Bankr. S.D. Tex. Sept. 28, 2021); In re Gutierrez, 2020 Bankr. LEXIS 1304 (Bankr. S.D. Miss. May 15, 2020).

The Petitioning Creditor in Hammond used Official Form 105 by checking the applicable boxes to read as follows:

[X] Each Petitioner is eligible to file this petition under 11 USC § 303(b).

[X] The debtor may be the subject of an involuntary case under 11 USC § 303(a).

[X] The debtor is generally not paying such debtor’s debts as they become due, unless they are subject of a bona fide dispute as to liability or amount.

On the third page of the involuntary petition, where it is asked to list information about all of the petitioning creditors, the petitioning creditor listed only itself and inserted “Matured loans remain unpaid” under the heading of “Nature of petitioner’s claim” and listed $1,690,359 under the heading “Amount of value of any lien.”

The alleged debtor filed a motion to dismiss under Federal Rule of Civil Procedure 12(b)(6) challenging the sufficiency of the allegations of the involuntary petition.  To defeat a motion to dismiss, Petitioning Creditor must meet Federal Rule of Civil Procedure 8(a)(2)’s requirements of “a short and plain statement showing that the pleader is entitled to relief.”  The United States Supreme Court in Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009) stated:

To survive a motion to dismiss, a complaint must contain sufficient factual matter, accepted as true, to “state a claim to relief that is plausible on its face. A claim has facial plausibility when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for them is conduct alleged.

Both Hammond and Gutierrez courts relied on Federal Rule of Bankruptcy Procedure 9009(a), which requires parties to use, without alteration, the Official Forms prescribed by the Judicial Conference of the United States in filing a bankruptcy petition.  The Rule states:

The Official Forms prescribed by the Judicial Conference of the United Sates shall be used without alteration, except as otherwise provided in these rules, in a particular Official Form, or in the national instructions for a particular Official Form.  Official Forms may be modified to permit minor changes not affecting wording or order of presenting information, including changes that:

  1. expand the prescribed areas for responses in order to permit complete responses;
  2. delete space not needed for responses; or
  3. delete items requiring detail in a question or category if the filer indicates—either by checking “no” or “none” or by stating in words—that there is nothing to report on that question or category. (emphasis added)

Each court denied the motion to dismiss and concluded that the better approach for issues such as  those raised by the motion to dismiss was a prompt trial.

The United States Supreme Court held in BFP v. Resolution Trust, that properties sold at “force-sale” mortgage foreclosure sales properly conducted pursuant to a state’s foreclosure statute are presumed to have been sold for “reasonably equivalent value” for purposes of Section 548 of the Bankruptcy Code.  511 U.S. 531, 114 S.Ct. 1757 (1994).  Accordingly, such sales generally cannot be avoided as a fraudulent transfer so long as the state statute complies with certain factors outlined by the Supreme Court as providing sufficient notice and bid procedures to maximize value. However, bankruptcy courts are split in their application of BFP to statutory “force-sale” state tax sales.

Section 548 of the Bankruptcy Code permits trustees or debtors in possession set aside fraudulent transfers.  11 U.S.C. § 548.  Transfers of property to an insolvent debtor (or which rendered a debtor insolvent) for “less than a reasonably equivalent value in exchange for such transfer” are considered constructively fraudulent and can be set aside by a bankruptcy trustee or debtor in possession.  11 U.S.C. § 548(a)(1)(B).

In BFP, the Supreme Court, noting that state governments have an interest in enforcing and carrying out their state-created real estate laws without being under a “federally created cloud” identified the following, non-exclusive factors (the “BFP Factors”) which supported its holding that [at least most] state mortgage foreclosure statutes are designed to result in sales which bring “reasonably equivalent value”:

  • Notice Requirement – notice is required to defaulting landowners;
  • Time Requirement – a substantial amount of time prior to the commencement of the action is provided;
  • Publication of Notice of Sale – requirement that the notice of sale be published; and
  • Bidding Procedures and Rules – bidders must strictly comply to bidding procedures and rules.

Id. at 544.

The Supreme Court emphasized that state foreclosure laws typically allow foreclosure sales to be set aside “if the price is so low that it ‘shocks the conscience’ or raises a presumption of fraud or unfairness” instead of on the grounds of fraudulent transfer.  Id.  Thus, there are safeguards under state foreclosure laws – as opposed to fraudulent transfer legal theories – to set aside foreclosure sales which do not render reasonably equivalent value.

Recently, the United States District Court for the Western District of New York affirmed an order from the Bankruptcy Court avoiding an in rem tax sale.  Duvall v. County of Ontario, 2021 WL 5199639 (W.D.N.Y. Nov. 9, 2021).  After recognizing that many courts have examined the applicability of BFP to state tax sales, the District Court declined to extend BFP’s “reasonably equivalent value” holding to New York’s tax sale statutes.  Id. at *3-4.

In Duvall, the Court distinguished New York’s state tax sale laws from state mortgage foreclosure laws, concluding that New York’s tax sale statutes fail to meet the BFP Factors.  First, the BFP notice requirement was not satisfied.  The County of Ontario took title to the property prior to the tax sale without providing sufficient notice to the debtor.  Id. at *5. Second, and most importantly, because the County took title to the property prior to the tax sale, there was no way for the debtor to receive any equity or benefit from the property, rendering the other BFP Factors meaningless.  Id.

Because tax sale statutes vary greatly from state to state, courts are split on this issue.  In most cases where a tax sale is upheld, the applicable state law satisfies at least one of the BFP Factors.  For example, in upholding a Colorado tax sale, the Tenth Circuit found that “the decisive factor in determining whether a transfer pursuant to a tax sale constitutes ‘reasonably equivalent value’ is a state’s procedure for tax sales, in particular, statutes requiring that tax sales take place publicly under a competitive bidding procedure.” In re Grandote Country Club Co., Ltd., 252 F.3d 1146, 1152 (10th Cir. 2001).

However, the Tenth Circuit declined to uphold a Wyoming tax sale, concluding that unlike the Colorado tax sale law, the Wyoming tax sale law did not satisfy the BFP Factors.  In re Sherman, 223 B.R. 555 (B.A.P. 10th Cir. 1998), a debtor’s residential property was sold to “a person selected in a random lottery for the amount of the outstanding taxes; in this case, less than $500. The Wyoming tax sale statutes do not permit a public sale with competitive bidding.”  Id. at 559.  The Tenth Circuit found that such a sale that lacked competitive bidding, and therefore, did not satisfy the BFP Factors.

In determining whether a state “forced-sale” statute qualifies as “reasonably equivalent value” under BFP, courts must consider whether any of the BFP Factors have been satisfied.  Since state forced sale statutes vary from state to state (even in the same Circuit as exemplified by the Tenth Circuit’s contrary holdings in Sherman and Grandote), counsel should pay careful attention to whether the applicable state tax sale statutes satisfy the BFP Factors.

A Delaware bankruptcy court recently held that the bar date for filing proofs of claim cannot be enforced against a creditor if the notice of the bar date was not sent by mail to that creditor.  In re Cyber Litigation Inc., No. 20-12702 (CTG) (Bankr. D. Del. Oct. 21, 2021).

Relevant Bankruptcy Rules

Bankruptcy Rule 3003(c)(3) provides that the court “shall fix . . . the time within which proofs of claims or interest may be filed.”  Bankruptcy Rule 2002(a)(7) provides “the clerk, or some other person as the court may direct, shall give . . . all creditors   . . . at least 21 days’ notice by mail of . . . the time fixed for filing proofs of claims pursuant to Rule 3003(c).”

Procedural status

Hansen Networks, the largest unsecured creditor in Cyber Litigation Inc.’s bankruptcy case, missed the deadline for filing proofs of claim. It filed a late proof of claim.  The debtor filed a motion to disallow the claim on the ground that the proof of claim was filed after the bar date.

The Bar Date Notice

Notice of the bar date was mailed to parties in interest and published in the national edition of the New York Times.  It was mailed to Hansen Networks in Las Vegas and to David Hansen, the principal of Nansen Networks, at an address in Puerto Rico where Mr. Hansen no longer resided at the time the notice was sent.

The debtor’s claim agent also emailed notice to an email address that Mr. Hansen actively used.  There is nothing in the record to suggest that the email was returned to the claims agent as undeliverable.  Mr. Hansen admitted that he used this address in a subsequent exchange with the debtor.

The court concluded that an email sent to this address was reasonably calculated to reach Mr. Hansen and thus Hansen Networks and that the email notice satisfied the requirements of due process which require that notice be provided in a means such as one desirous of actually informing the party to be bound might reasonably adopt to accomplish it.  The court noted:

It is well established that to bind a creditor to a claims bar date, known creditors must receive “actual notice.”  A long line of cases establishes that the paradigmatic means for proving “actual notice” is by mail to a creditor’s last known address. Here, it is stipulated that the address to which the bar date notice was mailed was not Hansen Networks’ last known address.

Mailing a notice to a creditor’s’ last known address, however, while surely sufficient to satisfy due process, has never been found to be a necessary element of due process.  Cyber Litigation at p.11.

The court found that the notice satisfied the requirements of due process.

The Notice Did Not Satisfy Rule 2002

The court, however, noted that the analysis did not end with due process, but that the requirements of Bankruptcy Rule 2002 must also be satisfied:

In addition to satisfying the requirements of due process, a debtor is also obligated to meet the requirements of the Bankruptcy Rules. .  . When the Supreme Court does promulgate . . . a procedural rule, those rules “are binding and courts must abide by them unless there is an irreconcilable conflict with the Bankruptcy Code.” Cyber Litigation at p.15.

Bankruptcy Rule 2002(a)(7) requires 21-day notice by mail of the time fixed for filing proofs of claim.  Bankruptcy Rule 2002(g) requires that notices to creditors shall be mailed to the address shown on the list of creditors or schedule of labilities, whichever is filed later, if the creditor has not made a request for mailing to a specific address.  The notice mailed to Mr. Hansen at a residence from which he had moved did not meet the requirements of Rule 2002.

The Failure to Provide Proper Notice Was Not Harmless Error

If the failure to comply with the requirement of Bankruptcy Rule 2002 was harmless error, it could be disregarded pursuant to Rule 61 of the Federal Rule of Civil Procedure which is incorporated into the Bankruptcy Rules by Bankruptcy Rule 9005.

In order to show that the failure to provide proper service by mail was harmless, however, it is insufficient to demonstrate that the creditor was sent notice by some other means by which he might or should  have learned of the bar date.  In the absence of a showing that the creditor obtained actual, subjective knowledge of the bar date, the Court is unable to conclude that the failure to meet the specific of the rule may be treated as no-harm-no-foul situation.  Cyber Litigation at p. 17.

As a result, the court overruled the debtor’s objection to the late filed proof of claim.