Getting Off the Omnibus: Fair Notice of Claims Objections

Everyone who has represented a general unsecured creditor in a big chapter 11 case has had this experience. After the proof of claim has been filed, and usually after the plan has been confirmed, you receive in the mail the “Reorganized Debtor’s First Omnibus Objection to Claims.” Attached to the objection is an exhibit listing, in very small type, literally hundreds of claims. The grounds for objection may be something like “required documentation not attached.” Unless a timely response is submitted, all of these claims will be disallowed.

Counsel for unsecured creditors in a large case are subjected to this kind of notice constantly. In one in which I am currently involved, the liquidating trust is up to its 31st omnibus objection. Its bad for clients, but worse for lawyers in some ways. A lawyer who has actually appeared for a client in one of these cases gets electronic service of all the papers. In the case I’m speaking of the 31st Omnibus Objection was docket entry No. 3189.

Lawyers have been let off the hook for missing their client’s claim in the list and failing to file a timely response to an omnibus objection. It took an appeal to the District Court to accomplish this is in In re Inacom Corp., 2004 WL 2283599 (D. Del. 2004). As the opinion describes it: “The Objection contests approximately 412 claims spread over 96 pages of exhibits. The exhibits are lettered A through H, with some exhibits containing multiple alphabetical listings of objections.” This hapless creditor’s name appeared on one of the alphabetical lists included in Exhibit E. The law firm’s mistake in failing to respond to the objection was not discovered until the expected distribution under the confirmed plan was not received.

On April 30, the United States Supreme Court approved changes to Federal Rule of Bankruptcy Procedure 3007. Absent Congressional action, the new rule will take effect on December 1, 2007. The new rule limits the grounds for an omnibus objection. Even where such objections are allowed, the new rule requires that the objection “list claimants alphabetically, provide cross references to claim numbers and, if appropriate, list claimants by category of claims.” The rule also contains an absolute limit of 100 claims which may be joined in an omnibus objection.

The practicalities of the mega case mean that application of the new rule will result in similar claims objections being spread over more omnibus notices, 100 at a time. Even so, the new rule will make things easier on everyone who needs to find a name on one of those lists.

Adbox Redux: Who Must Prove and Disprove Earmarking

In the previous post, I commented on In re Adbox, Inc., 2007 WL 1584582 (9th Cir. June 4, 2007), a case which explains the maybe not so obvious – why can’t creditors counterclaim in an avoidance action and offset their claims against their disgorgement liability?

I omitted to mention in that post, which was already long enough, that Adbox also contains a good, practical groundrule on who has the burden of proof to establish the “earmarking” defense to a preference claim. To quote the Court, “the ‘earmarking doctrine’ is a court-made exception [to preference liability] that applies when a third party advances funds to the debtor subject to an agreement requiring the debtor to use the funds to pay off another creditor.” This would be the case, for example, when a bank makes a loan subject to covenants that the loan proceeds will be used to make particular payments.

Does the trustee have the burden to disprove earmarking, because an element of preference liability is a transfer of property of the debtor (and not property in effect held in trust for another)? Or is earmarking an affirmative defense which must be proved by the creditor? The Ninth Circuit adopted the holding of an earlier BAP decision, In re Sierra Steel, Inc., 96 B.R. 271, 274 (Bankr. App. 9th Cir. 1989), holding that the Trustee must make a preliminary showing that the payment “was from one of the debtor's accounts over which the debtor ordinarily exercised total control.” Once that showing is made, “the burden then shifts to the defendant in the preference action to show that the funds were earmarked.”

Counterclaims in Avoidance Actions? Are We Sure We Know Why Not?

If you have defended a few preference actions, I’ll bet that you’ve heard this one from your client more than once: “Can I countersue them for what they owe me?" The obvious (to a bankruptcy lawyer) and correct response is “no,” but you might not have been 100% glib if called upon to explain why. Now the Ninth Circuit has come to your rescue, and you can just say “In re Adbox, Inc., 2007 WL 1584582 (9th Cir. June 4, 2007).

Adbox was a preference action by a chapter 7 trustee. The Metcalfs as defendants filed a counterclaim seeking damages for pre-petition torts by the debtor. The Ninth Circuit ruled that this was impermissible because a counterclaim may only be brought against an “opposing party” under Federal Rule of Civil Procedure 13. The Court reasoned:

The question presented here, however, is whether the trustee is an “opposing party” when he has brought a preference action that belongs to the bankruptcy estate and not to the debtor, but the counterclaim alleges causes of action that could have been brought against the debtor prior to its bankruptcy filing. We hold that he is not. The Metcalfs styled their counterclaim as against Golden “in his capacity as Chapter 7 trustee for the estate of Adbox,” but their allegations concerned the conduct of . . . Adbox prior to Adbox's bankruptcy filing. While the Metcalfs presumably sought to recover from Adbox's assets in bankruptcy, the trustee would have to stand in the shoes of the debtor to defend against the counterclaim. This would be a representative capacity different from the representative capacity in which a trustee brings a preference action, because a preference action belongs specifically to the bankruptcy trustee and could not have been brought by the debtor prior to its bankruptcy filing.

To me, this explanation sort of begs the question. After all, isn’t the pre-petition claim a liability of the bankruptcy estate? Or at least, I thought that the bankruptcy estate "stands in the shoes of the debtor." Another way of looking at this is that the creditor is prevented by the automatic stay from bringing a counterclaim, and is required to proceed via a proof of claim unless relief from stay is granted. But wait, that argument doesn’t dispose of the setoff issue, which isn’t directly addressed by Adbox. Is the only reason that a creditor can’t offset a claim against preference liability the prohibition of 11 U.S.C. §502(d), which prohibits allowance of claim until the preference is repaid? See, e.g., In re Allegheny Health, Education and Research Foundation, 292 B.R. 68, 94-95 (Bankr. W.D.Pa. 2003). What if the creditor doesn’t file a claim and just asserts offset?

Does it ever strike you that the more obvious a proposition seems to be to you, the harder it is to find authority for it? Sometimes its also hard to come up with reasons for these obvious rules when we are forced to go beyond our own peremptory judgments or innate sense of bankruptcy logic. I have little doubt that I’m missing something here, so please help me out. That’s what Comments are for.

No Need to Bother the Bankruptcy Judge – Continuing a Personal Injury Case After the Discharge to Reach Insurance

Bankruptcy Judge Lee of the Eastern District of California probably doesn’t think that it should be necessary to remind litigants that a personal injury plaintiff need not obtain relief from the post-discharge injunction in order to commence or continue a lawsuit against the debtor, so long as it is clear that the plaintiff will resort only to insurance coverage to pay the claim.

In re Zagala, 2007 WL 1772171(Bankr. E.D. Cal. June 19, 2007) is an unpublished Memorandum Decision on a motion to modify the post-discharge injunction to allow a peronal injury lawsuit to continue. Judge Lee ruled that the motion was “procedurally inappropriate and unnecessary.” The opinion cites an earlier BAP decision In re Beeney, 142 B.R. 360, 363-64 (Bankr. App. 9th Cir. 1992) in which the court ruled that a bankruptcy case need not be reopened, nor did the section 524 injunction need to be modified, for this purpose.

An interesting aspect of the ruling in Zagala is Judge Lee’s observation that “the bankruptcy court may enforce, or define the scope of the discharge injunction, but it may only do so through a declaratory judgment in a properly filed and served adversary proceeding.” I thought that at least the post-discharge injunction could be enforced via contempt proceedings. Question: In order to file such an adversary proceeding, must the underlying bankruptcy case be reopened? If so, then wouldn’t a contested matter in the reopened bankruptcy case be more efficient given the limited issues which are likely to be involved?

Aiieeee!! Phantom Expenses Haunt Means Testing

Bankruptcy Judge Jury of the Central District has joined the majority of courts across the land in holding that a chapter 7 debtor may deduct, for purposes of means testing, expenses which the debtor has sworn elsewhere in her bankruptcy papers she has no intention of paying. The case is In re Wilkins, 2007 WL 1933591 (Bankr. C.D.Cal.).

Ms. Wilkins owned property in Georgia which she indicated in her Statement of Intention that she would surrender to the secured creditor, Ameriquest Mortgage. The payment to Ameriquest was $1,994.07 per month. If Ms. Wilkins was not allowed to deduct the amount of that payment, she flunked the means test.

The Court was called upon to interpret 11 U.S.C. §707(b)(2)(A)(iii), which states that for purposes of means testing: “The debtor's average monthly payments on account of secured debts shall be calculated as the sum of-(I) the total of all amounts scheduled as contractually due to secured creditors in each month of the 60 months following the date of the petition.”

The US Trustee took the position that “scheduled” refers to the bankruptcy schedules, and that since the schedules in that case reflected that the payment would not be made, it should not be deducted. Judge Jury followed the reasoning of the majority of the courts in ruling that “scheduled” has the Webster’s dictionary meaning, and that those mortgage payments were, indeed, scheduled to be made under the mortgage contract.

Does the phrase “scheduled as contractually due” seem clear and unambiguous in this context? Wilkins is part of a crowded field of cases in which “plain language” reasoning is applied to reach a result which seems contrary to the purposes of BAPCPA.

Involuntary Bankruptcy Is Even Riskier Than You Thought

We all know that per 11 U.S.C. § 303(i), when an involuntary bankruptcy petition is unsuccessful, the court may grant judgment against the petitioning creditors for attorney fees, and may also award damages and punitive damages if the petition was filed in bad faith. The Bankruptcy Appellate Panel has sharpened those tools in a recent decision: In re Macke International Trade, Inc., 2007 WL 1845519 (Bankr. App. 9th Cir. June 8, 2007).

Macke manufactured pet care products. The single petitioning creditor, one Lawrence Weschler, was a competitor of the debtor who also happened to be a patent lawyer. Weschler won a $650,000 infringement judgment, then on appeal. The other two major creditors were lawyers who had represented Macke in the patent litigation. During the pendency of the appeal, the debtor made a general assignment for the benefit of creditors. The assignee liquidated Macke’s assets for $10,500. Weschler decided not to participate in the assignment, and did not file a claim.

Six months after the assignment, Weschler filed an involuntary bankruptcy petition against Macke. Macke moved to dismiss under the abstention provision, 11 U.S.C. §305(a), on the grounds that “the interests of creditors and the debtor would be better served” by dismissal (quoting the statute). The Bankruptcy Court agreed and decided to abstain, a decision which is “not reviewable by appeal or otherwise” under 11 U.S.C. § 305(c). That’s where the fun really began.

The Bankruptcy Court, having decided to abstain, did not abstain from awarding attorney fees against Weschler, relying on the language in section 303(a) which allows such an award “if the court dismisses a petition under this section other than on consent of all petitioners and the debtor. . . .”

To add insult to injury, the Court then ruled that the attorney fee award could not be offset against Macke’s indebtedness on the judgment. In so holding, the BAP followed the reasoning of In re Schiliro, 72 B.R. 147 (Bankr.E.D.Pa.1987), and quoted that decision as follows:

If the petitioning creditor could suffer no other recourse except a reduction in his probably-uncollectible judgment as a penalty for requiring a debtor to defend an unjustified case, and Congress has specifically stated should result in such a penalty, the disincentive built into the system to discourage such actions would evaporate. The rule sought by [the petitioning creditor] would surely be a boon to creditors who seek to wear down to submission small debtors such as the Debtor here.

To summarize: A creditor can file a completely meritorious involuntary bankruptcy petition, but the bankruptcy court can exercise its non-reviewable discretion to decline jurisdiction over the case. On its way out the door, however, the bankruptcy court can award attorney fees against that creditor for taking the wrong position on whether the “interest of creditors and the debtor” would be better served by bankruptcy. And the bankruptcy court can override the law of setoff by concluding on public policy grounds that the debt for attorney fees has greater dignity than a judgment for damages rendered by a United States District Court. Ouch!

Bankruptcy More of a Girl Thing

A major new source of fresh, meaningful bankruptcy statistics has come to my attention. The Institute for Financial Literacy is based in Portland, Maine. To quote from the IFL website:

The Institute for Financial Literacy is a non-profit organization whose mission is to make effective financial literacy education available to all American adults. The Institute accomplishes its mission by developing financial literacy education programs, partnering with non-profit, educational and governmental organizations, and publishing the National Standards in Adult Financial Literacy Education. The Institute is funded by program fees, private donations, and grants from public and private foundations.

The Institute is an educational organization focused on presenting unbiased, neutral information to its clients. The Institute does not create debt repayment plans or negotiate debts for its clients.

Recently, the IFL published what promises to be an annual study, entitled “Who Went Bankrupt in 2006.” This 22 page white paper is full of unbiased information about the causes of consumer bankruptcy, and the demographics of consumer debtors. The study draws no conclusions but identifies the “areas of growing concern”: (i) bankruptcy filing rates for seniors; (ii) the role of identity theft; (iii) women filing bankruptcy at higher rates then men; and (iv) what role education plays in financial management.

Consistent with earlier studies, IFL found that bankruptcies in 2006 were distributed between women and men at roughly 53.6% to 46.4%, respectively, as compared to the 51% to 49% ratio existing in the general population. The study wonders why this is, but it seems to me that any family lawyer could help you understand that one. Also, it is still the case that women are underemployed and underpaid compared to their male counterparts.

But how about this? While the percentage of white and black debtors roughly mirrors their shares of the general population, hispanic debtors file at a rate less than half of their share of the general population, topping the asians as the least bankruptcy prone ethnicity.

A Back Door to Chapter 7 for Means-Challenged Debtors?

There is now a difference of opinion in the published cases about whether means testing applies to determine chapter 7 eligibility in a case converted from chapter 13. Last month, Bankruptcy Judge Burns of the District of New Jersey decided In re Fox, 2007 WL 1576140 (Bankr. D. N.J. June 1, 2007).

In Fox, the debtor was a processing supervisor making $57,000 per year. Her chapter 13 plan was confirmed, but she lost her job a month later, and she successfully obtained a suspension of chapter 13 payments. After several months, her unemployment benefits and her payment suspension ran out at the same time. She finally got a job as a medical biller at $13.00 per hour, $30,000 per year less than previously. The debtor converted her case to chapter 7 a few days before starting her new job. She refused to file Official Form B22A, the Statement of Monthly Income and Means test, and the US Trustee filed a motion to dismiss the bankruptcy case. The Court denied the motion, ruling that means testing does not apply to the debtor in a chapter 7 case which was converted from chapter 13.

The rationale of Fox is simple and based on the “plain language” of BAPCPA. 11 U.S.C. § 707(b)(1) which provides authority for courts to dismiss a case, “filed by an individual debtor under this chapter . . . if it finds that the granting of relief would be an abuse of the provisions of this chapter.” Since the case wasn’t “filed under” chapter 7, the Court reasoned that it wasn’t subject to dismissal under section 707(b).

However much satisfaction may lie in literally interpreting the words of the poorly drafted, mean-spirited BAPCPA, the ruling of Fox may not wind up the majority rule. For one thing, Interim Bankruptcy Rule 1007(b)(4) requires that the statement be filed “in a chapter 7 case,” not just in a “case filed under” chapter 7. Also, there is already one published decision to the contrary, In re Perfetto, 361 B.R. 27 (Bankr. D.R.I. 2007). Perfetto was a case where the debtor converted her chapter 13 case within 2 weeks after the petition, and did not allege any change in circumstances. The Court required the debtor to file FormB22A, reasoning that it was the intent of Congress to apply the means test in all chapter 7 cases.

Neither of these decisions discusses the impact of the Supreme Court’s decision in Marrama v. Citizens Bank of Massachusetts, 127 S.Ct. 1105 (2007), which I blogged in February. Marrama holds that despite the “plain language” of 11 U.S.C. §706(a), there is no absolute right to convert a case from chapter 7 to chapter 13, and conversion could be denied based on bad faith. Perhaps a bad faith conversion standard could have been employed to achieve the same result in both cases?