Facts and Procedure:

Danilo Reed (Husband) had an extramarital relationship with Plaintiff Rhina Mejia that led to the birth of a child. In the subsequent divorce proceeding between Husband and Violeta Reed (Wife), a marital settlement agreement (“MSA”) was entered into, pursuant to which Husband transferred all his interests in jointly held real property to Wife and Wife conveyed all her interest in Husband’s medical practice to him. The MSA also provided that Husband would be solely responsible for his extramarital child support obligation. Within less than 2 years, Husband abandoned his medical practice, moved in with his mother and had no assets and little income.

Plaintiff Rhina Mejia then instituted this proceeding, asserting that the MSA was a fraudulent transfer under the UFTA. Plaintiff claimed that that the MSA was a fraudulent transfer by Husband to Wife with intent to hinder Plaintiff in her collection of future child support. Husband moved for summary judgment for failure by Plaintiff to provide evidence of intent to defraud on the part of Husband. Additionally, Husband claimed that the value of his medical practice at the date of separation was reasonably equivalent to the real property interests he conveyed to Wife. Plaintiff argued that the fair market value of the Husband’s medical practice was less than the present discounted value of Husband’s future child support, and thus Husband was insolvent at the time of the transfer rendering the MSA subject to the fraudulent transfer laws under the UFTA for making a transfer for less than reasonably equivalent value at a time when the debtor was insovent.

The trial court ruled that the UFTA applied to the MSA but granted Husband’s summary judgment motion on the grounds that no evidence was presented of actual intent to defraud and that the transfer did not render Husband insolvent. The Court of Appeal reversed, agreeing that the UFTA applied to MSAs and that the existence of triable issues of fact precluded summary judgment.

Analysis:

The trial court granted Husband’s motion for summary judgment and the court of appeal reversed. The California Supreme Court had to harmonize family law and fraudulent transfer statutes in this case in order to determine whether MSAs were generally subject to fraudulent transfer laws and how to value future income and future child support obligations with respect to defining insolvency for constructive fraud.

The UFTA is a series of statutes that provide remedies for creditors against transfers that would impede their ability to collect on their claims in certain circumstances. Under the UFTA, there are two main types of fraudulent transfers. First, an actual fraudulent transfer is a transfer made with actual intent to hinder, delay, or defraud any creditor of the debtor. Cal. Civ. Code §3439.04(a). This actual intent is often proven using “badges of fraud”, which are statutorily enumerated bad actions by the debtor from which an intent to defraud his or her creditors can be inferred. Second, a constructive fraudulent transfer is where the debtor did not receive a reasonably equivalent value in exchange for the transfer and either 1) the debtor was insolvent at the time of the transfer, or 2) the debtor became insolvent as a result of the transfer. Cal. Civ. Code §3439.05.

Under Family Code §916 (formerly Civil Code 5120.160), upon the dissolution of a marriage, any property received by a married person in the division is not liable for a debt incurred by the person’s spouse before or during marriage, and the person is not personally liable for the debt, unless the debt was assigned for payment by the person in the division of the property. Under Family Code §2550, “the court shall divide the community estate of the parties equally.” Absent an exception, a court’s “equal division” would constitute reasonably equivalent value, and thus not be considered constructively fraudulent. However, the Court in Mejia v. Reed used the preface of §2550, which states “[e]xcept upon the written agreement of the parties, or on oral stipulation of the parties in open court,” clarifying the exception to the general rule. In other words, if parties enter into a MSA, California law does not require that they divide marital property equally and courts do not scrutinize MSAs to ensure that they set out an equal division. Thus, MSAs are not per se equal distributions. Accordingly, MSAs are not disqualified from being considered a constructive fraudulent transfer.

In Mejia, the California Supreme Court rejected arguments on both sides regarding canons of statutory interpretation and legislative history due to the fact that the arguments made were based on the absence of legislative intent and action. Transfers before and after dissolution can be set aside as fraudulent conveyances per the Family Code and UFTA statutes; however the issue was whether the MSA itself can be considered a fraudulent transfer. Therefore, the Court viewed the two sets of statutes in light of the policy of protecting creditors, namely that it was unlikely that the Legislature “intended to grant married couples a one-time-only opportunity to defraud creditors by including the otherwise fraudulent transfer in an MSA” by failing to address this issue within the two statutory codes. Thus the court held that the UFTA applies to property transfers under MSAs.

The California Supreme Court found no triable issues of fact on the question of insolvency because support payments present a special type of claim under the UFTA: First, support payments are based on actual earnings (rather than liquidation of preexisting assets) and; Second, child support payments can be changed (in some cases retroactively) if there is a change in actual earnings or earning capacity. Thus, future child support obligations, according to the Court, should not be considered a “debt” under the UFTA. The Court explained that income not yet earned is not an asset under the UFTA unless it is subject to levy by a creditor, and it would be unfair to consider future child support payments should as a debt while the earning capacity from which they will probably be paid is not considered an asset (which would lead to the absurd result of unfairly tipping the scales in favor of finding insolvency in every case dealing with child support payments).

The Court remanded the case, finding that there were no triable issues of fact remaining as to constructive fraud (even though the transfer may have been for less than reasonably equivalent value), because the Husband was not insolvent at the time of the transfer nor did the transfer render him insolvent. Triable issues remained as to actual fraud.

Author’s Note:

The main takeaway for purposes of family law and bankruptcy law attorneys is that Marital Settlement Agreements can be fraudulent transfers under the UFTA. The likely path to avoid such findings is the costly and adversarial process of a divorce trial as opposed to a written or oral agreement by both Husband and Wife. Can a divorce trial be undertaken with intent to defraud, hinder or delay creditors? Can a creditor argue that the debtor went through a divorce trial with the intent to defraud creditors as opposed to the dissolution of the marriage? However, be aware that the creditor could argue that the entire divorce trial was a sham if the sole reason for divorce is for asset protection purposes and thus a fraud on the court and the creditors. Absent the divorce trial being a fraud on the court, it would be difficult to argue actual fraud in a divorce trial context. How can a creditor claim that a transfer was made for less than reasonably equivalent value when the family law judge is under a duty to divide property equally? It would be difficult for a creditor to argue that a transfer of marital assets in a divorce trial was constructively fraudulent unless there was a conspiracy to defraud the divorce court and judge. Finally, there could potentially be res judicata and collateral estoppel arguments to be made by a debtor who participated in a divorce trial which could bar a creditor from arguing that those transfers are constructively fraudulent in a bankruptcy court context.

Subsequent Case Law:

In Litke O’Farrell, LLC v. Tipton 204 Cal.App.4th 1178 (2012), the court held that the Family Code empowers a husband and wife to alter their property rights by a marital property agreement at any time without respect to court approval, and such an agreement is binding upon agreement. Thus court approval in a dissolution proceeding is not a prerequisite to the enforcement of an MSA in an independent action unless the agreement requires such approval. Once the MSA is agreed to and signed it becomes an enforceable contract that effects a division of community property and thus could be considered a fraudulent transfer.

Facts and Procedural History
Mr. and Mrs. Markosian (Debtors) filed a chapter 7 petition. Debtors’ chapter 7 petition was subsequently converted to a chapter 11 bankruptcy and then re-converted to a chapter 7. When Debtors initially filed their chapter 7 petition, the U.S. Trustee moved to dismiss Debtors’ case based on the Debtors high income level and their ability to repay creditors. As a result, Debtors elected to convert their case to chapter 11. However, the Debtors were unable to confirm a chapter 11 plan because Mrs. Markosian lost her job. Thus, Debtors re-converted their case to a chapter 7.

Many of the issues discussed in the case arose from the fact that Mr. Markosian received a large bonus from his employer for services that were rendered while the chapter 11 case was pending. The Debtors turned Mr. Markosian’s bonus over to the Trustee, but after re-converting their case to a chapter 7, filed a motion to compel the trustee to return the bonus to them arguing that the post-petition earnings were no longer the property of the estate upon conversion. The bankruptcy court found that the bonus constituted earnings from personal services within the meaning of §1115(a)(2), but concluded that it ceased to be property of the estate upon conversion to chapter 7.

Analysis
The court began its analysis by defining what constitutes property of the estate. For Chapter 7 purposes, under §§541(a)(6) and (7), property of the bankruptcy estate is distinct from the debtor’s property. Under §541(a)(6) post petition earnings in a Chapter 7 bankruptcy are not included in the debtor’s bankruptcy estate. By contrast, in a Chapter 11 case, what constitutes property of the estate is modified by §1115, which expressly includes post petition earnings of the debtor under §1115(a)(2). Thus, the issue before the court was what to do with the post petition earnings once the case had been converted to a Chapter 7 from a Chapter 11 case given that §541(a)(6) and §1115(a)(2) appeared directly at odds. The court first held that section §348 governs conversion from one chapter to another.

Under section §348(f)(1)(A), a debtor’s postpetition earnings are expressly excluded from the Chapter 7 estate once converted from Chapter 13. However, there is no parallel provision in §348 for Chapter 11 debtors. Congress was silent on this issue. Thus, the Markosian court applied a plain meaning interpretation to section §348(a) and determined that it applies to all cases under Title 11, not just conversions from Chapter 13 to Chapter 7. Further, the court expressly stated that the date of the petition remains unchanged, thereby bringing all post petition but pre conversion earnings within the scope of §348. Accordingly, because §348(f)(1)(A) applies to cases converted from Chapter 11 to Chapter 7, a debtor’s post petition earnings are considered property of the debtor upon conversion.

According to the court in Markosian, other courts have struggled with this issue because of Congress’s failure to enact a parallel provision to §348(f)(1)(A) for chapter 11 debtors. However, in Markosian, the BAP disagreed with divining intent from congressional silence, which the court noted has been cautioned against by the Ninth Circuit Court of Appeals. Specifically, the court found that the fact that Congress did not enact a parallel provision to 348(f)(1)(A) for chapter 11 debtors when it enacted section 1115 had no significance, and thus a plain reading of the statutes involved compelled the determination that upon conversion from Chapter 11 or Chapter 13 to a Chapter 7, post petition earnings should not be considered property of the estate.

Finally, the court concluded that there is no reason to treat Chapter 11 debtors differently than Chapter 13 debtors in the context of determining property of the estate upon conversion from a Chapter 7 case. The court noted that the purpose of statute section 348(f) was to “avoid penalizing debtors who first attempt a repayment plan,” and the court determined that there was “no policy reason as to why the creditors should not be put back in the same position as they would have been in had the debtor never sought to repay his debts”.

Author’s Note
One practice pointer to take away from this case is buried within a footnote. The court states that if a case is filed under Chapter 11 and then converted to a Chapter 7, it may be necessary to distinguish personal earnings from business earnings for debtors who own a business (or multiple businesses). In other words, in cases converted from Chapter 11 to Chapter 7 bankruptcy practitioners may need to analyze where earnings are coming from, and how closely they related to the business itself (when there is a debtor who owns a business). If the earnings are from the personal services of the debtor, then they should revert back to the debtor upon conversion. However, if the earnings are from the distributions of the business or profits of the business, then they should be considered property of the estate. This makes the situation of a debtor who personally owns a business a complex factual determination of where the income to the debtor is primarily derived from.

Facts:
More than 180 days after Debtors (Robert and Kathy Dale) filed a chapter 13 bankruptcy petition, the mother of one of the two joint Debtors passed away, leaving Mr. Dale approximately $30,000. Nearly 2 months later, Debtors filed a declaration with the bankruptcy court disclosing Mr. Dale’s inheritance. The Chapter 13 trustee demanded that Mr. Dale turn over the inherited funds to the Trustee for distribution to Mr. Dale’s creditors. The Trustee subsequently filed a motion to dismiss Debtors’ bankruptcy for failing to make payments under their proposed plan. Later, the Trustee filed an amended motion to dismiss because: 1) the Debtors’ had failed to comply with the Trustee’s recommendations; 2) the Debtors had failed to disclose and turn over the nonexempt inheritance proceeds; and 3) the Debtors were still delinquent on plan payments. The Debtors argued that their case should not be dismissed because Mr. Dale’s post-petition inheritance was not property of the bankruptcy estate because he received the inheritance rights more than 180 days after filing bankruptcy.

The bankruptcy court held that inheritance received by a chapter 13 debtor before the case is closed, dismissed or converted is property of the bankruptcy estate under §1306. The Debtors timely appealed this holding to the 9th Circuit Bankruptcy Appellate Panel (BAP), which reviewed de novo.

Issue:
The issue before the BAP was whether §§541(a)(5)(A) and 1306(a)(1) require that post-petition inheritance be included in a debtor’s bankruptcy estate in a Chapter 13 case where the debtor’s inheritance is received outside of the temporal limit of §541(a)(5)(A) (ie. “180 days after filing”) but within the temporal limit of §1306(a)(1) (ie. after filing, but “before the case is closed, dismissed, or converted”).

BAP Analysis:
The BAP began its analysis by looking to the plain language of both §541 and §1306. The court determined that the plain language of both statutes manifested Congress’s intent to expand a debtor’s bankruptcy estate in a Chapter 13 case by including the types of property described in §541 and expanding the time in which this property can be considered property of the estate post-filing. The 9th Circuit BAP court held that the plain language of §1306(a) incorporated the kind of property described in §541 into §1306(a)’s longer time period.

The court also stated that if the 180 day period prescribed by §541(a)(5)(A) restricted the property to be included in a Chapter 13 estate, then §1306(a), which expands this time period, would lose its meaning. The court noted that under the maxims of statutory interpretation, a court should not find that the legislature intended the absurd result of rendering a statute meaningless unless absolutely necessary. The court also cited the statutory maxim of specific provisions controlling the general provisions. The court in turn held that because §1306 is specific to Chapter 13 bankruptcies whereas §541 is a general provision, that §1306 applies to all Chapter 13 debtors and includes all property within §541.

Author’s Note:

This decision may be significant to professionals whose clients may be in in a position to receive some sort of large cash payment after filing a Chapter 13 bankruptcy but before the case is closed, dismissed or converted. Specific examples identified by the court include bequests, devises, and inheritances. Therefore, it may be advisable to ask a client about the health of family members and whether they expect to receive any inheritances from family members.

A question raised by the court’s decision is whether it extends to “kinds of property of the estate” identified in §541 other than inheritances, bequests and devises. The court specifically stated that it applies to all kinds of property under §541, therefore, it is subject to the expanded timeframe of §1306(a): from post-petition until the case is “closed, dismissed, or converted”.

Because the court’s decision extends to “kinds of property of the estate” identified in §541, a debtor’s settlement agreement or divorce agreement (for example) entered into before the Chapter 13 case is closed, dismissed or converted may be included in the Chapter 13 estate under §1306, whereas it would not be included in a Chapter 7 case under §541.

Another unanswered question is what happens to the debtor’s Chapter 13 plan if this new property is included in the estate. For example, the debtor receives an inheritance one day before the case is closed. Does the trustee use the inheritance to pay more to the unsecured creditors than they would have otherwise received by amending the confirmed chapter 13 plan? Does the debtor receive the remainder of what was distributed to creditors after the plan is amended? The case does not answer these questions.

Factual Background and Procedural History

Husband entered into various real and personal property transactions with creditors with whom the husband had a personal and business relationship. Creditors sued husband, his wife, and husband’s business in state court.

Husband and wife then filed a chapter 11 bankruptcy, which was converted to a chapter 7 bankruptcy. Creditors filed an adversary proceeding against the husband and wife debtors alleging the debtors: a) made misrepresentations to creditors with the intent to deceive them, b) had engaged in fraud or defalcations as fiduciaries, and c) willfully, maliciously and intentionally injured the creditors and converted their property. The creditors argued that the resulting debt should therefore be excepted from discharge under §523(a)(2)(A), §523(a)(4) and §523 (a)(6). Debtors filed an answer denying the allegations.

The bankruptcy court entered a judgment in favor of creditors against husband and declared that creditors’ claims against wife were discharged. A timely appeal was filed by creditors on September 27, 2012, challenging the part of the judgment holding that the claims against wife were not excepted from discharge.

Holding and Analysis

The BAP reviewed the bankruptcy court’s factual findings for clear error and found that the bankruptcy court did not err in concluding that creditors had not established the elements required for exception to discharge under §523(a)(2)(A) and affirmed the bankruptcy court’s finding that wife did not directly engage in any fraud.

However, with respect to whether husband’s liability could be imputed to wife, the BAP found that the bankruptcy court had made inadequate findings to support its decision not to impute liability to wife for the fraud of her husband. The BAP therefore vacated that portion of the judgment and remanded to the bankruptcy court to make the necessary findings.

The bankruptcy court received substantial briefing on the BAP’s published decision in Tsurukawa v. Nikon Precision, Inc. (In re Tsurukawa), 287 B.R. 515 (9th Cir. BAP 2002) (Tsurukawa II), in which it held that “even in the absence of any direct fraud, imputation of liability was possible in a §523(a)(2)(A) proceeding where the court finds a partnership or agency relationship existed between the spouses.” The BAP found it “problematic” that the bankruptcy court made no finding to support its conclusion that imputation was not appropriate when creditors introduced evidence that could provide a basis for imputing liability. The BAP concluded that the bankruptcy court had not made sufficient findings of fact.

The court in Tsurukawa I held that “a marital union alone, without a finding of a partnership or other agency relationship between spouses, cannot serve as a basis for imputing fraud from one spouse to the other.” The BAP also held that “[i]n a §523(a)(2)(A) action, one spouse’s fraud may be imputed to the other spouse under agency principles when, as in this case, they are also business partners.” Circuits outside the Ninth Circuit have also adopted the BAP’s position in Tsurukawa II that fraud may be imputed to a spouse under partnership and agency principles in a §523(a)(2)(A) action. Whether an agency or partnership relationship exists is a question of fact to be decided under state law.

In California, a partnership is defined as “an association of two or more persons to carry on as co-owners of a business for profit.” In determining whether a partnership exists, California courts consider factors such as whether the persons intended to share in profits, losses and management and control of the enterprise. In this case, the BAP found that there was evidence showing that wife did more than just reap the financial benefits of husband’s actions. The BAP noted that there appeared to be evidence that wife may have, among other things, prepared and mailed allegedly fraudulent accounting statements; maintained one bank account and check register for husband’s business and assisted in preparation of tax returns; reviewed and edited husband’s responses to billing disputes; directed the bookkeeper to ignore creditor’s complaints about bills; provided advice to husband in negotiations with creditor; prepared some of the bills that were sent to creditor; and signed letters on husband’s business letterhead relating to husband’s business matters. The BAP noted that the bankruptcy court may have considered this evidence and discounted it in order to come to its conclusion that liability could not be imputed, but that from the record before it, they simply did not know.

The BAP therefore vacated the portion of the judgment that found that wife’s debts to creditors were discharged and remanded the matter back to bankruptcy court for it to consider and make factual findings as to whether wife was involved in a partnership and whether an agency relationship existed with her husband such that his liability should be imputed to her for the purpose of exception to discharge under §523(a)(2)(A) as set forth in Tsurukawa I and Tsurukawa II.

Commentary

This case is a good reminder that facts make or break a case. Spouses often times help one another where one or both spouses have their own business. It is important to remember that the liability of one spouse may be imputed to the other spouse based on their conduct and actions, regardless of whether or not that spouse intended to create an agency or partnership relationship.

This article is intended to highlight some of the more notable differences between Beverly-Killea and RULLCA. This article has two parts. This is Part 2 of 2. For Part 1, click here – https://www.northerncaliforniabankruptcyattorneysblog.com/new-california-limited-liability-company-llc-regulations-coming-january-1-2014-the-basics-what-you/

Fiduciary Duties: Beverly-Killea does not specify the fiduciary duties owed by members or managers of an LLC, instead stating that the fiduciary duties of an LLC manager are the same as those of a general partner in a partnership (“[t]he fiduciary duties a manager owes to the limited liability company and to its members are those of a partner to a partnership and to the partners or the partnership”). RULLCA changes this by setting forth detailed provisions concerning fiduciary duties.

In addition, Beverly Killea provides that fiduciary duties may be modified but does not specify in extent or manner in which they can be modified (“[t]he fiduciary duties of a manager to the limited liability company and to the members of the limited liability company may only be modified in a written operating agreement with the informed consent of the members.”). By contrast, RULLCA provides that an operating agreement may not “unreasonably” reduce the duty of care and may not “eliminate” the duty of loyalty, but may with respect to the duty of loyalty “[i]dentify the specific types or categories of activities that do not violate the duty of loyalty, if not manifestly unreasonable” and “[s]pecify the number or percentage of members that may authorize or ratify, after full disclosure to all members of all material facts, a specific act or transaction that otherwise would violate the duty of loyalty.”

Voting: Like Beverly-Killea, RULLCA provides that absent a contrary provision in the operating agreement, voting by members is based on each member’s interest in the current profits of the LLC. Also like Beverly-Killea, RULLCA provides as the “default position” that changes to the articles of organization or the operating agreement require the consent of all members but that a vote of the majority of members is sufficient for all other matters for which a vote is required.

Contributions: RULLCA defines contribution as “any benefit” provided by a person to the LLC, which seemingly creates a potential valuation problem. By contrast, Beverly-Killea defines contribution as “money, property, or services rendered, or a promissory note or other binding obligation to contribute money or property, or to render services as permitted in this title.”

Tax Allocations: Unlike Beverly-Killea, RULLCA is silent on the allocation of profits and losses among LLC members for tax purposes. Thus, under RULLCA a company’s operating agreement should specify the method by which profits and losses are to be allocated.

Indemnification: Unlike Beverly-Killea, which states that an operating agreement may provide for indemnification of any person, RULLCA provides as a default rule that an LLC shall reimburse for any payment made and indemnify for any debt, obligation or other liability incurred by a member-manager or a manager.

This article is intended to highlight some of the more notable differences between Beverly-Killea and RULLCA. This article has two parts. This is Part 1 of 2. For Part 2, click here –

Operating Agreements: Both Beverly-Killea and RULLCA define an operating agreement to include both oral and written agreements. However RULLCA provides that LLCs are member-managed unless the articles of organization and a written operating agreement state that the LLC will be manager-managed. By contrast, Beverly-Killea only requires that the articles of organization state that the LLC is to be manager-managed. Therefore, unlike under Beverly-Killea, RULLCA requires that a written operating agreement be in place for an LLC to be manager-managed. Absent a written statement in the articles of organization and the operating agreement indicating that the LLC is manager-managed, RULLCA provides that that every member of the LLC is an agent of the LLC for the purpose of its business or affairs. As such, the act of any member for the apparent purpose of carrying out the usual business or affairs of the LLC binds the LLC unless (i) the member so acting in fact has no authority to act, and (ii) the person with whom the member is dealing has actual knowledge of this fact.

Under RULLCA, if a record filed with the Secretary of State conflicts with the operating agreement, the operating agreement controls as to members, managers, dissociated members, and transferees; the records of the Secretary of State prevail as to other persons to the extent they rely on such record. This is different than Beverly-Killea, which provides that in the event of a conflict between the articles of organization filed with the Secretary of State and the operating agreement, the articles of organization control.

In addition, RULLCA provides that a person who signs a record knowing the information is inaccurate, or a member or manager who had notice of the inaccuracy and could have cured it can be liable to third persons who rely on the incorrect information. Beverly-Killea limits such liability to managers who execute a certificate of amendment that contains a false statement.

Further, unlike Beverly-Killea, RULLCA provides that a member of an LLC will be deemed to assent to the terms of an operating agreement even if the member did not sign the operating agreement.

Management: Both Beverly-Killea and RULLCA state that the default rule is that an LLC is member-managed unless the articles of organization provide that the LLC will be manager-managed. However, under RULLCA this default rule applies unless the articles of organization and a written operating agreement state that the LLC is to be manager-managed. Therefore, although RULLCA defines operating agreement to include both an oral and written agreement, a manager-managed LLC must have a written operating agreement stating that the LLC is manager-managed.

Under Beverly-Killea and RULLCA, in a member-managed LLC, absent a contrary provision in the operating agreement, matters outside the ordinary course of activities of the LLC require the approval of all members. However, RULLCA provides that in a manager-managed LLC, as a default, managers have equal rights in the management and conduct of the LLC’s activities and that a majority of managers decide matters in the ordinary course of business, except that all members must approve: (1) the sale, lease, exchange or other disposal of all or substantially all of the LLC’s property, (2) the undertaking of any act outside the ordinary course of the LLC’s activities, (3) merger or conversion, and (4) any amendment to the operating agreement. This is a change from Beverly-Killea, which provides as a default that all decisions of the managers would be decided by majority vote.

Factual Background and Procedural History

In 1978, Petitioner’s father established a trust for the benefit of his five children. He made Petitioner the trustee and transferred to the trust a single asset, a life insurance policy. The trust instrument permitted Petitioner, as trustee, to borrow funds from the insurer that issued the life insurance policy against the policy’s value. Initially at his father’s request, and later on his own, Petitioner borrowed money from the trust. All of the money borrowed by Petitioner was repaid with interest.

In 1999, Petitioner’s brothers sued Petitioner in Illinois state court. The state court held that Petitioner had committed a breach of fiduciary duty, stating that Petitioner “does not appear to have had a malicious motive in borrowing the funds from the trust” but was nonetheless “clearly involved in self-dealing.” After Petitioner tried unsuccessfully to liquidate certain assets to make court-ordered payments, Petitioner filed for bankruptcy. BankChampaign, as trustee for the constructive trust imposed by the state court on Petitioner’s assets in order to secure Petitioner’s payment of the judgment against him, opposed Petitioner’s effort to obtain a bankruptcy discharge of his debts to the trust. The bankruptcy court granted summary judgment in BankChampaign’s favor, holding that Petitioner’s debts were non-dischargeable under Bankruptcy Code § 523(a)(4) “as a debt for defalcation while acting in a fiduciary capacity.” The Federal District Court and the Court of Appeals both affirmed, with the Court of Appeals finding that “defalcation requires a known breach of fiduciary duty, such that the conduct can be characterized as objectively reckless.”

Petitioner sought certiorari, asking the Supreme Court to decide whether the bankruptcy term “defalcation” applies “in the absence of any specific finding of ill intent or evidence of an ultimate loss of trust principal.” Noting lower courts’ disagreement over whether “defalcation” includes a scienter (intent) requirement and, if so, what kind of scienter it requires, the Supreme Court granted certiorari.

Holding and Analysis

Noting the long-standing disagreement over the mental state required by the term “defalcation” contained in Bankruptcy Code § 523(a)(4), after reviewing dictionary definitions of the word “defalcation,” which it found unhelpful, the Supreme Court turned to its own analysis and interpretation of the term “fraud” in the sections of the Bankruptcy Code containing exceptions to discharge. Citing its opinion in Neal v. Clark, 95 U.S. 704, 709 (1878), in which it held that “fraud” must mean “positive fraud, or fraud in fact, involving moral turpitude or intentional wrong” rather than “implied fraud, or fraud in law, which may exist without the imputation of bad faith or immorality,” the Supreme Court held that “the statutory term “defalcation” should be treated similarly.”

The Supreme Court therefore went on to hold that “where the conduct at issue does not involve bad faith, moral turpitude, or other immoral conduct, the term [defalcation] requires an intentional wrong. We include as intentional not only conduct that the fiduciary knows is improper but also reckless conduct of the kind that the criminal law often treats as the equivalent. Thus, we include reckless conduct of the kind set forth in the Model Penal Code. Where actual knowledge of wrongdoing is lacking, we consider conduct as equivalent if the fiduciary “consciously disregards” (or is willfully blind to) “substantial and unjustifiable risk” that his conduct will turn out to violate a fiduciary duty. That risk “must be of such a nature and degree that, considering the nature and purpose of the actor’s conduct and the circumstances known to him, its disregard involves a gross deviation from the standard of conduct that a law-abiding person would observe in the actor’s situation.””

Commentary

Bullock is a significant case, particularly in the Ninth Circuit, where prior cases have held that “even innocent acts of failure to fully account for money received in trust will be held as non-dischargeable defalcations; no intent to defraud is required,” meaning that most obligations of a trustee, even a non-professional trustee such as a family member under a family trust, were non-dischargeable in bankruptcy. Bullock changes this. Now, absent “knowledge of, or gross recklessness in respect to,” the improper nature of the fiduciary conduct giving rise to the fiduciary’s liability, a fiduciary’s obligations are no longer non-dischargeable in bankruptcy under the “defalcation” exception to discharge contained in Bankruptcy Code § 523(a)(4).

The opinion can be found at: http://www.supremecourt.gov/opinions/12pdf/11-1518_97be.pdf

Factual Background and Procedural History

In 2005, the Wongs contracted with debtor contractor, M.P. Construction Company, Inc., to remodel their home. After being paid over $1.6 million for services originally estimated to cost $995,000, debtor sued to collect approximately $75,000 in unpaid invoices. The Wongs countersued. Following a week-long arbitration, a $601,322 judgment was entered in the Superior Court in favor of the Wongs in January 2010. The unsatisfied judgment resulted in debtor’s contractor’s license being suspended by operation of law.

In July 2009, prior to the judgment being entered, a new entity named Avenue 35 Construction Co., Inc. (“Avenue 35”) was incorporated by the three adult children of debtor’s owners, Mario and Ana Piumetti. In August 2009, Avenue 35 acquired debtor’s assets for $120,000. To facilitate this transaction, Mr. Piumetti loaned each child $40,000. The $120,000 paid to debtor was then used to repay undocumented loans that Mr. Piumetti asserted he made to debtor. Mr. Piumetti then attempted to transfer debtor’s contractor’s license to Avenue 35.

Unfortunately for debtor, Cal. Bus. & Prof. Code § 7071.17(j) precludes an entity from receiving a contractor’s license if the entity’s responsible managing officer was affiliated with a judgment debtor whose license was suspended based on an unsatisfied judgment. Consequently, debtor was precluded from transferring its license to Avenue 35. Cal. Bus. & Prof. Code § 7071.17(f) however contains an exception where the unsatisfied judgment has been discharged by bankruptcy proceeding. Thus, debtor elected to file a voluntary chapter 7 bankruptcy petition on July 15, 2011. Debtor’s schedules reflected that debtor had no assets as of the petition date.

With the aid of discovery obtained through Bankruptcy Rule 2004, the Wongs filed a motion to dismiss debtor’s bankruptcy case pursuant to Bankruptcy Code § 707(a) on grounds that the petition was not filed in good faith because debtor was a corporation not entitled to a discharge and had no assets to distribute to creditors. The Wongs also sought Rule 9011 sanctions against debtor and its attorney. The bankruptcy granted the Wongs’ motion, finding that there was “absolutely…no legitimate purpose” for debtor’s petition and that the petition was only filed to benefit debtor’s principals. Debtor appealed.

Holding and Analysis

Among the issues before the Bankruptcy Appellate Panel (BAP) was whether the bankruptcy court erred when it determined that ’cause’ existed under § 707(a) to dismiss debtor’s chapter 7 case.

Section 707(a) states:
(a) The court may dismiss a case under this chapter only after notice and a hearing and only for cause, including –
(1) unreasonable delay by the debtor that is prejudicial to creditors;
(2) nonpayment of any fees and charges required under chapter 123 of title 28; and,
(3) failure of the debtor in a voluntary case to file, within fifteen days or such additional time as the court may allow after the filing of the petition commencing such case, the information required by paragraph (1) of section 521(a), but only on a motion by the Unites States trustee.

First, the BAP noted that it was undisputed that subparagraphs 1-3 of § 707(a) were not the “cause” for the dismissal of debtor’s case. However, the BAP found that it was well-settled that if the asserted ’cause” under § 707(a) was not covered by a specific provision, ie. § 707(a)(1-3), then the court was required to consider whether under the circumstances surrounding debtor’s filing there was “misconduct sufficient to constitute ’cause’ for dismissal.” In debtor’s case, the BAP found that there clearly was.

Citing the bankruptcy court’s decision, the BAP noted that chapter 7 bankruptcy relief is available for two overriding reasons: to provide the honest but unfortunate debtor a fresh start through the discharge provisions of the Bankruptcy Code, and to provide for the fair and equitable distribution of a debtor’s assets to its creditors. The BAP had no trouble agreeing with the bankruptcy court that neither reason was present in debtor’s case.

First, because debtor was a corporation it was plainly not eligible for a discharge. Second, debtor had no assets to distribute to its creditors. Accordingly, the BAP found that the bankruptcy court did not err when it found that ’cause’ existed to dismiss debtor’s bankruptcy case. The BAP also found that debtor’s bankruptcy case “was filed not for the purpose of securing bankruptcy relief for MP Construction, but for the purpose of protecting and benefitting MP Construction’s principals.”

Accordingly, the BAP affirmed the bankruptcy court’s ruling, including its award of Rule 9011 sanctions, finding that debtor’s filing was improper because debtor would not have benefitted from a bankruptcy and the filing of the case to affect a transfer of debtor’s contractor’s license was not a valid purpose.

Commentary

This case serves as a cautionary tale and reminder to debtors and their counsel of the purpose of Chapter 7 bankruptcy and the consequences of filing a bankruptcy petition for an improper purpose. The well-established purpose of a chapter 7 bankruptcy is to provide a fresh start for the honest but unfortunate debtor and to provide a mechanism for the fair and equitable distribution of the debtor’s assets to debtor’s creditors. As this case makes clear, the purpose is not to provide a tool or means for a debtor’s principals to benefit themselves. In the case of a non-individual (entity) debtor, without assets to distribute, there is no bankruptcy purpose for a chapter 7 filing given that an entity is not eligible for a bankruptcy discharge. Moreover, a Chapter 7 filing under such circumstances may likely subject both the debtor and its attorney to sanctions.

The opinion can be found at: http://cdn.ca9.uscourts.gov/datastore/bap/2013/03/05/MP%20Construction%20Memo%2012-1306%20and%2012-1307.pdf

Factual Background and Procedural History

Chapter 11 debtor Idalia Roxana Castillo (Debtor) owned six pieces of real property. One was a rental property against which creditor Deutsche Bank National Trust Company (Deutsche) held a first deed of trust to secure repayment of a promissory note with a principal balance of $1,031,330.56. The property’s appraised value for plan purposes was $500,000.

After Debtor filed bankruptcy, Deutsche asserted a secured claim for $1,072,498.94. Debtor then filed a plan of reorganization. Deutsche thereafter timely elected to have its entire claim treated as fully-secured pursuant to Bankruptcy Code Section 1111(b). After Debtor filed an amended plan and disclosure statement, Deutsche filed an amended proof of claim, increasing the total amount of its claim to $1,207,652.57. The increase reflected Deutsche’s post-petition attorneys’ fees and post-petition interest. Debtor objected, arguing, inter alia, that Deutsche’s amended proof of claim included post-petition interest and attorneys’ fees even though, according to Debtor, Deutsche was not eligible to recover such charges under Bankruptcy Code Section 506(b).

After dispensing with Debtor’s other objections to Deutsche’s amended proof of claim, Judge Bluebond held that the issue of “whether an undersecured creditor who elects the application of Section 1111(b) is entitled to include post-petition interest and attorneys’ fees in the amount of its secured Claim” was worthy of further consideration. After reviewing the parties’ supplemental briefing and hearing oral argument on the issue, Judge Bluebond issued a memorandum explaining her analysis and conclusions, which she noted were “novel and surprising.”

Holding and Analysis

Relying heavily on Ninth Circuit Court of Appeals’ decision in Infonet Mgmt v. Centre Ins. Co. (In re SNTL Corp.), 571 F.3d 826 (9th Cir. 2009) (SNTL Corp.), Judge Bluebond overruled Debtor’s Claim Objection in part, holding that “after making an 1111(b) election, an undersecured creditor may include in its 1111(b) secured claim post-petition attorneys’ fees, but not post-petition interest.”

Judge Bluebond found that in SNTL Corp., the Ninth Circuit “faced squarely the question of whether Section 506(b) should be read for the proposition that post-petition attorneys’ fees may be recovered only if they are available under Section 506(b).” In SNTL Corp., the court held that the bankruptcy court should look to Section 502, not Section 506, to determine whether a claim should be allowed, holding that Section 506 governs the extent to which a claim is a secured claim, not the extent to which the claim should be allowed. Judge Bluebond therefore found that SNTL Corp. dictated that “unless one of the subsections of section 502 provides for disallowance of the claim, a claim that would otherwise be valid under applicable nonbankruptcy law should be allowed.”

Applying SNTL Corp. to the facts before her, Judge Bluebond held that Deutsche was permitted to include in the amount of its 1111(b) secured claim attorneys’ fees that it was entitled to recover under the terms of its prepetition contract with Debtor, including post-petition attorneys’ fees. Judge Bluebond reasoned that under Section 502(b) and SNTP Corp., Deutsche would be entitled to an allowed unsecured claim for post-petition attorneys’ fees. Therefore, since Deutsche was entitled to post-petition attorneys’ fees, having made an 1111(b) election, Deutsche could include the amount of its post-petition attorneys’ fees in its Section 1111(b) secured claim.

With respect to post-petition interest, Judge Bluebond held that because Section 502(b) contains a provision disallowing claims for interest unmatured as of the petition date, Deutsche’s Section 1111(b) secured claim could not include post-petition interest, finding “[a]s Deutsche holds an 1111(b) secured claim only to the extent that it has an allowed claim under Section 502(b), and Section 502(b) disallows Deutsche’s claim for post-petition interest, it follows necessarily that Deutsche’s Section 1111(b) secured claim may not include post-petition interest.”

Commentary

This case is noteworthy because it allows a creditor to include attorney’s fees incurred post-petition that are otherwise recoverable by the creditor as part of its Section 1111(b) secured claim. The case is also a reminder that Section 506 governs the extent to which a claim is secured, not whether the claim is allowed; to determine whether a claim is allowed, one must look to Section 502.