Plaintiff as Debtor – Bankruptcy Basics for Trial Lawyers

21970042_s If your practice centers on non-bankruptcy civil litigation, you may be uncertain how to proceed when the plaintiff files bankruptcy.  You know about the “automatic stay,” but does it apply when the plaintiff files bankruptcy? How does the trustee fit into the picture?  The plaintiff’s bankruptcy could change the entire dynamic of the pending litigation.   If the stakes are high, consider consulting a bankruptcy lawyer.  If you decide to handle the bankruptcy related matters yourself, you should become familiar with “judicial estoppel,” “standing” and “real party in interest.” You should also be prepared for the involvement of the bankruptcy trustee and the Bankruptcy Court. A good starting place would be the cases cited in my previous post and the Mississippi Supreme Court case, Kirk v. Pope, 973 So.2d 981 (Miss. 2007).  Kirk v. Pope confirms that federal common law applies in Mississippi state courts when considering judicial estoppel due to bankruptcy omissions. The case also addresses “standing” and “real party in interest” related issues.  Whether you represent the defendant or the plaintiff in pending litigation, it is important to consider the following when the plaintiff files bankruptcy (hereafter, the plaintiff may be referred to as the Debtor):

1.  Did the Debtor have a duty to include the cause of action or pending lawsuit in his bankruptcy schedules?

The answer depends on whether the Debtor filed a Chapter 7 or a Chapter 13 bankruptcy.  [The analysis below is very abbreviated and sometimes issues arise.  However, as a general rule, if there is any doubt about whether a cause of action should be disclosed, the Debtor should choose disclosure.  If he asks the question “should I disclose?,” the default answer should be “yes.”]

In cases originally filed under Chapter 7 – If the cause of action arose before the bankruptcy petition was filed, then it is should be disclosed and included as an asset in the bankruptcy schedules.  11 U.S.C. §521; In re Coastal Plains, Inc., 179 F.3d 197, 207-08 (5th Cir. 1999).

In Chapter 13 cases – If the cause of action arose before the bankruptcy petition was filed, or while the Chapter 13 case was pending, the cause of action is property of the bankruptcy estate and should be included as an asset in the bankruptcy schedules. 11 U.S.C. §1306, §521. The law on post-confirmation duty to disclose has recently been settled by In re Flugence, 738 F.3d 126 (5th Cir. 2013). There are opinions issued as recently as 2012 that would likely be decided differently today. See, e.g. Byrd v. Wyeth, Inc., 907 F. Supp. 2d 803 (S.D. Miss. 2012).  Section 1327 of the Bankruptcy Code provides, “[e]xcept as otherwise provided in the plan or the order confirming the plan, the confirmation of a plan vests all of the property of the estate in the debtor.” (emphasis added). The uniform order confirming Chapter 13 plans provides that property does not vest in the debtor until discharge, dismissal, or conversion.  Therefore, property of the estate includes property that the debtor acquires post confirmation, including causes of action that arise post-confirmation.  The Chapter 13 debtor has a duty to amend the schedules and disclose causes of action that arise before the case is dismissed, converted or until the debtor receives his discharge.

In Chapter 7 cases converted from Chapter 13 – It depends.  Generally, if the cause of action arose after the Chapter 13 case was filed, but before it was converted to Chapter 7, it would NOT be property of the Chapter 7 bankruptcy estate. 11 U.S.C. §348(f)(1). There is an exception that could apply that involves the debtor’s bad faith. 11 U.S.C. §348(f)(2).

The date that a cause of action arises is determined under applicable state or federal law and depends on the nature of the claim.  The date a lawsuit is filed is not the applicable date for purposes of determining whether a cause of action is property of the bankruptcy estate.

2.  Did the Debtor disclose the cause of action to the Bankruptcy Court?

If the cause of action became property of the bankruptcy estate, it should be included as an asset in the bankruptcy schedules. If you have access to PACER, you can search the bankruptcy court records by federal court judicial district using the Debtor’s name.   You can simultaneously search every district in the United States with the Debtor’s Social Security number.  The schedules are usually one of the first docket entries. It is possible that the Debtor told the trustee about the pending lawsuit at the 341 Meeting of Creditors.  I specifically ask debtors if they are “suing anyone” and whether they believe they are “entitled to sue someone for any reason.”   Sometimes debtors disclose the existence of causes of action at the 341 Meeting of Creditors even though they did not include a claim on their written schedules.  You may obtain an official copy of the recorded meeting of creditors from the U.S. Trustee.  I maintain unofficial recordings of my 341 Meetings and will provide a copy to attorneys upon request.

If the Debtor had a duty to disclose a cause of action or pending lawsuit and failed to schedule the claim or to inform the trustee, your next actions will depend on whether you represent the Debtor (plaintiff) or the defendant.

If You Represent the Defendant

If you represent the defendant, you will want to assert “judicial estoppel” and you will have to decide how to raise the issue procedurally. I have seen Motions to Dismiss and Motions for Summary Judgment filed with the trial court.  I have also seen a Complaint for Declaratory Judgment in bankruptcy court seeking a determination that the Debtor is judicially estopped.  I do not know if there is a right or wrong way to raise the issue – it likely depends on the circumstances and the court in which the case is pending.   Remember that judicial estoppel does not apply to the bankruptcy trustee.  Reed v. City of Arlington, 650 F.3d 571(5th Cir. 2011)(en banc); Kirk v. Pope, 973 So.2d 981 (Miss. 2007).   Therefore, if the trustee decides to proceed, it is unlikely that the trial court will dismiss the case.  However, it is very possible that the court will judicially estop the plaintiff, which will prohibit him from receiving any benefit from the claim or suit. In re Flugence, 738 F.3d 126 (5th Cir. 2013).  Thereafter, with the bankruptcy trustee involved, settlement opportunities may arise.  At a very minimum, the Debtor, as a witness, has lost credibility.

In addition to raising judicial estoppel, defendants usually include a request for dismissal based upon lack of plaintiff “standing” or based upon the “real party in interest” requirement of F.R.C.P. or M.R.C.P 17(a).  Unless the case trustee decides not to pursue the case as plaintiff, these assertions should not result in a dismissal of the lawsuit.  However, it should prompt a response by the plaintiff to cause the trustee to be substituted as plaintiff in the case.

If You Represent the Plaintiff/Debtor

It is not uncommon for a plaintiff to file bankruptcy without the knowledge of the attorney pursing a civil case on his behalf.  If you discover that your client has filed bankruptcy, you should immediately contact the case trustee.  If the cause of action is property of the Debtor’s bankruptcy estate, the bankruptcy trustee is the sole representative of the estate and the only party with authority to continue with the action or consider a settlement.  11 U.S.C. §323.   The case trustee will decide whether to continue as plaintiff in the civil action.  The trustee’s inquiry is whether the potential recovery would make a “meaningful distribution” to the Debtor’s creditors.

If the trustee agrees to pursue the case, you must be hired as “Special Counsel” and the Bankruptcy Court must approve your fee arrangement.  Special Counsel may be hired “on any reasonable terms and conditions of employment, including on a retainer, on an hourly basis, on a fixed or percentage fee basis, or on a contingent fee basis.” 11 U.S.C. §§ 328, 330.  If multiple firms are involved, or there is a fee sharing arrangement among two or more firms, the arrangement must be disclosed and the Court may require each firm to be separately employed.  Disclosure and transparency are paramount in Bankruptcy Court.   There are no secret deals or under the table transactions. The Bankruptcy Court must approve any settlement and award of attorney’s fees. As a general rule, the Mississippi Bankruptcy Courts and the Office of the U.S. Trustee limit the total compensation (combined fees and expenses) awarded to Special Counsel to 50% of the gross judgment or settlement amount. However, in a case in which Special Counsel has actually incurred extraordinary expenses, an exception may be made. The trustee will file the requisite Applications with the Bankruptcy Court.

When you represent the trustee, you must provide quarterly updates about the status of the case.  A one-paragraph e-mail message should be sufficient in most cases.   Failure to keep the trustee advised of the case status may result in a conference with the bankruptcy judge.  Repeated failures could jeopardize your fees.

Finally, please remember that when you agree to represent the trustee as Special Counsel, you have a new client with the attendant duty of loyalty.  Although you may feel sympathy for the Debtor, it is inappropriate to advocate that the Debtor be included in a settlement or to otherwise receive a benefit from a settlement.

3.  Does the automatic stay apply?

The automatic stay does not apply to civil actions in which the Debtor is the plaintiff. The stay only applies to proceedings against the Debtor. 11 U.S.C. §362(a).  Unless there was a counterclaim filed against the Debtor, the automatic stay should not affect the pending case.

*****After I was almost finished with this post, I realized that it was based on the premise that civil attorneys were “surprised” by a plaintiff’s bankruptcy filing.   It certainly happens that a plaintiff will file bankruptcy while a civil case is pending. However, for those attorneys who regularly represent plaintiffs in civil litigation, I cannot stress enough the importance of checking PACER for bankruptcies before you file a civil lawsuit.  You cannot simply rely on the potential client’s representations regarding past bankruptcies.   Some examples of what they may say if a bankruptcy is discovered include…

  • Oh! That was only related to my divorce.
  • That was about my failed business, not me personally.
  • That case was discharged a long time ago.
  • I didn’t file bankruptcy on the car that was involved in the accident.
  • That was just to stop a foreclosure; it didn’t have anything to do with the accident.
  • I forgot.
  • My attorney got that bankruptcy dismissed.
  • That was under my maiden name.

With so much information available online, there is simply no excuse for failing to discover a prior bankruptcy.  Your client may not have standing as plaintiff and your fee may be in jeopardy. *****

Wait! The @#$% Trustee is Selling My Stuff for Pennies!

facial expressionDebtors are often dismayed by the amounts received or recovered by the trustee administering their bankruptcy estate assets. A debtor may think the rural land she inherited from Grandpa is worth a fortune. Or, more likely, a debtor may believe his slip and fall case will fund his retirement. When a debtor files a Chapter 7 bankruptcy case, all of the debtor’s assets become property of his bankruptcy estate. 11 U.S.C. §541. The trustee is the sole representative of the bankruptcy estate with full authority to sign deeds and bills of sale and to settle and release claims. 11 U.S.C. §704. Of course, all of the trustee’s actions must be approved by the bankruptcy court, usually upon a motion and proposed order filed by the trustee. Many debtors have a hard time understanding and/or accepting this fact. After all, HE is the one who slipped on the grape and hurt his back! Can a Chapter 7 debtor object to the trustee’s proposed sale of assets or settlement of claims? Sometimes a debtor can talk his lawyer into filing an objection to a trustee’s proposed action. However, in most cases, the debtor lacks standing to object to the trustee’s administration of estate assets.

There are many written opinions on the bankruptcy standing issue and the rulings are generally consistent. A person must have a “pecuniary interest” in the outcome of a bankruptcy proceeding in order to have standing to object to a trustee’s actions. In order to establish a pecuniary interest, a debtor must demonstrate a reasonable possibility of a surplus distribution after all creditors’ claims are satisfied. See Spenlinhauer v. O’Donnell, 261 F.3d 113 (1st Cir. 2001); In re Cult Awareness Network, Inc., 151 F. 3d 605 (7th Cir. 1998); In re Richman, 104 F.3d 654 (4th Cir. 1997); In re Andreuccetti, 975 F.2d 413 (7th Cir. 1992); In re El San Juan Hotel, 809 F.2d 151 (1st Cir. 1987); Gregg Grain Co. v. Walker Grain Co., 285 F. 156 (5th Cir. 1922).

The Seventh Circuit case In re Cult Awareness Network is one of the most frequently cited cases on the bankruptcy standing issue (probably because the underlying facts are so interesting). The Court’s ruling and its reasoning are consistent with the other cases cited. The Cult Awareness Network (“Cult Awareness”) was a non-profit entity engaged in anti-cult advocacy and cult victim support. In 1996, Cult Awareness filed Chapter 11 reorganization case in the Northern District of Illinois after it became embroiled in legal disputes with churches it had alleged to be cults. One such church was the Church of Scientology. Cult Awareness failed to get a plan confirmed and ultimately the case was converted to a Chapter 7 liquidation proceeding and a trustee was appointed.

The Chapter 7 trustee auctioned Cult Awareness’s trade name, mailing lists, telephone records and similar assets to an individual alleged to be associated with the Church of Scientology. The debtor filed an objection to the trustee’s motion to confirm the sale. The Bankruptcy Court ruled that Cult Awareness lacked standing to object to the sale because it lacked a “pecuniary interest” in the outcome of the sale. The District Court affirmed the opinion of the Bankruptcy Court.

On appeal, the Seventh Circuit upheld the rulings of the lower courts. The Court of Appeals confirmed that a debtor must show a “reasonable possibility of a surplus after satisfying all debts” in order to have a pecuniary interest and standing to object to the trustee’s actions. Cult Awareness, 151 F. 3d at 608 (citing Andreuccetti, 975 F 3d at 417). Cult Awareness argued that there was a possibility of a surplus distribution because judgments against it were on appeal. The Court found that the possibility of a surplus recovery was too remote. “The purpose of the pecuniary interest rule ‘is to insure “that bankruptcy proceedings are not unreasonably delayed by protracted litigation by allowing only those persons whose interests are directly affected by a bankruptcy order to appeal.”‘” Id. at 609 (citations omitted). The opinion further stated:

[c]ourts consistently have noted a public policy interest in reducing the number of ancillary suits that can be brought in the bankruptcy context so as to advance the swift and efficient administration of the bankrupt’s estate. This goal is achieved by narrowly defining who has standing in a bankruptcy proceeding.

Id. (quoting Richman, 104 F. 3d at 656-57).

In sum, the overwhelming majority of Chapter 7 cases are “no asset” cases that result in no distribution to creditors whatsoever. Very few cases result in a surplus distribution to the debtor. I believe the law is clear that if a debtor wants to object to a trustee’s sale of assets or settlement of claims, it is the debtor’s burden to demonstrate that there is a reasonable likelihood of a surplus distribution that confers a “pecuniary interest” in the outcome. Otherwise, the debtor lacks standing to contest the trustee’s actions.

As always, I assert my DISCLAIMER. I would very much be interested in your opinions and comments.