Judicial Estoppel in the Fifth Circuit, Part 1 – The Basics

8602181_sIn a previous post I stressed the importance of a debtor’s full disclosure of pending personal injury and other causes of action to the bankruptcy court and promised this post on the doctrine of “judicial estoppel.” Judicial estoppel cases are necessarily fact driven and sometimes require interpretation of ambiguous provisions of the Bankruptcy Code.  There are l-o-n-g articles available that go into great detail on every potential estoppel nuance.   I have decided that such an analysis is beyond the scope this blog – please consider this to be a primer.   I am working on “Judicial Estoppel, Part 2” which will deal with the practical application of judicial estoppel in Mississippi state courts and how to work with the bankruptcy trustee.

In recent years, the Fifth Circuit Court of Appeals has issued several opinions on judicial estoppel involving undisclosed claims by bankruptcy debtors and has created a fairly consistent body of law.  See In re Coastal Plains, Inc., 179 F.3d 197 (5th Cir. 1999); In re Superior Crewboats, Inc., 374 F.3d 330 (5th Cir. 2004); Kane v. Nat’l Union Fire Ins. Co., 535 F.3d 380 (5th Cir. 2008); Reed v. City of Arlington, 650 F.3d 571(5th Cir. 2011)(en banc); Love v. Tyson Foods, Inc., 677 F.3d 258, 261 (5th Cir. 2012).   These cases establish that “judicial estoppel” is a federal common law doctrine courts use to prevent a party from asserting a position in a legal proceeding that is inconsistent with a position taken in a previous proceeding.  For example, the official bankruptcy schedules of assets require debtors to disclose all property, tangible and intangible, including causes of action and claims of every sort.  If a debtor fails to schedule a personal injury claim, he has represented to the bankruptcy court that no such claim exists. Accordingly, judicial estoppel is invoked where “intentional self-contradiction is being used as a means of obtaining unfair advantage in a forum provided for suitors seeking justice.” Superior Crewboats, 374 F.3d at 334-35 (citations and quotations omitted).

The Fifth Circuit has established a three-part test for determining whether a debtor should be judicially estopped from pursing an undisclosed cause of action:

(1) The debtor is judicially estopped only if his position is clearly inconsistent with the previous one (the allegations in the complaint are clearly inconsistent with the representations in the bankruptcy schedules);

(2) The court must have accepted the previous position (the bankruptcy court discharged the debtor’s debts or took some other action relying on the bankruptcy schedules); and

(3) The non-disclosure must not have been inadvertent. “[T]he debtor’s failure to satisfy its statutory disclosure duty is ‘inadvertent’ only when, in general, the debtor either lacks knowledge of the undisclosed claims or has no motive for their concealment.” Superior Crewboats, 374 F.3d at 335 (quoting Coastal Plains, 179 F.3d at 210).

After Coastal Plains and Superior Crewboats were decided, there was a question whether judicial estoppel should apply to the bankruptcy trustee serving in the case. As a general rule, under Section 541 of the Bankruptcy Code a bankruptcy trustee succeeds to the debtor’s interest in property, but has no greater rights in property than the debtor. However, in Kane, 535 F.3d at 387, the Fifth Circuit ruled that a bankruptcy trustee should be able to pursue a claim on behalf of the creditors that the debtor himself would be judicially estopped from pursuing:

[The debtor’s] nondisclosure in bankruptcy harmed his creditors by hiding assets from them. Using this same nondisclosure to wipe out [the debtor’s claim against the defendant] would complete the job by denying creditors even the right to seek some share of the recovery. Yet the creditors have not contradicted themselves in court. They were not aware of what [the debtor] has been doing behind their backs. Creditors gypped by [the debtor’s] maneuver are hurt a second time by the district judge’s decision. Judicial estoppel is an equitable doctrine, and using it to land another blow on the victims of bankruptcy fraud is not an equitable application.

Id. at 387-388 (quoting Biesek v. Soo Line R.R. Co., 440 F.3d 410, 413 (7th Cir.2006)).  Similarly, Reed held that where a debtor is individually estopped from pursuing an undisclosed claim, the trustee can pursue the claim for the benefit of creditors and any remaining funds after distribution would be refunded to the defendants and not to the debtor.  Reed, 650 F.3d at 573.

A debtor’s failure to disclose pre-petition causes of action and pending litigation could be devastating to the lawyer who has spent time and incurred expenses pursuing the debtor’s personal injury case.  If the Trustee can pursue the claim, but the debtor cannot receive any benefit, how do the parties deal with the possibility that the trustee may collect more funds than are necessary to pay the debtor’s creditors in full?  Ordinarily, the debtor would receive the surplus.  The Fifth Circuit addressed this contingency in its most recent case on judicial estoppel, In re Flugence, 738 F.3d 126 (5th Cir. 2013).

In Flugence, the debtor failed to disclose a personal injury claim in her Chapter 13 case. She completed her plan payments and the case was closed. The personal injury defendants learned of the bankruptcy and petitioned the bankruptcy court to reopen the case.   The debtor amended Schedule B to add the personal injury suit as an asset and the Chapter 13 trustee hired the debtor’s personal injury lawyer to pursue the claim on behalf of the trustee and the bankruptcy estate. The defendants filed an adversary proceeding seeking a declaratory judgment that the debtor was “judicially estopped” from pursing the personal injury claim due to her failure to disclose her personal injury claim in her bankruptcy proceedings.  The bankruptcy court found that all of the elements of judicial estoppel were met and that the debtor was precluded from recovering any damages in the state court litigation. However, the court ruled that estoppel did not apply to the Chapter 13 trustee.  The defendants then argued that since the debtor was estopped, the trustee was limited to recovering an amount sufficient to pay off creditors. The bankruptcy court rejected the argument and ruled that the trustee could pursue the personal injury case without regard to the claims filed in the bankruptcy case.  This meant that the personal injury attorney could recover his full contingency fee under the original contract without limitation or reference to the claims filed in the case.

Neither side was satisfied and both sides appealed. The District Court overturned the bankruptcy court on the issue of judicial estoppel of the debtor and affirmed in all other respects.

 The Fifth Circuit disagreed with the district court and reinstated the judgment of the bankruptcy court.  The Court ruled that, “[w]here a debtor is judicially estopped from pursuing a claim he failed to disclose to the bankruptcy court, the trustee, consistent with Reed, may pursue the claim without any limitation not otherwise imposed by law.” Id. at 132.  The Court believed that to limit the recovery to creditors’ claims could negatively affect creditors because an attorney may not be willing to pursue the personal injury case if there were a limitation on the potential recovery.

If one clear message arises from the Fifth Circuit cases on judicial estoppel, it is that no one, especially the creditors in a case, should be negatively affected by a debtor’s failure to disclose a cause of action (no one other than the debtor).

One last point.  This post focused on the omission of personal injury or other causes of action and the effect on creditors and the trustee.  However, judicial estoppel could be applied in other contexts – consider bankruptcy schedules versus domestic relation disclosures in chancery court and similar proceedings.

The MBC Enters the 21st Century

The Mississippi Bankruptcy Conference has a new website! Visit now and find out how to register for the annual conference (and much more).  http://www.mississippibankruptcyconference.com/

Mississippi Bankruptcy Conference, Inc.
Thirty-third Annual Seminar
December 12 & 13, 2013
Hilton-Jackson
1001 E. County Line Road
Jackson, Mississippi  39211

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.

Single Member LLCs: Confusing and Messy in Bankruptcy

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Single member limited liability companies cause a lot of confusion in bankruptcy cases.   A small business owner operating through an LLC often considers the assets and liabilities of the company to be his, personally.  He acquired the company’s assets through his own toil and he likely guaranteed the company’s debt. He may know that “technically” the LLC is a separate entity, but he probably feels that he and his company are one and the same.  He is not alone.  The IRS ignores single member LLCs for most purposes. Many lawyers would also ignore the distinction and include the individual owner as a defendant in a lawsuit involving the business of the LLC.   Loosely speaking, rightly or wrongly, single member LLCs are widely ignored – except in bankruptcy court.

Consider the following: if the individual owner of a single member LLC files bankruptcy (any chapter) –

  • Are the assets of the LLC property of the debtor’s bankruptcy estate?
  • Can the individual debtor claim the assets of the LLC as exempt?  What if the assets are necessary for the debtor’s trade?
  • Does the bankruptcy filing of the individual debtor stay the collection efforts of the LLC’s creditors seeking to recover from the LLC’s assets?

The answer to these questions is, NO.  The individual and the LLC are separate legal entities, and the assets and liabilities of the individual are separate from the assets and liabilities of the LLC.   See Miss. Code Ann. §79-29-311; In re Chang, Bankr. S.D. Miss., Case No. 10-51012 NPO (Dk#123); In re Modanlo, 412 B.R. 715 (Bankr. D. Md. 2006), aff’d, 266 F. App’x 272 (4th Cir. 2008); In re Desmond, 316 B.R. 593 (Bankr. D.N.H. 2004).

If the primary cause of the debtor’s financial difficulty is business related, a Chapter 11 reorganization of the LLC may be the only option if saving the business is paramount.  In such a case, filing a bankruptcy for the debtor, individually, is likely the wrong course of action.   Filing a Chapter 13 case for the individual will not help because the LLC’s debts cannot be modified or adjusted.  In an individual Chapter 7 case, the debtor risks losing his business altogether.  Although the assets of the LLC are not property of the bankruptcy estate, the LLC membership interest is subject to the control of the trustee. LLC membership interests are intangible personal property under Mississippi law.  Miss. Code Ann. §79-29-701. Even if the LLC interest has no obvious value, the trustee may have an opportunity to sell the LLC interest. I know of one case in which a competitor of a debtor’s business offered the trustee $10,000.00 for the LLC interest just to close the debtor’s business and shut out the competition.  You should carefully consider the potential consequences before filing a bankruptcy case for an individual who operates his business through a single member LLC.

One last word of caution – don’t get too creative in attempting a “work around.”  An individual bankruptcy case filed as “John Q. Debtor” d/b/a “John Q. Debtor, LLC” will face tough scrutiny and may be dismissed as filed in bad faith.   Also, efforts to “dissolve” the LLC with the Secretary of State to transfer ownership of assets prior to filing an individual bankruptcy will not work.  Mississippi law prohibits most distributions from an LLC if the LLC is insolvent.  Proper procedures for winding-up the business must be followed before in-kind distributions can be made to the member(s) of an LLC.  See generally, the Revised Mississippi Limited Liability Company Act,  Miss. Code Ann §79-29-101, et. seq., and, specifically, Miss. Code Ann. §79-29-609 which limits distributions by insolvent LLCs.  The Bankruptcy Judges in the Southern District have made it clear that they follow the mandates of the Mississippi Code regarding dissolution and that they treat LLCs and their owners as separate legal entities.

If you ultimately determine that it is in the best interest of an individual debtor with an LLC to file bankruptcy (because of problems with personal indebtedness such as medical bills or credit card debt, e.g.), it is important that the schedules and statements properly reflect the membership interest in the LLC.

  • The debtor should not include the assets of the LLC in the schedules.
  • The debtor should include the membership interest in the LLC on Schedule B, Line 13 – “Stock and interests in incorporated and unincorporated businesses.”
  • The debtor should place a value on the membership interest in the LLC.
  • The debtor should not include debt secured by assets of the LLC on Schedule D – “Creditors Holding Secured Claims.”  If the debtor personally guaranteed the secured debts of the LLC, then the debtor should include the LLC’s creditors on Schedule F – “Creditors Holding Unsecured Nonpriority Claims.”
  • The debtor should not include the LLC’s secured debt on the Statement of Intent, and the debtor will not have the option to reaffirm the debt or surrender the property.

Personal Note: The debtor should be prepared to provide the trustee with the LLC’s tax returns, bank statements, a detailed list of assets and liabilities.  The easier you can make it for the trustee to assess the case, the faster the debtor will receive a discharge and get on with his fresh start.

DISCLAIMER

7th Circuit-Inherited IRA Not Exempt-Circuit Split

The Seventh Circuit Court of Appeals in In re Clark (12-1241) (April 23, 2013) disagreed with the Fifth Circuit case In re Chilton that held Inherited Individual Retirement Accounts are exempt.  I wrote about Chilton in an earlier post.   The Chilton case was fairly long and relied on highly technical language and definitions from the Internal Revenue Code. The Fifth Circuit held that an inherited IRA contains “retirement funds” within the meaning of §522(d)(12) and can include funds that others had set aside for retirement and are not limited to funds set aside by the debtors.   The Seventh Circuit disagreed and made itself clear in an 8 page opinion.

In Clark, the debtor claimed funds held in an inherited IRA as exempt.  The Bankruptcy Court (W.D. Wisc.) disallowed the exemption claim on the basis that the inherited IRA did not represent “retirement funds” in the hands of the debtor.  The District Court reversed on the basis that the question was “close” and should therefore be decided in favor of the debtor. The Seventh Circuit stated that the case was not close at all and found that the bankruptcy judge got it right.  The Court of Appeals stressed the differences between a regular IRA and in inherited IRA.  No new contributions can be made to an inherited IRA and it cannot be rolled over or merged with another account.  The inherited IRA cannot be used for the beneficiary’s retirement-the funds must be withdrawn in five years in most instances.  In short, the Court found that, “an inherited IRA does not represent ‘retirement funds’ in the hands of the current owner…” and that “money constitutes ‘retirement funds’ (a term that the Bankruptcy Code does not define) only when held for the owner’s retirement. “(Page 3).  Inherited IRAs are not “savings reserved for use after their owners stop working.” (Page 8).

The issue of inherited IRAs as exempt arises periodically in Mississippi.  Although Chilton and Clark construe the federal exemption statute, the same rationales would likely apply under the Mississippi exemption scheme.

Increases in Federal Exemptions and More!

The Judicial Conference increased certain dollar amount limitations found in the Bankruptcy Code effective for cases filed on or after April 1, 2013.  Debtors’ attorneys, don’t forget to update your software.  You may review all of the increases in the Federal Register here.  For example, the Chapter 13 debt limitation has been increased to $383,175.00 for noncontingent, liquidated, unsecured debt and increased to $1,149,525.00 for noncontingent, liquidated, secured debt.   Additionally, the federal residency exemption (homestead exemption) has been increased to $22,975.00, the federal motor vehicle exemption has been increased to $3,675.00, and the federal wildcard exemption has been increased to $1,225.00, plus up to $11,500.00 of unused residency exemption.   All other federal exemptions expressed in dollar amounts have also been increased.

In addition to the increased amounts in the Bankruptcy Code, the median incomes used in the means test have been adjusted for all states.   Mississippi’s median income for a single member household is now $36,240.00.  View all of the changes here.

Hey wait! Why would a Mississippi lawyer care about federal exemptions? Stay tuned.

Take My House – Please!

What happens when a debtor surrenders real estate in a bankruptcy case and the lender does not foreclose? The recent First Circuit case, In re Canning, III, 2013 WL 388060 (Feb. 1, 2013), expresses the consensus view that a creditor cannot be forced to foreclose or take possession of surrendered property. In Canning, III, the debtors’ bankruptcy schedules reflected that they intended to surrender their house to their mortgage lender. After the debtors received their discharge, they received a letter from the mortgage lender advising that it did not intend to initiate foreclosure proceedings and that it would not advance any payments for insurance or taxes. The letter stated that the debtors would be solely responsible for maintenance of the property. The debtors filed an adversary proceeding against the lender seeking actual and punitive damages for its failure to foreclose on the basis that the lender violated the discharge injunction by its actions. The First Circuit found in favor of the lender:

[The lender’s] chosen course of action, or inaction, did not make things easy for the Cannings. Forces remained at work that could make their continued ownership of the real estate uncomfortable-forces like accruing real estate taxes and the desirability of maintaining liability insurance for the premises. But those forces are incidents of ownership. Though the Code provides debtors with a surrender option, it does not force creditors to assume ownership or take possession of collateral. And although the Code provides a discharge of personal liability for debt, it does not discharge the ongoing burdens of owning property.

Id. (quoting In re Canning, 442 B.R. 165, 172 (Bankr. D. Me. 2011)).

Most courts have ruled similarly using the same rationale. See In re Service, 155 B.R. 512 (Bankr. E.D. Mo.1993) (The Court cannot compel acceptance of the surrendered property); In re White, 282 B.R. 418 (Bankr. N.D. Ohio 2002) (bankruptcy code does not provide for the court or the debtor to direct the means by which the secured creditor deals with the surrendered property); In re Arsenault, 456 B.R. 627 (Bankr.S.D. Ga. 2011)(Chapter 13 debtors’ surrender of property to secured creditor in full satisfaction of debt, pursuant to their confirmed plan, did not obligate creditor to take affirmative action to transfer title to property out of debtors’ names).

I found two cases that held otherwise. See In re Pigg, 453 B.R. 728 (Bankr. M.D. Tenn. 2011)(An equitable remedy  was fashioned to address the attempted surrender of a condominium made uninhabitable by a flood, where a bank had actively taken possession of the property.) and In re Perry, 2012 WL 4795675 (Bankr. E.D. N.C. 2012)(The court allowed a lender 60 days to foreclose, and if a foreclosure proceeding was not commenced, the debtor was authorized to execute, deliver and record a quitclaim deed to the creditor.).

Is this really a widespread problem? I asked a couple of colleagues and confirmed that it is happening in Mississippi; however, they did not believe it was necessarily a problem. The debtors either lived on the property “for free” or they leased it and collected rent. If the surrendered property is a condominium (or located in a neighborhood with an owners’ association), the association dues that accrue post-petition are not discharged in the bankruptcy, and the debtor should understand that he may remain responsible for the fees.

What do you generally advise your debtor clients to do when a lender refuses to take title to surrendered property? When would you advise your bank client NOT to foreclose?