Should the Widow Win? Part 2

Go here for Part 1 of this discussion (from nearly three months ago!).

Recapping the facts of In re Turnage, 

Widow of ne'er-do-well late husband files Chapter 7 bankruptcy with one asset--her home--valued at $180,000 subject to the following liens: a $52,000 mortgage, a $113,143 tax lien in favor of the IRS, and a $47,942 lien in favor of the Deportment of Taxation of North Carolina. Our widow is left with negative "equity" of nearly $34,000. In other words, the property is underwater, financially speaking. 

North Carolina law also affords our impoverished widow a homestead exemption of $55,000. Regrettably for her, however, the same law subordinates the homestead exemption to mortgages and tax liens.

How would bankruptcy help our widow? In the first place, it discharges her legal obligation to pay all three debts. This is important because her only significant income is from Social Security.

But what of her home?

Both federal and state law prohibit the relevant tax authorities from foreclosing on a homestead. In other words, their liens for unpaid taxes simply remain in place until the widow seeks to sell.  At that point they must be paid so a buyer will get clear title. The widow's death would lead to the same result. In short, she gets to live in the home as long as she wants/can and the liens are toothless until she or her estate sells the property. A win for the widow and delayed gratification for the tax authorities.

Enter the bankruptcy trustee. (Recall that the widow chose to file under Chapter 7 of the Bankruptcy Code, for better and for worse.) He asked the Bankruptcy Court for permission to sell the house and turn over the proceeds to the tax authorities. But why would he waste his time and go the the trouble (and expense) of doing this? After all, bankruptcy trustees are paid on a commission basis and generally don't get a cut from the sale of property whose value is more than swallowed by a lien.

In this case, however, the tax authorities agreed to take less than what was owed to them, thus freeing enough of the proceeds to pay the fees and expenses of the trustee. (And even a few dollars left over for unsecured creditors. Of course, the tax authorities also would have had the largest unsecured claims so they would get most of what's left over. C'est la guerre.)

Pretty slick. Or so it seemed.

Part 1 explained why I was unimpressed with the opinion of the United States Federal District Court judge barring this maneuver and leaving the widow in her home. The opinion of Bankruptcy Judge (linked above) is much more cogent. I don't have the inclination to articulate her reasoning because I want to make some observations on a path that was not followed, one that could have changed the result and let the bankruptcy trustee proceed with the sale.

Thirty years ago the United States Court of Appeals for the First Circuit (basically, the federal appellate court for the New England states) issued its opinion in In re SPM Manufacturing Corp. 984 F.2d 1305 (1st. Cir. 1993). The court in SPM permitted a result that in many respects is what the bankruptcy trustee was seeking in this case. The court permitted the secured creditor to "gift" a share from the sale of its collateral to general unsecured creditors even though other creditors held claims that had priority over unsecured claims. Essentially, the secured creditor was entitled to do what it pleased with the proceeds of its collateral.*

There was, however, one potentially significant legal difference between the situation in SPM and our case: the secured creditor in SPM had obtained relief from the automatic stay. In other words, the proceeds were the creditor's, not part of the bankruptcy estate. Still, the proceeds were distributed by the bankruptcy trustee under the aegis of the bankruptcy court. Not important, according the the appellate court.

I'm not sure whether the court in SPM would have reached a different result had the secured creditor not obtained relief from the stay. It went on to observe in dicta that a senior creditor could have purchased the non-priority unsecured claims to whom the trustee made the distributions in SPM and achieved the same result. An end-around the end-around.

There is a second difference between the facts of SPM and our widow's case: the widow has an exemption; she isn't asserting a priority claim. Treating the widow's exemption differently than that of a typical priority creditor makes sense as a matter of policy. Her position is, however, undercut by both federal and North Carolina law that subordinate a homestead exemption to tax liens.

I believe the bankruptcy trustee would have been unwise to appeal this case to the Fourth Circuit given the sympathies for the widow. I would like, however, to find out whether the Fourth Circuit would follow the precedent of SPM. This was not the case to make that effort.

* N.B. Most courts have held that out-of-priority-order gifting is not permitted in Chapter 11 cases because of the "absolute priority rule." Distributions in Chapter 7 cases are not subject to this rule.

Should the Widow Win? Part 1

Consider the following facts followed by two scenarios and three options.

Widow of ne'er-do-well late husband files Chapter 7 bankruptcy with one asset--her home--valued at $180,000 subject to the following liens: a $52,000 mortgage, a $113,143 tax lien in favor of the IRS, and a $47,942 lien in favor of the Deportment of Taxation of North Carolina. Our widow is left with negative "equity" of nearly $34,000. In other words, the property is underwater, financially speaking. 

North Carolina law also affords our impoverished widow a homestead exemption of $55,000. Regrettably for her, however, the same law subordinates the homestead exemption to mortgages and tax liens.

How would bankruptcy help our widow? In the first place, it discharges her legal obligation to pay all three debts. This is important because her only significant income is from Social Security.

But what of her home?

Scenario 1: The mortgage must continue to be paid. Bankruptcy discharges debts; it does not, generally speaking, discharge liens securing those debts. The mortgage lender will foreclose if she doesn't continue to pay.

What about the IRS and the NC Department of Revenue? While the judicial opinion from which these facts are taken doesn't explain why they wouldn't foreclose their liens, the tax authorities appear to be content to wait until the widow herself dies before collecting.

In short, in Scenario 1, the widow stays in her home.

Scenario 2: Consider an enterprising Chapter 7 bankruptcy trustee who suggests the following to the two tax authorities: "If you reduce your liens to 60% of what is owed, I will sell the home and pay off the mortgage. I'll then pay each of you your reduced liens (a bird in the hand ...), pay myself my statutory fees and reimburse myself for my out-of-pocket expenses (of say, about $30,000), and give the remaining $38,000 to other creditors of which the unpaid 40 of your claims are the largest part, and pay the remainder of about $2000 to the widow."

In short, in Scenario 2, all creditors are better off while the widow is on the street.

What's a court to do?

Option A: Let the widow keep her home in the spirit of equity? Or,

Option B: Let the bankruptcy trustee sell the home by following the letter of the law? Bankruptcy Code section 724(b), to be precise. Or,

Option C: "Interpret" the letter of the law in the spirit of equity and let the widow keep her home?

If you picked Option C you'd have on your side the authority of the the federal District Court for the Western District of North Carolina. You can read the opinion of the District Court in Summerlin v. Turnage (March 14, 2023) here where it affirmed the decision of the lower Bankruptcy Court.

Since leaving the practice where I generally represented commercial creditors in Chapter 11 corporate bankruptcy cases, I've come to appreciate better the plight of the many Americans caught in the maw of our financialized society. Leaving the widow Turnage in her home to the end of her days strikes me as good a result as can be expected.

On the other hand, there's the pesky Bankruptcy Code that appears to authorize what the Chapter 7 bankruptcy trustee proposed to do. For what it's worth, I am not persuaded by the District Court's opinion. It mischaracterizes what the trustee and two tax creditors agreed to do, misapplies the SCOTUS decision in Law v. Siegel (2014), and unnecessarily impugns the integrity of the trustee.

For a better explanation of why the trustee might be wrong, one can turn to the opinion of the lower Bankruptcy Court here. I hope to post my thoughts about it soon.

Puerto Rico And A Coda on Municipal Bankruptcy

I posted often during the course of the chapter 9 bankruptcies of Stockton and Detroit. You can read one on each here and here. I have not posted about Puerto Rico's extraordinary financial distress for two reasons: Puerto Rico is not eligible for any bankruptcy relief and others have been writing seriously and posting frequently about what can be done.

Today, however, I am breaking my Puerto Rico silence because this piece at the New York Times DealBook is spot on: Puerto Rico is the canary in the mine shaft.

Across America, dozens of cities, counties and states may be heading down the same financial rabbit hole. Illinois, New Jersey, Philadelphia, St. Louis and Jacksonville, Florida., to name just a few, are all facing their own slowly unspooling financial disasters.

Why?

Generous pension promises made decades ago, without enough funding, are now coming due as baby boomers retire. Bonds issued in the distant past to build bridges, highways and other projects also must be paid — even as the projects themselves could by now use expensive makeovers.

Exactly right. As I described at length in Municipal Bankruptcy: When Doing Less Is Doing Best (download here), American cities (and States) have promised their public-sector employees pensions and health benefits in amounts that are actuarially unsustainable, especially given current demographic trends. In addition, to try to reduce such benefits, once accrued, would violate the U.S. Constitution. Only if Congress permits cities (and States) to seek bankruptcy relief can anything be done.

Currently exceptionally low interest rates and the "flight to safety" that causes international investors to buy American debt securities are masking this problem. In not so many years, however, perhaps during the next presidential administration and certainly, in my opinion, by 2024, the time bombs hiding in state and local balance sheets will begin exploding. Were it not for the dysfunction endemic to our current political system, one might expect our elected leaders to begin planning for the inevitable. Reality being what it is, however, we'll find ourselves hanging on for dear life hoping for some means of redress.

No Bankruptcy For You: The Indirect Prohibition of Educational Reorganization

My spring semester Bankruptcy class is about to transition from the messy world of individual debt relief to the multi-variable universe of business bankruptcy. While I'm happy to let Dean (and former bankruptcy judge) Rich Leonard teach an advanced seminar in corporate reorganization, it is appropriate for all bankruptcy students to get at least a taste of the intricacies of Chapter 11 reorganization.

With a very few exceptions, the Bankruptcy Code permits any financially stressed corporation (or individual for that matter) to seek to reorganize its debts. Bankruptcy reorganization exists because the value of the whole is greater than its constituent parts. In other words, auctioning the assets of an insolvent business produces less value for its creditors than the same business with a new and improved capital structure. Not only are creditors made better off by reorganization, employees, customers, trading partners, and even the community as a whole do better if the business remains intact albeit under new ownership (and often new management).

At least that's the theory.

The implementation of corporate reorganization law is expensive and it's not clear if all of reorganization's potential gains are realized. Nonetheless, it  seems clear that the practice of corporate reorganization produces a net social gain. And, if that's the case (and I believe it is), there would be no good reason to prohibit an otherwise-eligible corporation from at least trying to reorganize, right?

No, there wouldn't. Yet as Matthew Bruckner explains in Bankrupting Higher Education (download here), institutions of higher education face an insuperable barrier to reorganizing their debts. Upon seeking any form of bankruptcy law relief, they automatically become ineligible to participate in federal financial aid programs, which means in virtually all cases they must shut their doors. Any residual value that creditors and others could realize through reorganization is lost.

You might think my response to this state of affairs would be a firm "meh" given my posts about the sad state of higher education in American (some examples here, here, and here). Yet consider Bruckner's well-tempered observation:

The effects of the college bankruptcy reorganization ban are more strongly felt among certain types of institutions. In particular, small colleges that have traditionally provided a liberal arts education and those that were founded to counter race- and gender-based discrimination appear especially vulnerable to financial distress, and are therefore more likely to need to take advantage of chapter 11’s toolkit. As a result, many of our nation’s most storied institutions have been forced to close their doors, preventing them from fulfilling their important missions, instead of being allowed to reorganize in bankruptcy. For example, almost twenty percent of all historically black colleges and universities (“HBCUs”) have closed since 1980.

To cut to the chase, it is the Higher Education Act and not the Bankruptcy Code that makes impossible reorganization of colleges and universities.

Bruckner's article is 61 pages long because it addresses not only the nature of the "death penalty" for colleges and universities that need to reorganize their debts but also why this should not be the case. In other words, he explains how the possibility of reorganization under federal bankruptcy law can preserve value for several groups of stakeholders and serve the common good, a two-fer that's generally not the case in the reorganization of most commercial enterprises.

None of this is to say, at least not in my opinion, that all colleges and universities in financial distress should reorganize. Bruckner addresses structural and cultural reasons why higher education in America finds itself in distress and Chapter 11 certainly will not solve those sorts of problems. Many schools should close but those for which there is no hope of financial recovery should not poison the well for those that could if given the chance.

In any event, Bankrupting Higher Education is an excellent piece of scholarship and should be of interest to those institutions that can gain the ear of lawmakers in Washington.

Bankruptcy Prophylaxis

Most folks have a general sense that, after going through the bankruptcy process, an individual's creditors may no long demand payment of a pre-bankruptcy debt. The source of this belief can be found in Bankruptcy Code § 524(a): "A discharge in a case under this title--(2) operates as an injunction against the commencement or continuation of an action ... or an act, to collect, recover or offset any such debt as a personal liability of the debtor."

The so-called discharge injunction is very broad and certainly extends to dunning phone calls and sending bills for unpaid pre-bankruptcy debts. Of course, some creditors don't much care and continue to send automatically generated billing statements notwithstanding the law. If that's the case, the penalty is contempt of court, and courts have been active in punishing creditors who do so.

But some creditors try to get a jump on the situation through clever drafting. Consider the fine print in the penultimate paragraph of the car loan bill sent to me by one of my students:

For what it's worth, I do not believe this will work. If a billing statement is a bill before bankruptcy, it's one afterwards as well. Thus, notwithstanding what Subaru's lawyers may hope, post-bankruptcy dunning violates the discharge injunction. What such language may accomplish, however, is to cause a discharged debtor to forego her right to have a court order a fine on account of such conduct. Gotta love those lawyers.

Student Loans and "Free" Higher Education (Updated)

Go here to read a post by friend Colin Chan Redemer titled "Minerva Has Left the Building." In even more unpleasant detail than the piece by Patrick Deneen (below the fold), Redemer explains that 

It is not the few tenured radicals, or the vocal woke students. It is not a few elite institutions. Rather the whole enterprise is rotten. From financing, to administration, to recruiting, to instruction, to accreditation, there is a tunneling wound in American higher education that I fear is fatal.

Just what is this tunneling wound? For an answer Redemer turns to history:

To understand a beast we must look to the head that guides it. In higher education that head is the administration. In the beginning, “administration” meant the servants of the university. The actual university was the faculty and the students.

But now: 

Is it an exaggeration to say that in the modern university the students and faculty exist for the benefit of the administration? Think about it in terms of sheer numbers. People think quite a lot about the student-to-faculty ratio when they are looking into investing in their higher education. But they should be asking about the faculty-to-administrator ratio. According to Forbes, a 2014 Delta Cost Project report shows that “the number of faculty and staff per administrator declined roughly 40% at most types of colleges and universities between 1990 and 2012, now averaging around 2.5 faculty per administrator.” In other words, in the span of just two decades, universities became 40% less efficient at providing instruction to students, if you measure efficiency by the number of administrators you hire per faculty member.

There's much more of value in Redemer's piece but little of hope so I will leave readers with his conclusion:

For now it is enough to say that as parents and students gain clarity on what they want and on what universities now are, the demise of what we think of as higher ed in America is certain. New institutions that kindle the fires of philosophia—the love of wisdom—will rise not because of a billionaire’s vision or bequest, but because humans, by nature, reach out to know. And when their desire to know profound truth touches the cold reality of the modern university, like a root growing on concrete, they will turn aside to deeper, more fertile soil. Granted, billionaires could help this along by donating to already nascent projects; but these will have to be projects run by people who understand that higher ed is dead, at least to its original purpose

_________________________________________________________________________

I've posted many times about America's student loan problem. I've addressed the law that student loans are well-nigh impossible to eliminate in bankruptcy (here), although I've also observed that there may be some cracks in the nondischargeability wall (here). I've also written about the peculiar way in which the student loan programs subsidize foolish choices, educational scams, and ultimately drive up the cost of higher education (here, here, and here).

Higher education has become part of the battlefield in the race for nomination as the Democratic Party candidate for president. To the best of my knowledge, the Republican candidates aren't talking about education or student loans but Bernie Sanders and Hillary Clinton certainly are.

But here's the rub: whether it's Clinton's easier loan-payback terms or Sanders's free higher education for all, what are students and taxpayers getting for their money? Rather than wading into the swamp myself, I'll direct folks to two blog posts that address these concerns in significant detail.

First, go here to read Patrick Deneen's post "Res Idiotica" that painfully illustrates the un-education for which we pay billions.

My students are know-nothings.  They are exceedingly nice, pleasant, trustworthy, mostly honest, well-intentioned, and utterly decent. But their minds are largely empty, devoid of any substantial knowledge that might be the fruits of an education in an inheritance and a gift of a previous generation. They are the culmination of western civilization, a civilization that has forgotten it origins and aims, and as a result, has achieved near-perfect indifference about itself.

Deneen is not a crank (he currently teaches at Notre Dame and has taught at Princeton), and his observations of students at elite American universities rings true. Modern-day college graduates are not stupid but they are the products of a federal "No Child Left Behind" program of primary and secondary "education" to learn the skills of taking standardized multiple choice tests as well as undergraduate programs that do little more than train for evanescent jobs in the service economy.

Well, one might ask, if what passes for education is such thin gruel, why does college cost as much as it does? Why does the cost of education continue to rise while its quality continues to decline? Why are students incurring such inordinate student-loan debt?

As James K.A. Smith writes in USA Today here, the educational-industrial complex spends ever-growing sums for "experiences" instead of education:

The story behind the story of student debt inflation is the inflation of the university into an expanding behemoth of goods and services that have little to do with education and more to do with expectations of coddled comfort. Rather than being an institution centered on education, the university now aspires to be a total institution that meets every felt need. The campus is now a sprawling complex of fitness centers and cineplexes, food courts and gargantuan coliseums. Students aren’t taking out loans to pay for an education; they’re effectively borrowing money to pay exorbitant, short-lived taxes for the privilege of living in a scripted, cocooned city.

I would appreciate learning what our candidates for America’s highest elective office have to say about this. Could any of them provide any rationale for education beyond the utilitarian? Could any of them specify what it is that an educated person should know? I am not, however, holding my breath for any answers.

ASARCO Bites: Boomerang Tube and Attorneys Fees for Committee Counsel

This past November I posted a series of entries dealing with bankruptcy cases from the Supreme Court's most recent term. In Part 5 here I discussed Baker Botts v. ASARCO. Briefly, the law firm of Baker, Botts did an outstanding job for a Chapter 11 debtor. In fact, through the law firm's efforts, ASARCO's creditors received payment of 100% of their claims. One entity, however, was most unhappy with the work of Baker, Boots, the parent corporation of ASARCO who Baker, Botts had sued for looting its subsidiary. Anyway, after losing the lawsuit against it and putting the cookies back into the jar, so to speak, and getting ASARCO's creditors paid, the parent corporation re-took control of it subsidiary and objecting to paying Baker, Botts for its work.

To no one's surprise, the courts, including SCOTUS, approved the fees incurred by Baker, Botts excluding, however, the fees it incurred in fending off the objections by the disgruntled parent corporation. In other words, Baker, Botts had to "eat" the cost of getting what every objective observer agreed it deserved.

The majority of SCOTUS came to its conclusion based on its reading of the relevant section of the Bankruptcy Code. The Court went on to note, however, that it might be possible for a firm in the position of Baker, Botts to recover the cost of successfully defending its fees if its contract with the Chapter 11 debtor so provided.

Fast forward to January 2016 when the law firm representing the committee of unsecured creditors in the Chapter 11 of Boomerang Tube inserted such a fee-shifting term in its agreement with the committee. Committees, for those not engaged with the details of Chapter 11 practice, jointly represent all unsecured creditors but, after court approval, are paid by the Chapter 11 debtor. The United States Trustee objected to inclusion of the fee-shifting provision and the bankruptcy court eliminated it.

The bankruptcy court found the provision objectionable for several reasons only one of which seems compelling to me: it would require a third party, the Chapter 11 bankruptcy estate, to pay for the defense fees of another party, its creditors' committee. You can read the full opinion here. The remainder of Judge Walrath's opinion is a cramped reading of every aspect of the Supreme Court's opinion in ASARCO and the relevant statutes.

I don't think it would be worth the Committee's time to appeal this decision. After all, getting a third party to pay fees spent in defending your fees is a stretch. I remain hopeful, however, that counsel for Chapter 11 debtors will fight for the contractual right to get paid in the face of formulaic objections to their fees from parties have no skin in the game. 

Duberstein 2016

In the spring of 2015 I posted several times about the experience of coaching a team from Regent University law school at the premier bankruptcy law moot competition (here, here, and here), which St. John's University law school has hosted every year. Duberstein 2015 focused on something close to every student's heart, the dischargeability of student loans. This time around, and drawing from the ignition switch litigation plaguing the aftermath of the reorganization of General Motors, Duberstein 2016 returns to the complexities of Chapter 11 and the constitutional scope of bankruptcy court jurisdiction. You can read the fact pattern here.

I regret that Regent has not entered a team this time. I am pleased, however, that my new academic home, Campbell University School of Law, will be sending a team to this year's competition thanks to the generosity of Raleigh-based law firm Stubbs & Perdue, P.A. (Read the news release here.) I look forward to mooting Campbell's team as it prepares for this opportunity to shine before America's leading bankruptcy judges and professionals in New York in March.

Inside Bankruptcy Baseball: Increasing Debt Limit for Chapter 12 Bankruptcies

I've often posted about Midwestern farmers including taking their fertile land for granted (here), absurd prices for that land (here), and their corporate welfare by means of ethanol subsidies (here and here). Lately, it appears that the wealth of those same farmers may be cresting. Exhibit 1 is the following news blurb:

With agricultural lenders fearing a tidal wave of farm bankruptcies as soon as this spring, lawyers in the Midwest say they want Sen. Chuck Grassley (R-Iowa) to raise the debt limit for so-called "family farmer" bankruptcies, Reuters reported yesterday. Farmers in states like Illinois, Indiana and Iowa are scrambling to secure lending for the 2016 growing season at a time when prices for their corn have halved from three years ago. As they seek restructuring advice, many are told their debts surpass the $4 million limit for a chapter 12 family farm bankruptcy, said at least five lawyers who represent either debtors or creditors. They say the $4 million cap is out of touch with most farms' current operating size, often thousands of acres of land paid for by expensive leases and worked using tractors that can cost more than $250,000. "The debt limit for chapter 12 bankruptcies should be raised to at least $10 million," said Joseph Peiffer, a bankruptcy attorney in Cedar Rapids, Iowa. Without a new limit, farmers would be forced into a more costly chapter 11 filing. (Emphasis added.)

In other words, rather than saving their windfall profits, many farmers bought land at prices that could be justified only by a belief--wrong as it's turned out--that commodity prices would ever-continue to increase. I suspect that the only thing's that's kept the foreclosure wolf at bay has been the even more precipitous fall in the price of oil and thus fuel that modern corporate farming behemoths use aplenty.

Increasing the debt limit for Chapter 12 bankruptcies may well be a good thing. Compared with the cost of Chapter 11 reorganization, the special bankruptcy provision for family [sic] farmers is less expensive.

Cheaper farm bankruptcies come at a price, however, and that price is lesser protection for farm lenders. No one feels much sympathy for lenders, of course, but Chapter 12 is structured in a way that the debt to such lenders man be written down to current land values thus leaving future appreciation, which will come eventually, in the hands of the farmer. Accomplishing such a result is not as simple as my brief description might suggest but its mere possibility effects bankruptcy negotiations between farmer and lender.

Last, even if Senator Grassley introduces a bill to increase the debt limits for Chapter 12, there's no guaranty it will simply pass as such. In other words, even an unobjectionable bill is an opportunity for logrolling. Stay tuned to see what gets larded onto what should be a straightforward change.

SCOTUS in Review: US Supreme Court Bankruptcy Cases 2014-2015 -- Part 6

It's been a long time since I've posted a segment of my paper presented at the annual meeting of the Bankruptcy Section of the North Carolina Bar Association. If you've lost track, go here, here, here, here, and here to read my five earlier posts on what the Supreme Court did in its most recent term. Here are my comments about the concluding case. I may eventually follow up with some thoughts about the overall direction of the Court in this area of the law.

V. “Allowed Secured Claims:” Dewsnup Lives!

Nearly twenty-five years ago, the Supreme Court decided Dewsnup v. Timm.[1] The majority in Dewsnup came to the peculiar conclusion that the expression “allowed secured claim” in Bankruptcy Code § 506(d) had a meaning other than that of the same expression in § 506(a). Aletha and LaMar Dewsnup had owned some farmland subject to a deed of trust that secured a debt in excess of the value of the land. Aletha ultimately filed for relief under chapter 7 and sought to redeem the property by paying the holder of the deed of trust the value of the creditor’s interest in the property, which was far less than the debt. Even though § 506(a) allows a creditor’s secured claim only to the extent of its value, the Court held that the undersecured portion of the claim is not void.[2] In other words, so long as the claim has been allowed, it is secured regardless of the extent of the security. Writing for the majority, Justice Blackmun admitted this construction of § 506(d) was difficult and noted that the decision should be limited to its facts, that is, situations where the creditor’s claim was undersecured but not entirely unsecured.[3] Justices Scalia and Souter dissented on the ground that the correct construction of the expression “allowed secured claim” in § 506(d) should be the same as 506(a) (and other places in the Code).[4]

Bank of America v. Caulkett[5] presented an opportunity to test the Court’s willingness to limit Dewsnup to its facts or to overrule Dewsnup altogether. Debtor David Caulkett filed for relief under chapter 7 and moved to avoid Bank of America’s entirely unsecured junior mortgages. Distinguishing Dewsnup on its facts (undersecured but not underwater), the bankruptcy court granted the debtor’s motion and on appeal, both the district court and the Eleventh Circuit affirmed. After granting the bank’s petition for certiorari, the Court reversed the Eleventh Circuit in an opinion written by Justice Thomas.

Justice Thomas began by reciting the rule from Dewsnup: “§ 506(d) permits the debtors here to strip off the Bank’s junior mortgages only if the Bank’s ‘claim’—generally, its right repayment from the debtors, § 101(5)—is ‘not an allowed secured claim.’”[6] He then restated the debtor’s argument in simple and straightforward terms:

[I]f the value of a creditor’s interest in the property is zero–as is the case here–his claim cannot be a “secured claim” within the meaning of § 506(a). And given that these identical words are later used in the same section of the same Act—§ 506(d)—one would think this “presents a classic case for the application of the normal rule of statutory construction that identical words used in different parts of the same act are intended to have the same meaning. Under that straightforward reading of the statute, the debtors would be able to void the Bank’s claim.[7]

Regrettably, at least from the debtor’s point of view, the Court, including Justice Scalia who had dissented in Dewsnup, held that the peculiar construction of Dewsnup foreclosed this "plain meaning" argument.[8]

Justice Thomas acknowledged the many academic criticisms of the Dewsnup decision[9] and on several occasions observed that the debtor had not asked the Court to overrule Dewsnup. A review of the transcript of the oral argument suggests that several members of the Court were frustrated that they did not have the opportunity to address the holding in Dewsnup head on.[10]

Apart from consistent statutory construction, the policy issue at work in Dewsnup and now Caulkett is straightforward: who gets the benefit of appreciation? In other words, the effect of the Court’s construction permits the secured creditor to realize the benefit of any subsequent appreciation in value of the undersecured or even underwater collateral. With its mortgage in place, Bank of America can wait five, ten, or even more years for the property to appreciate sufficiently before foreclosing. Reversal of Dewsnup would leave that contingent benefit with the debtor.

Hindsight suggests that the debtor’s tactical decision to attempt to distinguish Dewsnup on its facts was not the best approach. Given the tone of the Court’s opinion, there is reason to believe that a direct attack on Dewsnup might succeed. One should not, however, conclude that such an attack would necessarily be successful. Justices Kennedy, Breyer, and Sotomayor did not join in the footnote citing the criticism of Dewsnup and the transcript of the oral argument revealed that some of the justices were concerned that overruling Dewsnup might upset the settled expectations of mortgage lenders who had relied on that case in pricing mortgage loans.[11]

---

[1] 502 U.S. 410 (1992).

[2] Id. at 417 (“[W]e hold that § 506(d) does not allow petitioner to ‘strip down’ respondents’ lien, because respondents’ claim is secured by a lien and has been fully allowed pursuant to § 502.”).

[3] Blackmun observed that

 [h]ypothetical applications that come to mind and those advanced at oral argument illustrate the difficulty of interpreting the statute in a single opinion that would apply to all possible fact situations. We therefore focus upon the case before us and allow other facts to await their legal resolution on another day.

Id. at 416–17.

[4] Id. at 423 (“[A]bandoning the normal and sensible principle that a term (and especially an artfully defined term such as ‘allowed secured claim’) bears the same meaning throughout the statute, the Court adopts instead what might be called the one-subsection-at-a-time approach to statutory exegesis.”).

[5] 135 S.Ct. 1995 (2015). Disclaimer: I was a party to an amicus brief supporting respondents.

[6] Id. at 1998.

[7] Id. at 1999. (Citation and internal quotation marks omitted.).

[8] The Court commented that

Dewsnup’s construction of “secured claim” resolves the question presented here. Dewsnup construed the term “secured claim” in § 506(d) to include any claim secured by a lien and ... fully allowed pursuant to § 502. Because the Bank's claims here are both secured by liens and allowed under § 502, they cannot be voided under the definition given to the term “allowed secured claim” by Dewsnup. (Citation and internal quotation marks omitted.).

Id.

[9] Id. at 2000 (footnote).

[10] See Transcript of Oral Argument 13-1421 (March 24, 2015) at http://www.supremecourt.gov/oral_arguments/argument_transcripts/13-1421_0813.pdf.

[11] Justice Scalia questioned counsel for petitioner Bank of America as follows:

Now, I thought you were going to tell me, you know, I feel strongly that–Dewsnup was wrong, but I’m not going to upset expectation. I mean, if banks have been, you know, lending money for second mortgages on the assumption that they would not be stripped, I mean, that’s what I thought you were going to tell me. Oh, you know, many expectations that have been rested upon this this misbegotten opinion of Dewsnup.

Id. at 14.

SCOTUS in Review: US Supreme Court Bankruptcy Cases 2014-2015 -- Part 5

After a short break, it's back to my review of what the Supreme Court has recently done in connection with bankruptcy law. (Part 1, Part 2, Part 3, and Part 4.)

IV. Administration of the Estate: Attorneys’ Fees

In Baker Botts L.L.P. v. ASARCO LLC,[1] the work of the debtor’s attorneys helped lead to the rarest of all bankruptcy results: one where all creditors are paid in full. ASARCO, an integrated copper mining, smelting, and refining company, filed for relief under chapter 11 and retained Baker Botts and another firm as counsel for the debtor in possession. The firms represented ASARCO in a complex fraudulent conveyance action against its parent company and obtained a judgment valued between $7 and $10 billion.[2] Faced with this judgment, the parent provided cash to ASARCO sufficient to pay all its creditors in full. With the elimination of the interests of ASARCO’s creditors, its parent resumed control of the debtor and promptly caused it to object to the applications for attorneys’ fees of its counsel. After a six-day hearing, the bankruptcy court awarded attorney’s fees of over $120 million, plus a fee enhancement of $4.1 million for exceptional work and another $5 million for work involved in defense of the application.

On appeal, the district court largely affirmed the bankruptcy court and, in particular, held that Baker Botts was entitled to fees on the defense of its application.[3] The Fifth Circuit reversed and held that the attorneys were not entitled to fees in defense of their application because they, not the debtor, were the primary beneficiaries of that work.[4]

Notwithstanding the Fifth Circuit’s decision, the state of the law on this issue was confused[5] so the Supreme Court granted Baker Botts’s petition for certiorari and affirmed. Writing for the majority, Justice Thomas began with the “bedrock principle” of the so-called American Rule, in which each litigant pays its own fees unless a statute or contract provides otherwise.[6] The terms of retention of counsel by ASARO did not “provide otherwise” so the question became whether the policy, history,[7] or implications of Bankruptcy Code § 330 did so.

The majority concluded that the reference to “services” in Bankruptcy Code § 330(a)(1)(A) was limited to direct services to the debtor and that defense of a fee application was not such a direct service.[8] Moreover, defense fees were not indirect services to the debtor even though failure to award them would dilute the recovery of its professionals.[9] Third, the majority was unpersuaded that Bankruptcy Code § 330(a)(1)(6), which authorizes compensation for preparation of the underlying fee application, permitted fees for the defense of that application.[10] Finally, the majority rejected the argument that there should be a judicial exception for fees incurred in defending a fee application—subject as it is to attacks from multiple parties—because to do so would be to rewrite the statute.[11] Justice Sotomayor believed that the judicial exception discussion was unnecessary and thus concurred with the majority except with respect to that portion of Justice Thomas’s opinion. Justices Breyer, Ginsburg, and Kagan dissented.[12]

The majority opinion noted that, in addition to statutory reversals of the American Rule, contracting parties can agree to reallocate attorneys’ fees. This observation suggests that professionals retained by debtors or creditors’ committees under Bankruptcy Code § 327(a) could seek such a provision in their retention agreements. Alternatively, while it would not have been possible in the ASARCO case, a debtor could employ special counsel to vindicate the interests of its general bankruptcy counsel to payment of its fees. The fees of special counsel could be compensable as an expense of the estate under Bankruptcy Code § 330(a)(1)(B). Only time will tell if these alternatives will withstand objection.

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[1] 135 S.Ct. 2158 (2015). Disclaimer: I was a party to an amicus brief supporting petitioners.

[2] According to the Court of Appeals for the Fifth Circuit, this “was the largest fraudulent transfer judgment in Chapter 11 history.” Asarco, L.L.C. v. Jordan Hyden Womble Culbreth & Holzer, P.C. (In re ASARCO, L.L.C.), 751 F.3d 291, 293 (5th Cir. 2014).

[3] ASARCO LLC v. Baker Botts, L.L.P. (In re ASARCO LLC), 477 B.R. 661, 675 (S.D. Tex. 2012) (“The time spent defending a fee application is necessary and beneficial to the bankruptcy system as a whole, and indirectly, to each estate participating in the system.”) (Citation and internal quotation marks omitted.)

[4] In re ASARCO, 751 F.3d 299 (“The primary beneficiary of a professional fee application, of course, is the professional.”).

[5] See 3 Collier on Bankruptcy ¶ 330.03[16][a] (16th ed. 2013).

[6] ASARCO, 135 S.Ct. at 2164. For a critique of the Court’s assertion that the American Rule dates back to the eighteenth century see Bruce A. Markell, Loser’s Lament: Caulkett and ASARCO, 35 Bankr. L. Letter 1 (August 2015).

[7] The Court failed to address the history of Bankruptcy Code § 330. For a thorough consideration of the award of fees in defense of fee applications in Chapter X cases see Brief for Amici Curiae Bankruptcy Law Scholars in Support of Petitioners, 2014 WL 7145500 (2014).

[8] ASARCO, 135 S.Ct. at 2165 (“Time spent litigating a fee application against the administrator of a bankruptcy estate cannot be fairly described as ‘labor performed for’–let alone ‘disinterested service to’–that administrator.”).

[9] Id. at 2166.

[10] The majority was not persuaded for the following reason:

The Government argues that because time spent preparing a fee application is compensable, time spent defending it must be too. But the provision cuts the other way a § 327(a) professional’s preparation of a fee application is best understood as a “service[e] rendered” to the estate administrator under § 330(a)(1), whereas a professional’s defense of that application is not.

Id.

[11] Id. at 2168 (“More importantly, we would lack the authority to rewrite the statute even if we believed that undercompensated fee litigation would fall particularly hard on the bankruptcy bar.”).

[12] The dissenters rejected the majority’s wooden focus on “actual, necessary services” language in Bankruptcy Code § 330(a)(1)(A) in light of the introductory phrase, “reasonable compensation.” Id. at 2170 (“[W]ork performed in defending a fee application may, in some cases, be a relevant factor in calculating ‘reasonable compensation.’”).