Not a Good Idea to Object to Every Claim

You know that nothing good can come from an opinion which begins like this:

This is a case about an affluent debtor who sought to manipulate bankruptcy procedures to accomplish what the Code prohibits--the elimination of all of her credit card debts despite her obvious ability to repay those debts over time. The debtor, Diane Davis, obtained confirmation of a plan in which she proposed to pay her credit card debts in full. The debtor subsequently objected to every claim filed by her creditors based on their alleged failure to attach sufficient documents to their proofs of claim. The debtor withdrew several objections after the creditors responded. The Court has before it the debtor's request for a default order sustaining the remaining objections.

In re Diane Davis, No. 09-42865 (Bankr. E. D. Tex.3/31/11). p. 1. You can find the opinion here.

The Davis case is one of a debtor who tried to follow the letter but not the spirit of the law. The debtor was an above median income debtor who would not qualify for relief under chapter 7. She filed under chapter 13 but tried to avoid paying any of her unsecured debts. She scheduled all of her unsecured debts as disputed and then objected to every claim filed. If the creditor responded, she withdrew her objection. Since most of the creditors did not respond, she thought that she was home free. However, the court had other ideas.

A Few Facts

The Debtor was a single woman with gross monthly wages of $10,428 and disposable income of $3,923.92. The only debts she was delinquent upon were credit cards. She scheduled eight creditors with debts totaling $81,564. Every debt was listed as disputed with the notation "Debtor listed the balance shown on last statement; debtor not presently able to determine if balance is correct and is uncertain if trade name is correct legal creditor."

The debtor filed a plan proposing to pay $3,190 to the chapter 13 trustee for 60 months. Twelve creditors filed proofs of claim totaling$147,400.68. Because the plan proposed to pay $190,400 on claims which were less than this amount, no creditors objected to the plan and it was confirmed.

Then the debtor objected to every claim. The objections asserted that the creditors had not attached sufficient documentation to the claim and that the debtor would withdraw the objection if presented with adequate documentation. The debtor withdrew her objections to five claims after the creditors filed responses. However, the debtor sought default orders on the remaining seven claims. One of the claims that the debtor sought a default on was from Neiman Marcus. Neiman Marcus amended its claim to add documentation but did not file a response. The debtor's statement of financial affairs revealed that the debtor had been making payments on this claim prior to bankruptcy.

The court conducted several hearings on the claims objections. While the debtor was present at one hearing, she did not testify. Debtor's counsel offered a brief on why the claims should be denied but never presented any substantive grounds why the debtor did not owe the debts.

Can the Debtor Deny the Claims of the Non-Responding Creditors?

The Court's answer was "no." Failure to attach supporting documentation, without more, is not a sufficient ground for denying a claim. Judge Rhoades stated:

If an objection to a claim is raised, Section 502(b) provides that the court "shall allow the claim in such amount, except to the extent that" a grounds for disallowance provided by Section 502(b)(1)-(9) applies. (citation omitted). Thus, the Code requires us to overrule a claim objection that does not comply with Section 502(b)--even if the claimant does not appear to raise the issue.

Opinion, p. 11. Thus, the mere fact that the creditor failed to attach sufficient documentation to the claim and then failed to respond to the claims objection was not grounds for denying the claim.

Not only that, the court found that the claims did "substantially" conform to Bankruptcy Rule 3001 such that they were entitled to prima facie validity. Because the debtor did not produce evidence sufficient to rebut the prima facie validity of the claims, the creditor had no duty to respond.

An Interesting Twist

While Judge Rhoades found that the objections should be denied, she also raised the possibility that the debtor was asking for something she really didn't want.

The discharge in a chapter 13 case is different than in a chapter 7 case. (citation omitted). In a chapter 13 case, upon completion of plan payments, a debtor generally is discharged of all debts "provided for by the plan or disallowed under section 502" of the Code. (citation omitted). Section 1328(a) does not, by its terms, discharge a chapter 13 debtor of her obligation to repay claims denied solely under Bankruptcy Rule 3001.

Opinion, p. 15. Thus, had the debtor been successful in her non-substantive objections, she would not have discharged the debts.

The Ethical Obligations of the Debtor's Counsel

The Court was not amused as shown by the subheading "The Ethical Obligations of the Debtor's Counsel." The Court noted that filing the schedules and objecting to the claims, debtor's counsel

deliberately chose to (i) ignore the debtor's personal knowledge,and (ii) conduct no independent investigation prior to filing the debtor's bankruptcy schedules and claim objections."

Opinion, p. 21.

The Court went on to state:

It appears to the Court that the debtor and her counsel were motivated by the off-chance that the claimants would not respond to the objections and, consequently, that this Court would sustain the objections without substantive review. 'An off-chance does not satisfy [Bankruptcy] Rule [9011].' (citation omitted). 'This approach of throwing it against the wall and seeing what sticks is precisely the sort of conduct [Bankrutpcy Rule 9011] seeks to counter. (citations omitted).

Opinion, pp.21-22.

The Debtor's Obligation to Act in Good Faith

The Court was not any more impressed with the debtor's conduct.

Regardless of the advice the debtor may have received from her counsel regarding the claims allowance process, she has an obligation to the Court to act in good faith. To confirm a chapter 13 plan, the bankruptcy court must find, among other elements, that 'the plan has been proposed in good faith.' (citation omitted). . . Good faith in this context is not an esoteric legal concept that only lawyers and judges can understand. The question is whether the totality of the circumstances indicates that the plan is unreasonable or that the debtor is attempting to abuse the spirit of the Code. (citation omitted).

Opinion, pp. 22-23.

The Bottom Line

The Court overruled the claims objections, vacated the order confirming the plan, gave the debtor 30 days to file a new plan and scheduled a hearing to determine whether debtor's counsel violated Rule 9011.

What It Means

The chapter 13 bargain is about paying creditors in return for a discharge. The debtor had enough disposable income to pay all of the filed claims in less than sixty months. This would have been a good deal because the debtor would have been able to repay the debts without interest. However, the debtor tried to take a shortcut and eliminate all of her claims on a defect of form. The Court was right to be concerned about the good faith of this practice.

Random Thoughts From The National Conference of Bankruptcy Judges--Day 2

The most interesting programs I attended yesterday concerned consumer issues in the Post-BAPCPA world and real estate issues. I attended several other informative presentations (including a lunchtime history of the Constitution from former Judge Kenneth Starr), but will focus on these two in the interest of length.

Consumer Issues

I started Tuesday off with Post-BAPCPA Case Update for Consumer Practitioners. The two most interesting issues here were standing and the proposed amendments to the Bankruptcy Rules affecting claims. This one was enjoyable because there were many bankruptcy judges in attendance who contributed to the discussion, including the Hon. Eugene Wedoff, Joan Feeney, Keith Lundin, Brenda Rhoades, Eileen Hollowell and Sheri Bluebond. (They weren't all there at the same time. I repeated this program).

Standing Issues

The standing debate arises when a servicer, debt buyer or some other party files a proof of claim or motion to lift stay. As an initial matter, Sec. 501 provides that a creditor may file a proof of claim, while Sec. 362(d) provides that a party in interest may file a motion for relief from stay. Party in interest is broader than creditor, so that the party in interest language would allow a mortgage servicer to file a motion for relief. However, the disparity is equalled out by Rule 3001(b), which allows an authorized agent to file a proof of claim. A servicer would qualify as an agent.

The next issue is whether the person filing the motion or claim actually owns it. This issue applies to debt buyers and securitization trusts among others. Judge Wedoff argued that on a motion for relief from stay, it is the creditor's burden to show lack of equity. This entails showing that the person is the creditor and the amount of the debt. Not answered was what happens when the party in interest seeks relief for cause. Since the entire burden is on the debtor, does the movant have to prove that they are the actual creditor?

This gave rise to a vigorous debate in both iterations of this presentation that I attended. One view was that a motion for relief from stay is simply relief from an injunction, so that issues of standing could be determined in state court. The counter view was that especially in Western states with non-judicial foreclosure, there is no court review so that lifting the stay was tantamount to disposing of the property. This places the burden on the debtor to seek an injunction against foreclosure in state court.

Another debate had to do with assignees and proofs of claim. Whose interest should be protected when there is an issue regarding ownership of the claim? Is it the debtor or the original holder of the claim? If the original creditor is given notice of the bankruptcy case and a purported assignee files the only claim on that debt, it is safe to assume that the claimant actually holds the claim. On the other hand, when an assignee files a motion for relief from stay, the debtor has a direct interest in whether the person seeking relief is authorized to do so.

These issues are exemplified by cases involving MERS and securitization trusts. MERS is a national clearinghouse for mortgage assignments. The creditor names MERS as the nominee for the trustee under the deed of trust. Thus, if the mortgage is assigned, MERS continues to act as nominee for whoever the current trustee happens to be. The problem arises when MERS files a motion for relief from automatic stay. MERS does not hold the note. It is merely the nominee of the trustee under the deed of trust. Several courts have held that this does not give them standing to file a motion for relief from stay. Securitization trusts also give rise to a problem. Mortgages are put into pools with an indenture trustee. However, in one case which was mentioned, the entity contributing the mortgage loan to the trust was never the holder. There was simply a gap in title.

New Claims Opinion

One of the judges from New Hampshire mentioned the October 19 decision from the First Circuit BAP in In re Plourde, which can be found here. I have not had a chance to review this opinion in detail, but apprently it held that failure to file a claim in the proper form deprived it of prima facie validity, so that the creditor was only entitled to priority as a late filed claim. Not quite sure how they got to that result. It will likely go up to the First Circuit.

Proposed Rules Changes

The other interesting discussion concerned the proposed amendments to Bankruptcy Rule 3001(c) and Bankruptcy Rule 3002.1. The changes to Rule 3001(c) would require more documentation on a claim, including the most recent account statement on a credit card account, an itemized statement of interest, fees, expenses and charges, a statement of the amount necessary to cure an arrearage on a secured claim and an escrow account analysis if applicable. What is really significant about this amendment is that it states that the consequence of failing to provide this information on the claim is that the creditor would be precluded from using this information in any hearing "unless the court determines that the failure was substantially justified or is harmless." Furthere, the court may award sanctions in addition to or in lieu of exclusion of evidence. This is a huge change. Under the current rule, failure to properly document a claim deprives it of prima facie validity, but the creditor can still prove up its claim in a hearing. This rule would effectively provide that failure to properly document the claim means that it may be denied. Some of the speakers suggested that this was not too severe because the creditor could always amend the claim. However, in the Southern District of Texas, Judge Jeff Bohm has held that a creditor may not amend its claim without leave of court once it has been objected to. The rule is also huge because it allows sanctions for filing an improperly documented proof of claim. Under current law, sanctions may be awarded under Rule 9011 which has a safe harbor provision or under the court's inherent authority, which requires a finding of bad faith. Allowing sanctions for filing an improperly documented claim and nothing more is a quantum change.

Proposed Rule 3002.1 would require creditors with a security interest in the debtor's principal residence to file notice of certain charges and changes in payment amounts. If the payment amount changes post-petition due to an adjustment in the interest rate or the escrow amount, notice must be filed 30 days before the payment amount changes. The notice must be given in the same form applicable under non-bankruptcy law. Additionally, a creditor must file a notice of all fees, expenses or charges incurred post-petition as a supplement to its proof of claim. This notice must be filed within 180 days after the charges are incurred. The debtor and the trustee would then have one year to object to the charges. Additionally, the trustee would be required to file a statement indicating that the final payment necessary to cure an arreage on the mortgage has been made. All of these notices can be challenged in court. Failure to give the required notice would bar the charges.

These rules changes are open for comment at www.uscourts.gov/rules until February 16, 2010. If approved, they will go into effect on December 1, 2011.

Real Estate Issues

From there, I went on to the panel discussion on real estate issues moderaed by Prof. Mechele Dickerson from the University of Texas Law School. First up, was a summary of the state of the market from Ronald Greenspan with FTI Consulting. The residential real estate market has hit bottom and is on the upswing in all major markets except Detroit and Las Vegas. However, it had a steep decline, going from 1.7 million housing starts in 2005 to only 500,000 in 2009. Part of the reason that homes sales are recovering is the fact that the government is guarantying 80% of the new mortgages being made. One note of concern is that the level of vacant homes has risen from its typical rate of 1.0% to 2.5%, meaning that houses are sitting empty and subject to vandalism, blight, etc.

The outlook for commercial real estate is much darker. Commercial real estate did not peak until the first quarter of 2008 and has dropped precipitously. Sales ae down by 75%. Default rates have increased from 0.5% to 4.0%. Mr. Greenspan indicated that the commercial fundamentals could continue to go down for another three years.

The panel highlighted three recent real estate cases of interest. In Tousa, Inc., the bankruptcy court recently held that encumbering the property of one group of subsidiary companies to pay off the debts of a different subsidiary was a fraudulent conveyance. The opinion is some 180 pages long.

The panel opined that the Ninth Circuit BAP's opinion in Clear Channel has proven to be less problematic than anticipated. The Clear Channel opinion overruled approval of a Sec. 363 sale over the objection of a dissenting junior lienholder. It held that Sec. 363(f)(3), which allows sales free and clear of liens if the sales price exceeds the aggregate value of all liens refers to the total dollar amount of the lien, not the Sec. 506(b) value. Thus, you could not cut off the junior lienholder based on the argument that the lien was completely underwater. One case subsequent to Clear Channel allowed a sale under similar circumstances based on Sec. 363(f)(5) which allows sale free and clear of liens if the creditor could be forced to accept a monetary satisfaction "in a legal or equitable proceeding." In the specific case, Washington law allows a junior lienholder to be cut off in a foreclosure action, thus satisfying the section. The panel speculated about whether cramdown under chapter 11 would be "a legal or equitable proceeding" under the section.

The recent case of General Growth Properties illustrates what happens when you have a large number of single purpose entities with a central cash management system. The lenders required that each entity have an independent director to keep them bankruptcy remote. However, the debtor simply replaced the independent director on the eve of bankruptcy without notice to the lender or the independent director being replaced. The court noted that the independent director's duty was to the entity rather than to the lender. The court refused to dismiss the bankruptcy cases of solvent debtors who were current upon their debts. The lenders argued that the cases had been filed in bad faith because the debtors were current and had not sought to negotiate with the creditor. The creditor also argued that reorganization was futile because they would not agree to any reorganization plan proposed by the debtor. Of course, this undercut their argument that the debtors should have negotiated with them. The court rejected the motions to dismiss.

The case also raised the issue of whether you could use income from one debtor to pay the expenses of another pursuant to a central cash management system. The court analyzed the issue as one of adequate protection and found that the creditor was adequately protected by the value of the collateral. The panel raised the question of whether the lending could have been challenged as a transaction not in the ordinary course of business. If the cash negative debtors were having to borrow money from the cash positive debtors and were not able to get DIP financing, then the financing would presumably be on less than market terms. Thus, the transaction would not be in the best interest of the lending entity regardless of whether the lender was adequately protected.

Another issue raised by aggregations of single asset real estate debtors is whether there must be an impaired accepting class in each case or simply one impaired accepting class under the plan. Sec. 1129(a)(10) references the plan. An unreported opinion in the Enron case says that you need one impaired accepting class overall rather than in each case.

Another interesting isssue discussed was a springing guaranty. This is a guaranty which only comes into force if the debtor files bankruptcy. Obviously, it is intended as a poison pill to deter bankruptcy filings. The question raised was whether this violated public policy by giving principals of the debtor an incentive to violate their fiduciary duty by not filing bankruptcy to protect their personal financial interest.