Fifth Circuit Report: 1st Quarter 2017

It has been a while since I have done a Fifth Circuit report.   With the new year, I am going to try to get back to chronicling each quarter's decisions from my home circuit.

Breach of contract; attorney's fees; abuse of process; malicious prosecution; sanctions; due process

Texas Capital Bank v. Dallas Roadster, Ltd. (In re Dallas Roadster, Ltd), 846 F.3d 112 (5th Cir. 1/17/17)

This case has only a tenuous connection to bankruptcy but it includes many of the types of issues that lenders and borrowers litigate.    Texas Capital Bank financed Dallas Roadster.   The DEA informed the Bank that it was investigating the Debtor for money laundering.   The DEA ultimately raided the Debtor and arrested its president.    One day prior, the Bank declared the Debtor to be in default.   After the raid, the Bank filed suit and obtained a receivership on an ex parte basis using an affidavit that contained false statements.   Dallas Roadster filed chapter 11 and got its business back from the receiver.   The state court litigation between the Bank, the Debtor and the guarantors was removed to federal court.   The Debtor confirmed a plan in which it provided for all of the Bank's claims except for attorney's fees arising from the Litigation.   

The District Court granted summary judgment against the Guarantors on their counterclaims against the Bank.  The case went to trial on the Bank's claim to recover its attorney's fees incurred in the Litigation and the Debtor's breach of contract claims against the Bank.   The District Court denied recovery to both parties.   It found that the Debtor could not recover for breach of contract because it had materially breached the contract first.   The District Court ruled that the Bank could not recover attorney's fees for defending itself against claims of wrongdoing and also used its inherent authority to sanction the Bank and deny attorney's fees.

The Fifth Circuit affirmed denial of the counterclaims and also affirmed the ruling denying the Debtor's breach of contract claims.   However, it reversed the findings against the Bank.   It found that the District Court had made an incorrect Erie guess as to how Texas courts would rule.  It also found that the District Court was permitted to sanction the Bank but had to provide it with due process before doing so.

The opinion has a good discussion of the difference between abuse of process and malicious prosecution.    A claim for abuse of process must show that process was improperly used after it was issued.   On the other hand, a claim that malice or wrongful intent caused the process to be issued the claim is one for malicious prosecution.  Because the Guarantors sued for abuse of process based on obtaining the receivership they did not have a claim.   A claim for criminal malicious prosecution must show that a person provided false information to the prosecuting party and that this party acted in reliance on the false information.    The claim by the Debtor's president that the Bank did not provide the DEA with exculpatory evidence was not sufficient to give rise to a claim for criminal malicious prosecution.

The Fifth Circuit held that the Debtor breached the loan agreements prior to the date that it claimed that the Bank breached the agreements.   The court rejected the Debtor's arguments that its breaches, which consisted of obtaining other financing without notifying the bank, were not material.   The District Court properly weighed the factors identified in Mustang Pipeline Co. v. Driver Pipeline Co., 134 S.W.3d 195 (Tex. 2004) to determine that the breaches were material.  In particular, the reporting violations deprived the Bank of benefits it had negotiated for and placed it at risk.   Because the Debtor breached first, it could not complain about the Bank's subsequent defaults.   

The Court's ruling on the Bank's claim for attorney's fees incurred in the litigation involved an "Erie guess," that is, a prediction as to how Texas courts would resolve an issue of first impression.    In Zachary Construction v. Port of Houston Authority, 449 S.W.3d 98 (Tex. 2014), the Texas Supreme Court found that a contractual provision which would insulate a party from liability based on its own misconduct was unenforceable.   The contract between the parties contained a no damages for delay provision.   However, the Port deliberately and intentionally interfered with Zachary's performance.  In that context, the Texas Supreme Court found that the Port could not use the no damages for delay provision to shield itself from liability for its own misconduct.   The District Court concluded that Texas courts would extend this ruling to the case where the lender sought to recover attorney's fees for defending itself from claims of wrongdoing.    The Fifth Circuit found that there was a material difference between using a contractual provision to shield itself from wrongdoing as opposed to recovering the cost of successfully defending itself.   

The Fifth Circuit also reversed and remanded the District Court's sanctions award against the Bank.   The District Court found that where litigation was "instigated or conducted in bad faith or there's been willful abuse of the judicial process" it could dismiss claims under its inherent authority.   The Fifth Circuit found that the District Court did have the inherent authority to dismiss claims based on vexatious litigation.   However, before doing so, it had to give notice to the party against whom sanctions were sought and give it the chance to respond.   Because the District Court issued the sanctions sua sponte, it deprived the Bank of due process and a remand was required.

This case raised issues required citizenship for diversity jurisdiction purposes and what constitutes property under the Uniform Fraudulent Transfer Act.    Hometown obtained a judgment against Prime.  Prime had been a party to three management contracts which could only be terminated upon sixty days' notice.   The other parties to the contracts terminated them without giving the required notice and Prime acquiesced.   Hometown then sued the contract counterparties in U.S. District Court on the basis that waiving the fees due during the 60 day cancellation period was a fraudulent transfer.    The District Court dismissed finding that the contracts were not "assets" which could be transferred under TUFTA.

On appeal, the Fifth Circuit considered whether diversity jurisdiction was present.   Hometown was a Texas limited liability company with one member, U.S. Bank.  Citizenship of an artificial entity other than a corporation is based on the citizenship of its members.   U.S. Bank is a citizen of Ohio.  However, U.S. Bank was trustee of a trust.   Therefore the Defendants argued that it was necessary to determine the citizenship of each of the beneficiaries of a trust.   The Fifth Circuit rejected this argument, finding that citizenship of a trust is based on the citizenship of the trustee.   Because none of the defendants were from Ohio, there was diversity.   This ruling surprised me because I assumed that the citizenship of an LLC, which is a form of company, would be based on its state of formation.  However, this is not the case.

The District Court had relied on several Seventh Circuit cases which had held that termination of a contract according to its provisions was not a transfer of an asset under the Uniform Fraudulent Transfer Act.   The Fifth Circuit said:

As a result, termination of the contracts without giving 60 days' notice transferred the fees which would have been paid to the judgment debtor to the contract counterparties.   That was a transfer of property.   As a result, the Complaint stated a cause of  action and should not have been dismissed.

Diversity jurisdiction

Foster v. Deutsche Bank National Trust Co., 848 F.3d 403 (5th Cir. 2/8/17)

Homeowner sued lender and trustee in state court to enjoin a foreclosure sale.   The lender removed the case to federal court.    The district court denied a motion to remand based on lack of diversity.  It dismissed the homeowner's claims with prejudice.   The Fifth Circuit affirmed.

The Fifth Circuit agreed that the trustee was improperly joined.   It found that violation of the trustee's duties under the deed of trust would give rise to a claim for wrongful foreclosure.   However, because no foreclosure took place, this claim could not be asserted.    As a result, joining the substitute trustee as a defendant did not defeat diversity jurisdiction.   The Fifth Circuit found that Texas would not recognize a claim for attempted wrongful foreclosure.  As a result, it affirmed the dismissal of the homeowner's claims.   This left the lender free to post the property for a future foreclosure.

Denial of discharge

Chu v. Texas (In re Chu), 2017 Bankr. LEXIS 2370 (5th Cir. 2/9/17)(unpublished)

An orthodontist filed bankruptcy following accusations of Medicaid fraud.   The State of Texas filed suit to deny this discharge.   After a trial, the Bankruptcy Court denied the discharge under 11 U.S.C. Sec. 727(a)(4) and (a)(5).   The Fifth Circuit affirmed.

The Debtor argued that the State lacked standing to object to his general discharge because its debt would be non-dischargeable under 11 U.S.C. Sec. 523(a)(7).  The Fifth Circuit rejected this argument as speculation.  Because there was no final determination of the underlying claim, the State had constitutional standing to object to the global discharge. 

 The Court rejected the Debtor's argument that the Bankruptcy Court had aggregated his false statements to reach a conclusion of reckless indifference to the trust.   Instead, the Court found that the bankruptcy court was permitted to gauge the "cumulative effect of false statements." 

The Court found that the Debtor had failed to account for loss of assets.   In a personal financial statement four years before bankruptcy, the Debtor had listed assets of $75,500, including jewelry and watches.  In his schedules, he listed only $11,000 in household items, books and pictures worth $1,000 and a ring valued at $500.   Based on the Bankruptcy Court's finding that the Debtor had failed to offer a viable explanation for what happened to the assets, the Fifth Circuit affirmed the ruling that the Debtor had failed to account for assets.

 Federal Debt Collection Practices Act; turnover

United States v. Diehl, 848 F.3d 629 (5th Cir. 2/13/17)

This case involved another statute abbreviated as FDCPA, the Federal Debt Collection Practices Act.   The Court found that the FDCPA in its case did not prohibit the government from using the Texas Turnover Statute to collect a debt owed to the government.

Homestead exemption; fraudulent transfer

Wiggains v. Reed (In re Wiggains), 848 F.3d 655 (5th Cir. 2/14/17)

Debtor and spouse partitioned homestead on eve of bankruptcy to avoid limit on homestead exemption under 11 U.S.C. Sec. 522(p).   Court found that maximizing homestead was not sufficient reason to avoid partition as a fraudulent transfer.    Additionally, wife had no right to compensation under 11 U.S.C. Sec. 363(j) because entire community property interest entered estate.

Automatic Stay

Gathright v. Clark, 2017 U.S. App. 3258 (5th Cir. 2/23/17)

Automatic stay in bankruptcy did not preclude creditor from filing bad check charges.  Criminal actions are exempt from the stay.

Bankruptcy fraud

United States v. Grant, 850 F.3d 209 (5th Cir. 3/1/17)

Debtor filed five bankruptcy cases between 2008 and 2011.   In two of her cases, Debtor only disclosed one of her two social security numbers.   In another case, she failed to disclose two of her prior bankruptcies.   She was convicted on three counts of perjury and sentenced to fifteen months imprisonment..

Fraudulent transfer; damages

Galaz v. Galaz (In re Galaz). 850 F.3d 800 (5th Cir. 3/10/17)

Raul Galaz was married to Lisa Galaz.   He owned 50% of Artists Rights Foundation.   When they divorced, Lisa received 50% of Raul's 50% interest.    However, Raul transferred ARF's assets to another entity for no consideration.    Lisa filed chapter 13 bankruptcy and sued to avoid the transfer.  Julian Jackson, who owned the other 50% of ARF, sued Raul for breach of fiduciary duty.   The Bankruptcy Court ruled for Lisa and Julian awarding actual and exemplary damages. 

In the first appeal to the Fifth Circuit, the Court reversed and remanded.  The Court found that the Bankruptcy Court had no jurisdiction over the claims between Julian and Raul.   It also found that the Bankruptcy Court lacked jurisdiction to enter a final judgment on Lisa's claims against Raul.   On remand, the District Court referred the matter to the Bankruptcy Court for proposed findings and conclusions.   Based on the Bankruptcy Court's proposed findings, the District Court awarded actual and exemplary damages to Lisa.

The Fifth Circuit upheld the findings of liability.   Fraudulent intent was a question of fact reviewed under the clearly erroneous rule.   Court found that at least six badges of fraud were present.

The Fifth Circuit affirmed the award of $241,309.10 in actual damages to Lisa.   This was based on 25% of royalties received of $969,317.92 less certain reasonable expenses.    Appellants argued that the royalties should have been valued as of the time they were transferred (at which time value was negligible).   However, statute allowed the court to adjust the value "as the equities may require."   The Court also affirmed the award of $250,000.00 in exemplary damages.   Court found that factual finding that loss was caused by fraud, malice or gross negligence was not clearly erroneous.

Sanctions; All Writs Act

Carroll v. Abide (In re Carroll), 850 F.3d 811 (5th Cir. 3/13/17)

This is a sanctions case.   The Carrolls and their wholly owned company filed chapter 7 and were substantively consolidated.   The Carrolls engaged in "troublesome conduct" that "displayed (a) pattern of harassment" toward the trustee.    The Bankruptcy Court enjoined them from filing any further pleadings without court permission and awarded sanctions under 11 U.S.C. Sec. 105(a) in the amount of $49,432.  

The Court set out the standard for awarding sanctions under its inherent authority and enjoining vexatious litigants.
We begin by noting the bankruptcy court has numerous tools by which to sanction the conduct of individuals. "Federal courts have inherent powers which include the authority to sanction a party or attorney when necessary to achieve the orderly and expeditious disposition of their dockets."  "Such powers may be exercised only if essential to preserve the authority of the court and the sanction chosen must employ the least possible power adequate to the end proposed."  A court must make a specific finding of bad faith in order to impose sanctions under its inherent power.  Moreover, when sanctions are imposed under the inherent power, this court's "investigation of legal and evidentiary sufficiency is particularly probing" and this court must "probe the record in detail to get at the underlying facts and ensure the legal sufficiency of their support for the district court's more generalized finding of 'bad faith.'" 

Federal courts also have authority to enjoin vexatious litigants under the All Writs Act, 28 U.S.C. § 1651.  Moreover, under 11 U.S.C. § 105, "a bankruptcy court can issue any order, including a civil contempt order, necessary or appropriate to carry out the provisions of the bankruptcy code."  When considering whether to enjoin future filings, the court must consider the circumstances of the case, including four factors:
(1) the party's history of litigation, in particular whether he has filed vexatious, harassing, or duplicative lawsuits; (2) whether the party had a good faith basis for pursuing the litigation, or simply intended to harass; (3) the extent of the burden on the courts and other parties resulting from the party's filings; and (4) the adequacy of alternative sanctions.   830 F.3d at 815. (internal citations omitted).

The Court had no trouble sustaining a finding of bad faith, stating,  

Appellants' suggestion that their conduct was not done in bad faith is belied by their repeated attempts to litigate issues that have been conclusively resolved against them or that they had no standing to assert and by their unsupported and multiple attempts to remove Abide as the trusteeThe amount of the sanctions award was affirmed because it represented the amount of attorneys' fees incurred by the trustee in responding to the Carrolls' conduct.

Voidable preference

Tower Credit, Inc. v. Schott (In re Jackson), 850 F.3d 816 (5th Cir. 3/13/17)

 The Trustee sued to avoid a wage garnishment as a preferential transfer.   The Defendant argued that the transfer occurred when the garnishment order was issued, which was more than 90 days before bankruptcy.    The Court found that a transfer is made when it is "perfected," that is, when a judgment creditor could not obtain superior rights in the property.   However, a transfer also is not made until the debtor has rights in the property.   As a result, each time the debtor obtained wages and the garnishment lien reached those wages was a new transfer.   Therefore, the Court affirmed the judgment in favor of the trustee.

 Proof of claim; res judicata

Kipp Flores Architects, LLC v. Mid-Continent Cas. Co., 852 F.3d 405 (5th Cir. 3/24/17)

This case involved the effect of a proof of claim in subsequent litigation.   A creditor filed a proof of claim in a no-asset bankruptcy case.   No party objected to the claim.    The creditor then argued that because the proof of claim was "deemed allowed," it was res judicata in the creditor's subsequent claim against the debtor's insurance company.    The Court found that the claim did not have any preclusive effect where there was never a deadline to object to claims and adjudicating the claim would not have served a bankruptcy purpose.   

Sanctions

Armendariz v. Chowaiki, 2017 U.S. App.  LEXIS 5531 (5th Cir. 3/30/17)(unreported)

Plaintiffs sued various parties for RICO based on a fraudulent transfer action brought in U.S. Bankruptcy Court.    The District Court dismissed the suit but denied a motion for sanctions under Rule 11.    The Court did not give reasons for its denial of the sanctions motion.   The Fifth Circuit affirmed the order dismissing the suit.   However, it reversed and remanded the denial of sanctions.  The Court explained that when a court grants or denies sanctions, it must provide reasons sufficient for the reviewing court to determine the basis for the ruling.