NCBJ 2021: Even the Circuits Can't Agree

 ABI Editor at Large Bill Rochelle hosted a group of three panels discussing three different legal issues. The issues included one legitimate circuit split, a dispute between lower courts and a divided state court panel.

Recharacterization

Issue one was whether recharacterization of debt is an issue of state or federal law. Recharacterization is where an obligation nominally characterized as a debt is recharacterized to be an equity contribution.  Recharacterization was first recognized in the Supreme Court case of  Pepper v. Litton, 308 U.S. 295 (1938). The Third, Fourth, Sixth, Tenth and Eleventh Circuits all state that the issue is one of federal law while the Fifth and Ninth Circuits hold that it is a matter of state law.  

Luke Burbank argued the minority position arguing that where there is no clear and express bankruptcy authority, that state law would control and that state law defines property rights. Additionally, while each of the circuits applying the majority rule applies a multi-factor test, none of these tests are the same.

Camisha Simmons argued the majority position stating that Congress granted Bankruptcy Courts the exclusive power to establish the priority and classification of claims. Priorities are governed by both sections 507 and 726 and Bankruptcy Courts have the authority to use their equitable powers to reclassify claims.  Ms. Simmons argued that her position was supported by the fact that equitable subordination, one of the remedies allowed by Pepper v. Litton, made it into the code. 

The Supreme Court granted cert to resolve the split but denied the writ as improvidently granted. PEM Entities LLC v. Levin, 138 S. Ct. 41 (2017) did not. 

Judge Jeffrey Hopkins ruled in favor of the minority position saying that he felt like Butner v. United States, 40 U.S. 48 (1979), which announced the rule that state law controls in the absence of a clear bankruptcy statute, but said he hoped that Supreme Court would give bankruptcy judges more  equitable power. 

Venue for Small Preference Claims

Issue two was whether small dollar preference claims must be brought in the defendant's home district. 28 U.S.C. Sec. 1409(b) states that:

  (b)

The legislative history to this statute makes clear that it was intended to require trustees to bring small preference suits in the defendant's home district. However, Congress left out the phrase "arising under" from the statute. There are three types of bankruptcy jurisdiction: arising under, which means created by the Bankruptcy Code, "arising in" which means a type of action which could only arise in a bankruptcy case and "related to" which means matters related to a bankruptcy case which do not arise under the Code and do not "arise in" a case.  The problem is that preference claims are defined by 11 U.S.C. Sec. 547, which is clearly a part of the Code. Thus, the question is whether the omission of "arising under" from the statute means that small preference claims can be brought wherever the trustee chooses. 

The Ninth Circuit BAP held that the statute did limit small preference cases, Muskin, Inc. v. Strippit Inc. (In re Little Lake Indus.), 158 B.R. 478 (B.A.P. 9th Cir.1993). while a recent opinion from Judge Robert Grossman, Mendelsohn v. Central Garden & Pet Co. (In re Petland Discounts Inc.), 20-08088 (Bankr. E.D.N.Y. 1/26/21) read the statute literally to say that preference suits were not covered.  Several unpublished opinions in the Western District of Texas also state that venue of preference suits is not limited.

A young couple, Alexandra Duggan and Robert Miller, argued opposite sides and traded good-natured insults with each other.  Both advocates struggled to find an example of a dispute which would arise in a case under Title 11 but did not arise under Title 11 itself. While the legislative history suggests that the statute was intended to cover preference suits, "arising under" is used in each of the other four subsections of Sec. 1409 suggesting that its omission was intentional. However, a preference suit can only arise if there is a case under Title 11. A distinction not mentioned by the parties is that the bankruptcy courts have exclusive jurisdiction over bankruptcy cases but only concurrent jurisdiction over arising under, arising in and related to matters. Thus, although a preference suit may only be brought if there is a case under Title 11, it need not be brought in that case. While the banter between the couple was amusing, the straightforward answer appears to be that Congress committed legislative malpractice not once but twice when it drafted this section and then when it amended it to raise the floor for small actions to $25,000. The net result seems to be that a small action to recover an account receivable must be brought in the defendant's home forum but a small preference action need not. 

Pre-emption of State Law Tortious Interference Claims 

Issue three was whether federal law preempts third party tortious interference claims. This was not even a split between different courts. The New York Court of Appeals rendered a decision in Sutton 58 Assocs. LLC v. Pilevsky, 36 N.Y.3d 297 (N.Y. 2020), petition for cert. filed (U.S. Apr. 20, 2021) (No. 20-1483) holding that federal law does not preempt a tortious interference suit between non-bankrupt parties arising out of actions taken in connection with a bankruptcy case. The New York Court of Appeals is New York's highest appellate court. A petition for cert was filed supported by an amicus brief from eminent law professors, but the case settled before the Supreme Court could decide whether to take the case.  In this case, the split was between the majority opinion finding that there was no preemption and the dissent holding that there was.

The case involved a transaction intended to be bankruptcy proof. A housing project borrowed $150 million from a lender. The loan covenants prohibited the debtor from incurring other debt and acquiring other property. Before bankruptcy, a group of non-debtors loaned the debtor $50,000 to hire bankruptcy counsel, transferred three apartment units into the debtor and acquired an indirect 49% interest in the debtor. All of these actions violated the loan covenants. They also kept the debtor from being a single asset real estate entity with no unsecured creditors. The lender eventually got the property back but claimed that it lost value due to the bankruptcy filing. It sued the debtor's would-be white knights for tortious interference.

Keith Wofford of White & Case argued very persuasively for preemption. He pointed out that there are two types of preemption,  preemption of the field and obstacle preemption. When a party can be sued for actions taken in connection with a bankruptcy case, an obstacle to bankruptcy has been created. Although Mr. Wofford did not say so, all bankruptcies involve a breach of contract. If the loan covenants say that filing bankruptcy is a default, could debtor's counsel be sued for filing the case. Shelly DeRousse of Freeborn & Peters argued (convincingly in my opinion) that bankruptcy does not preempt all actions against anyone related to a bankruptcy. This is why suits against guarantors are neither stayed nor preempted.  She also argued that the offending conduct all occurred prior to the bankruptcy being filed and thus was not a part of the bankruptcy. Next she argued the presumption against preemption.  Finally, the argued that the Bankruptcy Code does not create a remedy for bad faith filings against third parties. Therefore, if state law remedies are preempted, there is effectively no remedy. In his rebuttal, Mr. Wofford argued that being allowed to bludgeon the supporting cast of a bankruptcy under state law will undermine Congress's intent to allow the bankruptcy remedy. 

Who is right? We will not find out because the parties settled and the petition for cert was withdrawn.