Intent To Benefit Certain Creditors Sufficient For Fraud

Bankruptcy Law Roundup

Sharp Thinking

No. 129    Perspectives on Developments in the Law from Sharp-Hundley, P.C.      May 2015

Intent To Benefit Certain Creditors Sufficient For Fraud

            The common intent to benefit friendly creditors by not listing them in one’s bankruptcy papers is sufficient intent to support denial of a bankruptcy discharge, the Seventh Circuit U.S. Court of Appeals has ruled.

            Moreover, dealing with an allegedly uneducated debtor, the court said that her “failing to seek advice of counsel, while knowing that she lacked legal training or knowledge, bespoke a reckless indifference to the truth, and no more is required for fraudulent intent in bankruptcy.”  In re Katsman, 771 F.3d 1048 (7th Cir. 2014).

            Although the Katsman debtor also had failed to disclose certain assets, it was the omission of creditors – often thought to be an immaterial matter – that drew most of the court’s ire.  It suggested omission of creditors was proper “only if the amount owed them was utterly trivial.” 

            The court rejected the debtor’s explanation that she hoped to pay the omitted creditors and thought that including them would prevent that.  “After she was discharged, she could pay anyone anything,” the court said, rejecting her premise.  Moreover, the intent to benefit one group of creditors is sufficient fraudulent intent, it said, rejecting an argument that the debtor must have intended to receive a pecuniary benefit for herself.

Panel Affirms Sanctions For Inappropriate “Unbundling”

            The Ninth Circuit Bankruptcy Appellate Panel (BAP) has affirmed a bankruptcy judge’s use of sanctions in an attempt to “promote a systemic change” in the practice of “mill” attorneys rotely excluding adversary actions from the scope of their retainer agreements.

            Recognizing that consumer bankruptcy attorneys can “unbundle” adversary proceedings from their agreed representation in some circumstances, the panel said that such “limited scope representation” must “comply with the rules of ethics and the Bankruptcy Code.  A qualitative analysis of each individual debtor’s case must be done at intake to ensure that his or her reasonable goals and needs are being met.”  In re Seare, 515 B.R. 599 (9th Cir. BAP 2014).

            In Seare the bankruptcy lawyer relied on an adversary-action exclusion provision in a form retainer contract to avoid making a defense to an adversary action seeking to except a debt from discharge on grounds of fraud.  The debt was already to the judgment garnishment stage when the attorney was consulted, and its fraud basis would have been revealed by a reasonable investigation, the bankruptcy court had found.  The BAP agreed with the bankruptcy judge that permanently stopping that garnishment was a principal motivation of the debtor in seeking bankruptcy relief and hence “unbundling” of the defense of the adversary was an inappropriate action under ethical rules applicable to “unbundling” issues.  In the view of both courts, the “unbundling” decision must be driven by the client’s interests, not the lawyer’s.

            The BAP affirmed the court’s order that its sanctions opinion be provided to any potential adversary clients the lawyer declined in the next two years.  It said the court “saw this sanction as a means of informing the bar that being disciplined for unethical conduct has repercussions beyond just paying a fine and moving on.  We find it difficult to disagree with this reasoning.”

Secured Lender Cannot Use Parol Evidence Against Trustee

            A secured lender cannot use parol evidence against a bankruptcy trustee to save a security agreement from a mistaken description of the debt secured, the Seventh Circuit U.S. Court of Appeals has held. 

            Conceding that the error at issue was the kind of mistake that could be corrected, as between the original parties to the loan, by reformation based on parol evidence, the court said the rule was different with respect to a bankruptcy trustee.  In re Duckworth, 776 F.3d 453 (7th Cir. 2014).

            In Duckworth, the security agreement misstated by two days the date of the promissory note secured.  Stressing “the importance of third parties’ ability to rely on unambiguous documents – even if the original parties can show they contained mistakes – to determine the validity and priority of security interests,” the court upheld the trustee’s “strong arm” avoidance power, which it characterized as a blunt tool that encourages lenders to give correct public notice of their security interests by “harshly penalizing those who fail to do so.” 

            “We find no limiting principle that would allow the courts or parties to distinguish reliably between small errors and big ones,” the court said.  “[P]arol evidence cannot be used to correct even the seemingly minor error in the security agreement.” 

Claim Filing Deadline Applies To Secured Claims

            Noting contrary views in some courts, the Court of Appeals for the Seventh Circuit has held that the proof-of-claim filing deadline set forth in Federal Rule of Bankruptcy Procedure 3002(c) applies to secured as well as unsecured claims.  In re Pajian, __ F.3d __, 2015 WL 2182951 (7th Cir. 2015).

            Rule 3002(c) requires creditors to file proofs of claim within 90 days of the date set for the first meeting of creditors.  Because Rule 3002(a) provides that unsecured creditors and equity security holders must file proofs of claim, many courts and attorneys had presumed that Rule 3002(c) applied only to the secured creditors also.

            The Court of Appeals said it thought the better interpretation was that all creditors are bound by Rule 3002(c).  Noting that the drafters specifically limited some of Rule 3002’s provisions to unsecured creditors but did not do so in 3002(c), it said “[t]hat they did not specifically mention unsecured claims when setting forth the 90-day deadline in subsection (c) . . . strongly implies that the deadline encompasses all claims” unless one of the rules express exceptions is applicable (court’s emphasis).

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