Bankruptcy Questions Answered

Equitable Subordination of a Creditor’s Secured Claim when such Secured Creditor is, itself, in Bankruptcy

In a majority opinion dated December 15, 2009, the Ninth Circuit Bankruptcy Appellate Panel held that a chapter 11 debtor may not equitably subordinate a creditor's claim and transfer the lien securing that claim, when such creditor is, itself, in bankruptcy, before first obtaining relief from the automatic stay under section 362 of the U.S. Bankruptcy Code in such creditor's bankruptcy case. Lehman Commercial Paper v. Palmdale Hills Prop. (In re Palmdale Hills Prop., LLC), 2009 Bankr. LEXIS 4294 (B.A.P. 9th Cir. Dec. 15, 2009).  

It is well established that a bankruptcy court has the power to reorder the priority of allowed claims based on equitable grounds. Indeed, under section 510(c) of the Bankruptcy Code, if the principles of equity so dictate and after appropriate notice and a hearing, the bankruptcy court may subordinate all or part of an allowed claim, and transfer any lien securing such subordinated claim to the bankruptcy estate.  The decision in the Palmdale Hills case adds a wrinkle to this process when the creditor is in bankruptcy. According to Palmdale Hills, if the subject creditor happens to be in bankruptcy, relief from the automatic stay applied in such creditor's case upon filing must first be obtained before such creditor's secured claim can be equitably subordinated. 

The debtors in the Palmdale Hills case were integrated companies formed as part of a joint venture to develop residential real estate projects with affiliates of Lehman Brothers, Inc. Lehman and its affiliates, including Lehman ALI, Inc. ("Lehman ALI") and Lehman Commercial Paper Inc. ("Lehman Commercial"), provided the financing for the projects through a series of loan agreements and equity arrangements on the debtors' projects. The debtors contended that the structure of these financing arrangements constituted manipulative lending practices and fraudulent conveyances, and that Lehman's complete control over the use of the funds created their significant debt burdens and eventually forced them to file bankruptcy.

Soon after filing bankruptcy in California, the debtors sought blanket relief from the automatic stay in Lehman Commercial's bankruptcy case pending in New York. The purpose of this relief was to allow the Palmdale Hills debtors to administer their California bankruptcy cases without the need to file repeated motions for relief from the automatic stay in Lehman Commercial's New York bankruptcy cases.  However, the New York bankruptcy court denied the broad relief requested by the debtors without prejudice to the debtors' rights to refile specific requests for stay relief.

Eventually, the debtors proposed a chapter 11 plan based principally on equitably subordinating the claims of Lehman ALI (an entity not in bankruptcy) and Lehman Commercial (who is in bankruptcy, together with Lehman ALI, the "Lehman Lenders"). The debtors also filed an adversary proceeding against Lehman ALI to equitably subordinate its claim, which they later proposed to amend to include a request to equitably subordinate Lehman Commercial's claim and transfer its lien to the estate if the California bankruptcy court determined that such action would not violate the automatic stay applicable in Lehman Commercial's bankruptcy case.

The Lehman Lenders filed a motion for relief from stay in the debtors' California case arguing that they were owed more than $649 million on their loans to the debtors, and that the properties securing these loans lacked equity and were declining in value. The Lehman Lenders also argued that the debtors' reorganization would fail because it was based on equitably subordinating Lehman Commercial's claim, which Lehman Commercial argued violated the automatic stay applicable in its bankruptcy case.

The California bankruptcy court did not, however, grant the Lehman Lenders' stay relief motion, and instead treated it as an informal proof of claim. The court also ruled that the debtors could pursue equitable subordination, through either an adversary proceeding or a plan, as a defense to Lehman Commercial's stay relief motion without violating the automatic stay imposed in Lehman Commercial's bankruptcy case. Lehman Commercial appealed, challenging the California bankruptcy court's decision regarding the scope and application of Lehman Commercial's automatic stay.

The BAP reversed, holding that the California bankruptcy court erred in finding that the debtors could pursue equitable subordination of the Lehman Commercial's claim and transfer its lien to the estate without first obtaining relief from the automatic stay in Lehman Commercial's New York bankruptcy case. While the BAP agreed that equitable subordination could be asserted as a defense to a motion seeking relief from the automatic stay without the necessity for seeking relief from the automatic stay, the BAP concluded that, under the facts of the case, equitable subordination was not merely a defense to the relief from stay motion. According to the BAP, when the California bankruptcy court permitted the debtors to pursue equitable subordination of Lehman Commercial's claim, it conflated equitable subordination as a defense to a relief from stay motion with equitable subordination as an objection to a claim. Because the adjudication of the debtors' equitable subordination of Lehman Commercial's claim sought affirmative relief and was not merely a defense, it rose to the level of violating Lehman Commercial's stay. 

The BAP also rejected the debtors' contention that, because a complete disallowance of a claim through a claim objection could be achieved without a stay violation, their "lesser defensive remedy" of claim subordination could not possibly violate the automatic stay. The BAP noted that when a claim is disallowed, the creditor effectively never had the right to payment under that claim and the debtor did not recover any property from the creditor; whereas under equitable subordination, the creditor has a right to payment, but that right is modified based on equitable grounds and, if the claim is secured by a lien, that lien is transferred to the estate. According to the BAP, it was this key difference that transformed the debtors' claim of equitable subordination from a proper defense to Lehman Commercial's stay relief motion into an offensive action against Lehman Commercial's estate.

Finally, the BAP also noted that if the debtors were allowed to subordinate Lehman Commercial's claim in the California bankruptcy court without first moving for a stay relief in Lehman Commercial's New York bankruptcy case, Lehman Commercial's creditors would be deprived of notice and the chance to challenge the subordination action even though their rights would be affected.

One judge dissented in the Palmdale Hills case and disagreed with the majority's principal holding (as characterized by the dissent) that a debtor may not, in its own bankruptcy, unilaterally defend against a lender's inequitable claim if that lender is also a bankruptcy debtor. According to the dissent, the majority's distinction between claim disallowance and claim subordination is a distinction without a difference and does not constitute a good reason to require a debtor to seek permission of its creditor's bankruptcy court to avoid an equitable result in its own case. Alternatively, according to the dissent, Lehman Commercial waived its right to raise automatic stay issues once it filed its proof of claim. 

Ultimately, the Palmdale Hills decision represents a warning sign for a debtor in bankruptcy to tread carefully when dealing with claims filed in its own case. In light of the large number of bankruptcy filings in recent months, it may behoove such a debtor intending to equitably subordinate a creditor's claim, to first check the bankruptcy status, if any, of such creditor and avoid violating the creditor's automatic stay if it happens to be in bankruptcy itself.

Authored By:

Robert Sahyan
(415) 774-3146
rsahyan@sheppardmullin.com 

Posted in 9th Circuit Caselaw | Comments Off

Actions Taken In Violation Of The Automatic Stay Are Void… Sometimes

In Burkhart v. Coleman, (In re Tippett) --- F.3d ---, 2008 WL 4070690 (9th Cir. Sept. 4, 2008), the Ninth Circuit held that an unauthorized post-petition sale of real property may be upheld where: 1) the bankruptcy trustee failed to record the bankruptcy petition with the county recorder; and 2) a bona fide purchaser thereafter bought and recorded title in the property.  As welcome as this news is to bona fide purchasers in California, the opinion raises interesting issues pertaining to acts arguably taken in violation of the automatic stay under section 362 of the Bankruptcy Code by holding that the automatic stay may not apply to sales or transfers of property initiated by the debtor under certain circumstances.

Mr. and Mrs. Tippett filed a Chapter 7 petition in May of 2001.  On their schedules, the Tippetts listed their homestead as having a value of $140,000, with two liens against it totaling approximately $135,000.  The bankruptcy Trustee did not abandon the bankruptcy estate's interest in the residence, but did not record the Tippetts' petition with the county recorder.  

Without obtaining bankruptcy court approval, in November of 2002, the Tippetts sold their home to Seitu Coleman for $225,000.  This sale resulted in the receipt by the Tippetts of over $75,000 after payment of all liens on the property.  To purchase the property, Coleman signed purchase money notes in favor of two mortgage companies.  These notes were secured by deeds of trust that were duly recorded.  It was undisputed that Coleman was a bona fide purchaser of the property. 

The Trustee filed an adversary proceeding against the Tippetts, Coleman, and the lenders seeking to recover the sale proceeds under 11 U.S.C. § 542, avoid the lenders' liens, and quiet title to Coleman.  The bankruptcy court, however, ruled in favor of the Trustee, and held that the Tippetts' grant deed and the lenders' liens were void ab initio as violations of the automatic stay under 11 U.S.C. § 362.  On appeal, the Bankruptcy Appellate Panel reversed and entered judgment in favor of Coleman, concluding that the Tippetts' unauthorized transfer of the residence to Coleman did not violate the automatic stay.

The Ninth Circuit affirmed the BAP decision and held that the Bankruptcy Code does not preempt California's bona fide purchaser status as it applied to the foregoing transaction.  Additionally, the Court held it was "adher[ing] to the established proposition that the automatic stay triggered by a debtor's bankruptcy petition does not void transfers of estate property initiated by the debtor." 

Preemption

The Ninth Circuit found that California's Bona Fide Purchaser Statute was not preempted by the Bankruptcy Code.  In making this determination, the Court found that Chapter 7 of the Code embodies two ideals: 1) giving a debtors a fresh start, and 2) equitably distributing a debtor's assets among competing creditors.  The Court found that California's bona fide purchaser statute was "wholly consistent" with the second goal, and thus there was no federal preemption. 

The Automatic Stay

The Trustee also contended that the automatic stay rendered the transfer of the real property to Coleman a nullity pursuant to 11 U.S.C. § 362.  This argument would appear to persuasive as the Ninth Circuit has consistently stated that violations of the automatic stay are void, not merely voidable.  However, the Court in In re Tippett concluded otherwise. 

The Court's rationale was as follows: section 549 of the Bankruptcy Code, allows (but does not mandate) a trustee to avoid a transfer of property of the estate that occurs post-petition and without authorization.  According to the Bankruptcy Court, the expansive definition of "transfer" in section 549 means that sections 362 and 549 of the Bankruptcy Code, at times, govern the same transactions.  In addition, section 549 of the Bankruptcy Code implies that some transactions will be valid unless challenged by a trustee.  Thus, the Court noted that some have argued section 362 of the Bankruptcy Code cannot be interpreted to void these overlapping transactions, for doing so would render section 549 of the Bankruptcy Code moot. 

The Court also found that there was a key difference between section 549 and section 362: section 362 protects the debtor, not creditors, while section 549 is designed to protect creditors against unauthorized transfers by the debtor.  Moreover, the Court cited Schwartz v. United States (In re Schwartz), 954 F.2d 569, 574 (9th Cir. 1992), for the proposition that in most circumstances, section 549 applies to transfers in which the debtor is a willing participant; in contrast, the automatic stay under section 362 does not apply to sales or transfers of property initiated by the debtor.  As a result, the transfer from the Tippetts to Coleman was not rendered void by the automatic stay. 

Unfortunately, the Court does not provide any analysis as to why section 362 does not apply to sales or transfers of property initiated by the debtor.  Rather, the Court found itself bound by the principles of stare decisis, and concluded that "there is no question that the analysis and conclusion in Schwartz that the automatic stay did not apply to transfers by debtors was an important and focused part of the panel’s reasoning."  The "analysis" in Schwartz, however, is non-existent, and Schwartz fails to include a single case in support of this proposition. 

As a result, the few short paragraphs in the opinion that discuss the automatic stay add a further wrinkle to the well established Ninth Circuit authority that renders actions taken in violation of the automatic stay as "void," at least when the debtor is the one initiating the action.  Although it is clear from reading the opinion that the automatic stay does not apply to transfers by debtors, at least under certain circumstances, the rationale for this proclamation is uncertain. As a result, it is unclear how future cases will apply section 362 if it involves transfers by the debtor. 

If In re Tippett is held to its facts, the potential impact on the Ninth Circuit's interpretation of the automatic stay may be quite limited.  However, the possibility that In re Tippett could be extended beyond its particular facts is one that creditor and debtor attorneys should be aware of.

Authored by:

Stephanie M. Seidl

(213) 617-4177

sseidl@sheppardmullin.com

Posted in 9th Circuit Caselaw | Comments Off