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In this Spring 2013 issue:

U.S. Supreme Court Interprets Discharge Exception for Defalcation While Acting in a Fiduciary Capacity to Require a Culpable State of Mind

Mechanics Lien Held Invalid Due to Faulty Affidavit and Failure to File §546(b) Notice

Connecticut District Court Changes Law on Lien-Stripping in “Chapter 20” Cases – A Chapter 7 Followed By a Chapter 13 Case

Connecticut District Court Reverses Bankruptcy Court’s Ruling that Liquidating Agent Had No Standing to Pursue Fraudulent Transfer Claims Against Debtor’s Professionals

Debtor’s Breach of Non-Competition Covenant was Not a Non-Dischargeable Debt Based on a “Defalcation While Acting in a Fiduciary Capacity,” 11 U.S.C. §523(a)(4), or a “Willful and Malicious Injury” Under 11 U.S.C. §523(a)(6)   

Bankruptcy Court Awards Partial Return of Liquidated Damages Deposit Under Real Estate Contract

Debtor’s Motion for Relief from the Automatic Stay to Proceed with a State Action as Plaintiff Denied on the Basis that the Automatic Stay Does Not Apply to Actions by the Debtor

 

U.S. Supreme Court Interprets Discharge Exception for Defalcation While Acting in a Fiduciary Capacity to Require a Culpable State of Mind   

In Bullock v. Bankchampaign, N.A., 2013 WL 1942393 (May 13, 2012), the Supreme Court decided the state of mind which a debtor must have in order for a debt to be excepted from discharge based on “defalcation while acting in a fiduciary capacity.”  11 U.S.C. §523(a)(4).  The lower courts had held that a debt could be excepted from discharge under this section if the debtor’s conduct was objectively reckless, while courts in other jurisdictions required a more culpable state of mind. 

In this case, the debtor's father established a trust for the benefit of petitioner (the debtor) and his siblings, and made the petitioner the (nonprofessional) trustee.  The trust’s sole asset was the father’s life insurance policy.  The petitioner borrowed funds from the trust three times, but all of the borrowed funds were repaid with interest.  His siblings obtained a judgment against him in state court for breach of fiduciary duty, though the court found no apparent malicious motive.  The court imposed constructive trusts on certain of the petitioner’s interests—including his interest in the original trust—in order to secure the petitioner’s payment of the judgment, with the respondent serving as trustee for all of the trusts.  The petitioner filed for bankruptcy and the respondent opposed discharge of the petitioner’s state court-imposed debts to the trust.  The Bankruptcy Court granted the respondent summary judgment, holding that the petitioner’s debts were not dischargeable pursuant to 11 U.S.C. §523(a)(4), which provides that an individual cannot obtain a bankruptcy discharge from a debt “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.”  The Federal District Court and the Eleventh Circuit affirmed.  The latter court reasoned that “defalcation requires a known breach of fiduciary duty, such that the conduct can be characterized as objectively reckless.”  Here, the Supreme Court ruled that the term “defalcation” in the Bankruptcy Code includes a culpable state of mind requirement requiring knowledge of, or gross recklessness with respect to, the improper nature of the fiduciary behavior. The judgment of non-dischargeability judgment was vacated.

 

Mechanics Lien Held Invalid Due to Faulty Affidavit and Failure to File §546(b) Notice

At issue in In re Derby Development Corp., Case No. 10-50259, Adv. Pro. No. 11-5036 (Apr. 10, 2013) (Shiff, J.), was the validity of a mechanics lien filed by the uncle of the sole shareholder of Derby Development Corp., the debtor (“Derby”).  The lien was for the amount of $160,000 for architectural services allegedly rendered by the sole shareholder’s uncle.   

During the chapter 11 case, the uncle transferred his mechanics lien to a newly formed entity known as Viking Acquisitions, LLC (“Viking”) at about the same time as a pre-confirmation status conference on Derby’s plan of reorganization.  The transfer was made after CPC, a secured creditor of the debtor, objected to confirmation of the debtor’s plan on the basis that the only impaired, accepting class of creditors was the uncle’s mechanics lien claim, which, according to CPC, could not be counted as an impaired, accepting class because the uncle was an insider of the debtor.  See 1l U.S.C. §1129(a)(10).

In a prior ruling, the bankruptcy court, on motion to designate the accepting vote of Viking as having been cast in bad faith, 11 U.S.C. §1126(e), ruled that Viking’s vote would not be counted and therefore, the debtor’s plan could not be confirmed.

Under CPC’s plan, the mechanics lien claim then or formerly held by the uncle was to be determined according to CPC’s adversary proceeding to declare the lien invalid.  In ruling on the adversary proceeding, the bankruptcy court held that the mechanics lien was invalid for two reasons.  First, the affidavit filed by the uncle with the mechanics lien, which was required by Connecticut statute, C.G.S. §49-34, was faulty because, although it stated that he had “made solemn oath that the facts stated therein are true,” the testimony at trial was that the uncle simply signed the affidavit without making any oath, which was followed by the notary public’s acknowledgement.  Second, since the mechanics lien was filed on August 9, 2009, the uncle was required to commence an action to foreclose the lien within one year of that date, C.G.S. §49-39, but failed to do so or provide the notice that is authorized by Bankruptcy Code §546(b).

With respect to this second ground for disallowance of the lien, the bankruptcy court found that the uncle, while automatically stayed from commencing a foreclosure action, could have, but did not, file a notice under Bankruptcy Code §546(b)(2)(A), which provides for continuation of perfection of a lien by notice if applicable law would otherwise require commencement of an action to continue the lien’s perfection.  Generally, this provision of the Bankruptcy Code applies only where the action that is necessary for “continuation of perfection” will, under applicable non-bankruptcy law, relate back for purposes of lien priority to the date of initial perfection.

 

Connecticut District Court Changes Law on Lien-Stripping in “Chapter 20” Cases – A Chapter 7 Followed By a Chapter 13 Case

 In Rogers v. Eastern Savings Bank (In re Rogers), 2013 WL 1309619 (D. Conn. Mar. 28, 2013) (Hall, J.), the Connecticut District Court affirmed the ruling of the bankruptcy court that a Chapter 13 debtor who previously obtained a Chapter 7 discharge could not lien-strip a mortgage against her residence down to the fair market value of the residence.  The affirmance was based on the Supreme Court’s decision in Nobelman v. Am. Sav. Bank, 508 U.S. 324 (1993) (prohibiting lien stripping of under-secured mortgage in Chapter 13 where mortgage is against real property that is the debtor’s principal residence).

While affirming, the district court went out of its way to express disagreement with the rationale used by the bankruptcy court in refusing to allow the lien stripping.  The bankruptcy court (Weil, J.), followed Judge Dabrowski’s decision in In re Sadowski, 473 B.R. 12 (Bankr. D. Conn. 2011), in ruling that the debtor’s attempted lien stripping would not be allowed.  Sadowski, which dealt with a wholly unsecured (based on value) junior mortgage against the debtor’s residence, held that the proposed lien stripping would not be allowed because Bankruptcy Code §1328(f) (providing that no discharge may be granted in a Chapter 13 if the debtor obtained a discharge under Chapter 7 within four years of the Chapter 13 filing), which was enacted as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), created a per se prohibition against voiding an otherwise modifiable lien under Bankruptcy Code §1322(b)(2).  The Sadowski court reasoned that filing a Chapter 13 after receiving a Chapter 7 discharge was an impermissible circumvention of the rule in Chapter 7 that the debtor may not strip liens.  Accordingly, Sadowski held that lien stripping under Bankruptcy Code §1322(b)(2) would not be allowed in a Chapter 13 case that is filed within four years of a Chapter 7 discharge because the debtor’s inability to receive a Chapter 13 discharge would render the petition and plan as per se lacking good faith.

The district court expressly disagreed with Sadowski’s holding, and adopted the view that proposing to lien strip an otherwise modifiable mortgage under Bankruptcy Code §1322(b)(2) in a Chapter 13 case filed within four years of a Chapter 7 discharge is a permissible way of dealing with the in rem lien that remains after the Chapter 7 discharge.  The district court also observed that the crucial question in no-discharge Chapter 13 cases like Sadowski is whether a discharge is necessary to strip the lien or whether the order of confirmation is all that is necessary.  “Absent a determination that a discharge is needed for this purpose – which is an issue that Sadowski referenced but did not answer… -- the rationale in Sadowski fails for the reasons discussed.”

 

Connecticut District Court Reverses Bankruptcy Court’s Ruling that Liquidating Agent Had No Standing to Pursue Fraudulent Transfer Claims Against Debtor’s Professionals

 In Ivey, Barnum & O’Mara v. Bear, Stearns & Co., Inc., (In re Stanwich Financial Services Corp.), 2013 WL 1309593 (D. Conn. Mar. 26, 2013), the Liquidating Agent under a confirmed Chapter 11 plan brought claims against two professionals of the debtor, Bear Stearns and Hinckley, Allen & Snyder, for assisting in a leveraged buy-out that itself was claimed to have been a fraudulent transfer of the debtor.  Some of the claims against the professionals were in the nature of aiding and abetting a breach of fiduciary and fraud perpetrated by the management of the debtor, but also included were claims for recovery of actual fraudulent transfers to the professionals.

The bankruptcy court (Shiff, J) ruled that all claims against the professionals were essentially based on the assistance they provided in connection with the fraudulent LBO, and were therefore barred by the in pari delicto doctrine stated in Shearson Lehman Hutton, Inc. v. Wagoner, 944 F. 2d 114, 118 (2d Cir. 1991).  Wagoner held that “a claim against a third party for defrauding a corporation with the cooperation of management accrues to the creditors, not to the guilty corporation.”  Essentially, under Wagoner, the fraud of a debtor’s management is imputed to the debtor corporation and therefore, infects the standing of a trustee that attempts to recover against third parties for the fraud engaged in by the debtor’s management.

In reversing the bankruptcy court, the district court (Underhill, J.) ruled that Wagoner was inapplicable to fraudulent transfer claims under Bankruptcy Code §§544(b) and 548 because under those sections, the trustee is given the rights of any creditor of the debtor to avoid fraudulent transfers and therefore, standing was statutorily conferred on the trustee to assert such claims.

 

Debtor’s Breach of Non-Competition Covenant was Not a Non-Dischargeable Debt Based on a “Defalcation While Acting in a Fiduciary Capacity,” 11 U.S.C. §523(a)(4), or a “Willful and Malicious Injury” Under 11 U.S.C. §523(a)(6)                                                              

In Syncom Industries, Inc. v. Wood (In re Wood), 488 B.R. 265 (Bankr. D. Conn, Mar. 8, 2013) (Dabrowski, J.), the creditor, Syncom, sought a determination that a debt based on the debtor’s breach of a non-competition covenant in his employment contract rose to the level of a non-dischargeable debt as a “defalcation while acting in a fiduciary capacity, 11 U.S.C. §523(a)(4) or as a “willful and malicious injury.” 11 U.S.C. §523(a)(6).  The debtor, Wood, was employed by Syncom, a company engaged in cleaning movie theatres, as Vice President of Sales.  His employment agreement contained a covenant not to compete or solicit customers of Syncom in Syncom’s business territory for three years after his employment ended.

Under the employment agreement, the debtor was to be paid a weekly salary of $1,000 plus commissions to be determined by later agreement.  When no agreement could be reached on commissions in the ensuing six months, the debtor began making plans to leave and start his own cleaning company, which he did shortly thereafter.  His company then obtained two big customers that had been customers of Syncom.

In New Hampshire state court, Syncom sued the debtor and two employees his company hired away from Syncom  and got a judgment against the debtor for breach of fiduciary duty and breach of contract.  The New Hampshire Supreme Court reversed and remanded on the ground that the restrictive covenants were overly broad and therefore unenforceable.  The remand was for the trial court to determine whether the covenants could be reformed and if so, for a proper calculation of damages.  The debtor filed bankruptcy before the trial court held a hearing on remand.

As to the §523(a)(4) claim, the bankruptcy court held that although, as a corporate officer of Syncom, the debtor might be considered a fiduciary with respect to corporate property and owe a duty of loyalty to Syncom, that duty was not breached by the debtor because it does not prohibit a former corporate officer from competing with his former corporation after the employment ends.  The only duty, according to the bankruptcy court, is to refrain from actively competing with the employer during the tenure of employment.  Accordingly, the bankruptcy court held that the debtor’s active planning to start his own company while employed by Syncom did not breach any duty of loyalty to Syncom.

As to the claim under §523(a)(6), Syncom argued that a “inquiry” was established based on the collateral estoppel effect that should be accorded to the New Hampshire court’s finding that the debtor’s actions were knowing and premeditated in open defiance of his employment contract. 

The bankruptcy court rejected this argument for several reasons: (i) no finding of “willful and malicious injury” was made by the New Hampshire court; (ii) the restrictive covenant upon which Syncom’s claims were based was held to be unenforceable by the New Hampshire Supreme Court; and (iii) the lower court’s findings, because of the reversal and remand, were not final.

In ruling there was no “willful and malicious injury” within the meaning of §523(a)(6), the bankruptcy court emphasized that “willful” requires “a deliberate or intentional injury, not merely a deliberate act that leads to injury,” such that a knowing breach of contract would not qualify.  As for the requirement that the injury be “malicious,” the bankruptcy court instructed that when a debtor acts for economic gain or with a profit motive, his conduct, however deplorable, will not come within §523(a)(6) in the absence of some additional, aggravating conduct on the part of the debtor to warrant a inference of actual malice.  Such conduct was not proven in this case.

 

Bankruptcy Court Awards Partial Return of Liquidated Damages Deposit Under Real Estate Contract

In Chorches v. Trinity Lutheran Church (In re Peburn), 2013 WL 752473 (Bankr. D. Conn. Feb. 26, 2013) (Dabrowski, J.), the Chapter 7 trustee sought to recover a $40,000 deposit put up by the debtor prepetition under a contract to purchase real estate for the sum of $245,000.  A provision in the sale contract established the deposit as liquidated damages in the event of the purchaser’s default.  The sale contract also required a closing by April 30, 2005.

After several extensions of the closing date were agreed to by the parties, the seller demanded in writing that a closing occur by June 30, 2005.  No closing took place.

Less than one week later, another buyer, Singh, appeared and sent a proposed sale contract to the seller on July 5, 2005.  After negotiated changes, a sale contract was signed with Singh on August 5, 2005 for the purchase of the same real estate for $260,000.  Before that sale closed, the debtor recorded his sale contract on the land records, despite a contract provision prohibiting such recordation, in order to improve his negotiating position for a return of the deposit.  The closing with Singh took place on September 20, 2005.  The debtor later filed for bankruptcy and his trustee inherited his claim for return of the deposit.

In addressing the trustee’s claim, the bankruptcy court started by surveying Connecticut decisional law on the enforceability of liquidated damages provisions.  Essentially, Connecticut law provides that liquidated damages provisions will be enforceable unless the purchaser proves it did not willfully breach and that the seller would be unjustly enriched because the damages suffered by the seller were less than the moneys received from the purchaser.  Connecticut law also establishes that liquidated damages will be unenforceable if the seller sustains no damages, and that liquidated damages of 10 percent of the contract price will be given a rebuttable presumption of enforceability.

The bankruptcy court first found that the debtor did not willfully breach the sale contract because he reasonably believed that the ultimate contract purchaser, Singh, would instead be investing funds with the debtor in a joint venture to purchase the property. 

As to unjust enrichment of the seller, the bankruptcy court analyzed that requirement by first noting that 10 percent of the contract price, $24,500, was entitled to a presumption of enforceability.  It then reduced that damage amount by $15,000, the amount of the increase in the purchase price realized by the seller from the sale contract with Singh ($260,000 less $245,000), thus entitling the trustee to a recovery of $30,500 ($40,000 less ($24,500 minus $15,000) equals $30,500).  This was subject to additional damages incurred by the seller, however.  The additional damages consisted of $6,000 in mortgage payments the seller had to make as a result of the debtor’s breach and $2,310 in interest which the court added because $60,000 of the seller’s funds were tied up for one year with a title company due to the debtor’s improper recordation of the sale contract.  Thus, the Trustee was given a judgment of $22,190.

It is unclear why the bankruptcy court, in analyzing the damages, started with the proposition that the seller was entitled to an unassailable liquidated damage claim of $24,500, which was 10 percent of the contract price, and then reduced it by the $15,000 which the seller gained by the later contract closing with Singh.  If the 10 percent of the contract price rule is a rebuttable presumption for a proper and enforceable liquidated damages amount, and may be rebutted by a showing that no damages were incurred, then it would appear that the trustee did rebut the presumption.  By closing with a party for $15,000 more than the contract price with the debtor, it would not appear that the seller suffered any damages, even accounting for the damages the bankruptcy court attributed to the debtor’s default and breach ($8,310).

On the trustee’s motion for reconsideration, the bankruptcy court upheld its decision, 2013 WL 1397454 (Bankr. D. Conn. Apr. 5, 2013), reasoning that the trustee did not present any controlling decisions or matters the court overlooked, as opposed to arguing that the court was just wrong.  The proper channel to asset alleged errors of this nature, according to the court, is by appeal.

 

Debtor’s Motion for Relief from the Automatic Stay to Proceed with a State Action as Plaintiff Denied on the Basis that the Automatic Stay Does Not Apply to Actions by the Debtor

The debtor in Quality Sales LLC v. Gitlan Campise LLC (In re Quality Sales LLC), 2013 WL 492499 (Bankr. D. Conn. Jan. 31, 2013) (Dabrowski, J.), was the plaintiff in a prepetition state court action against his former accountants.  The trustee, with the approval of the bankruptcy court, hired the debtor’s litigation attorney to continue proceeding with the action on behalf of the estate, with the trustee becoming the plaintiff.  Apparently unilaterally, the litigation attorney moved for relief from the stay on behalf of the debtor to proceed with the action.   The bankruptcy court denied the motion on the ground that the debtor lacked standing to proceed with the state court action, which was an asset of the estate that had to be pursued by the trustee, and because the action, having been initiated by the debtor and not against the debtor, was not subject to the automatic stay.  The court construed the defendant’s objection to the motion for relief from the automatic stay as a request to lift the stay in order for the defendant to assert defenses and counterclaims in the action.  That relief was granted.  

 

Please feel free to contact any of our attorneys in this practice area for additional information.

Elizabeth Austin                                                         Irve Goldman
eaustin@pullcom.com                                             igoldman@pullcom.com
203.330.2243                                                             203.330.2213

Jessica Grossarth                                                      
jgrossarth@pullcom.com                                       
203.330.2285       

 

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