Legislatures encourage entrepreneurial risk taking by allowing individuals to form artificial entities to limit their personal exposure for corporate debts.    Plaintiffs’ lawyers attempt to tear down those walls by piercing the corporate veil.   In recent years, the Texas legislature has moved away from a formulaic approach to veil piercing (i.e., did the entity keep regular minutes) toward one focusing on whether the corporate vehicle had been used by the owner to perpetuate a fraud.   A Texas court of appeals has now confirmed that this principle applies to limited liability companies even prior to the enactment of corrective legislation.    Shook v. Walden, 368 S.W.3d 604 (Tex. App.—Austin, 2012, pet. filed).    The case involved a father who wanted to set up his new son-in-law in business.   Shook, the father, and Jahne, the son-in-law, formed S & J Endeavors, LLC.   S & J was supposed to build a home for the Waldens.    Problems ensued and the Waldens sued.   After a fourteen day trial, the jury rendered a verdict against S & J and Jahne for fraud but did not award damages.   The jury also found that S & J had breached its contract with the Waldens and awarded $80,000 in actual damages and $315,000 in attorney’s fees.   The jury imposed personal liability on both Shook and Jahne by finding that S & J was the alter ego of the individuals, that they constituted a “single-business entity” and that the LLC was a “sham.”    On appeal, the Waldens conceded that “single-business entity” was no longer a viable theory for piercing the corporate veil under Texas law.  See SSP Partners v. Gladstrong Invs. (USA) Corp., 275 S.W.3d 444 (Tex. 2008).    This left the alter ego and sham findings.The Court noted that the Texas legislature had restricted the alter ego doctrine in cases involving business corporations to cases where the defendant used the corporation to commit an “actual fraud” for his “direct personal benefit.”   This eliminated veil piercing based on failure to keep minutes and other technical violations.   While this legislation was evolving over the period from 1989 to 1997, the legislature created the limited liability company as a new form of entity in 1991.   While the legislation contained general provisions that the members of an LLC were not liable for the entity’s debts, it did not address veil piercing principles until 2011.  See Business Organizations Code Sec. 21.223 and 21.224.    Unfortunately, this legislative change did not apply to Shook's case.Nevertheless, after an extensive discussion, the Austin Court of Appeals concluded that the “actual fraud” for “direct personal benefit” standard should apply to a limited liability company even prior to the recent legislative amendments.    While this seems like a sensible conclusion, one Justice dissented and a petition for review is now pending before the Texas Supreme Court.   For cases arising after September 1, 2011, the new legislation dictates the higher standard for veil piercing.   I would suggest that the facts of the Shook case illustrate why the legislature was right to make this change.    Mr. Shook invested approximately $200,000 in the home-building business.    He was one of two members and managers.    The company used the Shook residence as its mailing address and he signed a few checks.    Shook contributed some nominal services to the company such as helping to install door hinges, door knobs and towel bars.   Mr. Shook would have been quite justified in asking, "Does this make me a bad guy?"The issue submitted to the jury allowed them to find that “a corporation is the alter ego of a shareholder when there is such a unity between the corporation and the shareholder that the separateness of the corporation has ceased, or when a corporation operates as a mere tool or business conduit of its shareholder” as “shown from the total dealings” of the shareholder and the corporation.    The jury was also instructed to consider eight other factors including “the amount of financial interest, ownership and control the shareholder maintains over the corporation.”  Unfortunately, the instructions submitted to the jury gave them virtual carte blanche to impose liability based upon their subjective whims.  In my personal view, if the legislature is going to allow persons to use artificial entities to do business, the Courts should respect that judgment by setting a high bar to impose personal liability.    While it is reassuring that the much-maligned Texas legislature has set standards to rein in the courts, it is also comforting that in this particular case, the appellate court (or at least 2/3 of its members) did the sensible thing.   Note:  While the reader may discern that I have some personal opinions about the issue in this case, I did not have any involvement.

In a display of pre-election bipartisanship, the Fifth Circuit affirmed a fraudulent transfer judgment in favor of Stanford International Bank Receiver Ralph Janvey against five Democratic and Republican campaign committees totaling approximately $1.6 million.    Janvey v. Democratic Senatorial Campaign Committee, Inc., No. 11-10704 (5th Cir. 10/23/12), which can be found here. While the opinion involved a receivership rather than a bankruptcy proceeding, the issues under the Texas Uniform Fraudulent Transfer Act have bankruptcy implications as well.The District Court granted summary judgment to the Receiver on claims that the contributions were made with actual intent to hinder, delay or defraud creditors.    The Receiver alleged, and the District Court agreed, that payments made as part of a Ponzi scheme are presumptively made with intent to hinder, delay or defraud.   According to the Receiver, this shifted the burden to the committees to show a defense such as good faith or reasonably equivalent value.   The Committees did not argue on appeal that the Stanford entities received reasonably equivalent value for their political contributions.   Unfortunately this meant that the opinion did not contain what would have been an interesting discussion of what contributors receive for their donations.   The Committees no doubt concluded that the political risks of arguing that fraudsters receive a reasonably equivalent benefit for their contributions was too dangerous to advance (even if it could have been factually supported).Instead, the Fifth Circuit addressed three issues.   First, the Court ruled that a Receiver, like a bankruptcy trustee, may pursue claims under the Texas Uniform Fraudulent Transfer Act on behalf of creditors.   The Committee had argued that the Receiver was not himself a creditor and therefore lacked standing to pursue the claims.Next, the Court concluded that the transfers were made within the applicable limitations period.    Under Tex. Bus. & Com. Code Section 24.010(a)(1), a plaintiff must institute an action to recover transfers under the intent to defraud provision within one year after the later of when the transfers were made or when they "reasonably could have been discovered by the claimant."    In this case, the Receiver was appointed on February 16, 2009 and filed suit on February 20, 2010.    The Committees argued that because records of  the contributions were available online and had been discussed in the media, that the Receiver should have known about them not later than February 18, 2009, which would have made the suit untimely.   Because February 16 was President's Day, the Receiver was not able to gain access to the Stanford offices until February 17.    While this would have given the Receiver two days to discover the fraud, the Fifth Circuit applied a more sympathetic standard.   It stated: Given the extent of the Stanford enterprises, the Receiver’s duties with regard to them, and the extent of the fraudulent transfers, it would not have been reasonable to expect him to immediately discover the fraud. Opinion, p. 7.   Furthermore, the Court noted that it was the Defendants' burden to prove the limitations defense which meant that they were required to prove when the Receiver should have discovered the fraud.   Apparently, three days to discover a fraud, even one based on publicly available records, was reasonable.   Because 11 U.S.C. Sec. 546 gives a bankruptcy trustee two years to commence an avoidance action, the benefit of the one year discovery rule is not readily apparent.    However, if a transfer took place more than one year prior to bankruptcy but was not readily discoverable during that time, a trustee could still file suit within two years after the order for relief.   Assume that a transfer was made on January 1, 2010 and the Debtor filed bankruptcy on January 1, 2012.    If creditors of the Debtor could not have discovered the transfer during the one year period prior to bankruptcy, then the trustee would have until January 1, 2014 to file suit.   While the discovery rule does not extend the trustee's period of time to file suit after bankruptcy is filed, it would extend the reach-back period for avoiding a transfer made prior to bankruptcy.    Finally, the Fifth Circuit held that federal election law did not preempt TUFTA.    The Federal Campaign Act of 1971 preempts "any provision of State law with respect to election to federal office."    Unfortunately for the Committees, the Court held that generally applicable fraudulent transfer laws are not state laws "with respect to election to federal office."   The Court also held that the federal election laws do not occupy the field of election law so thoroughly as to preempt the suit.   The Court wrote that the federal election law did not apply to a contributor using an impermissible source of funds as opposed to the committee making an improper use of those funds.   Further, the Court noted that the committees' argument would lead to the absurd result that funds "stolen by force or fraud" would be protected so long as the committees otherwise complied with election law.Because firms likely to fail have been known to curry favor by making political contributions, this opinion may help trustees avoid preemption arguments in the future.  

Upper Crust Pizza files for Chapter 11 bankruptcy protection. Upper Crust is a Boston based chain of pizza parlors. Prior to the filing, they operated 17 locations. As part of the restructuring of those locations has been closed. This company plans to keep operating the other 16 locations. The filing of a bankruptcy petition under [...]

The Fifth Circuit has added a new decision to its judicial estoppel jurisprudence, holding that a creditor that submitted claims in different amounts in successive cases was not estopped.   While it may seem that the court is applying the estoppel doctrine in an uneven manner, penalizing debtors but not creditors, the decision faithfully follows the elements laid out by the court.    Wells Fargo Bank, N.A. v. Oparaji (Matter of Oparaji), No. 11-20871 (5th Cir. 10/5/12), which can be found here.   What HappenedThe Debtor Titus Chinedu Oparaji filed a chapter 13 proceeding on September 2, 2004 (“First Case”).   During the First Case, he fell behind on his mortgage payments to Wells Fargo.   Over time, Wells Fargo filed several amended claims and the Debtor filed several modified plans.   The amended claims filed by Wells Fargo understated the amount of the post-petition arrearages.  When the Debtor failed to complete his plan payments within five years, the First Case was dismissed.After the First Case was dismissed, the Debtor continued to miss payments to Wells Fargo.  On February 1, 2010, the Debtor filed his second chapter 13 case (“Second Case”).   By this time, the arrearage owed to Wells Fargo had grown to $86,003.25.   The Debtor argued that based on the claims filed in the First Case that the arrearage could not possibly be that high.   The Bankruptcy Court found that Wells Fargo was bound by the claims filed in the First Case under the doctrine of judicial estoppel and the District Court affirmed.The RulingThe Fifth Circuit reversed, finding that Wells Fargo had not “asserted a legally inconsistent position that was accepted by the Bankruptcy Court.”   Opinion, p. 6.   The elements of judicial estoppel are: (1)  a party asserts a legal position that is “plainly inconsistent” with the position taken in another case; (2) the court in the other case accepted the party’s original position; and (3) the inconsistent positions were not taken inadvertently.The Court found that a creditor who files a post-petition claim in one case is not estopped from asserting a higher claim in a subsequent case.   Under section 1305(a), a creditor may file a post-petition claim but is not required to.   This contrasts with the common scenario where a debtor omits an asset.   While a debtor must list all assets in its schedules, the creditor is not under a duty to amend its proof of claim to include post-petition arrearages.   The Debtor argued that while Wells Fargo was not required to file a post-petition claim, that once it did so, it was required to include all post-petition amounts.   The Fifth Circuit distinguished the Oparaji case from In re Burford, 231 B.R. 913 (N.D. Tex. 1999).  In Burford, the confirmation order required the creditor to create a payment schedule that would “fully retire the debt.”   However, in this case, the creditor submitted a claim without expressly representing that there were no additional amounts owing.Because Wells Fargo never asserted that the amount contained in its post-petition claim constituted all the amounts owed, the Fifth Circuit found that it had not asserted inconsistent positions.   As a result, judicial estoppel did not apply.    The Court went further and found that even if Wells Fargo had asserted inconsistent positions, the dismissal of the First Case meant that the parties were returned to their position status quo ante.  What It MeansJudicial estoppel is meant to prevent parties from gaming the system. While, on the surface, it might appear that Wells Fargo took inconsistent positions, its inconsistency was not legally significant.  Wells Fargo’s only fault was that they did not assert their rights in the First Case as aggressively as they could have.   Had the Debtor completed its plan in the First Case, the parties and the Court would have had a difficult time sorting out which post-petition defaults were included in the plan and which ones were not.   Had the Debtor filed an “all current” motion at the conclusion of its plan and obtained an order, it could have bound Wells Fargo.  However, neither one of these occurred.   The Debtor did not complete its plan and it did not obtain a determination that it was current on its mortgage.   As a general rule, a dismissed case should rarely, if ever, give rise to judicial estoppel.   By definition, a dismissed case is one in which no party obtains relief (although the debtor enjoyed the benefits of the automatic stay for a period of time).    If a party does not obtain relief, then it is hard to say that the court accepted the party’s position in any meaningful respect.   The real benefit of this case may be for debtors who omit a creditor or an asset in an initial case and then accurately disclose it in a subsequent case.   In that instance, Oparaji should be good precedent that judicial estoppel will not apply.

  Life has a way of moving on, even when the client is in a Chapter 13. Assets come and go, life gets better or sometimes worse. The direction of travel changes. When a Chapter 13 case converts to Chapter 7, bankruptcy lawyers struggle with what assets the Chapter 7 trustee can liquidate. The facts in Warfield v. Salazar illustrate the problem: the debtors filed Chapter 13 when they were entitled to a pre petition tax refund. They did not succeed in confirming a plan and the case converted.  Only between filing and conversion, they had received and spent the tax refund. The Chapter 7 trustee made demand on the debtors for the amount of the refund. There was no contention that the right to the refund wasn’t property of the estate as of the commencement of the case.  But at conversion, it no longer existed. Both the bankruptcy court and the Bankruptcy Appellate Panel held that the plain language of 348(f) controlled:  Except as provided in paragraph (2), when a case under chapter 13 of this title is converted to a case under another chapter under this title— (A) property of the estate in the converted case shall consist of property of the estate, as of the date of filing of the petition, that remains in the possession of or is under the control of the debtor on the date of conversion; The refund didn’t exist as of the conversion date and therefore the debtor has no obligation to turn over its value to the Chapter 7 trustee. In the absence of bad behavior that lend to the loss of the asset, the plain language of the statute prevails. Note too how 348 deals with one of the other condundrums of Chapter 13:  the provisions of §1306  that property of the estate includes all property acquired during the Chapter 13 and all earnings after the commencement of the case. Suppose the debtor has prospered during the 13 and has twice the cash on hand at conversion that he had at filing.  Or he inherited property more than 6 months after filing, or he received a gift or other windfall. Section 348 provides that the Chapter 7 estate upon conversion is limited to the assets the debtor had at filing and still has at conversion. Not only does 348 simplify our analysis, but it assures the debtor, worried about the reach of 13 into their post filing life, that the good that comes after filing but before conversion is not lost to creditors. Image courtesy of InAweOfGod’sCreation. Like This Article? You'll Love These! What You Need To Know About Converted Cases Exemptions & Property of the Estate Convert, Don’t Dismiss, That Bankruptcy Case

Letters in the client’s mailbox superficially offer great news:  the junior mortgage will be forgiven! That good news just adds on a new facet to our job description:  spotting possible  tax consequences and alternatives for our clients by reason of  tax on cancellation of debt. As  the National Mortgage Settlement  gains momentum, we can expect to encounter this more often. The topic is huge and the taxes nominally involved may swamp all the other unsecured debt that a prospective client has. All I can do here is outline the issues and the resources for further study.  Master this area and your clients will think you walk on water. In the beginning We start with the principle that when debt is forgiven, the amount forgiven is treated for tax purposes as if it was received in cash by the debtor.  It is included in income and subject to tax  IRC 108 lists the statutory exceptions to that rule, including our stock in trade: bankruptcy.  Debts forgiven in bankruptcy do not cause the inclusion of  the forgiven debt in income. Foreclosure Your clients may be surprised or dismayed to learn that a foreclosure may result  not only in the loss of the property but in a tax bill to boot. Where the value of real estate has fallen dramatically, a foreclosure not involving bankruptcy may generate a 1099-C  (the statement of the amount of cancelled debt) for the difference between the loan balance and the deemed fair market value of the property.  Six digit numbers are easily possible. Therein is one of the stellar qualities of a bankruptcy solution to debt.  If the individual’s personal liability for a junior mortgage loan is discharged in bankruptcy, should the debt be subject to a foreclosure in the future, no tax consequences ensue.  It is also one of the reasons that I have taken clients with no significant, existing debt, into bankruptcy before the inevitable foreclosure.  The bankruptcy discharge will insulate them from tax on the difference between the mortgage balance and the fair market value of the property. Qualified principal residence safe harbor When the foreclosure crisis started, perhaps  the  only useful Congressional response was creating an exclusion from inclusion in taxable income for qualified debt on a taxpayer’s principal residence. The exclusion only applies to debt used to buy, build or substantially improve the home.    So, if the debt is a refinance, your client may not qualify. Further, the provision is set to expire at the end of 2012. Insolvency Another exception to the rule that cancelled debt is included in gross income for tax purposes is insolvency.  If the debtor is insolvent, the cancelled debt is not included.  The non obvious trap here is that retirement assets are included in the balance sheet test.  So, your client may think he has nothing, but if there is a fat 401(k), they may not be as broke as they think they are.  The worksheet for calculating insolvency for these purposes is found in IRS publication 4681. So, if you have the opportunity to counsel a homeowner who has received an announcement that their line of credit loan is being cancelled, point out the issues to them.  Look at the alternatives and be prepared to send them to sophisticated tax advisors who can assess the tax consequences of the disappearing debt. Image courtesy of Pixabay.  Like This Article? You'll Love These! Beware The Taxes That Follow Foreclosure Lien on Phantom Property Upsets Debt Totals How Long Can Underwater Lien Hold Its Breath?

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If you are not current on your car payments, your options will depend greatly on the type of bankruptcy you choose. If Chapter 7 bankruptcy is right for you, because you have mostly unsecured debt or would like to complete the process quickly, you may be wondering whether you have to surrender your car in [...]

Filing for bankruptcy is a huge decision, that will have an impact on your life for years to come. This impact can be good, and it can also be bad. For most people, it is a huge relief with some negative side effects. But no matter what your situation, below are a list of things [...]

Continuing our series of e-mails on real estate workouts, many clients are concerned about potential exposure to deficiency judgments resulting from real estate foreclosures. The New York law that deals with deficiency judgments is § 1371 of the Real Property Actions & Proceedings Law. The law provides that: 1. A plaintiff in a mortgage foreclosure action may bring an action for a deficiency judgment if the defendant has been personally served in the action. 2. The action for the deficiency judgment must be made within 90 days after the foreclosure sale. 3. The law provides that the deficiency judgment shall be equal to the amount the defendant is liable to the plaintiff (as determined by the judgment), plus interest, plus the amount owing on any subordinate liens and encumbrances, including interest, costs and disbursements, including referee's fees, less the market value of the property as determined by the court at the time of the foreclosure sale. Accordingly, if the value of the property is greater than the deficiency owed, the plaintiff will not be able to obtain a deficiency judgment. Notwithstanding the language in RPAPL § 1371, before commencing deficiency judgment actions, secured creditors (such as banks) go through a calculation. They ask themselves the following questions: 1. If we bring a deficiency action, does the defendant have assets or earnings to satisfy the judgment? For example, if the bank believes that the defendant will file Chapter 7 personal bankruptcy to protect his or her assets, or if the defendant is "judgment proof," then they will not commence the action. Some borrowers who do have the ability to pay some or all of the judgment will come forward and offer to settle before an action for deficiency is commenced. 2. Does the defendant have the potential for good future earnings (such as a medical doctor), such that if the creditor obtains the judgment (which is good for 20 years under New York State law), they will be able to collect the judgment from future earnings? 3. What is the fair market value of the property? As mentioned above, the court will determine the fair market value at the time of the foreclosure sale, which can become a battle of appraisals, so creditors must prepare to bring in expert witnesses to testify on this issue. 4. How long will it take and how much will it cost to obtain and collect the judgment? 5. Is the deficiency a result of a "strategic default"? A "strategic default" involves a borrower who has the ability to pay his or her mortgage but chooses not to. Often that decision is tied directly to the property being "underwater" (the fair market value of the property is less than the outstanding liens encumbering the property (mortgages, home equity lines of credit, etc.)). Loan originators rely heavily on their servicers (the entities that are responsible for day–to–day management of mortgage accounts) to determine if a borrower is a strategic defaulter and then makes a determination whether to seek a deficiency judgment. Clients or colleagues having questions about deficiency judgments should not hesitate to contact Jim Shenwick.