Chira: Equitable Subordination, Insiders, Fiduciary Duties, Constructive Fraud, Civil Conspiracy, Section 105 (a), Reverse Piercing

The recent case of Sonya L. Salkin, Trustee v. Elizabeth Chira, et al. (In re Chira), 353 B.R. 693 (Bkrtcy.S.D.Fla.2006)(Olson J.) was an adversary proceeding by a trustee to, inter alia, determine the validity, priority, and amounts of deeds made and obligations incurred by the debtor with respect to his ex-spouse in regards to a beachfront hotel. The forty-five page decision (per West Bankruptcy Law Reporter) is a magnum opus of bankruptcy and bankruptcy related law. The following are excerpts (mostly verbatim) from the treasure-trove of law in the decision.

Equitable Subordination

The common law principle of equitable subordination has long been recognized by the Supreme Court, Pepper v. Litton, 308 U.S. 295 (1939), and is specifically adopted as one of the bankruptcy courts’ equity powers by 11 U.S.C. § 510(c). Equitable subordination law in the 11th Circuit derives from the former Fifth Circuit’s decision in In re Mobile Steel Co., 563 F.2d 692, 700 (5th Cir.1977) and holds that equitable subordination must be based upon inequitable conduct by the creditor. Mobile Steel laid out three conditions a bankruptcy court must find to exist before it equitably subordinates a claim. One, the claimant must have engaged in some type of inequitable conduct. Two, the misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant. And three, equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Code. The Mobile Steel test was formally adopted by the Eleventh Circuit. In re N & D Properties, Inc., 799 F.2d 726, 731 (11th Cir.1986). The test does not require that the claimant’s misconduct rise to the level of an intentional tort.

The power of equitable subordination may, in appropriate circumstances, be used to subordinate even the claim of a secured creditor. See 124 Cong. Rec. H. 11,095 (Sept. 28, 1978); S 17,412 (Oct. 6, 1978); In re Tri-O-Clean, Inc., 230 B.R. 192 (Bankr.S.D.Fla.1998).

The plaintiff bears the burden of presenting material evidence of unfair conduct. Once this has been done, the insider defendant must prove the good faith and fairness of its dealings with the debtor or the claim will be subordinated. Allied Eastern States Maintenance Corporation v. Miller (In re Lemco Gypsum, Inc.), 911 F.2d 1553, 1557 (11th Cir.1990). The policy of requiring an insider creditor to demonstrate the inherent fairness of his or her claim, can be traced to Richardson’s Executor v. Green, 130 U.S. 104, 10 S.Ct. 280, 33 L.Ed. 516 (1889).

Officers’, directors’, and stockholders’ dealings with the corporation are subjected to rigorous scrutiny and where any of their contracts or engagements with the corporation is challenged the burden in on the director or stockholder not only to prove the good faith of the transaction but also to show its inherent fairness from the viewpoint of the corporation and those interested therein.

A claim may be subordinated only to the extent necessary to offset the harm caused by the claimant to the Debtor and its creditors. In re Mobile Steel, 563 F.2d 692, 701 (5th Cir.1977).

Insider relationship

Insiders, those in a position of influence over a debtor, are held to a higher standard than non-insider claimants. Their claims may be subordinated more easily than those of parties who dealt with a debtor at arm’s length. In re Multiponics, 622 F.2d 709, 714 (5th Cir.1980)); In re Epic Capital Corp., 290 B.R. 514 (Bankr.D.Del.2003). An insider’s actions may subject him or her to equitable subordination on the basis of inherent unfairness alone. In re Lemco Gypsum, Inc., 911 F.2d 1553, 1556 (11th Cir.1990).

“Insider” is a flexible term. Rather than defining it, the Bankruptcy Code gives non-exclusive examples. “The term ‘insider’ includes….” 11 U.S.C. § 101(31). “ ‘Includes’ and ‘including’ are not limiting.” 11 U.S.C. § 102(3). The legislative history of the 1978 Code defines an insider as a person or entity with “a sufficiently close relationship with the Debtor that his conduct is made subject to closer scrutiny that those dealing at arm’s length with the Debtor.” S.Rep. No. 95-989, 95th Cong., 2d Sess., reprinted in 1978 U.S.Code Cong. & Admin.News 5787, 5810. Among the examples given are “an affiliate, or an insider of an affiliate as if such affiliate were the Debtor.” 11 U.S.C. § 101(31)(E). “Affiliate” is defined as including a corporation 20% or more of whose stock is owned by the Debtor. 11 U.S.C. § 101(2)(B). “Affiliate” is also defined as including an “entity that operates the business or substantially all of the property of the Debtor under a lease or operating agreement.” 11 U.S.C. § 101(2)(D). The term “entity” includes person…. 11 U.S.C. § 101(15). The term “person” includes … corporation…. 11 U.S.C. § 101(41).

Even where the relationship does not fit within the examples given in the Bankruptcy Code, a person may hold insider status. Courts that have considered the issue often hold that a former spouse is an insider as that term is used in bankruptcy law, where their relationship puts the non-debtor party in a position to exercise some degree of control or influence over the Debtor. Hunter v. Dupuis (In re Dupuis), 265 B.R. 878, 885 (Bankr.N.D.Ohio 2001).

Fiduciary Duties

Fduciary duties may be imputed by the course of conduct between the parties. Maxwell v. First United Bank, 782 So.2d 931, 933 (Fla. 4th DCA 2001). When a fiduciary relationship is implied in law, it is based on the specific facts and circumstances surrounding the transaction and the relationship of the parties. This can arise when “confidence is reposed by one party and a trust accepted by the other.” In this sense, breach of fiduciary duty is a broad theory of recovery which “can include conduct which is merely negligent but does not rise to a level of fraud.” Niles v. Mallardi, 828 So.2d 1076, 1078, n. 1 (Fla. 4th DCA 2002); Horizons Rehabilitation, Inc. v. Health Care and Retirement Corp., 810 So.2d 958, 964 (Fla. 5th DCA 2002). If a relation of trust and confidence exists between the parties (that is to say, where confidence is reposed by one party and a trust accepted by the other, or where confidence has been acquired and abused), that is sufficient as a predicate for relief. Doe v. Evans, 814 So.2d 370, 374 (Fla.2002)

Ordinarily, to establish a fiduciary or confidential relationship between the parties, there must be a showing of substantial evidence indicating dependency by one party and some undertaking by the other party to advise, counsel, and protect the weaker party. See Lanz v. Resolution Trust Corp., 764 F.Supp. 176, 179 (S.D.Fla.1991). Moreover, evidence that one party placed trust or confidence in the other party does not create a fiduciary relationship in the absence of “some recognition, acceptance or undertaking of the duties of a fiduciary on the part of the other party.

Courts have sometimes found a breach of fiduciary duty even among parties who are ostensibly dealing with one another at arm’s length, such as the relationship between borrowers and lenders, where the bank knows or has reason to know of the customer’s trust and confidence under circumstances exceeding an ordinary ‘customer relationship’ ”, or where the customer is “relying on the bank so as to counsel and inform him” or in some cases where the lender takes on extras services for a customer, receives any greater economic benefit than from a typical transaction, or exercises extensive control. Capital Bank v. MVB, Inc., 644 So.2d 515, 519-521 (Fla. 3d DCA 1994).

Constructive Fraud

Florida law recognizes an equitable cause of action for constructive fraud when a fiduciary or confidential relationship has been abused. See First Union National Bank of Florida v. Whitener, 715 So.2d 979, 982 (Fla. 5th DCA 1998). In cases alleging corporate malfeasances this cause of action is often asserted in conjunction with the more familiar claims for breach of the fiduciary duty of care and breach of the fiduciary duty of loyalty. See, e.g., Halkey-Roberts Corp. v. Mackal, 641 So.2d 445 (Fla.App.1994). Banco Latino International v. Gomez Lopez, 95 F.Supp.2d 1327, 1335 n. 9 (S.D.Fla.2000).

Constructive fraud is simply a term applied to a great variety of transactions … which equity regards as wrongful, to which it attributes the same or similar effects as those which follow from actual fraud, and for which it gives the same or similar relief as that granted in cases of real fraud. Pomeroy’s Eq. Jur. (4th Ed.) §992 Halkey-Roberts Corp. v. Mackal, 641 So.2d 445, 447 (Fla. 2d DCA 1994)

Civil Conspiracy

A breach of fiduciary duty can also form the basis for an independent tort of civil conspiracy. Blatt v. Green, Rose, Kahn & Piotrkowski, 456 So.2d 949, 951 (Fla. 3d DCA 1984). Civil conspiracy under Florida law requires a showing that two or more persons have taken concerted action to accomplish some unlawful purpose, or to accomplish some lawful purpose by unlawful means. Robinson v. State, 610 So.2d 1288 (Fla.1992); Segal v. Rhumbline International, Inc., 688 So.2d 397 (Fla. 4th DCA 1997). The basis for the conspiracy must be “an independent wrong or tort which would constitute a cause of action if the wrong were done by one person.” American Diversified Insurance Services v. Union Fidelity Life Insurance Co., 439 So.2d 904, 906 (Fla. 2d DCA 1983); Liappas v. Augoustis, 47 So.2d 582 (Fla.1950); Kee v. National Reserve Life Ins. Co., 918 F.2d 1538 (11th Cir.1990).

Parties are acting in concert when they act in accordance with an agreement to cooperate in a particular line of conduct or to accomplish a particular result. The agreement need not be expressed in words and may be implied and understood to exist from the conduct itself. Whenever two or more persons commit tortious acts in concert, each becomes subject to liability for the acts of the others, as well as for his own acts. The theory of the early common law was that there was a mutual agency of each to act for the others, which made all liable for the tortious acts of any one. Restatement of Torts (Second) § 876(a), comment. However, a civil conspiracy does not require more than knowledge and general participation in the conspiracy to commit a civil wrong. Voll v. Randazzo, 674 So.2d 892 (Fla. 5th DCA 1996).

Section 105 (a)

Section 105(a) of the Bankruptcy Code in providing that “the court may issue any order, process or judgment that is necessary or appropriate to carry out the provisions of this title,” provides supplemental authority to the All Writs Statute, 28 U.S.C. § 1651, which has similar language. Together, the two statutes are the source of the bankruptcy court’s equity jurisdiction. See H. Rep. No. 95-595, 95th Cong., 1st Sess., 316 (1977), 735 U.S.Code Cong. & Admin.News 1978, pp. 5963, 6273. This jurisdiction is not permitted to be exercised in a way which conflicts with other statutes, but it is expected that courts will rely upon equity’s “broad authority to modify creditor-Debtor relationships.” United States v. Energy Resources Co., 495 U.S. 545, 549, 110 S.Ct. 2139, 109 L.Ed.2d 580 (1990).

The bankruptcy courts have exercised these equitable powers in passing on a wide range of problems arising out of the administration of bankrupt estates. They have been invoked to the end that fraud will not prevail, that substance will not give way to form, that technical considerations will not prevent substantial justice from being done. Pepper v. Litton, 308 U.S. 295, 304-05, 60 S.Ct. 238, 84 L.Ed. 281 (1939). Federal courts exercising their equity jurisdiction have repeatedly found that they may direct that a lease between insiders, the terms of which were never performed, be disregarded as a sham. See Staats v. Butterworth Properties, Inc. (In re Humble), 19 Fed.Appx. 198, 2001 WL 1006148 (6th Cir.2001); B & M Leasing Corp. v. United States, 331 F.2d 592 (5th Cir.1964); United States v. Rockwell, 677 F.Supp. 836 (W.D.Pa.1988); MCI Telecommunications v. O’Brien Marketing, Inc., 913 F.Supp. 1536 (S.D.Fla.1995).

Reverse Piercing

A Trustee may bring an action, frequently called a Trustee’s “reverse piercing” action, to draw the assets of the Debtor’s mere instrumentality into the Debtor’s estate. He may bring the action so long as piercing the corporate veil is an action available under state law in those circumstances to creditors generally. In re Icarus Holding, LLC, 391 F.3d 1315, 1321 (11th Cir.2004). Some bankruptcy courts have even permitted substantive consolidation of Debtor corporations and non-Debtor corporations upon equitable grounds. See, e.g., In re Lease-A-Fleet, Inc., 141 B.R. 869 (Bankr.E.D.Pa.1992); In re New Center Hospital, 179 B.R. 848 Bankr.E.D.Mich.1994); In re Munford, Inc., 115 B.R. 390 (Bankr.N.D.Ga.1990).

910 Vehicle Surrendered – Full Satisfaction of Claim

Yesterday the court issued an important decision in In re Johnson, Case No. 06-10611 (Bankr.S.D.Fla. July 2, 2007)(Olson J.) on the subject of the “910 car claim”. The specific issue before the court was whether 11 USC 1325(a)(5) and the “hanging paragraph” allow the debtor to surrender a vehicle in full satisfaction of the claim. That is, in other words, whether these provisions deny a creditor an unsecured deficiency claim if a vehicle is surrendered.

The court adopted what it noted was the majority position that allows a vehicle to be surrendered in full satisfaction of the claim. These courts conclude that the hanging paragraph applies to section 1325(a)(5) as a whole and that it applies to the retention of a vehicle under 1325(a)(5)(B) as well as the surrender of a vehicle under 1325(a)(5)(C). In re Ezell, 338 B.R. 330 (Bankr.E.D.Tenn. 2006). This may allow the creditor a great benefit when the vehicle is retained but may advantage the debtor if the vehicle is surrendered. The Court noted that if Congress intended the hanging paragraph to be limited to either subsection A, B, or C of 1325(a)(5), that it could have inserted the proper limiting language.

The court rejected the minority position that the surrender of a 910 vehicle does not achieve full satisfaction of the creditor’s claim. Some of these courts have determined that the hanging paragraph was ambiguous and looked to the legislative history to divine Congress’s intent. In re Duke, 345 B.R. 806 (Bankr.W.D.Ky.2006). The Court also reviewed and rejected other rationales used by other courts reaching the minority position.

In contrast to yesterday’s Johnson decision, today the 7th Circuit Court of Appeals issued its opinion under the minority approach in In re Wright, Case No. 07-1483 (7th Cir. 2007). The court reasoned that the hanging paragraph by “knocking out” section 506, leaves the parties to their contractual entitlements. The court states that the majority position is mistaken that section 506 is the only source of authority for a deficiency and that per Butner v. United States, 440 U.S. 48 (197) that state law determines rights and obligations when the Bankruptcy Code does not supply a federal rule. The court noted that section 306(b) of BAPCPA which enacted the hanging paragraph is captioned “Restoring the Foundations for Secured Creditor” and that this implies replacing section 506 with an agreement freely negotiated between the parties. The court reasoned that making the loan non-recourse would not “restore the foundations for secured credit.” The Court noted that when section 506 does not apply, the fallback under Butner is the parties’ contract which entitles the secured lender to an unsecured deficiency.

The Wright case went straight to the 7th Circuit Court on a direct appeal from the bankruptcy court as allowed by 28 U.S.C. 158 as amended by BAPCPA.

One may refer to a research paper entitled “A History of the Automobile Lender Provisions of BAPCPA” by University of Wisconsin Law Professor William Whitford for further information on the background of the hanging paragraph.

$125,000 Cap of 522(p) is Stackable in Joint Case

The Court in In re Limperis, 2007 WL 1586502 (Bkrtcy.S.D.Fla.)(Olson J.) held that each debtor in a joint case is entitled to claim $125,000 ($136,875 since April 1, 2007) of equity as exempt per the 522(p) cap. In this case the debtors acquired their homestead within 1215 days prior to the filing of the bankruptcy and were therefore subject to the exemption cap of section 522(p) which restricts the homestead exemption to $125,000. The Court adopted the reasoning set forth in In re Ramussen, 349 B.R. 747 (Bankr.M.D. Fla.2006) and held that each debtor in a joint case may claim a $125,000 interest in the homestead as exempt. The Court in Ramussen reasoned that stacking is not inconsistent with current practice under Florida law and the Bankruptcy Code governing other exemptions and that each debtor gets to claim exemptions separately.

Fla. Supreme Court: Legal Malpractice Claims Generally Not Assignable

In yesterday’s 5-2 decision in Law Office of David J. Stern, P.A. vs. Security National Servicing Corporation, No. SC06-361 (Florida July 5, 2007), the Florida Supreme Court quashed the Fourth District Court of Appeal’s decision and held that an assignee of a note and mortgage did not have standing to bring an action for legal malpractice as there was lacking an attorney-client relationship and it did not acquire the cause of action. A law firm reportedly committed malpractice in its pursuance of a mortgage foreclosure action. During the time in question, the involved note and mortgage were transferred several times. The ultimate holder sought to sue the law firm for malpractice.

The Florida Supreme Court held that ultimate holder of the mortgage did not have standing to bring a legal malpractice action based upon acts that occurred during the law firm’s representation of a prior holder of the note and mortgage. The Court noted that the time of the alleged negligent act or omission is the critical point for testing the scope and existence of the attorney-client relationship. The ultimate mortgagee did not gain standing to sue the law firm for prior acts of legal malpractice at the trial court level by forming an attorney-client relationship during the appeal of the foreclosure action.

The Court also held that the ultimate mortgagee did not receive a valid assignment of the right to sue the law firm. The Court adopted the majority view that legal malpractice claims are generally not assignable. “Legal malpractice claims are not assignable because of the personal nature of legal services which involve a confidential, fiduciary relationship of the very highest character, with an undivided duty of loyalty owed to the client.” Forgione v. Dennis Pirtle Agency, Inc., 701 So.2d 557, 559 (Fla. 1997) Furthermore, the Court refused to recognize the assignment of a legal malpractice claim as part of a general assignment of a note and mortgage. The Court also found that the ultimate mortgagee was not assigned and did not acquire the legal malpractice claim when it purchased the note and mortgage by general assignment.

The Court noted two major policy concerns justifying a general prohibition against the assignment of legal malpractice claims of protecting attorney-client confidences and preventing a market for legal malpractice claims.

In Non-Bankruptcy Court, Florida’s Homestead Exemption “Rules”

The Florida Homestead exemptions “rules” – at least generally in non-bankruptcy courts. In the recent case of Brian Dowling v. Davis, Slip Copy, 2007 WL 1839555 (M.D. Fla. June 26, 2007), Plaintiff Dowling held an Illinois judgment and filed a three count complaint in the District Court of the Middle District of Florida for 1. fraudulent asset conversion under Fla. Stat. Section 222.30, 2. to impose an equitable lien, and 3. to avoid fraudulent transfers Fla. Stat. Section 726.101, et. seq. The Illinois judgment was obtained in 2002 and the married defendants purchased real property in Florida in 2003 as tenants by the entirety. The purchase money was comprised of a bank loan and personal funds. The Defendants maintained that Florida’s constitutionally-created homestead exemption protected their Florida residence.

The Court concluded that the Plaintiff’s claims failed as the Florida Supreme Court has expressly held “[t]hat the transfer of nonexempt assets into an exempt homestead with the intent to hinder, delay, or defraud creditors is not one of the three exceptions to the homestead exemption provided for in article X, section 4″ of the Florida Constitution. Havoco of Am., Ltd. v. Hill, 790 So. 2d 1018, 1028 (Fla. 2001)(“Havoco I”) (emphasis added); Havoco of Am., Ltd. v. Hill, 255 F.3d 1321,1322 (11th Cir. 2001)(“Havoco II”) ( affirming that judgment debtor’s purchase of home with intent to hinder creditors did not overcome homestead exemption, based on answer to certified question in Havoco I). The Court stated that “the homestead exemption does not contain an express exception for real property that is acquired in Florida for the sole purpose of defeating the claims of out-of-state creditors. Havoco II, 255 F.3d at 1322; Havoco I,790 So. 2d at 1028; Bank Leumi Trust Co. v. Lung, 898 F. Supp. 883,887 (S.D. Fla. 1995); In re Adell, 321 B.R. 562,569-70 (Bankr. M.D. Fla. 2005).

The Court further noted that equitable liens may only be imposed in limited circumstances where a debtor fraudulently procured funds to invest in, purchase, or improve a homestead. See Palm Beach Savings & Loan Assoc. v. Fishbein, 619 So. 2d 267, 270 (Fla. 1993) (affirming imposition of equitable lien against wife’s residence where debtor husband obtained mortgage by fraud); Jones v. Carpenter, 106 So. 127,129-30 (Fla. 1925) (affirming imposition of equitable lien in action by trustee of bankrupt corporation against former president for embezzling funds used to improve homestead). The Plaintiff did not argue that this type of fraud was perpetrated against him but only alleged that Defendant purchased a homestead knowing that a judgment was imminent and used funds that could have been used to satisfy the judgment. The Court further noted that the exceptions to the homestead exemption are to be strictly construed. Havoco I, 790 So.2d at 1021-22.

One may query what the result may have been if these facts and issues had arisen in a bankruptcy case (voluntary or involuntary) under the full panoply of the BAPCPA amendments. See e.g. section 522(o) (reduction of homestead for dispositions made during prior 10 years with intent to hinder, delay, or defraud a creditor), 522 (p) (cap on homestead acquired within 1215 with certain exceptions), 522(b) (domicile and exemptions). Perhaps the homestead exemption would have been reduced or capped. Perhaps the Florida homestead exemption would not have applied at all and the Defendant/Debtor would have been required to use the Illinois or Federal exemptions. Perhaps an attempt to exempt the real property as tenants by entireties property under 522(b)(3)(B) would have been subject to avoidance.