By Ryan C. Wood
Which came first, the chicken or the egg? When a bankruptcy case is filed a bankruptcy estate is created including all claims of the bankruptcy filer at the time of the filing of the case. The timing is down to the hour, minute and second. The second the bankruptcy case is filed the automatic stay takes effect stopping any and all collection activity and draws a line in the sand as to what is part of the bankruptcy estate and what is not. The bankruptcy estate includes potential claims or causes of action that exist at the time the bankruptcy case is filed that may or may not be collectable or possible to be pursued. “Legal causes of action are included within the broad scope of § 541.” Goldstein v. Stahl (In re Goldstein), 526 B.R. 13, 21 (9th Cir. BAP 2015) (citing Sierra Switchboard Co. v. Westinghouse Elec. Corp., 789 F.2d 705, 707 (9th Cir. 1986) ). More key words are the claim has to be “sufficiently rooted in the pre-bankruptcy past.”
The issue that is the subject of this article is about whether a claim that would not exist but for what took place in the bankruptcy case a claim that is property of the bankruptcy estate? Which came first, the chicken or the egg?
Appellate Part of the Story
This particular case is a recent Ninth Circuit Bankruptcy Appellate Panel appeal from the State of Nevada involving an alleged malpractice claim against the bankruptcy attorney of the bankruptcy filers. This happened to be a Chapter 7 case and the Chapter 7 trustee assigned to the case argued the malpractice claim against the attorney for the bankruptcy filers was property of the estate given the problem arguably arose prior to the bankruptcy case being filed. The issue was the filing of an extension for a tax return that made certain taxes not dischargeable in the Chapter 7 bankruptcy case. The case was filed on October 10, 2016, and the order of discharge was signed and entered in February 21, 2017. If the chapter 7 bankruptcy case had been filed six days later the tax debt for tax year 2012 would have been dischargeable. The bankruptcy case was not closed though due to other issues. In June 2017 the Internal Revenue Service sent notice to the bankruptcy filers they still owed the IRS $257,570.46 for tax year 2012. Not good. The bankruptcy filers obtained new counsel filed their malpractice claim against their original bankruptcy attorney alleging damages including their passports being revoked due to the tax debt, one of the bankruptcy filers could not obtain employment so they alleged total damages of over $1 million. The lower bankruptcy court held the malpractice claim was not part of the bankruptcy estate and the Chapter 7 trustee appealed this ruling.
The Part of the Story That is Not Part of the Appellate Record
One of the biggest problems with tales like is context. Us business owners get bit by this all the time and probably many people in general. Someone has a gripe or complaint about a service they received but when telling others about it they leave out certain facts and the part that will make them seem unreasonable for having a problem. There are always two sides to a situation. So here is some more context as obtained in the actual bankruptcy petition filed under chapter 7 that is the subject of this appeal.
Secured Debt: The bankruptcy filers owned a house in Las Vegas, NV with secured debt totaling $883,948 and an alleged fair market value of $650,000; so the house is underwater.
Unsecured Priority Debt: These are unsecured debts that are not dischargeable. The bankruptcy filers owed a total of $106,000 to the State of Nevada for unpaid sales tax from their businesses.
General Unsecured Debt: These are unsecured debts that are dischargeable.
1. American Express: $195,919.00
2. Bank of America: $236,305.59
3. Chase: $54,197.00
4. Dino Sattalante Trust: $1,500,000.00
5. Forum Shops, LLC: $60,000.00
6. Internal Revenue Service:
—Tax Year 2011 $311,495.92
—Tax Year 2012 $243,231.67
7. James G. Naughton Trust: $55,000.00
8. Mario Herman, Esq. $40,000.00
9. MOAC Mall Holdings, LLC $196,809.20
10. RPAI South West Management $440,000.00
11. Sphere Investments, LLC $628,000.00
12. Wells Fargo Bank $19,632.00
TOTAL: $3,989,473.48 in dischargeable general unsecured debts that were ultimately discharged upon the entry of the debtors’ order of discharge on February 27, 2017, but for the 2012 taxes owed to the IRS.
Let Us Have Fun With Numbers
For some additional context let us compare debts discharged in this case with a 30 year work life for a normal American. If we divide $3,989,473 by 30 years it works out to $129,666.66 a year or more than 95% of Americans earn in a lifetime……..
The bankruptcy attorney that is subject of the malpractice claim charged the bankruptcy filers $10,000, a pretty good lick, for her services and successfully helped them discharge 85% of their debts. A realtor would have received $111,974.19 in commission for selling a house with a value of $3,732,473 …..
Please note there is no issue in this case regarding the $3,732,473 in debt discharged or the $311,495.92 owed to the IRS for tax year 2011. It is all discharged; poof, gone. So again the issue is the unpaid taxes owed to the IRS totaling $243,231.67 for tax year 2012 only.
Some Additional Context Regarding The Timing of The Filing of This Chapter 7 Not Provided in the Appeal Facts
These bankruptcy filers had a judgment entered against them by Sphere Investments, LLC, listed above totaling $680,000 prior to the case being filed and the Sphere Investments, LLC, levied on the bankruptcy filers’ Wells Fargo Bank accounts obtaining $29,069.23. I am going to speculate a little here, but it is more than plausible and makes sense. The part of the story that is not told is that the levy took place on July 12, 2016. This chapter 7 case was filed on October 6, 2017, or less than 90 days after the levy of the bankruptcy filers’ bank accounts and the seizing of the $29,069.23 by Sphere Investments, LLC. The filing of the chapter 7 bankruptcy case within 90 days of the levy made the levy a voidable preference claim/transfer pursuant to Section 547 of the Bankruptcy Code and the levied funds would have to be turned over to the chapter 7 trustee and/or possibly returned to the bankruptcy filers depending upon circumstances. I am speculating here again, but I could absolutely understand if the plan was to file the chapter 7 to prevent any further levy on bank accounts and file the case within 90 days of the levy to try and get some of the levy funds back. If anything at least the judgment creditor Sphere Investments, LLC will not get to keep the levied funds. Again, I am speculating, but the bankruptcy filers’ say great, the litigation with Sphere Investments, LLC was very bitter so let us hurry up and file the chapter 7 petition within 90 days if the levy date. No mention that an extension regarding their 2012 tax return was filed extending the time for the taxes to be dischargeable……. Again, I am speculating some here, but very plausible.
The chapter 7 trustee and judgment creditor ended up settling that each would get half of the levied funds. The point is if the chapter 7 case has been filed
Back To The Appeal And Is The Malpractice Claim Property Of The Bankruptcy Estate
The bankruptcy court held that the malpractice claim against the bankruptcy filers’ attorney was not a claim of the bankruptcy estate and the Ninth Circuit Bankruptcy Appellate Panel affirmed the bankruptcy court’s ruling. The bankruptcy filers’ alleged the attorney was negligent for not advising them about the consequences of the six month extension they filed with the IRS regarding the 2012 tax return.
The definition of what is a claim when filing for bankruptcy protection is broad on purpose and the broad definition is for a good reason. So is a claim created by the filing of the bankruptcy case recoverable by the trustee assigned to the case for the benefit of the creditors in the bankruptcy case? When did the claim arise?
The Ninth Circuit Bankruptcy Appellate Panel agreed with the lower bankruptcy court and affirmed that the malpractice claim was not part of the bankruptcy estate and arose after the case was filed. The chapter 7 trustee argued that the bankruptcy filers’ had a contingent interest in the malpractice claim at the time the case was filed that was sufficiently rooted in the bankruptcy filers’ pre-bankruptcy given the bankruptcy attorney’s legal representation began prepetition/before the case was filed. The lower bankruptcy court applied Nevada Law regarding the malpractice claim and focused on the actual damages. For there to be a claim actual damages must accrue. In this case the bankruptcy court held the actual damages did not accrue until after the bankruptcy case was filed when the original bankruptcy attorney did not seek to dismiss the chapter 7 case before discharge or after the June 2017 letter was received by the bankruptcy filers informing them the 2012 taxes were not discharged.
Ninth Circuit Bankruptcy Panel has previously held that to be sufficiently rooted in the prebankruptcy past the payment or claim must arise from some prepetition right or entitlement. In re Bender, 385 B.R. 800 (Table), 2007 WL 4896288, *4 (9th Cir. BAP 2007), appeal dismissed, 586 F.3d 1159 (9th Cir. 2009)(“[The Ninth Circuit] has limited its use of Segal to situations where a debtor received a post-petition benefit pursuant to a pre-petition right or entitlement.”); see also In re Bolton, 584 B.R. 44, 55 (Bankr. D. Idaho 2018).
In sum if the damages arise post-petition then the claim should not be part of the bankruptcy estate even though some of the facts or events that led to the post-petition damages took place before the case was filed.