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About Phillips & Thomas LLC

We are Phillips and Thomas LLC, a Kansas City law firm with attorneys practicing in the areas of bankruptcy and criminal defense.

Director Must Prove Elements Of Refusal Of Breath Test In DWI Cases

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In a recent decision, the Missouri Court of Appeals upheld the standard required for the Director of Revenue to prove in DWI cases involving an alleged refusal to submit to a breath test.  The case was Ryan McPhail v. Director of Revenue (ED101307, from December 2014).  The Appellant, McPhail, argued that the Director had not proved he refused to submit to a breath test under RSMo. 577.041.1.  The Appellate Court agreed with him.

The facts were as follows.  The police officer conducted a traffic stop after observing a vehicle swerving and hitting parked cars.  The officer told the driver to get out and sit on the curb, and then told him to get his license and insurance.  The officer claimed he noticed signs of impairment, like slurred speech and stumbling; he asked McPhail to perform sobriety tests and take a breath test, and McPhail allegedly refused.  He was then arrested.

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Charitable Contributions In Bankruptcy: What Is Reasonable?

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How much charity should a person in bankruptcy be able to contribute?  At some point, can donations become excessive?  These issues often come up in bankruptcy cases.  Some debtors need to tithe as part of their religious obligations.

Some debtors have a need to contribute as part of their work obligations.  These were the questions under consideration in a recent 10th Circuit bankruptcy appellate case from 2012.  The case was In Re McGough (B.A.P. No. CO-11-038).

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Aggravated Battery Conviction Does Not Require Intention Of Resulting Harm

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In January of this year, the Kansas Supreme Court published an opinion that clarified its position on the type of proof needed to sustain a conviction for aggravated battery.  The case was State v. Hobbs  (Docket No. 107,667).  To sustain an aggravated battery conviction, is the prosecutor required to prove that the defendant intended the consequences of his act, or just the act itself?  It is a question that is constantly present in these cases.

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Copyright Violations Can Be Willful And Malicious Injuries In Adversary Proceedings Under Section 523(a)(6)

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Can a bankruptcy debtor’s copyright violation ever rise to the level of a willful and malicious injury, such that it would be excepted from a bankruptcy discharge under 11 U.S.C. §523(a)(6)?  The answer is yes, according to the Bankruptcy Appellate Panel for the 8th Circuit (which includes Missouri).  The case here is In Re Walker, decided in August 2014 by the 8th Circuit B.A.P. (No. 14-6012).

The facts of the case were these.  The debtor (Walker) was a managing member of an establishment called Twister’s Iron Horse Saloon.  Twister’s often played music and hosted musical performances. Some of the music played or performed was included in the repertoire of the American Society of Composers, Authors and Publishers. ASCAP is a professional membership organization of song writers, composers and music publishers.  In accordance with Federal copyright law, ASCAP licenses and promotes the music of its members. It also obtains compensation for the public performances of their works and distributes the royalties based upon on those performances. Several music companies granted ASCAP a nonexclusive right to license public performance rights of their works.

Twister’s did not hold a public performance license. ASCAP became aware of this and promptly contacted the debtor to offer him a license. The debtor did not respond to ASCAP’s offer. ASCAP unsuccessfully attempted to contact the debtor an incredible 44 times: twice in person, 14 times by mail and 28 times by telephone.  None of the mail was returned as undeliverable. The phone calls were made on various days and at various times.  The debtor was often on the Twister’s premises but refused to acknowledge the communications.  An investigator from ASCAP visited Twister’s and noted that unauthorized musical performances were taking place.

ASCAP in 2009 informed the debtor of the violations and offered to settle for a monetary amount. The letter was delivered to Twister’s return receipt requested. The receipt was signed by the debtor and confirmed that delivery was made on September 23, 2009.  The debtor signed for the letter but claimed not to have read it.

In June 2010, the music companies brought an action for copyright infringement against the debtor in the Eastern District of Missouri.  The debtor did not contest the case and lost by default.  A judgment of $41,231 was entered against him.  When the debtor filed a Chapter 7 bankruptcy, the music companies filed an adversary proceeding against him under §523(a)(6), which prevents the discharge of debts incurred through “willful or malicious” injury.  The trial court found that the debtor had willfully failed to obtain an ASCAP license and maliciously disregarded the rights of ASCAP’s members and Federal copyright law. The debtor appealed.

The case is an interesting one, since adversary proceedings under §523(a)(6) are rare.  Proving “malice” and a “willful injury” is not an easy matter.  An intentional tort must be inflicted on some opposing party.  The B.A.P.’s analysis focused on the meaning of the words “willful,” “malicious,” and “injury.”  Under case law in the Eighth Circuit, the terms must be separately analyzed.  Furthermore:

Malice requires more than just reckless behavior by the debtor. Scarborough, 171 F.3d at 641 (citing In re Miera, 926 F.2d at 743). The defendant must have acted with the intent to harm, rather than merely acting intentionally in a way that resulted in harm…

If the debtor was aware of the plaintiff-creditor’s right under law to be free of the invasive conduct of others (conduct of the sort redressed by the law on the underlying tort) and nonetheless proceeded to act to effect the invasion with particular reference to the plaintiff, willfulness is established. If in so doing the debtor intended to bring about a loss in fact that would be detrimental to the plaintiff, whether specific sort of loss the plaintiff actually suffered or not, malice is established. Sells v. Porter (In re Porter), 375 B.R. 822, 828 (B.A.P. 8th Cir. 2007) aff’d, 539 F.3d 889 (8th Cir. 2008) (quoting KYMN, Inc. v. Langeslag (In re Langeslag), 366 B.R. 51, 59 (Bankr. D. Minn 2007)).

The debtor made the rather unconvincing argument that he did not “intentionally” injure the music companies because he was not aware he needed an ASCAP license.  He claimed he was not aware of the violations until suit was filed against him in court.  The court was not persuaded, noting that he had been contacted 44 times, and never responded.  Furthermore, the court found that Walker (the debtor) failed to distinguish between the concepts of injury and harm:

The Supreme Court [has] analyzed willfulness in terms of injury. Injury is the “invasion of any legally protected interest of another.” Restatement (Second) of Torts § 7(1). Under § 523(a)(6), a judgment debt cannot be exempt from discharge unless it is based on an intentional tort, which requires the actor to intend “the consequences of the act rather than the act itself.” Restatement (Second) of Torts § 8A, comment a, at 15; Geiger, 523 U.S. at 61. In effect, Geiger requires that the debtor intend the injury.

The debtor had a duty, the court found, the obtain the required license.  He also signed for a settlement letter from the plaintiffs, but later claimed he had not read it. These types of arguments did little to win the debtor friends among the judges.  The court then turned its attention to the concept of harm:

The Eighth Circuit analyzed maliciousness in terms of harm…Harm is the “existence of loss or detriment in fact of any kind to a person resulting from any case.” Restatement (Second) of Torts § 7(2). In this case, the debtor’s actions were malicious because he intended to harm the appellees. The debtor did not obtain a public performance license yet he continued to play music covered by the license. The district court for the Eastern District of Missouri found the debtor to be in violation of Federal copyright law and entered judgment against him. The Eighth Circuit has held that the bankruptcy court may consider a violation of a statute as evidence of malicious intent. In re Fors, 259 B.R. at 139. And, one court has held that the debtor’s intentional violation of a Federal copyright law was an aggravating feature which evinces a voluntary willingness to inflict injury. Knight Kitchen Music v. Pineau (In re Pineau), 149 B.R. 239 (D. Me. 1993).

The debtor admitted he had a general knowledge of federal copyright law.  When all was said and done, the court plainly could see that the debtor knew he needed to obtain a license, and deliberately avoided doing so because then he would have to pay royalties.  Thus, he intended the financial harm which was the logical consequence of his actions.  Thus, the B.A.P. had no trouble in upholding the ruling of the lower bankruptcy court on making the debt nondischargeable. Presumably, what irked the court most was the repeated and deliberate evasions of the plaintiff creditor’s communications.  At some point, willfulness can be inferred from this sort of extrinsic evidence.

Read More:  Bankruptcy Adversary Proceedings Under Section 523

For A DUI Stop, Police Need “Reasonable Suspicion” Of Criminal Activity

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Every now and then, a DUI decision comes along that sums up a very important point of law. One of these decisions came down in January 2015 from the Missouri Court of Appeals for the Western District.

If the police wish to stop a motorist for a suspected DUI, they must have a reasonable suspicion of criminal activity.  Stops based on mere curiosity, or based on pretexts, are not legally valid.  This was the rule that the Missouri Court of Appeals for the Western District recently (2014) reminded the legal community of.  The case was State v. Cardwell (WD76791), on appeal from Cole County, Missouri.  After a bench trial, Mr. Cardwell was convicted of driving while intoxicated under Section 577.010 of RSMo.  On appeal he argued that the trial court should have granted his motion to suppress evidence. The Court of Appeals agreed with Cardwell and reversed the conviction.

Cardwell had filed a motion to suppress evidence during the case.  He argued that, because the officer who stopped him did not have reasonable suspicion or probable cause to do so, all evidence obtained thereafter should be suppressed. His motion was denied, and he was convicted.  When the officer initiated the stop, Cardwell argued, he did not have reasonable suspicion or probable cause to believe that Cardwell’s behavior suggested that he may be involved in illegal activity.  Thus the officer’s stop and seizure of Cardwell was unreasonable, and evidence obtained thereafter should have been suppressed.

The officer testified that when he first stopped Cardwell, he observed Cardwell to have watery, bloodshot eyes, could smell the odor of alcohol from his car, and Cardwell admitted to the officer that he had been drinking.  But the real issue, the Court found, was whether Cardwell should have been stopped in the first place.

The testimony of the police officer was the heart of the case.  The officer testified that on September 16, 2011, he was on his way to assist another officer, at approximately 1:00 in the morning, when he observed a vehicle in front of him traveling “very slow.”  The road was  gravel and “not a very wide road.” He testified that he quickly caught up with the vehicle, which was traveling in front of him and going in the same direction. The officer testified that the vehicle then stopped in the right hand lane and the driver motioned for him to go around and left him room to do so.

The officer said he instead chose to “check on the driver, make sure everything was okay[,]” and so he turned his lights on “so that he would know that it was a deputy behind him and that it wasn’t someone that was possibly a threat to him and also as a warning beacon to anyone else that would come up behind us or a beacon for other deputies should I need help.” At that point, the officer testified that he contacted the driver and had him show his driver’s license. The officer said although Cardwell then told him he was fine, he could smell alcohol coming from inside the vehicle.

The officer said he had not observed the vehicle commit any traffic offense. The officer testified that most people do not drive fifty-five miles per hour on a gravel road, indicating his perspective that driving slower than that was not “unusual conduct which [would] lead[] him reasonably to conclude in light of his experience that criminal activity may be afoot, as required for the existence of reasonable suspicion.

Cardwell was detained when the officer activated his emergency lights. At that moment, the Court noted, a reasonable person would have believed he was not free to leave.  From looking at the entire circumstances, the Court found nothing to indicate that the detention of Cardwell was justified in the first place.  In other words, the officer had no reason to believe that criminal activity was in progress or had occurred. The detention and the arrest never should have occurred.

The Court summed up its position with this brief but succinct expression of the law in this area.  It is worth quoting here:

However, “whether an officer lacked reasonable suspicion ‘turns on an objective assessment of the officer’s actions in light of the facts and circumstances confronting him at the time and not on the officer’s actual state of mind at the time the challenged action was taken.’” Id. (quoting Maryland v. Macon, 472 U.S. 463, 470–71 (1985)) (emphasis added). An objective assessment of the events leading to Sergeant Huffman’s [the officer conducting the stop] stop of Cardwell fails to reveal any specific and articulable facts and rational inferences therefrom that would reasonably warrant the stop. Driving slowly on a rural gravel road in the early morning, coming to a stop when quickly approached from behind by another vehicle, and motioning the approaching vehicle to go around with adequate room to do so does not constitute “unusual conduct” leading reasonably to a conclusion that criminal activity is taking place. There was no indication Cardwell’s vehicle was in any way disabled or that Cardwell was in need of help. In fact, Cardwell waved the officer on.

Taking all of the circumstances into consideration, then, the Court was able to find that the officer never should have stopped Cardwell in the first place.  Why?  He had no reason to.  There was no indication that anything of a criminal nature had happened or would happen. The law is clear on this point, and it is good for law enforcement to be reminded of it.  For this reason, the Court reversed Caldwell’s conviction.

Read More:  The Field Sobriety Test In A DUI Or DWI Case

10th Circuit BAP: Means Test Includes All Income Received During Look-Back Period

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A recent decision by the Bankruptcy Appellate Panel for the 10th Circuit (which covers the state of Kansas) dealt with an interesting issue of statutory interpretation.  The case was In Re Miller, (BAP No. WY-14-002), on appeal from a bankruptcy court in Wyoming, and decided in October 2014.  The question in the case involved the calculation of the income figures for the “means test.”  When a bankruptcy case is filed, there is normally a requirement to submit financial data (on Form B22A) showing the average monthly income and expenses in the six months preceding the month of the filing of the case.

The issue was whether a debtor’s wages need to be both earned and received during the applicable six-month “look-back” period in order to be included as part of his “current monthly income” (called “CMI”) under 11 U.S.C. § 101(10A).  In Miller’s case, the Wyoming bankruptcy court concluded that his CMI figures were high enough to disqualify him from proceeding under Chapter 7.  The Trustee felt he should convert his case to Chapter 13.  When this did not happen, the case was dismissed.  Miller then appealed.

The critical issue was the dispute on the interpretation of what should be considered “income.”  The United States Trustee (UST) contested Miller’s CMI calculations, which Miller based on his understanding of the term “current monthly income,” as defined in § 101(10A). That definition includes, “income from all sources that the debtor receives . . . without regard to whether such income is taxable income, derived during the 6-month period.” Miller argued that the “derived during” language means “earned during,” such that his CMI only need include income he both received and earned during the look-back period.  The UST read the definition to include all money received during the six month look-back period, regardless when it was earned.

The bankruptcy court agreed with the UST interpretation, holding that all income received by a debtor in the look-back period must be included in the calculation of CMI “without relation to when that income was earned.” The bankruptcy court dismissed Miller’s case pursuant to § 707(b)(2) when he declined to convert to a Chapter 13 proceeding.

The BAP first noted that the 10th Circuit had not previously ruled on this issue.  The court, applying principles of statutory construction, then proceeded to look at the plain language meanings of the words “derived from.”  While the interpretations of “received” and “derived” were a bit ambiguous, normal meanings should be applied.  After reviewing the accepted definitions for the term “derived,” in the context of the phrase “derived during,” the Court concluded that the phrase “income derived during the look-back period” had the plain meaning “income received during the look-back period.”  In other words, all income received during the look-back period should be included.

The Court found that this interpretation also was in accord with the original purpose of the statute (Sect. 101(10A)), which was to evaluate the debtor’s income level.  The court said “Finally, the doctrine that we should be guided by the underlying public policy of the statute reinforces our interpretation of CMI as requiring inclusion of all income received by a debtor during the look-back period….Although both parties present persuasive arguments on this difficult issue of statutory interpretation, we conclude that the plain meaning of § 101(10A) is that the term ‘current monthly income’ includes all income a debtor receives in the look-back period, regardless when it was earned.”

Readers should note that this ruling is not as harsh as it might appear.  There are times when a debtor receives an atypical amount of money during the means test period, that is not representative of his or her normal “income.” For example, sometimes people cash in retirement plans, receive personal gifts, or income from the sale of an asset.  In these situations, all a debtor has to do is to file a rebuttal of the presumption of abuse, and explain why this atypical amount should not be factored into the CMI calculation.  In the present case, the court might have been influenced by a perception that the debtor was artificially understating his normal salary figures.

Read More:  Confirmation Of A Chapter 13 Plan:  The Effects

Failure To Register As A Sex Offender In Missouri Not A Strict Liability Crime

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In Missouri, failing to register as a sex offender is a class C felony, pursuant to RSMo. Sections 589.400 and 589.425.  The Missouri Court of Appeals for the Southern District recently had an opportunity to rule on some important aspects of this offense, and reached an interesting conclusion.  The case was State of Missouri v. William Wilder, No. SD33140, on appeal from Wright County, Missouri.  The decision was reached on January 16, 2015.

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Compelling A Bank To Accept Surrendered Real Estate In A Chapter 13 Plan: Vesting Without Consent

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It is no secret that the 2008 financial crisis, and the real estate collapse that followed, threw the real estate market into chaos.  Many lenders found themselves reluctant to foreclose on properties that might have left them liable for homeowners’ dues, association fees, or property taxes.  Many of these lenders also found out—or already knew—that the values of their properties were not worth what they had been saying they were worth.  As a result, many properties were stuck in limbo.  They did not want to continue to deal with property maintenance issues for properties they wanted to surrender back to the banks.

But what happens when the bank refuses to foreclose, or takes an unreasonably long time?  In some jurisdictions, the non-payment of property taxes can trigger an automatic foreclosure after several years.  But what if a debtor doesn’t want to wait that long?

A bankruptcy court in the District of Oregon dealt with this issue in October 2014.  The case was In Re Watt, 520 B.R. 834 (D. Oregon, 2014).  In this case, the debtors filed a Chapter 13 plan that provided for the surrender of their property back to the creditor, Bank of NY Mellon.  The plan contained language that said the following:

Upon entry of an Order Confirming this Chapter 13 Plan, the property at 56 B NW 33rd Place in Newport, Oregon shall be vested in The Bank of New York Mellon fka The Bank of New York, as trustee for the Certificateholders of the CWALT, Inc., Alternative Loan Trust 2006–OA21, Mortgage Pass–Through Certificates, Series 2006–OA21, its successors, transferees or assigns pursuant to 11 U.S.C. 1322(b)(9). This vesting shall include all of Debtor’s legal and equitable rights. This vesting shall not merge or otherwise affect the extent, validity, or priority of any liens on the property. Creditors potentially affected by this paragraph include:  The Bank of New York Mellon aka Select Portfolio Servicing, the Bank of America, Lincoln County Tax Assessor and Meritage Homeowners Association.

The bank objected to this language, claiming that it could not be compelled to accept the property.  The court first noted that 11 U.S.C. § 1325(a)(5)(C) provides that with respect to a secured claim, a plan may surrender the property securing the claim to the holder of the claim. The debtors had vacated the property and made it available to BONY Mellon.  But the court noted that surrender merely establishes the debtor will not oppose the transfer of the collateral. Absent some further action, such as foreclosure, deed in lieu of foreclosure or short sale of the property, surrender does not divest a debtor of ownership and its obligations.  The court cited  In re Spencer, 457 B.R. 601 (E.D.Mich.2011) and In re Anderson, No. 12–37458–tmb13, Hr’g Tr. 23–24.

But can a Chapter 13 plan be used to “vest” property in another party, against their will?  This was the big issue.  The court approached it methodically.  It first noted that the debtors were in an unfair situation:  they wanted to get a fresh start, but the bank was sitting on its hands and not foreclosing.  At the same time, homeowner’s dues were continuing to accrue, and under the Bankruptcy Code, post-petition homeowner’s dues continue to be the debtor’s responsibility until his or her ownership interest in the property ends.  The situation was preventing the debtors from getting a fresh start, which is one of the primary purposes of the Bankruptcy Code.

The debtors argued that §1322(b)(9) of the Code permitted them to use a plan to transfer title in real estate back to the lender, even against the lender’s consent.  The bank, of course, disagreed.  The debtors cited a Chapter 13 case in which debtors sought to compel a secured party to take title to property surrendered in a bankruptcy proceeding.  The cited case was In re Rosa, 495 B.R. 522 (Bankr. D. Haw. 2013).  In this case, the debtor proposed a plan which provided for surrender of her real property and that title to the property would vest in the secured lender upon confirmation.

The Chapter 13 Trustee in Rosa objected to the plan, arguing that the plan provision vesting title in the secured lender was improper. The debtor disagreed, arguing that the vesting provision of the plan was authorized by §1322( b)( 9). The bankruptcy court agreed with the debtor in this case.  However, the court concluded that a debtor’s rights under §1322( b)( 9) were somewhat limited by the requirements of §1325(a)(5) regarding treatment of secured claims.

The debtors also cited another case, In re Rose, 512 B.R. 790 (Bankr.W.D.N.C. 2014).  In this case the debtors sought to quitclaim the property back to the lender, the SBA, by using a motion, rather than language in a confirmed plan.  The Rose court did not agree that a bank could be compelled to accept title in property without going through the foreclosure process.  It concluded that a secured lender could not be compelled to accept title without its consent as “taking title by deed could impair a lender’s rights in the collateral, subject it to ownership liabilities that it never would have voluntarily assumed and contravene state property law.”  This was a disappointing conclusion, and probably wrongly decided.  It focused entirely on the bank’s rights, while ignoring the rights of the debtors, and the significant hardship that was being imposed on them by being “in limbo” with regard to the property.

Finally, the Watt court was ready to issue its ruling.  It disagreed with both the Rosa and the Rose decisions.  Section 1322(b)(9) could indeed be used to force a lender to accept back its real estate, period.  The court noted that the plain language of the Code section read “vest.”  Vesting means transfer of title.  It was not appropriate to read additional qualifiers into that language.  It was plain and simple:  there was nothing in the plain language of §1322(b)(9) that required a lender’s “consent” in the vesting process.

The only limitation to using Section 1322(b)(9) for this purpose was “good faith.”  The vesting provision could not be used as an aid to fraud or malfeasance, in other words.  The court said the following:

However, under § 1325(a)(3), the court may not confirm a plan unless it is proposed in good faith. Accordingly, confirmation could be denied if a debtor attempts to use §1322(b)(9) to transfer property to a third party in order to relieve him or herself of responsibility for nuisance or environmental problems associated with it. In this case, there are no such concerns.

Obviously, such concerns (i.e., property transfers in bad faith to avoid some sort of “ticking time bomb”) are extremely rare.  In the real world of bankruptcy practice, debtors just want to shed themselves of their real estate involvements, and get a fresh start.  The court ruled that, in situations where lenders refuse to move, a confirmed plan can accomplish this goal.

What the court found particularly irksome was the bank’s refusal to act.  After all, it was the banks who had caused the financial crisis in the first place; and now some of them were trying to keep bad loans on their books by refusing to foreclose.  This situation is not acceptable.  It hurts the debtors, the other people in the homeowner’s association (who have to absorb the costs), the neighborhood, and the economy at large.  The court used the following colorful language:

BONY Mellon resists taking title and surrender but yet seeks relief from the automatic stay to foreclose at an undeterminative date with no commitment to moving forward. BONY Mellon did not offer to waive its security and be treated as an unsecured creditor. It reminds me of the old adage of the dog in the manger. The dog cannot eat the hay but refuses to let the horse or the cow eat it either. BONY Mellon would rather sit on the hay. This creates a stalemate.

It seems likely that such “vesting” cases will become more common in the near future.  Bankruptcy courts may (hopefully) in the coming years take a dim view of banks who continue to clog up the local and national economy by refusing to foreclose on properties that belong to them.  It is hoped that the Watt case will be a portent of things to come with regards to the glut of surrendered properties in many parts of the country.  Thus far, legislators have been blind to the problem.  For many debtors, action on this front can’t come soon enough.

Read More:  Defalcation In A Fiduciary Capacity:  Adversary Proceedings Under Section 523(a)(4)

Sexting Laws In Kansas And Missouri

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“Sexting” is the term used to describe the sending or receiving of sexually explicit images, usually by means of a hand-held smart phone.  The ready access to photographic technology, and the ease with which photos can now be taken, mean that users of cell phones are more likely to take advantage of the technology.  Cell phones and smart phones are here to stay, and with this presence comes possible dangers.  What may seem funny or amusing is most certainly not.  When minors “sext” photos to others, even photos of themselves, serious criminal issues can be implicated.

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With Guarantor, Separate Classification Of Unsecured Claim In Chapter 11 Plan Allowed

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A Ninth Circuit B.A.P. case from 2012 addressed an issue in a Chapter 11 “single asset” real estate case where the debtor sought to confirm its plan over the objection of an undersecured lender.  The case was In Re Loop 76 v. Wells Fargo Bank, na (465 B.R. 525 (9th Cir. B.A.P. 2012)).  The key issue in the case was whether the bankruptcy court could consider a “third party” source of payment (in this case, a guarantor), when deciding whether unsecured claims are substantially similar under 11 U.S.C. §1122(a).  Basically, the debtor wanted a large unsecured claim (a guarantor claim on a secured debt) to be classified separately from other unsecured creditors, so that the anticipated “no” vote on confirmation would not taint the acceptance of the plan by the other unsecured creditor class.

Often in real estate cases there are very large unsecured claims, possibly arising out of deficiency claims.  If such a deficiency claim were placed in the same class as the other general unsecured creditors, it might negate the acceptance of that class.  However, if such a debt were placed in a separate class, it might give the debtor more flexibility in confirming a plan over the objection of the creditor.

Loop 76 was a commercial real estate developer which had obtained a commercial loan of about $23 million from Wells Fargo Bank.  The loan was secured against an office complex.  There were also personal guarantees for the loan, signed by the principals of Loop 76.  Loop 76 eventually defaulted on the loan, due to the collapse of the real estate market in 2008-2010.  A Chapter 11 petition was eventually filed by Loop 76.  Since the property in question was only worth about $17 million, there was a large deficiency claim held by Wells Fargo.  The proposed plan attempted to classify the deficiency claim separately from the other unsecured creditors.

Wells Fargo objected to this treatment, believing that they should be lumped in with all the other unsecured creditors.  They were, according to Wells Fargo, “substantially similar” to the other unsecured creditors such that separate classification was not justified.  The attempt to create a separate class was, argued the creditor, nothing more than an attempt to “gerrymander” acceptance of the plan by needlessly creating a separate class of creditor.  Wells Fargo also continued to pursue the guarantors of the real estate loan in state court.

The bankruptcy court, weighing the issues, ruled against Wells Fargo.  Examining the history and intent of Section 1122(a) and Section 1129(a)(10), the court found that Wells Fargo had an alternate source of repayment, what it called a “third party” repayment source.  Such a creditor is different from a creditor who has no such alternate source of repayment.  Wells Fargo could provide no evidence that the guarantors themselves were insolvent or that they were no longer pursuing the guarantors.  Thus, the court found that there was a legitimate basis for putting Wells’s deficiency claim in its own class.

Wells Fargo appealed the decision to the 9th Circuit B.A.P.  The B.A.P. affirmed, noting that Wells had a third-party repayment source, unlike any of the other general unsecured creditors.  Thus, there was a compelling reason to put it in its own class.  Having a guarantor was a situation that no other unsecured creditor had.  A court can consider third party sources of repayment, the B.A.P. held, when trying to decide if unsecured claims are substantially similar under Section 1122(a).

Furthermore, it caught the B.A.P.’s attention that, if Wells’s claim were placed in the same class as all the other unsecured creditors, it would have dwarfed all the other unsecured claims, since it was such a large dollar amount.  It would have controlled the class and have been able to veto the acceptance of the proposed plan.  In the interests of fairness, it made sense to put Wells’s claim in its own class, segregated from the other unsecured claims. The Bankruptcy Code permits the creation of separate voting classes of creditors, provided that there is a rational basis for it and the claims are not “substantially similar.”  Not surprisingly, this issue can become a litigated one, if voting on plan confirmation turns on the acceptance or rejection of such a class.

Read More:  Classification Of Claims And Interests In Chapter 11 Bankruptcy