July 14, 2011 Articles

Litigation Claims in Consumer Bankruptcy Cases

Courts have split on Chapter 13 issues with decisions turning on plan-vesting provisions, the nature of the cause of action, and the debtor's chosen exemption scheme.

By Deborah B. Langehennig

Causes of action held by a debtor are property of the bankruptcy estate, whether they arise pre- or post-petition. Some confusion arises in Chapter 13 cases, as section 1303 of the Bankruptcy Code provides that Chapter 13 debtors retain the right to use estate property, and seems to suggest that the debtor is the proper party to pursue this pending litigation. However, courts have split on these issues with decisions turning on plan-vesting provisions, the nature of the cause of action, and the debtor’s chosen exemption scheme.

Debtors in bankruptcy must make full disclosure of all legal or equitable interests of the debtor in property as of the commencement of the case. 11 U.S.C. § 521(a)(1) and 541(a)(1). In a Chapter 13 case, property of the estate further includes property acquired after the commencement of the case. 11 U.S.C. § 1306(a)(1). The Bankruptcy Code imposes on debtors an affirmative duty of full disclosure, which “extends to ‘contingent assets’ such as causes of action pursued against another party.” In re Kane, 628 F.3d 631, 636, citing Ryan Operations G.P. v. Santiam-Midwest Lumber Co., 81 F.3d 355 (3d Cir. 1996), and Krystal Cadillac-Oldsmobile GMC Truck, Inc. v. Gen. Motors Corp., 337 F.3d, 314, 316 (3d Cir. 2003). For post-petition actions, “[a] debtor has an affirmative duty to supplement the list of assets with any claims arising during the pendency of the bankruptcy proceeding.” In re Barger, 279 B.R. 900, 906 (Bankr. N.D. Ga. 2002); Wolfork v. Tackett, 526 S.E.2d 436, 437–38 (Ga. Ct. App. 1999).

The difficulty for the debtor and debtor’s counsel is in valuation of a cause of action or a potential cause of action. Full disclosure of assets requires a proper valuation with a reasonable basis. However, both the bankruptcy attorney and the attorney handling the underlying litigation will want to assign a valuation that is not binding on the debtor in the litigation. Perhaps cautionary phrasing, such as “valuation for bankruptcy disclosure and exemption purposes only––not binding” would protect the debtor from taking a position on damages in the underlying litigation. Another difficulty for the debtor is the consequence of non-disclosure of a pending or potential cause of action, as demonstrated in the many cases construing the effect of judicial estoppel in bankruptcy cases.

The Current State of Judicial Estoppel in Bankruptcy

Judicial estoppel is intended to protect the judicial process by preventing parties from taking conflicting positions in litigation. It is an equitable doctrine, similar in some respects to other estoppel doctrines, such as equitable estoppel and the preclusion doctrines of collateral estoppel/issue preclusion and res judicata/claim preclusion.

The U.S. Supreme Court, in New Hampshire v. Maine, 532 U.S. 742, 121 S. Ct. 2808 (2001), highlighted the factors giving rise to a claim of judicial estoppel. In litigation, a party’s later position must be “clearly inconsistent” with its earlier position; the party must have succeeded in persuading a court to accept that party’s earlier position so that judicial acceptance of the inconsistent position in a later proceeding would create a perception that one court was misled; and the party seeking to assert the inconsistent position would derive an unfair advantage on the opposing party. Id. at 750.

Judicial estoppel often arises when a debtor in bankruptcy fails to disclose a claim or cause of action in its bankruptcy schedules, and then later pursues the cause of action in separate litigation. With the filing of the schedules, the debtor asserts a position with respect to its assets and liabilities that is relied upon by creditors, the bankruptcy trustee, and the Bankruptcy Court.

Several circuit-court decisions echo the essential elements for judicial estoppel. Kane v. Nat’l Union Fire Ins. Co. 535 F.3d 380 (5th Cir. 2008); Eastman v. Union Pac. R.R. Co., 493 F.3d 1151 (10th Cir. 2007); Burnes v. Pemco Aeroplex, Inc., 291 F.3d 1282 (11th Cir. 2002). A “party is judicially estopped only if its position is clearly inconsistent with the previous one.” In re Superior Crewboats, 374 F.3d at 335; see also In re Walker, 323 B.R. at 195. Failure to list an asset is the same as stating that the asset does not exist and may be deemed an admission. Id. Later asserting to a court that the cause of action exists is inconsistent with the prior statement.

It is essential that “the court must have accepted the previous position.” Id. The court in Superior Crewboats stated that “adoption does not require a formal judgment; rather, it only requires ‘that the first court has adopted the position urged by the party, either as a preliminary matter or as part of a final disposition.’” In re Superior Crewboats, 374 F.3d at 335, quoting In re Coastal Plains, 179 F.3d at 206. Detrimental reliance is not an element in most cases. “[B]ecause judicial estoppel is designed to protect the judicial system, not the litigants, detrimental reliance by the party opponent is not required.” Id. at 334.

Also necessary for the application of judicial estoppel is a finding that “the non-disclosure must not have been inadvertent.” In re Superior Crewboats, 374 F.3d at 335; see also In re Walker, 323 B.R. at 195. If there is no motive for a nondisclosure, it is likely inadvertent. Wolfork v. Tackett, 526 S.E. 2d 436 (Ga. Ct. App. 1999). The typical motive is for the debtor to pay the creditors less than 100 percent in the bankruptcy case, and later receive the full recovery of the claim in litigation without any encumbrance by the creditors. If, however, the reorganization plan that is approved calls for creditors to be paid in full, there is no motive for nondisclosure. A second means by which nondisclosure could be inadvertent is when the debtor is truly not aware of the cause of action––the cause of action may not have accrued.

In Eastman v. Union Pacific Railroad Co., 493 F.3d 1151 (10th Cir. 2007), a railroad worker held a claim against multiple defendants with respect to an injury from an accident while in the employ of the railroad. After filing a Chapter 7 case, in response to the trustee’s examination at the meeting of creditors, the debtor and his attorney alluded to the accident but failed to disclose the claim in the bankruptcy schedules and failed to inform the trustee of the subsequent lawsuit. Upon discovery of the action, the trustee moved to reopen the bankruptcy case and also substituted as the real party-in-interest in the personal-injury action. The trustee settled the claim with two of the defendants, which provided the bankruptcy estate with sufficient assets to pay all creditors’ claims. The trustee then abandoned the estate’s remaining interest in the lawsuit.

Facing a claim of judicial estoppel, the debtor asserted that his failure to disclose the personal injury action was due to “[m]istake, inadvertence, confusion, lack of understanding, lack of legal sophistication, and the like[.]” Id. at 1157. He also blamed his bankruptcy attorney for failure to include the information in the bankruptcy papers. The court rejected the debtor’s claim of inadvertent omission: “Where a debtor has both knowledge of the claims and a motive to conceal them, courts routinely, albeit at times sub silentio, infer deliberate manipulation.” Id. at 1157, Burnes v. Pemco Aeroplex, Inc., 291 F.3d at 1287.

An appellate court found error in a bankruptcy court’s refusal to consider evidence from the debtors concerning intent to deceive the court and the trustee by their failure to disclose a cause of action. In re Riazuddin, 363 B.R. 177, 188 (Bankr. 10th Cir. 2007). A successful claim of judicial estoppel should be supported by a finding that the party’s prior position was not based on inadvertence or mistake. The court should evaluate all equitable considerations and all relevant factual circumstances of the situation. See also Jethroe v. Omnova Solutions, Inc., 412 F.3d 598 (2005) (The court inferred that the nondisclosure by the debtor was intentional as the debtor was actively involved in the litigation of her discrimination case before and during the bankruptcy case, without disclosing its existence to the Bankruptcy Court.)

In the Chapter 11 context, the bankruptcy court in In re LJM2 Co-Investment, L.P., 327 B.R. 786 (Bankr. N.D. Tex. 2005), found that the defendant overstated the reach of the doctrine of judicial estoppel. The debtor filed a fraudulent transfer claim against multiple defendants, following approval of its Chapter 11 disclosure statement and confirmation of the Chapter 11 plan. The disclosure statement revealed potential litigation and the investigation of potential claims against entities based on their relationship with the debtor prior to the bankruptcy filing. The plan expressly reserved all claims, rights, and causes of action against one of the defendants, and included payments or transfers made to or for the benefit of third persons. The plan transferred those causes of action to a litigation trust for later adjudication, and provided that the confirmation of the plan would have no preclusive effect. The bankruptcy court, in its written decision, concluded that the claim against the defendant had been disclosed, even though this particular related defendant was not expressly named.

The court points out that, at the time of the disclosure-statement hearing, the debtor requested that the court make a finding concerning the adequacy of the information in the disclosure statement. Therefore, the debtor did not induce the court to accept a position inconsistent with the prosecution of the claims. Judicial estoppel did not bar later litigation of the fraudulent transfer claims.

Can the Debtor Cure a Deficiency?

One important query is whether the debtor can cure a deficiency in the schedules to allow the cause of action to proceed. If the debtor has not yet been judicially estopped, it appears that the debtor can cure the omission by amending the schedules. Once an estoppel defense has been raised, some courts have found that “allowing [the debtor] to back-up, reopen the bankruptcy case, and amend his bankruptcy filings, only after his omission has been challenged by an adversary, suggests that a debtor should consider disclosing personal assets only if he is caught concealing them.” In re Superior Crewboats, 374 F.3d at 336, quoting Burnes v. Pemco Aeroplex, Inc., 291 F.3d at 1288 (11th Cir. 2002).

The better rule, consistent with procedural rules allowing liberal amendments to schedules, may be to allow the debtor to amend schedules to disclose the cause of action. Recall also that in a Chapter 13 case, section 1306 brings a post-petition cause of action into the bankruptcy estate, and debtors are expected to update schedules as necessary. Many courts now recognize that the undisclosed cause of action, like every other omitted asset, continues its existence as property of the estate protected by the automatic stay even after the bankruptcy case is closed. In re Barger, 279 B.R. 900 (Bankr. N.D. Ga. 2002); Klein, Ponoroff and Borrey, Principles of Preclusion and Estoppel in Bankruptcy Cases, 79 Am. Bankr. L.J. 839 (2005). Property can only be abandoned and returned to the debtor if the trustee knows of its existence and knowingly relinquishes the property.

Shall the Trustee Also Be Barred?

Earlier decisions in bankruptcy cases developed the theory that judicial estoppel would bar both the debtor and the trustee from pursuing a cause of action. In re Superior Crewboats, Inc., 374 F.3d 330 (5th Cir. 2004). Courts had determined that accurate and complete disclosure in the schedules were more important than a potential recovery and distribution for the benefit of creditors. “It goes without saying that the Bankruptcy Code and Rules impose upon bankruptcy debtors an express, affirmative duty to disclose all assets, including contingent and unliquidated claims.” In re Coastal Plains, Inc., 179 F.3d 197, 207–08 (5th Cir. 1999). As the doctrine has continued to develop and as currently applied in most circuits, the trustee will not be barred by judicial estoppel for the failure of the debtor to disclose the potential claim.

Section 554(c) of the Bankruptcy Code provides that property that is scheduled but not otherwise administered when a case is closed is abandoned to the debtor and, for purposes of section 350, is administered. If the potential claim is not scheduled, it is neither administered nor abandoned at the closing of the case. It remains property of the bankruptcy estate, available for pursuit by the trustee. In re Riazuddin, 363 B.R. 177 (Bankr. 10th Cir. 2007). Courts may draw the distinction between claims that had been formally abandoned by the trustee under section 554 and claims that were never abandoned and therefore remained property of the bankruptcy estate, subject to administration by the bankruptcy trustee. If a claim is never abandoned, it remains property of the estate, and the trustee becomes the real party-in-interest. The estate and the estate’s creditors stand to benefit from the litigation claim. As an equitable consideration, the court may determine that a claim abandoned by the trustee may provide a windfall to the debtor at the expense of the creditors and apply estoppel. Contrast Kane v. Nat’l Union Fire Ins. Co., 535 F.3d 380 (5th Cir. 2008), and In re Superior Crewboats, 374 F.3d 330 (5th Cir. 2004).

In the case of Reed v. City of Arlington, 620 F.3d 477 (5th Cir. Sept. 16, 2010), bad facts may make inconsistent law in the Fifth Circuit. Judge Edith Jones wrote the opinion, describing the Fifth Circuit’s decisions applying judicial estoppel, as “a mosaic” and suggested that the court should attempt an “en banc harmonization.” In the Reed case, the debtors failed to disclose a $1 million judgment against the City of Arlington in their schedules. The circuit court determined that the trustee would be estopped from pursuing the judgment because “she succeeds to the debtor’s claim with all its attributes, including the potential for judicial estoppel.” Because so few creditors actually filed claims, only a small portion of any recovery would go to creditors. Most of the recovery would go to legal fees and the trustee’s fee. The court concluded that equity would not support further continuation of the litigation and determined that both the debtor and the bankruptcy trustee were barred. The court recently granted the trustee’s petition for rehearing en banc.

The difficulties that arise in handling litigation claims in bankruptcy cases counsel that both the litigation attorney and the bankruptcy attorney work together to properly disclose causes of action and potential causes of action, properly value these claims, and at the same time, not bind the debtor to a specific valuation that may be inconsistent with the debtor’s request for relief in the litigation. In the case of undisclosed claims, the best interests of creditors should be a primary concern, and the trustee should be substituted as the real party-in-interest to protect the assets of the estate. A debtor in bankruptcy should not receive the benefit of a discharge, free and clear of obligations, unless the debtor has shown an entitlement to that fresh start by disclosing all assets and making those assets available for distribution toward the claims of creditors.

Deborah B. Langehennig – July 14, 2011

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