RECENT DEVELOPMENTS
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DFW BANKRUPTCY CONFERENCE
RECENT DEVELOPMENTS:
TEXAS BANKRUPTCY COURT,
TEXAS FEDERAL DISTRICT COURT,
FIFTH CIRCUIT COURT OF APPEALS,
UNITED STATES SUPREME COURT
BANKRUPTCY DECISIONS
Honorable Harlin D. “Cooter” Hale
UNITED STATES BANKRUPTCY JUDGE FOR
THE NORTHERN DISTRICT OF TEXAS
1100 Commerce Street, 14th Floor
Dallas, Texas 75242
(214) 753-2016 – Telephone
(214) 753-2036 - Telecopier
Gerrit M. Pronske
2200 Ross Avenue
Suite 5350
Dallas, Texas 75201
(214) 658-6501 Telephone
(214) 658-6509 – Telecopier
[email protected]
October 21, 2013
BIOGRAPHICAL INFORMATION
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HONORABLE HARLIN D. “COOTER” HALE
Born in Natchez, Mississippi.
B.S., 1979, Louisiana State University.
J.D., 1982, Paul M. Herbert School of Law, LSU, Order of the Coif.
1982-1982, Law Clerk to the Honorable James L. Dennis, Associate Justice, Louisiana Supreme
Court, now Judge on United States Fifth Circuit Court of Appeals.
1983-2002, Private practice of law in Dallas, Texas.
November 1, 2002, appointed United States Bankruptcy Judge, Northern District of Texas.
Membership: Dallas Bar Association; Dallas Bankruptcy Bar Association; Louisiana State Bar
Association; Texas Bar Association; American Bar Association; National Conference of
Bankruptcy Judges; Master, John C. Ford American Inn of Court.
GERRIT M. PRONSKE
B.A., 1980, Texas Tech University, with High Honors
J.D., 1983, Texas Tech University School of Law
Shareholder, Pronske & Patel, P.C., Dallas, Texas
Author, Pronske’s Texas Bankruptcy, Annotated - 2013, (Thirteenth Edition), published by
Texas Lawyer Press
Chairman, Bankruptcy Section of the Federal Bar Association, 2007 to 2008
Chairman, Dallas Bankruptcy Bar Association - 2005
Editor, Texas Bankruptcy Decisions - 1995 to 2003
Editor, Texas Bankruptcy Court Reporter - 1986 to 1995
Former Law Clerk to Honorable Robert C. McGuire, United States Bankruptcy Judge for the
Northern District of Texas, Dallas Division
Membership: Dallas Bar Association; Dallas Bankruptcy Bar Association; Turnaround
Management Association; American Bankruptcy Institute; Master, John C. Ford
American Inn of Court; Texas Bar Association; American Bar Association; Federal Bar
Association
Licensed in the States of Texas, Colorado and New Mexico
Frequent author and lecturer at continuing legal educational programs
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RECENT DEVELOPMENTS:
TEXAS BANKRUPTCY COURT,
TEXAS FEDERAL DISTRICT COURT,
FIFTH CIRCUIT COURT OF APPEALS, AND
UNITED STATES SUPREME COURT
BANKRUPTCY DECISIONS
DISCHARGEABILITY
Bullock v. Bankchampaign, N.A., 133 S.Ct.
1754 (U.S. Sup. Ct., May 13, 2013) (Justice
Breyer)
Issue: Whether the term “defalcation,” as used
in section 523(a)(4) of the Bankruptcy
Code excepting from discharge a debt
“for fraud or defalcation while acting in
a fiduciary capacity, embezzlement, or
larceny,” includes a culpable state of
mind requirement involving knowledge
of, or gross recklessness in respect to,
the improper nature of the relevant
fiduciary behavior.
Prior to the filing of a Chapter 7
bankruptcy by the petitioner, petitioner’s father
established a trust for the benefit of petitioner
and his siblings, and made petitioner the
(nonprofessional) trustee. The trust’s sole asset
was the father’s life insurance policy. The
petitioner borrowed funds from the trust three
times; all borrowed funds were repaid with
interest. His siblings obtained a judgment
against him in state court for breach of fiduciary
duty, though the court found no apparent
malicious motive. The court imposed
constructive trusts on certain of petitioner’s
interests in order to secure petitioner’s payment
of the judgment, with respondent serving as
trustee for all of the trusts. Petitioner filed for
bankruptcy. Respondent opposed discharge of
petitioner’s state-court-imposed debts to the
trust, and the bankruptcy court granted
respondent summary judgment, holding that
petitioner’s debts were not dischargeable
pursuant to section 523(a)(4), which provides
that an individual cannot obtain a bankruptcy
discharge from a debt “for fraud or defalcation
while acting in a fiduciary capacity,
embezzlement, or larceny.” The Federal District
Court and the Eleventh Circuit affirmed. The
latter court reasoned that “defalcation requires a
known breach of fiduciary duty, such that the
conduct can be characterized as objectively
reckless.”
On appeal to the Supreme Court, issue
was, essentially, whether the term “defalcation”
contained a scienter requirement. In reversing
the Eleventh Circuit, the Court held that the
term “defalcation” in section 523(a)(4) includes
a culpable state of mind requirement involving
knowledge of, or gross recklessness in respect
to, the improper nature of the fiduciary
behavior. While “defalcation” has been an
exception to discharge in a bankruptcy statute
since 1867, legal authorities have long disagreed
about its meaning. Broad definitions of the term
in modern and older dictionaries are unhelpful,
and courts of appeals have disagreed about what
mental state must accompany defalcation’s
definition.
The Court has previously interpreted the
term “fraud” in section 523(a)(4) to mean
“positive fraud, or fraud in fact, involving moral
turpitude or intentional wrong, as does
embezzlement; and not implied fraud, or fraud
in law, which may exist without the imputation
of bad faith or immorality.” The Court found
that the term “defalcation” should be treated
similarly. Thus, where the conduct at issue did
not involve bad faith, moral turpitude, or other
immoral conduct, “defalcation” requires an
intentional wrong. An intentional wrong
includes not only conduct that the fiduciary
knows is improper but also reckless conduct of
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the kind that the criminal law often treats as the
equivalent. Where actual knowledge of
wrongdoing is lacking, conduct is considered as
equivalent if, as set forth in the Model Penal
Code, the fiduciary consciously disregards, or is
willfully blind to, a substantial and unjustifiable
risk that his conduct will violate a fiduciary
duty.
The Court found that several considerations
supported this interpretation, including statutory
context, the fact that the Court’s interpretation
did not make the word identical to its statutory
neighbors, “Embezzlement,” “larceny,” and
“fraud”, and the fact that their the interpretation
was consistent with the longstanding principle
that exceptions to discharge should be confined
to those plainly expressed. It was also consistent
with statutory exceptions to discharge that
Congress normally confines to circumstances
where strong, special policy considerations,
such as the presence of fault, argue for
preserving the debt, thereby benefiting, for
example, a typically more honest creditor. Next,
the Court found that some Circuits have
interpreted the statute similarly for many years
without administrative or other difficulties. And
Finally, the Court found that it was important to
have a uniform interpretation of federal law.
The Court therefore reversed the decision of the
Eleventh Circuit.
ATTORNEYS’ FEES
Frazin v. Haynes & Boone, LLP, et al (In re
Frazin), 2013 WL 5495920 (5th Cir. October 1,
2013, Prado, J.)
Issue: Whether the Bankruptcy Court has
authority in light of Stern v. Marshall to
enter final judgment on state law
counterclaims
of
professional
malpractice, breach of fiduciary duty,
and DTPA in the context of professional
fee applications under Section 330.
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Holding:
The Bankruptcy Court has the
authority to enter final judgment on
state-law counterclaims for professional
malpractice and breach of fiduciary duty
in the context of professional fee
applications under Section 330, but lacks
the authority to enter final judgment on
DTPA
claims
against
estate
professionals since determination of
these claims is not necessary to enter a
ruling on the fee application.
Chapter 13 Debtor obtained court
approval to employ state court litigation counsel
and later appellate counsel as estate
professionals to prosecute state-court litigation,
a portion of the proceeds from which were
intended to fund payment to unsecured claims
under the confirmed plan. The professionals
successfully obtained a multi-million judgment
that was paid into the estate and sought
Bankruptcy Court approval of payment of their
professional fees from the estate under Section
330. In his objection to the professional fee
applications,
Debtor
raised
state-law
counterclaims for negligence, breach of
fiduciary duty, and violations of the Texas
Deceptive Trade Practices Act (“DTPA”). After
a six day trial, the Bankruptcy Court ruled
against Debtor’s state-law counter-claims and
awarded the professional fee claims in the
amounts requested. The District Court approved
the judgment in all respects.
On appeal, Debtor argued that the
Bankruptcy Court lacked judicial authority to
enter final judgment on the state-law claims
raised in the objection to the professional fee
applications under the precedent set by Stern v.
Marshall. With respect to professional
malpractice/negligence and breach of fiduciary
duty claims, the Court reasoned that the award
of professional fees and malpractice arise from a
common nucleus of operative fact, looking to
the Interlogic opinion and the res judicata effect
of a final professional fee order with respect to
malpractice claims. Osherow v. Ernst & Young,
LLP (In re Interlogic Trace, Inc.), 200 F.3d 382
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(5th Cir. 2000). The Debtor’s counter-claims for
malpractice and breach of fiduciary duty were
not “independent of the federal bankruptcy
law,” but rather were “necessarily resolvable”
by the Bankruptcy Court in the process of ruling
on the professional fee applications and
therefore fell constitutionally within the
Bankruptcy Court’s authority to enter final
orders under Stern. With respect to the DTPA
claims, however, the Court found that it was not
necessary for the Bankruptcy Court to
adjudicate the merit of the state-law claims to
determine the allowance of the professional fees
such that adjudication of the DTPA claims fell
outside the authority of the Bankruptcy Court to
enter final orders, although the Bankruptcy
Court’s factual determinations made in the
course of analyzing the DTPA claims were
within its constitutional authority because such
underlying facts were necessarily resolved in
adjudicating the fee applications.
In a brief concurring opinion, Judge
Owen added that a party objecting to a fee
application should not reserve grounds for
litigation in another forum simply because the
grounds may also be at issue in a state-law
cause of action, arguing that issues necessary to
a fee application must be adjudicated in the
Bankruptcy Court. Additionally, Judge Owen
argued that, once those issues are finally
adjudicated by the Bankruptcy Court, the court
that adjudicates the state-law counter-claims
outside of the Bankruptcy Court’s judicial
authority may apply issue preclusion principles
to prevent wasteful and unnecessary relitigation
of factual and legal issues.
ESTOPPEL
Axis Surplus Ins. Co. v. Flugence (Matter of
Flugence), 2013 WL 5508123 (5th Cir., October
4, 2013) (Judge Jerry E. Smith)
Issue: Whether, for purposes of establishing
judicial estoppel, a debtor in a Chapter
13 case has a duty to disclose a post-
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confirmation personal injury claim.
Issue: Whether, for purposes of establishing
judicial estoppel, a Debtor can establish
inadvertence for nondisclosure of a postconfirmation
personal-injury claim
where the Debtor knows the facts
underlying the claim but does not know
that disclosure is required.
Issue: Whether application of judicial estoppel
against a Debtor (but not against
innocent creditors) recovery against a
Defendant should be limited strictly to
amount owed creditors.
Debtor filed for Chapter 13 bankruptcy
protection and a plan was confirmed. Following
confirmation, Debtor was injured in a car
accident, and she hired an attorney a month
later. After that, an amended Chapter 13 plan
was confirmed. In the following year Debtor
sued Defendants for personal injury. After that,
Debtor received her Chapter 13 discharge.
During the pendency of the bankruptcy case and
the plan, Debtor never disclosed to the
bankruptcy court that she had been in an
accident and might prosecute a personal-injury
claim. When the Defendants discovered this
non-disclosure, they had the bankruptcy case
reopened and sought to have the Debtor
judicially estopped from pursuing the
undisclosed claim. The bankruptcy court
declared that although Debtor was estopped
from pursuing the claim on her own behalf, her
bankruptcy trustee was not similarly estopped
and could pursue the claim for the benefit of
Debtor’s creditors in accordance with Reed v.
City of Arlington, 650 F.3d 571 (5th Cir.2011)
(en banc).
On appeal, the district court reversed,
holding that Debtor did not have a potential
cause of action prior to her initial application for
bankruptcy protection, she relied on her
attorney’s advice as to whether she must
disclose her potential cause of action to the
bankruptcy court, and because of the flux in the
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law at the time regarding a debtor’s duty to
disclose in post-confirmation, Chapter 13
proceedings.
On further appeal to the Fifth Circuit, the
court reversed the district court, holdings that
there is a continuing duty to disclose in a
Chapter 13 proceeding, and that the Debtor had
met all the elements of judicial estoppel.
Judicial estoppel has three elements: (1) The
party against whom it is sought has asserted a
legal position that is plainly inconsistent with a
prior position; (2) a court accepted the prior
position; and (3) the party did not act
inadvertently. Since those elements were met,
the Fifth Circuit found that the bankruptcy court
did not abuse its discretion by finding Debtor
estopped. It may be uncertain whether a debtor
must disclose assets post-confirmation, but this
was a pre-confirmation non-disclosure. Here,
the plan explicitly stated that the estate’s assets
would not revest in the debtor until discharge.
Further, the court found that to prove that the
Debtor did not know of the inconsistent
position, she must show not that she was
unaware that she had a duty to disclose her
claims but that she was unaware of the facts
giving rise to them. Here, the Debtor clearly
knew of the facts underlying her personal-injury
claim.
The court further found that nothing in
the Reed case required that recovery be limited
strictly to the amount owed creditors. Reed
requires only that, after a claim is prosecuted
and the creditors and fees have been paid, any
remaining recovery must be returned to the
personal-injury defendants. The court therefore
reversed the judgment of the district court and
rendered, reinstating the judgment of the
bankruptcy court.
SANCTIONS
In re Jones, Slip Op., Adv. No. 06-1093 (E.D.
La., March 18, 2013)
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Issue: Whether the bankruptcy court erred in
failing to afford a creditor due process
by imposing punitive damages and
contempt sanctions for alleged conduct
that occurred not only in the present case
but also in other cases after the
bankruptcy court's judgment.
Issue: Whether the bankruptcy court erred in
awarding any punitive damages and,
even if punitive damages were
awardable, in setting the amount of those
damages, and in imposing any contempt
sanction and, even if the court had the
authority to impose such a sanction and
the sanction was justified, in setting the
amount of that sanction.
Debtor filed an adversary proceeding in
an effort to recoup overpayments made to lender
on his home mortgage loan. The complaint
requested return of the overpayments,
reimbursement of actual damages, and punitive
damages for violation of the automatic stay. At
trial, the parties severed debtor's request for
compensatory and punitive damages from the
merits of debtor's claim for return of
overpayments.
At a hearing on sanctions, damages, and
punitive relief lender agreed to implement
several remedial measures designed to correct
systemic problems with its accounting of home
mortgage loans. These procedures were
embodied in a judgment, and included
$67,202.45 in compensatory sanctions for
attorney's fees and costs, and implementation of
the new procedures in lieu of punitive damages.
In a reversal of its agreement with the court, the
lender appealed the judgment to the district
court, which affirmed the compensatory
damages (with an increase) and remanded for
the issue of punitive damages.
At the remanded sanctions and punitive
judgment hearing, the bankruptcy court imposed
the original sanctions ordered (the accounting
procedures) in lieu of punitive damages.
Additionally, the bankruptcy court found that
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the lender had willfully violated the automatic
stay when it charged debtor's account with
unreasonable fees and costs; failed to notify
debtor that any of these post-petition chargers
were being added to his account; failed to seek
court approval for same; and paid itself out of
estate funds delivered to it for payment of other
debt.
The
bankruptcy court
imposed
$3,171,154.00 in punitive damages on the
creditor in connection with its violation of the
automatic stay.
On appeal of the $3 million punitive
damage award, district court affirmed the award.
Section 362 allows for the award of actual
damages, including costs and attorneys' fees, as
a result of a stay violation, and punitive
damages "in appropriate circumstances." Cases
interpreting the standard for "appropriate
circumstances" have indicated that punitive
damages can be supported when the conduct at
issue is intentional and egregious, or when the
defendant acted in "bad faith," or with actual
knowledge that he was violating the federally
protected right or with reckless disregard of
whether he was doing so." The court found that
the lender knew of debtor's pending bankruptcy
and lender is a sophisticated lender with
thousands of claims in bankruptcy cases
pending throughout the country. The lender
assessed postpetition charges on the loan while
in bankruptcy. Despite assessing postpetition
charges, lender withheld this fact from its
borrower and diverted payments made by the
trustee and debtor to satisfy claims not
authorized by the plan or court. Lender admitted
that these actions were part of its normal course
of conduct, practiced in perhaps thousands of
cases. Considering those facts, the bankruptcy
court found that lender’s conduct was willful,
egregious and exhibited a reckless disregard for
the stay it violated.
The court found that punitive damages
serve a function broader than compensatory
damages - "they are aimed at deterrence and
retribution." Punitive damages may properly be
imposed to further a State's legitimate interests
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in punishing unlawful conduct and deterring its
repetition. The Supreme Court has established
three factors for courts to consider when
reviewing punitive damages: (1) the degree of
reprehensibility of the defendant's misconduct;
(2) the disparity between the actual or potential
harm suffered by the plaintiff and the punitive
damages award; and (3) the difference between
the punitive damages awarded by the jury and
the civil penalties authorized or imposed in
comparable
cases.
In
determining
reprehensibility of the behavior, the court found
that heavier punitive awards have been thought
to be justifiable when wrongdoing is hard to
detect (increased chances of getting away with
it), or when the value of the injury and the
corresponding compensatory award are small
(providing low incentives to sue).
The lender took the position that every
debtor in the district should be made to
challenge, by separate suit, their own stay issues
with the lender. The court disagreed, finding
that over eighty percent of chapter 13 debtors in
this district have incomes of less than $40,000
per year. The burden of extensive discovery and
delay is particularly overwhelming. Finding that
there is a strong societal interest in deterring
such future conduct through the imposition of
punitive relief the court found that the
bankruptcy court was correct in deeming
lender’s behavior reprehensible and finding that
an award of punitive damages was appropriate.
With respect to the ratio between the
punitive damages and the actual harm, the court
found that these were not excessive. Exemplary
damages must bear a "reasonable relationship"
to compensatory damages. The proper inquiry
for this factor is whether there is a reasonable
relationship between the punitive damages
award and the harm likely to result from the
defendant's conduct as well as the harm that
actually has occurred. High awards are justified
where a particularly egregious act has resulted
in only a small amount of economic damages
and in cases in which the injury is hard to
detect. Potential harm to others should also be
considered. Additionally, size of the corporation
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is a factor.
The court finally found that the lender
was on notice that its actions were
impermissible and could incur significant
penalties and assessing punitive damages at ten
times the amount of compensatory damages was
within the constitutional limits. The court
therefore affirmed the decision of the
bankruptcy court.
DISCHARGEABILITY
Kinkade, v. Kinkade, 707 F.3d 546 (5th Cir.,
February 6, 2013) (Judge Jennifer Walker
Elrod)
Issue: Whether the discharge exception of
section 523(a)(15) for divorce-related
debts not in the nature of support,
applies to both community debts and
separate debts.
Issue: Whether a portion of a judgment debt
reflecting a sum of money that judgment
creditor loaned the debtor before the
parties’ marriage fell within the subject
discharge
exception
of
section
523(a)(15).
In the debtor’s Chapter 7 bankruptcy
case, a judgment creditor, who was debtor’s exwife, filed adversary complaint seeking
determination that debt arising from the parties’
state-court
divorce
proceedings
was
nondischargeable. The issue before the
bankruptcy court was whether the debtor owed
his ex-wife was dischargeable in bankruptcy.
The bankruptcy court, and the district court on
appeal, held it was not. On appeal to the Fifth
Circuit, the court found that the ex-wife had
loaned the debtor two sums of money: some
before the parties’ marriage, and some during
the marriage. Both amounts came from exwife’s separate property. During the ensuing
divorce proceeding, the state-court judgment
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awarded the ex-wife certain debts. After the
debtor filed for Chapter 7 bankruptcy, ex-wife
initiated an adversary proceeding to contest
discharge of the debt pursuant to section
523(a)(15).
The central question on appeal was
whether section 523(a)(15) applied to the debt.
Ex-wife contested the bankruptcy court’s
decision on two grounds. First, she argued that
section 523(a)(15) applies only to community
debts, not separate obligations. The Fifth Circuit
disagreed, finding that the bankruptcy statutory
text suggested no such distinction. The statutory
language requires only that the debt be incurred
by the debtor in the course of a divorce or
separation. The debtor next argued that section
523(a)(15) did not apply to the sum of money
that the ex-wife loaned him before the parties’
marriage, and that her right to reimbursement
was a contractual one, not a marital one, and
cannot suddenly gain additional status by being
included in a petition for divorce and partition.
The Fifth Circuit disagreed, finding that in the
present case the debtor and his ex-wife did
marry, and the state court resolved their
obligations to one another—including the
debt—in the course of their divorce proceeding.
This made the debt nondischargeable under
section 523(a)(15) of the Bankruptcy Code. The
court therefore affirmed the judgment of the
bankruptcy court.
AUTOMATIC STAY
In re Law, 2013 WL 4602858 (Bankr. N.D.
Tex., August 29, 2013)
Issue: Whether a post-petition pre-discharge
letter mailed by motor vehicle lender to
Chapter 7 debtor was in nature of willful
violation of automatic stay of section
362(a)(6), as an improper attempt to
collect prepetition debt, warranting
award of actual damages in amount of
$1,000, punitive damages in amount of
$10,000, and reasonable attorney fees of
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$5,880, together with injunction against
mailing out such letters in future.
After the filing of a Chapter 7
bankruptcy case, after the debtor filed a
statement of intention, indicating her intention
to surrender the vehicle, and prior to the
discharge, a car lender sent the debtor letter (and
not also to debtor’s counsel), which notified the
debtor in repeated fashion of the “AMOUNT
NOW DUE” and “LAST DAY FOR
PAYMENT” on the Debtor’s account, and
indicated where the Debtor should send
payments to cure her defaults. The vehicle in
question was in the possession of debtor’s
estranged husband, who was not a joint debtor
in the Chapter 7 case. The debtor and her
counsel believed that, under the circumstances,
the letter from the lender was an improper
attempt to collect on a prepetition claim against
the debtor, since the automatic stay had
terminated as to the vehicle (but not to the
debtor ), and there was nothing preventing the
lender from repossessing the vehicle.
The court held a hearing to determine
whether the letter constituted a willful violation
of the automatic stay. The court found that there
was no dispute that the lender had notice of the
bankruptcy. Among other things, the court
found that the letter left an uncomfortable
concern that the precise business strategy of the
lender may have been to send the letter and see
if possibly the debtor would send in a payment.
The debtor testified that left her confused and
anxious. The court held that the letter
constituted a willful violation of the automatic
stay, and awarded the debtor, pursuant to
section 362(k), (a) $1,000 in actual damages; (b)
$10,000 in punitive damages; and (c)
reimbursement of attorneys’ fees to Legal Aid
of Northwest Texas (the debtor’s pro bono
counsel) of $5,880. The court also enjoined the
lender, pursuant to section 105(a) of the
Bankruptcy Code, from sending further letters
in the style and format of the letter to any other
debtors in the Northern District of Texas.
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The court found that lenders should not
send letters to debtors, who are represented by
counsel, and who have filed Statements of
Intention to surrender their vehicles, with words
screaming (in all capital letters) “AMOUNT
NOW DUE” and “LAST DAY FOR
PAYMENT.” Even so-called bankruptcy
disclaimer language (which was not in all
capital letters) was found to be somewhat
ambiguous to a debtor like the one in the caseat-bar. The problems with the letter were that:
(a) it went to the debtor only and not her
attorney, while she still had an open case and no
discharge yet; (b) the lender had received full
notice of the debtor’s bankruptcy case; (c) the
debtor filed a timely Statement of Intention
indicating she desired to surrender the vehicle;
(d) the debtor conspicuously stated in her
Schedules that she did not have possession of
the vehicle; (e) the time had passed where the
automatic stay no longer applied to the vehicle
and the lender was free to exercise in rem relief
as to it; (f) there was nothing in Texas law that
required the lender to send to the debtor any
notice of the lender’s intention to repossess the
vehicle. Based on this, the court found that the
letter crossed the line into being a stay violation.
It looked and smelled like a collection attempt
or other attempt to put pressure on a debtor who
quite plainly expressed an intention to surrender
the vehicle and who, quite plainly, was still in a
bankruptcy case and represented by counsel.
EXEMPTIONS
In re Garcia, Slip Op, Case No. 11-41094-rfn13 (Bankr. N.D. Tex., September 27, 2013)
(Judge Russell Nelms)
Debtors sold their homestead after filing
for bankruptcy under chapter 13. During the six
months that passed after the sale, the debtors did
not reinvest the proceeds in another homestead.
Instead, the debtors moved to modify their plan
to permit them to keep the proceeds.
The trustee objected to the plan
modification, arguing that the proceeds were no
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longer exempt, and so the modified plan must
provide for their distribution to unsecured
creditors. Debtors argued that the homestead
proceeds were exempt because their homestead
exemption became final when no party timely
objected to their claim of exemption.
Alternatively, they argued that the trustee’s
objection was barred by res judicata because he
failed to lodge his objection when the debtors
sought this court’s authority to sell the
homestead.
The bankruptcy court held that (1) the
homestead proceeds lost their exempt status
after six months from the date of sale and (2) the
trustee’s objection was not barred by res
judicata. The court therefore denied the
requested plan modification pursuant to the best
interest of creditors requirement of section
1325(a)(4), which requires as a condition to
both plan confirmation and plan modification
that chapter 13 debtors pay unsecured creditors
at least the amount they would receive if the
estate were liquidated in chapter 7. The court
found that proceeds from the sale of the
homestead fall under the definition of property
of the estate because (1) they are the proceeds of
the homestead, an asset held as of the
commencement of the case, or (2) the proceeds
themselves are an asset acquired by the debtors
post-petition. Under section 41.001(c) of the
Texas Property Code, when a Texas homeowner
sells his homestead, the proceeds are exempt for
only six months from the date of the sale.
The leading case regarding the impact of
section 41.001(c) of the Texas Property Code on
bankrupt debtors is the 2001 Fifth Circuit case
of In re Zibman, where the the debtors sold their
Texas homestead and kept the cash proceeds
two months prior to filing Chapter 7. In that
case, the Fifth Circuit held that the case was
filed with the 6 month time clock running on the
exemption, and the bankruptcy trustee was
therefore entitled to the proceeds if they were
not reinvested into another homestead.
The Fifth Circuit reached the same result
in Studensky v. Morgan in 2012. There, the
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debtor filed a chapter 7 petition but did not
claim his homestead as exempt. After filing
bankruptcy, he sold his homestead and used the
proceeds to pay his brother, who claimed a lien
on the homestead. When the trustee learned of
the payment, he contested the brother’s lien and
demanded return of the proceeds. In response to
the trustee’s demand, the debtor amended his
exemptions to claim the proceeds as exempt
under section 41.001(c). The trustee objected to
the exemption, arguing that the proceeds were
not exempt because more than six months had
passed since the sale of the home. The Fifth
Circuit found in that case that the debtor never
claimed his homestead as exempt, but instead
only claimed the proceeds as exempt. The court
then followed Zibman and held that the
exemption of the proceeds was subject to the
time limitation under Texas law.
The court found that Zibman had to be
reconciled with section 522(c) by a two-step
analytical process. First, one must conclude that
exempt property is not withdrawn from the
estate, but remains property of the estate
insulated from the claims of creditors for as long
as the asset enjoys exempt status under state
law. Second, one must conclude that section
522(c) does not preempt Texas’s homestead
laws. In a chapter 13 case, the effect of this
construction is to place the debtor in the same
position with regard to exemptions as he would
have been in had he not filed for bankruptcy.
The pendency of the bankruptcy case neither
expands nor reduces his exemption rights. So,
once an asset no longer enjoys exempt status
under state law, that asset becomes vulnerable to
claims and, hence, distributable to creditors.
The court held that since it had been
more than six months since the debtors sold
their homestead, the homestead proceeds were
non-exempt property of the estate as of the date
of the debtors’ plan modification and, as such,
were necessarily part of any hypothetical
liquidation analysis under the best interests test.
Because the plan failed to provide for the
distribution of the sale proceeds to creditors, it
did not comply with section 1325(a)(4).
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