Attorneys Danny Newman and Eric Levine wrote an in-depth article recapping recent Ninth Circuit case decisions for the recent edition of the Oregon State Bar Debtor-Creditor Section Newsletter. You can read their article in full below.
Danny Newman is a partner in Tonkon Torp’s Litigation Department, where he focuses his work in bankruptcy, reorganization, and insolvency and serves as Co-Chair of the Government Law & Disputes Practice Group.
Eric is an associate in Tonkon Torp’s Litigation Department. He has authored briefs filed in state and federal courts, including the U.S. Court of Appeals for the D.C. Circuit and the D.C. Court of Appeals; and he has contributed to amicus briefs filed with the Supreme Court of the United States.
NINTH CIRCUIT CASE NOTES
‘Tax-First’ Method Required to Allocate Proceeds Between Taxes and Penalties
In re Leite, 112 F.4th 1246 (9th Cir. 2024)
This appeal presented the question of how to allocate sale proceeds among the IRS and bankruptcy estate after the tax penalty portion of a tax lien is avoided under Section 724(a) and the trustee stands in the shoes of the IRS for lien priority under Section 551. The 9th Circuit was confronted with two competing methodologies: the “pro rata” method, and the “tax-first” method. The 9th Circuit adopted the “taxfirst” method and concluded that the unavoidable taxes and interest must be paid in full before the sale proceeds could be used to pay the trustee for the avoidable portion of the tax lien.
The 9th Circuit began with the statutory framework. It noted that courts interpret the Bankruptcy Code with a presumption that the Code does not change preexisting pre-Code practice. Section 724(a) and Section 551 both expressly deviate from pre-Code practice. Section 724(a) deviates because it makes some claims for penalties “voidable not void” in order to permit the penalty lien to revive if a Chapter 7 bankruptcy is converted to a Chapter 11 bankruptcy. Section 551 “preserves” the estate by allowing a trustee to stand in the shoes of a lienholder whose lien has been avoided under seven statutes, including Section 724(a).
It then rejected the pro rata method. Section 724(a) allows for partial avoidance of a tax lien. A trustee may avoid the penalty portions only, but they may not avoid the compensatory tax provisions of tax liens. Section 551 preserves only what Section 724(a) avoids — the non-compensatory penalties.
This limitation on Section 551 creates three problems with the pro rata method. First, it preserves part of the unavoidable tax lien because it reduces the actual amount recovered from the unavoidable tax lien. Second, it runs counter to policy. Section 724(a) is to protect unsecured creditors from the debtor’s wrongdoing. Instead, the pro rata method prioritizes unsecured creditors by placing them on the same level as the unavoidable portion of the tax lien. Third, it conflicts with priorities set out in the Bankruptcy Code. Generally, the Bankruptcy Code prioritizes secured creditors over unsecured creditors and taxes over penalties. But the pro rata method reduces recovery for the IRS’s secured tax lien for compensatory unpaid taxes.
The last important section of the opinion provides further explanation for the distinction between taxes and penalties and the different treatment they receive under the Bankruptcy Code, as reflected in subordination under Section 726(a)(4). Thus, when a trustee avoids a tax penalty, the trustee stands in the shoes of the IRS insofar as the trustee is ahead of junior secured creditors but remains subordinated behind the IRS’s unavoidable portion of the tax lien.
Chapter 15 Stays Are Effective When Recognized by an American Court, Not When Petition Filed International Petroleum Products and Additives Company, Inc. v. Black Gold S.A.R.L., 115 F.4th 1202 (9th Cir. 2024)
This case presented two questions: (1) does a stay under Section 1520 apply retroactively when an order denying a petition is later overturned on appeal, and (2) does a stay under Section 1520 encompass alter ego claims against a foreign debtor company’s sole owner? The answer to both is no.
The facts and procedural history of this case are long and entertaining. International Petroleum Products and Additives Company (“IPAC”) had a sales agreement with Black Gold S.A.R.L. (“Black Gold”), a limited liability company headquartered in the Principality of Monaco. The sales agreement involved various nondisclosure and noncompete agreements, which Black Gold blatantly violated.
Mr. Napoleoni left Black Gold to found PXL Chemicals BV (“PXL”), a company based in the Netherlands. He started PXL with “a confidential password-protected Excel spreadsheet ‘detailing the identity, vendor, price, and relative composition for each component in each of IPAC’s products,’ as well as ‘large amounts of other IPAC Confidential Information relating to IPAC sales in pricing.’” IPAC later discovered the breaches and sued Black Gold. At the arbitration hearing, when Mr. Napoleoni was asked how PXL so quickly produced a product so similar to IPAC’s, he said he “had [IPAC’s information] available, and yeah. That’s it.”
The arbitration panel found in favor of IPAC, but IPAC had trouble collecting from Black Gold. IPAC registered its judgment in the Northern District of California and entered post-judgment asset discovery. Black Gold completely stonewalled and ignored court orders to compel production. Two years after IPAC won in arbitration, Black Gold filed for bankruptcy in Monaco and filed for recognition of those proceedings under Chapter 15 of the Bankruptcy Code. The bankruptcy court denied the Chapter 15 petition, which Black Gold appealed.
Notably, Black Gold did not move for a stay of the district court post-judgment proceedings pending appeal of its denied Chapter 15 petition, so IPAC continued its collection efforts. IPAC moved to amend its judgment to include Mr. Napoleoni and his wife as judgment debtors on the theory that they were Black Gold’s alter ego. The district court granted adverse inferences against the Napoleonis for their discovery misconduct and granted the motion to include them as judgment debtors.
Meanwhile the appeal of Black Gold’s denied Chapter 15 petition progressed. The BAP reversed the bankruptcy court’s denial of the Chapter 15 petition. Despite agreeing that the Monaco proceedings were a sham, that was insufficient to deny a petition that otherwise satisfied the pleading requirements of Chapter 15 (which it did). IPAC did not appeal the BAP’s decision, which became final. The reversal triggered the automatic bankruptcy stay, but the 9th Circuit limited it. It ordered that the stay applied to proceedings against Black Gold, and not against the Napoleonis individually, who had been added as judgment debtors to IPAC’s arbitration award.
On remand to the district court in the post-judgment proceedings, the Napoleonis argued that the alter ego claim was subject to the automatic stay. The district court rejected the argument, and the case found itself on appeal before the 9th Circuit directly from the district court.
Automatic stays under Chapter 15 take effect only after the entry of an order granting recognition of a foreign bankruptcy proceeding. The court held that the answer to when the stay takes effect — and whether it is retroactive — “is as straightforward as the question is novel.” Because the bankruptcy court’s order did not “grant recognition” of the foreign bankruptcy proceedings, the stay did not take effect. It was only the later-in-time reversal that granted recognition and started the stay. The 9th Circuit also refused to give retroactive application of the stay because the Napoleonis failed to seek a stay under Rule 8007. A Rule 8007 stay requires the court to balance the interests of all parties, not just the losing party, and could be conditioned on the losing party posting a bond or other security. No bond or security was placed, so the 9th Circuit refused to retroactively impose a stay when the Napoleonis failed to seek one prospectively.
On the issue of whether the alter ego claim belonged to the estate, the 9th Circuit held that the Napoleonis had failed to comply with Federal Rule of Civil Procedure 44.1 and so were precluded from raising the argument. Rule 44.1 requires a party who intends to rely on a foreign country’s law to give notice of that intention. The court reasoned that whether the claim belonged to the estate was a matter of state law and here, that state was Monaco and Monegasque law. The Napoleonis failed to give Rule 44.1 notice, so they could not argue that under Monegasque law, the alter ego claim belonged to the estate. Instead, the court applied California law, which provides that an alter ego claim remains with a creditor unless there is an injury alleged to the corporation itself.
Finally, the Napoleonis argued that if they are the alter ego of Black Gold, then Black Gold is their alter ego as well. Thus, because there is an automatic stay against Black Gold, that should apply to them too. The 9th Circuit refused to adopt the Fourth Circuit’s “unusual situation” exception and held that this was not the correct procedural posture to rule on it because it was raised in the first instance on appeal.
Chapter 13 Debtor May Dismiss Chapter 13 Petition Without Proving Chapter 13 Eligibility
In re Powell, ___ F.4th ____, No.22-60052, 2024 WL 4352615 (9th Cir. 2024)
This case presented the question of whether the absolute right of a Chapter 13 debtor to dismiss their petition under In re Nichols, 10 F.4th 956 (9th Cir. 2021), is conditioned on the bankruptcy court determining that the debtor is in fact eligible for Chapter 13 relief. The 9th Circuit said no.
Jason Powell filed a petition under Chapter 13 of the Bankruptcy Code, and his former employer, TICO Construction Company, Inc. (“TICO”), filed a claim. Later, Powell voluntarily dismissed his Chapter 13 case and TICO opposed. The bankruptcy court interpreted In re Nichols to give Powell an absolute right to voluntarily dismiss his Chapter 13 bankruptcy case, so it granted the motion. TICO appealed. The BAP and 9th Circuit both affirmed.
The 9th Circuit began with four elements under Section 1307(b) for a voluntary dismissal: (1) a request, (2) by a debtor, (3) who has a Chapter 13 case, (4) that has not been converted to another enumerated chapter under Title 11. TICO conceded that those four elements were satisfied, and that the 9th Circuit previously held that the right to dismiss under Section 1307(b) survives even if the debtor filed the Chapter 13 petition in bad faith. However, TICO continued that only debtors who are entitled to relief under Section 109(e) have an absolute right to dismiss the petition under Section 1307(b). So, when a Chapter 13 debtor seeks to dismiss their case, the bankruptcy court must determine if the debtor is, in fact, entitled to relief under Section 109(e). If ineligible, the case cannot be dismissed unless it is in the best interests of the estate and creditors.
The court explained the flaws in TICO’s position. It took issue with the definition of “debtor” and requirement to resolve eligibility. “Debtor” is not defined under Section 1307(b), but it is in Section 101(13). A debtor is “a person or municipality concerning which a case under this title has been commenced.” It does not define debtor as someone who meets chapter-specific eligibility requirements.
The court thus rejected TICO’s strained argument that the Section 101(13) definition’s use of the word “commenced” necessarily incorporates Section 301(a), which uses the phrase “may be a debtor” — the same phrase used in Section 109(e) defining Chapter 13 eligibility — leading TICO to conclude that Sections 101(13), 109(e), and 301(a) must all be tied together such that Section 101(13)’s definition of debtor is limited to those who may be a debtor under Chapter 13. But the 9th Circuit pointed out that Section 101(13) defines “debtor” for the entire title, so it does not make sense that the definition would incorporate only a reference to a single chapter.
The eligibility determination was similarly rejected. That is because under Section 301(a), a case is commenced when a petition is filed, not when eligibility is confirmed. And the filing entity’s certification of eligibility presumptively establishes that the entity may be a debtor under the designated chapter. In support of this, the court noted that when a debtor is later determined to be ineligible for relief under their designated chapter, it does not render void all proceedings occurring to that point. Because there is a presumption of eligibility until proven ineligible, an entity that has filed a Chapter 13 petition retains the absolute right to dismiss the petition.
Judge Collins dissented. He argued that the benefits of Chapter 13 should inure only to those who are eligible for Chapter 13 relief. Section 109(e) determines Chapter 13 eligibility. If a creditor challenges a debtor’s exercise of a Chapter 13 power, then a bankruptcy court must confirm Chapter 13 eligibility before allowing the debtor’s action.
Depletion of Estate Property Is Injury-in-Fact to Trustee
In re O’Gorman, 115 F.4th 1047 (9th Cir. 2024)
This case presented the question of whether a bankruptcy trustee had standing to assert fraudulent transfer actions when no creditor was harmed by the transfer. The 9th Circuit concluded that the depletion of assets of the estate constituted an injury-in-fact to the trustee.
Debbie Reid O’Gorman owned a 30-acre plot of land that she lived on, valued at $2.5 million. It was subject to a mortgage and second deed of trust. O’Gorman paid the mortgage, but the holder of the second deed of trust, Grant Reynolds, who was O’Gorman’s former attorney, threatened foreclosure. William Utnehmer, another attorney, approached O’Gorman with a scheme to prevent foreclosure. Utnehmer’s plan was to create three trusts (“transferees”). The transferees were structured so, ultimately, O’Gorman would be paid $235,000, and the remaining proceeds of the sale of the land would be split 80-20, with 80% inuring to Utnehmer and 20% to O’Gorman. O’Gorman agreed to the plan and transferred the land to the transferees for no consideration to prevent Reynolds from foreclosing. O’Gorman fired Utnehmer before the land was sold and filed a Chapter 7 petition.
The Chapter 7 trustee filed an adverse action against the transferees to avoid the transfer of the land. The trustee moved for summary judgment, supported by a declaration from O’Gorman stating that it was her understanding that the transfer would prevent or delay Reynolds from foreclosing on his deed of trust and that was her only reason for following Utnehmer’s advice. The transferees opposed summary judgment, arguing that there was insufficient evidence of actual intent to hinder, delay, or defraud Reynolds, and the summary judgment motion was otherwise premature because the parties had not conducted a Rule 26(f) conference. They did not submit an affidavit contesting any facts put forth by the trustee. The bankruptcy court granted the motion for summary judgment and denied the continuance until after a Rule 26(f) conference because the transferees had not submitted an affidavit. They appealed.
The transferees first argued that the trustee lacked standing because no creditors were harmed by the transfer. The transfer included a $235,000 priority distribution to O’Gorman in the event of a sale, the Chapter 7 creditors’ claims were less than $235,000, so upon sale of the land there would be sufficient funds to pay all creditors in full. Since no creditor would be harmed, there was no injury-infact, but the 9th Circuit disagreed. It framed the fraudulent transfer as harming the estate by depleting its assets and held that a trustee suffers an injury-in-fact when the estate is harmed.
Next, the 9th Circuit addressed whether an injury to a creditor is an element of a Section 548 claim. Noting that it had not ruled on the issue before, the 9th Circuit joined the 4th and 8th Circuits in concluding no harm is necessary because the statute permits a trustee to avoid “any” fraudulent transfer of the debtor’s property.
Finally, in the longest analysis section of the opinion, the court concluded that summary judgment was appropriate. The essence of the section is that O’Gorman’s declaration was unrebutted direct evidence of actual intent to hinder and delay Reynolds’ foreclosure efforts and if the transferees wished to contest it, they could have submitted an affidavit in opposition. They failed to do so, so the material facts were uncontested, and summary judgment was appropriate as a matter of law.
The Schedules Do Not Necessarily Control When Chapter 11 Debtor Makes Contradictory Statements to Creditors During Period to Object to Exemptions
In re Masingale, 108 F.4th 1195 (9th Cir. 2024)
At the time that Rosana and Monte Masingale (“the Masingales”) filed for Chapter 11 bankruptcy, the maximum homestead exception that they could claim was $45,950. Their house was valued at around $165,000. On their schedules, they claimed a homestead exemption for “100% of FMV.” Before the 30-day window for creditors to object ended, the Masingales filed a disclosure statement and proposed Chapter 11 Plan. There, they claimed that their homestead exemption did not exceed the statutory limit. The question presented by this case was whether creditors could rely on the Masingales’ statements, or if the schedules were operative. The 9th Circuit concluded that creditors could rely on the statements outside the schedules.
In the Chapter 11 proceedings, no creditors objected to the homestead exemption. Over a year later, the United States Trustee moved to convert the case to a Chapter 7 liquidation. Because it had been over a year, the creditors could not raise new objections to the homestead exemption.
Rosana Masingale24 subsequently tried to sell her home for $400,000 without giving any proceeds to the bankruptcy estate. She argued that because she claimed “100% of FMV” as the value of her exemption on the schedules and no creditor objected to the exemption, her entire interest in the home was withdrawn from the estate.
Masingale and the Trustee filed cross motions—Masingale to compel the Trustee to abandon the property, and the 24 Monte Masingale passed away while the proceedings were ongoing. Trustee for authority to sell the home. The bankruptcy court granted the Trustee’s motion and denied Masingale’s, holding that she was entitled only to the statutory cap on her homestead exemption. The Trustee sold the property for $422,000. Masingale appealed.
The 9th Circuit Bankruptcy Appellate Panel reversed in a published opinion. It ruled the “100% of FMV” on the schedules were dispositive and that such a ruling was compelled by Taylor v. Freeland & Fronz, 503 U.S. 638 (1992) and Schwab v. Reilly, 560 U.S. 770 (2010). The BAP went on to criticize Masingale and her counsel for the “frivolous” claim for exemption and suggested sanctions as a remedy, but because no creditor objected to the exemption, Masingale was not limited to the statutory cap.
The 9th Circuit reversed. It began by drawing principles from Taylor — where the exemption warranted an objection because it signaled the debtor’s intention to withdraw the asset from the bankruptcy estate — and Schwab — where it did not. The Schwab Court opined that language such as “100% of FMV” may be sufficient to put creditors on notice that the debtor intends to remove an asset from the bankruptcy estate.
The court did not rule on whether the “100% of FMV” claim on the schedules raised the “warning flag” that creditors had a “make-it-or-lose-it objection.” That was because it looked outside the schedules to the statements that the Masingales made to creditors during the 30-day period to object. The 9th Circuit reasoned it was appropriate to look outside the schedules because the Masingales had fiduciary duties to their creditors and, while trying to win support for the confirmation of the Chapter 11 Plan, they had told creditors that they would not claim above the statutory cap.
The court also outright rejected Masingale’s proposed per se rule. She had argued that when there are potentially conflicting statements by a debtor, the schedules should always control. The court reasoned that such a rule would incentivize frivolous exemption claims and require objections. Such a rule would reduce efficiency in the bankruptcy process, so the court refused to adopt it.
Proving the Objective Criteria of a Ponzi Scheme Satisfies the Mens Rea Requirement for Fraudulent Intent
In re EPD Investment Company, LLC, 114 F.4th 1148 (9th Cir. 2024)
This case presented the question of whether a mens rea jury instruction is required in fraudulent transfer cases alleging the operation of a Ponzi scheme. The 9th Circuit held that the instruction was not required.
The appeal arose in a unique posture. EPD Investment Company, LLC (“EPD”)’s creditors successfully forced it into a Chapter 7 bankruptcy. Ann Kirkland served as trustee to one creditor, Bright Conscience Trust (“BC Trust”). She was married to John Kirkland. This case began when the trustee filed an adversary proceeding against John seeking to avoid fraudulent transfers made by EPD to John. However, because John was not a party to the bankruptcy nor did he file a proof of claim, the fraudulent transfer case against John went before a jury in the district court.
The jury returned a verdict in favor of John. It found that he received reasonably equivalent value for his payments from EPD and received them in good faith. However, it also found that EPD was operated by the Chapter 7 debtor as a Ponzi scheme. Because that finding would have preclusive effect on BC Trust’s proofs of claim in the Chapter 7 bankruptcy, Ann Kirkland appealed from a verdict in her husband’s favor. She sought vacatur of the jury finding that EPD was a Ponzi scheme.
The 9th Circuit first concluded that it had standing. The trustee argued that she did not because she was not a party to John’s trial. However, because the bankruptcy court held that all findings from the jury would be binding on the bankruptcy proceedings — including that EPD was operated as a Ponzi scheme — the findings were binding on BC Trust, so its trustee had standing.
Ann challenged the jury instructions for two reasons. First, she contended that the court erred when it did not include a mens rea jury instruction. Second, she argued that the court erred in instructing the jury that lenders are investors for the purposes of a Ponzi scheme.
The court concluded that no mens rea instruction was necessary. In fraudulent transfer cases, if a trustee proves that the debtor operated a Ponzi scheme, then the trustee is entitled to an irrebuttable presumption that the debtor transferred money with actual fraudulent intent under 11 U.S.C. § 548. That is because a Ponzi scheme, by definition, gives investors the impression that a legitimate profitmaking business opportunity exists when, in fact, no such opportunity existed. The court extended this logic to proving mens rea. In operating a Ponzi scheme, there can be no intent but fraudulent intent; thus, proving the objective criteria of a Ponzi scheme also satisfies proving the mens rea requirement of the perpetrator.
Next, she argued that the district court erred in including “lenders” as a possible category of victims of a Ponzi scheme. Her logic was that only “investors” could be injured by a Ponzi scheme because an investor expects a business generating a profit and would not invest in a Ponzi scheme if they knew there was no profit-generating business to invest in. Conversely, a “lender” provides a loan, which has fixed terms of repayment and does not depend on the existence of a profit-generating business.
The court did not buy it. It noted that Charles Ponzi’s eponymous Ponzi scheme was based on short-term loans to defraud lenders. Ann presented two additional arguments, one challenging the sufficiency of the evidence, and the second on the admission of expert testimony. Neither was availing, so the court affirmed.
The panel drew a dissent from Judge Clifton, who argued that the majority’s logic was circular because a Ponzi scheme is a form of fraud, proving fraud requires proving fraudulent intent, so proving a Ponzi scheme cannot prove fraudulent intent, because fraudulent intent is an element of a Ponzi scheme.
Employment Claims Based on Single Course of Continuing Conduct That Begins Prepetition and Continues Post-Petition Is a Claim Belonging to the Bankruptcy Estate
Bercy v. City of Phoenix, 103 F.4th 591 (9th Cir. 2024)
The case presents the question of who can bring a hostile work environment claim arising from a course of discriminatory conduct that began prepetition and continued post-petition. The court concluded that the claim belonged to the bankruptcy estate, so only the Trustee could bring the case.
Bercy worked for the City of Phoenix. During that time, a co-worker made offensive and bigoted remarks about Bercy’s race and ethnicity. Bercy filed a Chapter 7 bankruptcy petition seeking relief from her debt, in part so that she could leave her job. As part of her Chapter 7 petition, she stated that she had no claims against third parties, including employment disputes or rights to sue. The bankruptcy court discharged her debts.
Bercy then filed suit against the City of Pheonix. During discovery, the City learned about the bankruptcy case and moved for summary judgment, asserting that Bercy’s claim belonged to the bankruptcy estate. The trustee moved to reopen the bankruptcy case and agreed to a settlement with the City, pending the district court’s dismissal of the hostile work environment claim with prejudice. The district court granted the motion for summary judgment. Bercy appealed, arguing that she was personally entitled to pursue damages for post-petition conduct.
The court rejected Bercy’s argument and affirmed. Relying on Title VII case law, the court concluded that the individual acts creating a hostile work environment are not individually actionable. Rather, they collectively create a hostile work environment. Because the conduct creating the hostile work environment began prepetition, Bercy’s cause of action accrued before the bankruptcy proceedings, so the claim belonged to the bankruptcy estate under 11 U.S.C. § 541(a)(6).
The court also distinguished Bercy’s primary case, O’Loghlin v. County of Orange, 229 F.3d 871 (9th Cir. 2000). The court explained that case involved whether a creditor’s claim was discharged as a debt, rather than whether a debtor’s claim was included in the estate as property.
District Court Cannot Enter a Stay Without Considering Prejudice to the Parties
In re PG&E Corporation Securities Litigation, 100 F.4th 1076 (9th Cir. 2024)
This case presented the question of whether the district court abused its discretion when it sua sponte issued a stay without considering prejudice to the parties. The 9th Circuit held that it did.
The case originated with the Northern California wildfires of 2017 and 2018. Plaintiffs filed two nearly identical complaints against two sets of defendants: a company—PG&E Corporation and Pacific Gas & Electric Company—and its agents—current and former officers, directors, and bond underwriters. PG&E declared bankruptcy, so the claims against it were referred to bankruptcy court, whereas the complaint against the individual defendants remained in the district court.
The bankruptcy court moved fast. Between January 2020 and April 2021, it set up several processes for handling the claims against PG&E, which resulted in over 7,000 securities claims being filed and about 1,600 of those claims settling. Relevant to this case, not all claims against the individual defendants could be resolved in the bankruptcy court, with the first stage of the bankruptcy proceedings expected to take four to seven years before moving to the second stage.
The district court moved slowly. Between January 2020 and April 2021, the district court did not rule on a fully briefed motion to dismiss the claims against the individual defendants. In April 2021, in seeming reliance on plaintiffs’ statements about the overlapping nature of the district court case and bankruptcy case, the court sua sponte issued a notice of intention to stay the proceedings. The plaintiffs opposed. Eighteen months later, the court issued the stay while the fully briefed motion to dismiss was still pending. Plaintiffs filed an interlocutory appeal challenging the stay.
The 9th Circuit first addressed whether it had jurisdiction over the interlocutory appeal. Applying the Moses H. Cone doctrine from Moses H. Cone Memorial Hospital v. Mercury Construction Corp., 460 U.S. 1 (1983), it concluded that it did. That doctrine gives appellate jurisdiction over stay orders if it effectively places a plaintiff out of court. The court held that the first phase of the bankruptcy proceedings could take as long as seven more years, which effectively put the plaintiffs out of court.
Having concluded it had jurisdiction, the 9th Circuit considered the merits of the district court’s stay order. The order cited only judicial economy as the reason for the stay. The 9th Circuit agreed that the stay promoted judicial economy. In so doing, it rejected the plaintiffs’ argument that the bankruptcy proceedings would not assist the district court because they would not be binding. Instead, the court reasoned that the district court would receive considerable assistance in resolving the issues presented in the case if they were first addressed by the bankruptcy court.
However, the 9th Circuit vacated the stay because the district court did not weigh the hardships that the stay may cause. Neither the district court nor individual defendants articulated a single prejudice they would suffer from having to litigate the case, whereas the plaintiffs identified many hardships, including the fading of memory and other spoilation of evidence. Because these issues were not addressed by the stay order, the district court abused its discretion in granting it.
States Do Not Waive Sovereign Immunity When Filing Unsuccessful Involuntary Bankruptcy Petitions
In re Blixseth, 112 F.4th 837 (9th Cir. 2024)
This case presented two questions: whether a state waives sovereign immunity when it petitions for involuntary bankruptcy, and whether 11 U.S.C. § 303(i) abrogates sovereign immunity.
This case began when the State of Montana Department of Revenue, Idaho State Tax Commission, and California Franchise Tax Board filed an involuntary bankruptcy petition against Timothy Blixseth under 11 U.S.C. § 303(b)(1). Blixseth settled with Idaho and California, which withdrew as petitioning creditors. The bankruptcy court granted Blixseth summary judgment, finding that Montana’s claim was the subject of a bona fide dispute as to the amount of liability, Montana lacked standing to pursue the claim in bankruptcy court, and the petition could not be sustained based on the existence of only one remaining petitioning creditor (who joined before Idaho and California settled). Montana appealed, but that was ultimately affirmed, and the involuntary petition was dismissed for want of prosecution.
During a hearing in the bankruptcy court, the court indicated its opinion that Montana had waived sovereign immunity by submitting to the jurisdiction of the court, to which counsel for Montana replied, “I believe that’s correct, Your Honor.”
Blixseth brought an adversary proceeding against Montana seeking attorneys’ fees and costs, proximate and punitive damages, and sanctions against counsel under Section 303(i). Montana moved to dismiss, asserting sovereign immunity. The bankruptcy court denied the motion for three reasons. First, because Montana voluntarily invoked the bankruptcy court’s jurisdiction by filing the involuntary petition, it waived sovereign immunity. Second, counsel’s statement to the court clearly and unequivocally waived sovereign immunity. Third, and finally, the claim under Section 303(i) was ancillary to the bankruptcy’s in rem jurisdiction such that it abrogated sovereign immunity.
The 9th Circuit Bankruptcy Appellate Panel denied the appeal, citing a lack of jurisdiction over the interlocutory appeal. The 9th Circuit reversed, holding it was an incorrect application of Supreme Court and Circuit precedent, then turned to the merits.
The court first concluded that Montana had not voluntarily invoked the jurisdiction of the bankruptcy court by filing an involuntary petition. The court began by noting that Montana had never filed a proof of claim, and therefore Gardner v. New Jersey, 329 U.S. 565 (1947) — which held that a state waives sovereign immunity when it files a proof of claim — was not implicated. Thus, the waiver could arise only if the counterclaim was predicated on the same transaction or occurrence as Montana’s involuntary petition. The court held, as a matter of law, that a Section 303(i) claim is not equivalent to a compulsory counterclaim because a Section 303(i) claim cannot arise out of the same factual predicate for involuntary petition. The simple reason was that filing an involuntary petition is itself an element of a Section 303(i) claim. The court also distinguished 303(i) claims from Rule 11 sanctions because the former is a fee-shifting provision, and the latter is not.
Next, in a single paragraph, the court held that Montana’s counsel’s statement to the bankruptcy court was not unequivocally expressed and therefore did not constitute a waiver of sovereign immunity.
Finally, the 9th Circuit concluded that the bankruptcy court’s ancillary jurisdiction under Central Valley Community College v. Katz, 546 U.S. 356 (2006), did not abrogate sovereign immunity. In Katz, the court recognized that states agreed to a limited waiver of sovereign immunity when ratifying the Bankruptcy Clause of the Constitution. This waiver was limited to subordination of sovereign immunity to the extent necessary to effectuate the in rem jurisdiction of a bankruptcy court. Specifically, the waiver is limited to “the exercise of exclusive jurisdiction over all of the debtor’s property, the equitable distribution of that property among the debtor’s creditors, and the ultimate discharge that gives a debtor a ‘fresh start’ by releasing him, or her, or it from further liability for old debts.” The remedial nature of Section 303(i) claims does not implicate control over the estate or its equitable distribution. Additionally, a Section 303(i) claim does not concern property of the res of the bankruptcy estate because, after an unsuccessful involuntary petition, no res was created.
After determining that Montana had sovereign immunity, it reversed the bankruptcy court and remanded with instructions to dismiss the adversary proceeding.
Malicious Prosecution Claims Based on Bankruptcy Proceedings Completely Preempted by Federal Law
Cogan v. Trabucco, 114 F.4th 1054 (9th Cir. 2024)
This case presented the question of whether the Rooker-Feldman doctrine barred a state civil action for malicious prosecution of a claim in a bankruptcy proceeding. The 9th Circuit held that the Bankruptcy Code created exclusive federal jurisdiction for malicious prosecution claims arising from bankruptcy proceedings, so the state court lacked subject matter jurisdiction, and the Rooker-Feldman doctrine was inapplicable.
The parties here are Arnaldo Trabucco, a surgeon and Chapter 7 debtor, and Jeffrey Cogan, an attorney who represented a creditor in the Chapter 7 bankruptcy. Separately, the family members of a patient that Trabucco performed surgery on, who later passed away, sued Trabucco for medical malpractice in an Arizona state court. Cogan came to represent that family in the Arizona case, as well as the bankruptcy proceedings.
In the bankruptcy case, Cogan filed an adversary complaint seeking a determination that Trabucco’s liability to the family was nondischargeable under 11 U.S.C. § 523(a) (2)(A) and (a)(6). That included the allegation that Trabucco committed a willful and malicious injury to his patient during surgery, and that he later made false statements to the family. The adversary complaint was ultimately dismissed with prejudice upon stipulation that the state court proceeding could continue without any claims about malicious or intentional conduct.
Trabucco then filed a complaint against Cogan and the family for malicious prosecution, abuse of process, and intentional infliction of emotional distress. After the medical malpractice claim was dismissed and the bankruptcy discharge issued, the only remaining litigation was Trabucco’s complaint.
Trabucco won an $8,000,000 judgment against Cogan, and Cogan appealed. The Arizona appeals court affirmed Cogan’s liability for the malicious prosecution claim, reversed as to the other claims, and remanded for a new trial on the malicious prosecution damages only. Trabucco appealed to the Arizona Supreme Court. There, Cogan filed a motion to dismiss the case for lack of subject matter jurisdiction. He argued that the state courts lacked jurisdiction because the underlying conduct involved a federal bankruptcy proceeding. The Arizona Supreme Court denied the petition for review and the motion to dismiss. Before the new trial on damages in state court, Cogan filed a complaint in the district court to collaterally attack the state court judgment against him.
While the collateral attack was pending, Trabucco and Cogan settled the malicious prosecution case. Relevant here, it reimposed $8,000,000 but on terms where Trabucco could never effectively collect it. Then, Trabucco moved to dismiss the collateral attack action because it was barred by the Rooker-Feldman doctrine. The case was dismissed. Cogan appealed to the 9th Circuit.
For background on the Rooker-Feldman doctrine: the doctrine prevents district courts from reviewing the civil judgments of state courts. The reasoning announced by the Supreme Court was that district courts are limited to original jurisdiction, and reviewing a state court judgment would be an exercise of appellate power. The Supreme Court is the only federal court with appellate jurisdiction over state court judgments.
First, the 9th Circuit determined that the case was not moot. It held that there was a difference between an invalid judgment because the state court lacked subject matter jurisdiction, and an unenforceable judgment because of a settlement agreement. The settlement agreement did not moot the dispute over the parties’ underlying substantive rights. If Cogan prevailed in the federal case, then the state court’s substantive determinations would be rendered void and Cogan’s liability to Trabucco will be eliminated. Conversely, if Trabucco prevailed, then the state court’s liability findings against Cogan would be preserved and his ensuing liability will be fixed and payable in accordance with the settlement’s terms. In other words, the case was not moot because if Cogan prevailed, the judgment would be void, which is different than if Trabucco prevailed, where the judgment would exist (despite being unenforceable).
Cogan contended that Trabucco’s malicious prosecution action was within the exclusive jurisdiction of the federal courts; that any judgment in that case is therefore subject to collateral attack in federal court; and therefore, Rooker-Feldman does not apply.
Previously, in MSR Exploration, Ltd. v. Meridian Oil, Inc., 74 F.3d 910 (9th Cir.), the court held that state malicious prosecution actions for events taking place within bankruptcy court proceedings are completely preempted by federal law. Because of the highly complex bankruptcy laws, the court concluded that Congress intended to insulate bankruptcy proceedings from even the slightest incursion or disruption from state courts.
The specter of state malicious prosecution action may have a chilling effect on bankruptcy proceedings, such as by deterring a creditor from filing a proof of claim. That led the court to hold that Congress intended to remove such an action from the subject matter jurisdiction of the state courts. Because claims for malicious prosecution arising from bankruptcy claims are exclusive federal jurisdiction, the state court issued a judgment without jurisdiction, and that decision could be reviewed in a federal district court.
This article was originally published in the Fall 2024 issue of the Oregon State Bar Debtor-Creditor Newsletter.