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November 2013 Archives

Under Washington Law, Marriage Establishes No Express or Technical Trust With Respect to the Exception from Discharge Provided in Bankruptcy Code Section 523(a)(4)

In In re Mele, 13 C.D.O.S. 12737, No. WW-13-1173-DTaKu (November 25, 2013), the Bankruptcy Appellate Panel of the United States Court of Appeals for the Ninth Circuit held that a property allocation judgment arising from marital dissolution proceedings in Washington is dischargeable in a chapter 13 case notwithstanding Bankruptcy Code Section 523(a)(4), which excepts from discharge debts "for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny...."

In Mele, the separated husband spent the spouses' $274,000 retirement savings, including spending hundreds of dollars on comic books and related expenses, and stopped paying child support, all apparently in violation of a court order.  Accordingly, the family court awarded the wife a judgment for return of her interest in the funds.  The husband commenced a chapter 13 bankruptcy case, and the bankruptcy judge ruled in favor of the wife in her nondischargeability action.

The BAP reversed.  First, there was a subsequent change in the law when the Supreme Court of the United States decided Bullock v. BankChampaign, N.A., 133 S.Ct. 1754 (2013), in which the Court rule that "defalcation" includes "a culpable state of mind requirement akin to that which accompanies application of the other terms in the same statutory phrase.  We describe that state of mind as one involving knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior." The former standard was very low and was triggered by even the most minor failure to observe fiduciary duties.  The bankruptcy court did not apply the new, higher standard.

More fundamentally, the BAP determined that a marital relationship under Washington law does not constitute an express or technical trust, which is a requirement that courts have long ascribed to the words "while acting in a fiduciary capacity."  An express trust is one created by expressly by the parties by words or agreement.  A technical trust arises from statute or at law.  In re Lewis, 97 F.3d 1182 (9th Cir. 1996).

Crucial to the BAP's ruling is that Washington has a statute governing when and how a trust is created, which was not applicable to marriages in general.  Revised Code of Washington Section 11.98.008.  Although there is Washington case law describing the fiduciary duties of spouses as arising from a confidential relation of trust, the court found no authority actually holding that a marriage constitutes an express or technical trust.  It will be interesting to see how this ruling is used in the context of other states' marital property regimes.Also seen on Legal By the Bay, the Bar Association of San Francisco's New Blog.

The Current Chapter 15 Landscape and International Insolvency

Four recent cases shape the current landscape of international insolvency practice under Chapter 15 of the Bankruptcy Code, namely:  In re Vitro, S.A.B. de C.V., 701 F.3d 1031 (5th Cir. 2012); Morning Mist Holdings Ltd. v. Krys (In re Fairfield Sentry Ltd.), 714 F.3d 127 (2d Cir. 2013); In re Lehman Brothers Holdings Inc., No. 08-13555 (Bankr. S.D.N.Y.) (JMP); and In re Nortel Networks, Inc., No. 09-10138 (Bankr. D. Del.) (KG).

In re Vitro

In re Vitro began with a "concurso mercantil" in Mexico, similar to a chapter 11 reorganization.  Unlike the Bankruptcy Code, the concurso involves only a single class of creditors and provides for the termination of a guarantor's liabilities.  Following approval of a plan in the concurso, Vitro commenced a chapter 15 case in New York for the purposes of enforcing the plan against holders of bonds issues in the United States.  Thereafter, the chapter 15 case was transferred to Texas, where certain creditors had previously commenced involuntary chapter 11 proceedings.

The bondholders objected to recognition of the plan approved in the concurso, arguing that the result was too different from the likely outcome of an American reorganization.  The United States Court of Appeal for the Fifth Circuit agreed, applying a multi-step statutory approach and ultimately concluding that the result of the foregoing proceeding must be compared to the result that could be obtained under the Bankruptcy Code.

First, a the court must decide whether the relief requested by the foreign representative comes within the mandatory items enumerated in Bankruptcy Code Section 1521(a)(1)-(7).  If not, the court must determine whether it can grant “appropriate relief” under the terms of Bankruptcy Code Section 1521(a), which the Fifth Circuit held is limited to relief that is permissible under Bankruptcy Code Section 304 or would otherwise be available under United States bankruptcy or non-bankruptcy law.  

If not, the court next must consider whether “additional assistance” is appropriate under Bankruptcy Code Section 1507.  In making this determination, the court must consider whether the grant of additional assistance will “reasonably assure”:

     1.  The just treatment of all holders of claims against or interests in the debtor’s property;

     2.  Protection of claim holders in the United States against prejudice and inconvenience in the processing of claims in such foreign proceeding;

     3.  Prevention of preferential or fraudulent dispositions of property of the debtor;

     4.  Distribution of proceeds of the debtor’s property substantially in accordance with the order prescribed by the Bankruptcy Code; and

     5.  If appropriate, the provision of an opportunity for a fresh start for the individual that such foreign proceeding concerns.

Finally, relief otherwise available under the foregoing analysis must also satisfy Bankruptcy Code Section 1506.  

The court found that the treatment of creditors in the Mexican proceedings was too different from the results that would have been obtained under the Bankruptcy Code.

Vitro is subject to significant criticism.  Some critics suggest that it defeats the interests of international comity, which chapter 15 was designed to support.  More particularly, the principals applied in enforcing an ordinary foreign judgment focus upon whether the requested relief is manifestly contrary to the public policy of the United States; this standard is embodied in Bankruptcy Code Section 1506.  Critics suggest that the court should start with Section 1506, and it would be hard to say that the United States has a public policy against third-party releases because the circuit courts themselves are split on the issue.  It remains to be seen whether Mexican courts will retaliate by refusing to recognize American chapter 11 plans.

Morning Mist Holdings

In Morning Mist Holdings Ltd., the debtor was subject to liquidation proceedings under the British Virgin Islands Insolvency Act and a subsequent chapter 15 bankruptcy case in the Southern District of New York.  The United States Court of Appeals for the Second Circuit held that the time for determining the debtor's center of main interest ("COMI") was the date on which the chapter 15 petition was filed.

Determination of the COMI is important.  If the COMI is within the country where the foreign proceeding is pending, then the proceeding will be recognized as a "foreign main proceeding" under Bankruptcy Code Section 1517, and certain relief will become effective, including the automatic stay.

The bankruptcy court's recognition of the foreign proceeding triggered the automatic stay against all actions in the United States, including a prepetition shareholder derivative action.  The plaintiffs argued that the COMI should be determined by reference to the debtor's 18-year history of operations.  The plaintiffs also argued that recognition the foreign proceeding would be manifestly contrary to United States public policy because the court records in the foreign proceeding were sealed.  The court concluded that the right to access court documents is not absolute and is not so fundamental that recognition of the foreign proceeding would trigger the public policy exception of Bankruptcy Code Section 1506.

The Second Circuit concluded that the time for determining the COMI is the petition date, although consideration of prior activity may be appropriate to ensure there has been no manipulation.  The clear holding in Morning Mist Holdings is likely to aid attorneys and courts in determining whether to recognize foreign insolvency proceedings.

Lehman Brothers

The plan confirmed in the Lehman Brothers cases resulted from a cooperative, streamlined procedure that could serve as a model for other complex international insolvency proceedings.  

In June, 2009, Judge Peck of the United States Bankruptcy Court for the Southern District of New York adopted a protocol for international cooperation that involved 16 jurisdictions.  Most such protocols are bilateral arrangements between courts of two countries.

The protocol encouraged notice, communication and data sharing; permitted insolvency representatives in one country to appear and be heard at meetings and hearings in other countries, to communicate among courts and committees and to maximize the realization on the assets in each country; and allowed the courts and parties to deal with complex issues arising from extensive intercompany claims.

The protocol, among other things, is credited with fostering the consensual chapter 11 plan ultimately confirmed in the Lehman Brothers cases, which at the time constitutes the larges and most complex bankruptcy in history.

Nortel Networks

By contrast, Nortel Networks, Inc. provides and example in which lack of cooperation has delayed the distribution of funds in an otherwise successful case.

In Nortel Networks, the debtor's assets were sold for more than $7 billion, which process itself involved successfully overcoming significant challenges.  The funds were deposited to escrow, where they remain today.

Thereafter, the case became complicated by the apparent existence of three COMI's.  Currently, the United States and Canadian courts involved intend to conduct a joint trial in early 2014 to determine how to divide the sale proceeds. Both rejected a demand from the United Kingdom interests to arbitrate the dispute.  This decision is on appeal by the U.K. interests.


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