How many times have you been involved in state court litigation and your adversary advises you that his/her client has just filed bankruptcy? Don’t fret—it may just be your lucky day! In order to understand how a bankruptcy can be used to your client’s advantage, and often at nominal expense compared to the cost of continued litigation, it is necessary to understand the basic principles of “property of the estate” and “abandonment” as defined by the Bankruptcy Code.1
Upon the filing of any bankruptcy case, an estate is created. Property of the estate includes, but is not limited to, all of the debtor’s legal or equitable property interests and most community property, as well as interests in property either recovered by a trustee, preserved for the benefit of the estate, or ordered transferred to the estate, such as avoidable preferences and fraudulent transfers. See 11 U.S.C. §
541 (aX1-7). In a Chapter 7 case, a trustee is appointed.2 It is the trustee’s job to review the assets of the debtor and to determine whether there are any non-exempt3 assets that can be converted to cash for the benefit of unsecured creditors. If the trustee determines there are assets that can be sold or otherwise converted to cash, those assets will be administered and the funds distributed to unsecured creditors. However, if the trustee believes there are no non-exempt assets, or that the nonexempt assets that do exist are “burdensome…or of inconsequential value and benefit to the estate,” the case will be closed as a “no asset” case. When the case is closed, all of the debtor’s scheduled property not otherwise administered by the trustee will be “abandoned” back to the debtor. See 11 U.S.C.§ 554.
Let’s take a simple example to see how this works. Assume that prior to any bankruptcy, your client sold the debtor a mobile home, received some cash and took back an unsecured promissory note for the balance.4 The debtor failed to pay, and your client sues. The debtor answers and files a cross-complaint seeking damages for repair costs he incurred based on your client’s failure to make certain disclosures. The debtor then files a Chapter 7 bankruptcy case and the automatic stay imposed by 11 U.S.C. §362 prevents your client from proceeding with the lawsuit. Unless you believe you have grounds to allege that the debt should not be discharged, e.g. because the debt was incurred by the debtor’s fraud,5 the debtor will receive a discharge of your client’s claim although your client will have a claim (albeit possibly worthless) against the bankruptcy estate. But what happens to the cross-complaint may depend on whether or not you contact the trustees.
The cross-complaint is property of the estate and should have been listed on the debtor’s personal property schedule. Therefore, since the trustee stands in the shoes of the debtor, the trustee has the right to pursue the cross-complaint. Whether or not the trustees does decide to pursue the cross-complaint will depend on whether the trustee believes that the likely recovery to the estate will outweigh the cost of pursuing it.6
Prior to the Meeting of Creditors, the trustee will have reviewed the bankruptcy documents filed by the debtor, including all property scheduled and the property claimed exempt.7 The trustee will generally ask the debtor about the cross-complaint, or any pending litigation, and will make a determination as to whether the cross-complaint (if claimed exempt) is properly claimed exempt, or if not exempt, whether it is burdensome or of inconsequential value to the estate. It is often the practice in state court litigation to file a cross-complaint for defensive reasons, and without any other information than what is gleaned from the debtor, the trustee will determine that the asset has no value to the estate. If there are no other non-exempt assets to be administered, the trustee will close the case, the cross-complaint will be abandoned back to the debtor who will then be able to proceed with the claim against your client in state court.”8
But what if you had contacted the trustee and let him/her know that your client might be willing to settle the cross complaint, as well as the claim against the estate, for a reasonable sum? 9 The trustee
is always interested your proposal will generate money for unsecured creditors in addition to an amount sufficient to pay the trustee’s administrative fees. If a deal can be negotiated, the state court litigation will be dismissed. When the bankruptcy case is closed, the cross-complaint will not be abandoned back to the debtor since it will have been administered by the trustee. You will have achieved an excellent result for your client since the price paid to the trustee to settle the case will generally be far less than the cost of defending the cross-complaint in state court if the debtor elected to again pursue the claim against your client when it was abandoned.
The foregoing hypothetical assumes a simple set of facts; however, the process of resolving state court litigation by negotiating and settling with a trustee can be used when your client is involved in complex litigation with multiple parties. For example, your client may be able to obtain possession of equipment or other real and/or personal property that secures a debt by negotiating a sale of the assets and/or a settlement of the dispute with the trustee, thereby eliminating the costs incurred in foreclosing against the property in state court. Similarly, if your client has a fraudulent transfer claim against a debtor, you may be able to negotiate with the trustee to either purchase the right to pursue the claim and/or the right to receive the recovered asset(s) or a portion thereof.10 In a case where there is a dispute as to ownership of property between your client and the debtor, your client may be able to purchase the debtor’s interest in the property from the trustee. Even in cases where there are multiple parties, it may be possible to fashion a settlement that resolves all disputes. For example, in one case, my client entered into a settlement pursuant to which he paid the trustee a small fee, paid a third party involved in the litigation a small settlement, and was then assigned the third party’s claim in the bankruptcy case, pursuant to which my client ultimately received some distribution.
It is important to understand that any settlement with the trustee or sale of estate assets must be approved by the Bankruptcy Court after notice of the settlement or sale has been given to all creditors and other parties in interest. Generally, 11 U.S.C. § 363 provides the trustee with the authority to sell property of the estate. A settlement will ordinarily be approved by the Bankruptcy Court as long as it is fair and equitable.11
Conclusion
Litigation is expensive-settlement is generally in the best interest of all parties. The debtor’s bankruptcy filing may provide you with an opportunity to achieve an excellent result for your client by resolving the pending litigation with a substantial saving of time and money.
1 Unless otherwise stated, all statute references will be to sections of Title 11 of the United States Cod, commonly referred to as the Bankruptcy Code
2 . This article has been written with Chapter 7 (liquidation) cases in mind, although some of the information may be useful in Chapter 11 (reorganization) cases where an unrelated third party has been appointed trustee.
3 Exempt Property (property a debtor is entitled to retain) is determined by state law in California. A debtor is entitled to use the exemptions set forth in either C.C.P. § 703.140 or C.C.P. § 704.010 et. acq.
4 Although you would think the seller would have secured the note (which would have made the hypothetical a bit more complex.
5 Certain debts, including but not limited to debts incurred by fraud or based on a breach of a fiduciary duty, may be excepted from discharge, Sec. 11 U.S.C. § 523(a).
6 If the trustee does pursue the cross-complaint, your client shuld seek relief from the automatic stay to proceed with the complaint against the estate only for purposes of determining your client’s claim against the estate.
7 The debtor may have some basis to exempt the cross-complaint (or certain types of lawsuits such as claims for personal bodily injury), or the proceeds derived therefrom, either in full or in part, See footnote 3.
8 Even if other assets in the case were administered by the trustee, if the cross-complaint was not sold, settled or otherwise administered by the trustee, the right to pursue it will revest in the debtor upon the close of the bankruptcy case (even if it has been more than a year since the filing).
9 An attorney I know who almost exclusively deals in state court recently had a matter arise which required obtaining information from the bankruptcy trustee. I advised him to give the trustee a call; however, he indicated that he had never had much success when he called bankruptcy trustees. This may very well be a familiar scenario with most state court attorneys. As we all know, it helps when you know the players and speak the language, in order to achieve the best results for your client, you may very well require the assistance of competent bankruptcy counsel.
10 Because there is a split of authority on whether or not a trustee can sell and/or assign his/her avoidance powers, it may be necessary to use caution in structuring any settlement. See In re P.R.T.C., Inc. (9th Cir. 1999) 177 F.3d 774 and In Briggs v. Kent (In re Professional Inv. Properties of Am.) (9th Cir. 1992) 955 F.2d 623.
11 In determining the fairness, reasonableness and adequacy of a proposed settlement agreement the court must consider: (a) The probability of success in the litigation; (b) the difficulties, if any, to be encountered in the matter of collection; (c) the complexity of the litigation involved, and the expense, inconvenience and delay necessarily attending it; (d) the paramount interest of the creditors and a proper deference to their reasonable views in the [property]. In re A & C Properties (9th Cir. 1986) 784 F.2d 1377, 1,381.
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