Summer 2019 • Issue 66, page 1

Recent Developments in Business Bankruptcy 2018 (Part 2)

By Johnson, Honorable Stephen & Hayes, Jennifer & Katz, Ori*

Property of the Estate, Claims, and Priorities / Exemptions
Validity of homestead exemption is controlled by California law

In re Gilman, 877 F.3d 956 (9th Cir. 2018).

Creditor contended debtor’s real property did not qualify for homestead because it was in contract for sale when bankruptcy case was filed. Creditor argued property held in trust, as it alleged this property was pending the sale, could not qualify for exemption. California has opted out of the federal exemption scheme so state law provisions control. The Bankruptcy Court determines the merits of claimed state exemptions by interpreting state law. Citing California case law, the court rejected creditor’s argument that title is necessary to claim a homestead exemption. However, because the Bankruptcy Court did not make findings on whether debtor intended to continue to live in the property, which is an element of a homestead exemption, the Ninth Circuit remanded for consideration of that issue.

Judgment creditor’s restitution claim was disallowed on the basis of issue preclusion because creditor raised it as a defense in an avoidable transfer action by the trustee and lost.
Matter of Maui Industrial Loan & Finance Co., 580 B.R. 886 (D. Haw. 2018).

Debtor operated a Ponzi scheme. Prepetition, judgment creditor purchased 40% of the stock in Debtor and later entered into a stock repurchase agreement. Debtor defaulted on the agreement and judgment creditor obtained a state court judgment. Debtor then filed a chapter 7 case. Judgment creditor filed a proof of claim for about $2 million. Trustee successfully sued judgment creditor to recover the amounts paid under the stock repurchase agreement as avoidable transfers. Trustee then objected to the claim on the basis of issue preclusion contending the same issues were decided in the avoidable transfer action. The Bankruptcy Court disallowed the claim and the District Court affirmed. It held the “issue” of creditor’s restitution claim, which creditor had asserted as an affirmative defense, was litigated and determined in the adversary proceeding. Thus, in awarding judgment to the trustee, the Bankruptcy Court had necessarily decided that creditor did not have a restitution claim.

Debtor’s former executive was not automatically entitled to a pro-rated portion of his contractual salary as an administrative expense claim.
In re Cook Inlet Energy LLC, 583 B.R. 494 (B.A.P. 9th Cir. 2018).

Chapter 11 debtor’s executive chairman, who was not paid his post-petition compensation by debtor, filed a request for administrative expense for over $250,000 based on his pro-rated salary from petition date to date of rejection of his employment contract. After a trial, the Bankruptcy Court reduced the amount awarded to $15,000. The claimant appealed. The BAP affirmed.

The case addresses the evidentiary weight to be accorded a claim for administrative expenses. The claimant here argued this his claim was entitled to a presumption of reasonableness because his postpetition salary was calculated based on his later-rejected employment contract. The BAP held that the contract price for services in a rejected employment contract is not presumptive of the value of the services rendered. Administrative claims, like the claimant’s here, are subject to careful scrutiny, consistent with preserving the estate for distribution to creditors. The burden of proving an administrative expense rests with the claimant. The contract rate was only probative of the reasonable value of services and no presumption attached to it. The Bankruptcy Court’s determination of the reasonable value of those services was not incorrect.

Whether claimant’s right to payment of severance benefits vested outside the 180-day period established by § 507(a)(4) is a question of federal, not state law.
In re Golden Gate Community Health, 577 B.R. 567 (Bankr. N.D. Cal. 2017).

Planned Parenthood’s former president and CEO filed a claim for, inter alia, severance benefits. The claim was based on a contract entered into eleven years prepetition and modified “in or about June to September 15, 2010,” such that eight months of severance was due during the 180-day § 507(a)(4) priority period that began on September 1, 2010 (i.e. 180 days prior to the cessation of business operations). In a prepetition state-court lawsuit filed by claimant, she alleged that she became entitled to receive her severance benefit and made a written demand on Debtor to make payment on March 26, 2010. Thus, claimant had acknowledged in litigation that her right to payment vested in March 2010. The subsequent modification of her severance agreement to change payment terms did not change that vesting date. Therefore, no amount of the claim was entitled to priority payment. The Court denied the request of Trustee’s counsel for attorney fees. The claim objection was an interpretation of bankruptcy law not a determination of the enforceability of the employment agreement.

Debtor’s obligation to state for quarterly fees was a fee and not a tax entitled to administrative priority. Even if a tax, the obligation arose prepetition and therefore was not entitled to administrative priority.
In re Gardens Regional Hospital and Medical Center, Inc., 573 B.R. 811 (Bankr. C.D. Cal. 2017).

The Court examined whether quarterly Hospital Quality Assurance fees owing by hospitals under a California state statute (Medi-Cal Hospital Reimbursement Improvement Act of 2013 (the “Act”)) were a “fee” or a “tax”. The answer turned on whether the HQA “exactions” were imposed for a public purpose. If so, they were a tax entitled to administrative priority. The purpose of the HQA exactions was to strengthen hospitals’ balance sheets and not to benefit the public at large. The legislative history showed that the Act’s purpose is to increase the total funding available to California hospitals. Provisions in the Act reinforce its purpose of supporting the hospital industry (e.g. the California state agency is required to “work in consultation with the hospital community to implement” the Act’s provisions.) The Court found that, although the question was close, hospitals received the preponderance of the benefit of the HQA exactions, so they should be classified as fees and not taxes Even if the exaction were a tax, however, it arose prepetition because the State could fairly contemplate its claim prepetition even though it didn’t know the exact amount.

Excise taxes are not entitled to priority treatment if they came due before the statutory look back period of § 507(a)(8).
In re USA Sales, Inc., 580 B.R. 852 (Bankr. C.D. Cal. 2018).

Debtor operated a cigarette distribution business. Under California law, it was required to pay excise taxes for cigarettes sold and to file a monthly report of sales. Debtor filed the reports for 2007 and 2008. The State Board of Equalization audited these reports and determined that Debtor had underpaid its cigarette taxes by $1.26 million. Debtor timely filed a petition for redetermination. At the time of the bankruptcy filing, SBOE’s audit division had not finished its work. Five days after the petition, it issued a decision essentially remanding the matter back to the SBOE for further determination. In 2016, SBOE filed a proof of claim seeking $1.5 million, to which debtor filed an objection, contending they were not entitled to priority treatment under 11 U.S.C. § 507(a)(8)(E) because they were “old taxes”.

The decision turns on the Bankruptcy Court’s interpretation of several different aspects of § 507(a)(8). First, the Bankruptcy Court determined that the taxes were excise taxes because they were imposed based on the performance of an act, the distribution of cigarettes. Second, it found that the “transaction” giving rise to the taxes was not the final decision on the appeal, as SBOE contended, but Debtor’s distribution of cigarettes, as reflected in its monthly tax reports. Finally, the court also examined SBOE’s argument that the so-called “flush language” of § 507(a)(8), which tolls the running of the priority period under “for any period during which a governmental unit is prohibited from collecting a tax as a result of request by a debtor for a hearing and an appeal of any collection action . . . .” It found this section did not apply to the cigarette taxes based on express provisions of California law. The California Revenue and Taxation Code provides that a collection of taxes is abated while an appeal is pending. Debtor only requested a hearing on its liability for taxes, not on the collection of those taxes. Thus, on its face, the “flush language,” did not apply.

Debtor’s lack of knowledge that she had a prepetition claim did not prevent the cause of action from becoming property of the estate.
In re Carroll, 586 B.R. 775 (Bankr. E.D. Cal. 2018).

Debtor filed a chapter 7 case and received her discharge in 2009. Debtor was part of a class action recovery on a product liability claim in 2015. She received an award of $240,000 for damages stemming from a medical device implanted in 2003 which was not scheduled in the bankruptcy case. Debtor argued that she did not know of any legal claim available to her until 2014 so her claim did not accrue until 2014.

Section 541 defines property of the estate as including all legal interests existing at the commencement of case, regardless of whether a debtor is aware of such interests. A legal interest exists when all elements for a cause of action are present. The court concluded that all the elements for a product liability action under California law were present in the mid-2000’s and debtor had a prepetition claim, regardless of whether she realized it. Debtor’s arguments regarding the delayed discovery rule under California law addressed that question of the statute of limitations on an action and did not affect the conclusion that the recovery was property of the estate under § 541.

An account receivable is subject to turnover under § 542(b), and not § 542(a).
Pringle v. Facility Services of America, Inc. (In re Southern Pacific Janitorial Group), 586 B.R. 769 (Bankr. C.D. Cal. 2018)

The trustee sought turnover of an account receivable under § 542(a). The court denied the motion with prejudice. In so doing, the court held that § 542(a) did not apply to an account receivable because, while the account is property of the estate, it is not property that may be used, sold or leased under § 363. The court noted that accounts receivable are the type of property subject to a demand under § 542(b) – requiring an entity that owes a debt that is matured and not subject to dispute or offset to pay it to the trustee. In this case, the trustee had not proceeded under that section.

Stripped off lien resulted in unsecured claim that was discharged in chapter 7 case. Debtor could not avoid paying that unsecured claim when she filed a later chapter 13 case.
In re Washington, 587 B.R. 349 (Bankr. C.D. Cal. 2018).

Debtor filed a chapter 7 case and obtained a discharge of her personal liability on promissory notes. She later filed a chapter 13 case and a motion to value her real property under § 506(a). Normally, this results in a bifurcation of the mortgage lender’s claim into secured and unsecured claims. The property’s value was low enough that the secured creditor’s claim was wholly unsecured. Debtor argued that by virtue of her discharge in her chapter 7 case, she was not required to pay anything to the creditor. The Bankruptcy Court disagreed and held that a party cannot use “chapter 20” to avoid the obligation to pay the unsecured claim notwithstanding the discharge because the unsecured claim resulting from the lien strip is against the estate, not Debtor personally.

Part 3 of Recent Developments continued in RN#67.

*Judge Stephen L. Johnson was appointed to the bench in the Northern District of California by the Ninth Circuit Court of Appeals in 2010.

*Jennifer C. Hayes is a partner of Finestone Hayes LLP, a San Francisco law firm specializing in insolvency law, bankruptcy law, and business disputes. Prior to her current firm, Ms. Hayes was a partner at the international law firm, Dentons.

*Ori Katz is a partner in the Finance and Bankruptcy practice group in the San Francisco office of Sheppard, Mullin, Richter & Hampton LLP, where he is also the Co-Office Managing Partner. He specializes in business bankruptcies and other aspects of insolvency law.