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A Commercial Boomerang: Why Lenders Need to Check Their Contracts Twice

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The recent Eleventh Circuit decision of Cadle Co. v. Martinez (In re Martinez), No. 04-11760 (11th Cir. July 13, 2005), serves as a warning to commercial lenders: Attorneys' fee clauses in lending contracts may come back to bite you in the debtor's bankruptcy. In Martinez, the debtor borrowed $50,000 from a bank and executed a Business Note and Security Agreement. After entering bankruptcy, the debtor sought a discharge of the commercial loan. Cadle Co. acquired the debtor's promissory note on the loan and filed an adversary proceeding in the bankruptcy case objecting to the dischargeability of the debt under 11 U.S.C. §§523(a)(2) and (6) because the debtor made oral and written misrepresentations in obtaining the loan—namely, the debtor represented that the loan was intended for his business, but instead he shifted the proceeds to his brother. The bankruptcy court granted summary judgment in favor of the debtor on the §523(a)(6) claim and held a full trial with regard to the §523(a)(2) claim. The bankruptcy court ultimately concluded that the lender failed to prove that the debtor made any false misrepresentations upon which the lender relied. The debtor then moved for attorney's fees and costs, which the bankruptcy court granted.

 

Cadle appealed the award of attorney's fees to the district court, which reversed the bankruptcy court's decision. The focal issue was a clause in the security agreement that provided for attorneys' fees and legal expenses incurred by the lender in connection with the enforcement of the contract. Under the contract, that included fees and costs associated with bankruptcy proceedings. Although such a clause would seem a nullity in the event that the lender lost any contract enforcement action, Florida law, which governed the contract, guarantees that contractual provisions for attorneys' fees cannot be one-sided.1 The reciprocal provision essentially allows for fee-shifting, giving a court the discretion to award attorneys' fees to the other party when that party prevails in any action with respect to the contract.2 The statute makes no distinction between plaintiff and defendant. Rather, the focus is on the prevailing party.

In reversing the award of attorneys' fees, the district court relied primarily on In re Sheridan.3 Although a Seventh Circuit case, Sheridan concerned a Florida commercial lending contract and squarely addressed whether the Florida statute providing for reciprocal attorney's fees applied to a prevailing debtor in a dischargeability action in bankruptcy. The Sheridan court explained that the "American Rule" prevents a prevailing litigant from collecting a reasonable attorney's fee from his opponent "unless authorized by federal statute or an enforceable contract between the parties."4 By extension, then, the American Rule applied equally to litigation in bankruptcy courts. As a result, the only statutory authorization for an award of attorneys' fees in connection with a dischargeability proceeding under §523(a)(2) is provided by §523(d), and only applies in cases concerning consumer—not commercial—debt.5

The parties in both Sheridan and Martinez agreed that the debt was commercial in nature, effectively rendering the fee provision in §523(d) useless, requiring the prevailing debtor to focus on the underlying contract for any recovery. In Sheridan, as in Martinez, the underlying contract contained a provision for attorneys' fees to the creditor, but lacked one for the debtor. The debtor turned to the Florida reciprocity statute. Sheridan flatly rejected the application of state law to the contract.6 Sheridan recharacterized the issue as being one of choice of law, and concluded that the nondischargeability question still is "a matter of federal law governed by the terms of the Bankruptcy Code."7 Thus, despite the fact that the validity of a contract claim may be governed by state law, federal law supplants the relevant reciprocity statute, and a dischargeability action does not "qualify as one with respect to the contract under the Florida statute."8 In giving the Code a strict, literal reading, Sheridan noted that Congress only intended one instance in which a prevailing debtor may recover the fees incurred in a dischargeability action: where the creditor's challenge to the dischargeability of a consumer debt was not substantially justified, under §523(d).9 Where §523(d) has no applicability, then, a court has no authority to award fees to a prevailing debtor.

With that as the backdrop, the district court in Martinez reversed the fee award, and reinforced lenders' confidences that a plain reading of §523 (d) of the Code would prevent any fee-shifting in commercial dischargeability disputes. Of course, that buoyancy was only temporary because the Eleventh Circuit, in direct opposition with the Seventh Circuit, reversed the district court, holding the reciprocal fee statute to be applicable to a dischargeability proceeding.10 In bucking the trend, Martinez found Sheridan's dissent persuasive.11 In drawing a parallel to prior circuit precedent, Martinez observed that when a creditor successfully opposes the dischargeability of a debt, it may recover attorneys' fees when such fees are provided for by an enforceable contract between the creditor and debtor.12 When a creditor prevailed in a bankruptcy action, then attorney's fees associated with that action were included within the concept of the nondischargeable debt to be paid by the debtor. By analogy, the court reasoned, the converse must be true; "the debtor's rights should be no different" regardless of whether the result is as "neat a solution as would pertain if the creditor prevailed."13 In eschewing the Sheridan majority, Martinez turned to policy to rationalize its decision, lamenting that "[t]o deny a debtor attorney's fees and costs for prevailing in a dischargeability proceeding brought by a creditor...would contravene the primary purpose of the bankruptcy statute, which is to relieve the honest debtor from the weight of oppressive indebtedness and permit him to start afresh."14

The Effect

While it may seem that Sheridan and Martinez might be limited to their facts in that both address the applicability of the Florida reciprocal fee statute, the contrasting decisions have a more pervasive effect. Many other states have similar or even identical provisions, and contracts themselves contain mutual remedies.15 Prior to Martinez, the state of law in the context of attorneys' fees associated with dischargeability actions generally allowed a creditor to recover attorneys' fees if that creditor had a valid contractual right to attorneys' fees under state law. Recoverable fees included those associated with the litigation of a §523 claim.16 Given that a successful creditor has no statutory right to attorneys' fees similar to §523(d), it might be said, then, that a commercial lender's only vehicle for recovery of post-petition attorneys' fees is when a contract right is enforceable under state law.17 This notion, however, has not received absolute acceptance. The Ninth Circuit denied attorneys' fees to the successful creditor, even with the presence of the token contract clause and applicable reciprocal fee statute.18

Regardless of whether the creditor could recover attorneys' fees as part of dischargeability proceedings, prior to Martinez it at least seemed settled that an unsuccessful creditor would not be liable to the debtor for attorneys' fees and costs. The Sheridan majority perhaps best enunciates why this is—or was—so. Although the opinion conceded that the validity of a creditor's claim is assessed by looking to the relevant state law rules, "the alleged nondischargeability of that debt presents an issue of federal law independent of issue of the validity of the underlying claim."19 As a fundamental precept, a dischargeability action is the exclusive creation of federal bankruptcy law. State law can neither interfere with nor preempt the federal laws governing such actions.20 Therefore, a dischargeability proceeding does not concern the formation or enforcement of a contract. Rather, it relates to only the validity of the debt itself, and Sheridan drove a hard wedge between the contract and the dischargeability of the debt. Because the dischargeability of the debt is "a matter of federal law," the American Rule prevails.21 Absent a fee-shifting statute, lenders could find some sense of security in bringing dischargeability actions, even if the litigation was unsuccessful.

Martinez debunked this logic. It did not see the distinct compartmentalization of the underlying contract and the dischargeability of that contract. To the contrary, Martinez appears to hold that the two issues are simply not severable—that from the outset, dischargeability and validity are inextricably linked. Moreover, Martinez seemed to characterize its decision as an equitable one, whereby attorneys' fees should equally apply to debtors who successfully defend dischargeability actions as it does to creditors that successfully prosecute them. But does this syllogism run afoul? Sheridan seems to make sense in the context that it would be stretching the principles of bankruptcy law to conclude that attorneys' fees should apply "to debtors in litigation that is not a civil suit in the orthodox sense, but merely a determination of dischargeability, vel non, of a debt...in which the only provision which permits the award of attorneys' fees to a debtor is pursuant to §523(d)."22 Indeed, a statute providing the mutuality of remedy provisions is an inherently civil remedy to level the bargaining field between lenders and loan recipients. Bankruptcy, on the other hand, is an entirely separate occurrence, generally not brought upon by the contract or the lender.

The Ninth Circuit agrees that this is the better approach. Where a contract or statute provides for an award of attorneys' fees, a creditor may be entitled to such fees in bankruptcy proceedings and the award is governed by state law.23 Where the litigated issues, however, "involve not basic contract enforcement questions but issues peculiar to federal bankruptcy law, attorney's fees will not be awarded absent bad faith or harassment by the losing party."24 Attorney's fees are not recoverable by any prevailing party—plaintiff and defendant alike.

This begs the question of where a commercial lender now stands on the matter. In jurisdictions that have reciprocal fee statutes (including California, Connecticut, Florida, Montana, Oregon, Washington and Utah) or fee-shifting implied at common law, Martinez makes lenders vulnerable for loss beyond the dischargeability of the contract itself. In effect, it creates risk and exposure and produces increased litigation expenses when the dischargeability dispute morphs into a wrangle over attorney's fees. Moreover, with Martinez in their pocket, debtors can use a §523 action to their benefit, particularly under the new bankruptcy scheme. The additional demands and obligations placed on debtors under the new Code increase the debtor's financial burdens. In turn, debtors will seek out any available opportunity to shift costs and recover any funds in order to satisfy the new requirements of the Code.

This increased litigation results in a pecuniary loss to lenders beyond the potential discharge of the debt. Debtors, on the other hand, now have an alternative source of recovery in Martinez that allows them to tap additional sources to fund their bankruptcy. Prior to Martinez, if consumer creditors brought a dischargeability action, they had to be leery of §523(d) of the Code. In contrast, commercial lenders could bring an action under §523(a)(2)(B), without the repercussions of cost liability. Martinez cuts through this safety net. Commercial lenders must now be cautious about any dischargeability action because of the amplified liabilities. The consequence may be that lenders forego legitimate disputes in favor of limited exposure.


Footnotes

1 Fla. Stat. §57.105(7) (2005). Return to article

2 Id. In pertinent part, the statute provides:

If a contract contains a provision allowing attorney's fees to a party when he or she is required to take any action to enforce the contract, the court may also allow reasonable attorney's fees to the other party when that party prevails in any action, whether as plaintiff or defendant, with respect to the contract. This subsection applies to any contract entered into on or after Oct. 1, 1988. Return to article

3 105 F.3d 1164 (7th Cir. 1997), pet. for reh'g. denied, 1997 U.S. APP. LEXIS 4736 (7th Cir. March 12, 1997). Return to article

4 105 F.3d at 1166. Return to article

5 Id. Return to article

6 Id. at 1167. Return to article

7 Id. (internal quotations omitted). Return to article

8 Id. Return to article

9 Id. Return to article

10 In re Martinez, ___ F.3d ___, 2005 WL 1630811 (11th Cir.). Return to article

11 Id. at *3. Return to article

12 Id. at *2 (citing TranSouth Fin. Corp. v. Johnson, 931 F.2d 1505, 1509 (11th Cir. 1991)). Return to article

13 Sheridan, 105 F.3d at 1169 (Cudahy, J., dissenting). Return to article

14 Martinez, at *4 (internal quotations omitted). Return to article

15 See, generally, Cal. Civ. Code §1717 (2005); Conn. Gen. Stat. §42-150bb (2005); Fla. Stat. §57.105(7) (2005); Mont. Code Ann. §28-3-704 (2005); Or. Rev. Stat. §20.096; Utah Code Ann. §78-27-56.5 (2005); Wash. Rev. Code §4.84.330 (2005). Return to article

16 In re Martin, 761 F.2d 1163, 1168 (6th Cir. 1985); In re Johnson, 756 F.2d 738 (9th Cir. 1985) (denying prevailing debtor attorney's fees after relief from stay action, despite fee provision in contract and state statute that shifted fees to prevailing party); Matter of Young, 995 F.2d 547, 549-50 (5th Cir. 1993) (denied dischargeability of debt under §523(a)(2)(B) and awarded attorney's fees to creditor as provided for by an indemnity agreement). Return to article

17 Matter of Luce, 960 F.2d 1277 (5th Cir. 1992). Return to article

18 In re Hashemi, 104 F.3d 1122, 1126 (9th Cir. 1996). Return to article

19 Sheridan, 105 F.3d at 1167. Return to article

20 Id. Return to article

21 Id. Return to article

22 In re Maestrelli, 172 B.R. 368, 371 (Bankr. M.D. Fla. 1994). Return to article

23 In re Coast Trading Co., 744 F.2d 686, 693 (9th Cir.1984); In re Sparkman, 703 F.2d 1097, 1099 (9th Cir. 1983). Return to article

24 In re Fobian, 951 F.2d 1149, 1153 (9th Cir. 1991); see, also, In re Coast Trading, 744 F.2d 686, 693 (9th Cir. 1984) (refusing to award fees where creditor brought a nondischargeability action); In re Fulwiler, 624 F.2d 908, 910 (9th Cir. 1980) (refusing to award fees for creditor's action under §546). Return to article

Journal Date: 
Thursday, September 1, 2005

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