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Benchnotes Feb 1999

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Disqualification and Disgorgement

In In re Angelika Films 57th Inc., 227 B.R. 29 (Bankr. S.D.N.Y. 1998), Bankruptcy Judge Arthur J. Gonzalez gives a good refresher course on chapter 11 counsel's "disinterestedness," disqualfication, allowance of fees and the continuing risk of disqualification. The court concluded that even if counsel qualified as debtor's counsel at the beginning of the case, it lost that status when it took actions post-petition that the court found were more to benefit and protect the debtor's sole principal than to benefit the debtor. Counsel's request for compensation and reimbursement of expenses as counsel to debtor and debtor-in-possession was denied and counsel was directed to disgorge the $22,000 retainer it had received from a third party.

Obtaining Proper Service

Even in bankruptcy, valid service of process is a prerequisite to the court's assertion of personal jurisdiction over a defendant. In In re Blutrich Herman & Miller, 227 B.R. 53 (Bankr. S.D.N.Y. 1998), the bankruptcy court found that the petitioning partner in an involuntary case failed to serve the summons and a copy of the involuntary chapter 7 petition on the debtor partnership or on the other partners of the debtor. Although an order for relief had been entered, the court found that this failure to obtain proper service, as a prerequisite to the court's exercise of personal jurisdiction over the debtor partnership, rendered the entry of the order for relief invalid. The court, sua sponte, vacated the entry of the order for relief, determining that it should not have been entered in the first place, and entered an order dismissing the involuntary case.

Retention of Collateral

In In re Sokolowski, 227 B.R. 16 (Bankr. D. Conn. 1998), the debtor filed a chapter 7 petition and obtained an uncontested discharge. The trustee filed a report of no distribution and the case was closed. The debtor owned an automobile subject to a lien that secured a retail installment contract. The trustee did not administer the automobile as an asset of the case. At all times relevant to the proceedings, the debtor was current in her monthly payments and had maintained adequate insurance coverage. The retail installment contract contained a default provision providing that the filing of bankruptcy would be an "event of default." When the bank attempted to repossess the automobile based apparently only upon the default related to the debtor's bankruptcy, the debtor filed a motion to reopen the case and filed an adversary proceeding for declaratory judgment and injunction to prevent the bank from repossessing the automobile. As the court framed the issue, "The issue in this matter is the enforceability, after a debtor's chapter 7 case has closed, of two clauses in a retail installment contract..., secured by the debtor's automobile, providing that a bankruptcy filing by the buyer is an event of default permitting repossession of the automobile." The opinion sets forth a number of cases on both sides of the issue and concludes that the bank may not enforce the default clause based upon the debtor's bankruptcy filing as an event of default. In doing so, the court depended on the decision in In re Boodrow, 126 F.3d 43 (2nd Cir. 1997), cert. denied, 118 S.Ct. 1055 (1998) which in turn cited Joann Henderson, The Gaglia-Lowry Brief: A Quantum Leap from Strip Down to Chapter 7, 8 Bankr. Dev. J. 131, 137 (1991), who wrote as follows: "[Reinstatement is] the debtor's right to retain the collateral by continuing regular payments under the security agreement and thereby completing the contract, albeit a somewhat different contract because any personal obligation has been discharged. To qualify for reinstatement, debtors cannot be in default, except for technical defaults such as bankruptcy clause defaults, and must pay the entire debt in accordance with the contract."

First Amendment Rights

In In re Dow Corning Corp., 227 B.R. 111 (Bankr. E.D. Mich. 1998), the Official Committee of Unsecured Creditors filed an emergency motion "for an Order Establishing Procedures With Respect to Any Media Campaign Launched Prior to the Approval of a Disclosure Statement with Respect to a Plan of Reorganization to be Filed by the Debtor and/or the Tort Claimants Committee" seeking an order of the court placing limits on the debtors and the Tort Claimants Committee's ability to publicize their Joint Plan of Reorganization prior to the court's approval of the Disclosure Statement regarding the plan. The court denied the motion, analyzing the issue as one impacting First Amendment rights as well as the Disclosure Statement process, securities law implications and equitable considerations. The court concluded that "When it comes to placing prior restraints on speech, we believe that courts should proceed with great hesitancy. And after considering all of the evidence, courts should hesitate again. Assuming that proponents' proposed communication is commercial speech, and assuming that this speech may later be found to be a solicitation, sufficient remedies are available post-hoc in the bankruptcy context to correct any harm that may have been caused."

Treatment of S Corporation Debtor

In In re Bakersfield Westar Inc., 226 B.R. 227 (Bankr. 9th Cir. 1998), the Ninth Circuit Bankruptcy Appellate Panel (BAP) reversed the bankruptcy court and held that the corporate debtor's pre-petition right to make or revoke its election to be treated as a subchapter S corporation for federal income tax purposes constituted "property," or an "interest of the debtor in property," within the meaning of 11 U.S.C. §541(a). Thus, the shareholders' pre-petition revocation of the chapter 7 debtor corporation's subchapter S status was a fraudulent transfer under 11 U.S.C. §548(a). The liquidation of the corporation's assets would result in a capital gains tax liability. With the subchapter S election in place, the tax liability would pass through to the shareholders. The filing by the shareholders with the Internal Revenue Service of the appropriate statement of revocation assured that the tax liability would be with in the chapter 7 debtor corporation. The result of the revocation of the subchapter S status was a shifting of responsibility for capital gains taxes that arose from the sale of the debtor's assets from the shareholders by virtue of the pass-through resulting from the subchapter S status to the debtor, as a result of the revocation of that subchapter S status. However, the court found that the corporation/debtor did not receive reasonably equivalent value for the transfer of this "asset" or "property" (that is, the subchapter S status), and the revocation resulted in a fraudulent transfer that could be avoided so as to preserve the benefit to the corporate debtor's estate of the "pass through" status of a subchapter S corporation.

Recoupment vs. Setoff

In Matter of Kosadnar, 157 F.3d 1011 (5th Cir. 1998), the Fifth Circuit reviewed the question of recoupment versus setoff arising out of an insurance company's withholding insurance agent/debtor's post-petition pay amounts to cover pre-petition overpayments to the agent. Finding that the overpayments arose from the same transaction as the debtor/agent's pay, the Fifth Circuit found that the recovery out of the post-petition pay constitutes a recoupment rather than a setoff and is permitted. Since post-petition recoupment does not violate the automatic stay, the Fifth Circuit held that the bankruptcy court and the district court were "correct in declining to hold [the insurance company] in contempt of court for violating the automatic stay" by accomplishing the post-petition recoupment from the post-petition pay to the debtor/agent.

"Known" and "Unknown" Creditors

In In re Union Hosp. Ass'n of Bronx, 226 B.R. 134 (Bankr. S.D.N.Y. 1998), the debtor ("a recidivist chapter 11 debtor") sought to expunge from its "current" bankruptcy case an administrative claim asserted by three parties. The claim was based upon contribution or indemnity arising out of two tort actions that predated the first bankruptcy petition and that had not been asserted against the debtor in the non-bankruptcy forum prior to the last date to file proofs of claim in either chapter 11 case. The court held that the claimants were "unknown creditors" of the first bankruptcy case and that the publication notice provided by the debtor in the first bankruptcy case was adequate for purposes of providing constitutional notice to "unknown creditors." The first case resulted in a confirmed plan effectively discharging the debtor from its unsecured claims. The motion to expunge the claim was granted. The opinion provides a good refresher course on the concepts of due process notice in bankruptcy and "known" and "unknown" creditors.


  • In re DePasquale, 225 B.R. 830 (Bankr. 1st Cir. 1998) (if qualified institution or agency provides funds, credit or financial accommodations to debtor for educational purposes under contemporaneous, mutual understanding of future repayment, arrangement may be a "loan" within the discharge exception, even if funds were not actually advanced);
  • In re CRS Steam Inc., 225 B.R. 833 (Bankr. D. Mass. 1998) (the debtor's pre-petition, court-ordered assignments of patents to judgment creditor asserting an alleged constructive trust constituted a transfer of a beneficial property interest for preference avoidance purposes, and is a transfer on account of an antecedent debt);
  • In re Steslow, 225 B.R. 883 (Bankr. E.D. Pa. 1998) (inclusion of security interest in tax and insurance escrow permits modification of first mortgage lien in a chapter 13);
  • In re Metal Brokers Intern. Inc., 225 B.R. 920 (Bankr. E.D. Wis. 1998) (creditor/assignee lacks standing to assert chapter 7's trustee's avoidance powers where proposed transferee/defendant had not been given notice of a proposed assignment and thus could not be denied the right to challenge the creditor's standing without depriving him of his due process rights); and
  • In re Reed, 226 B.R. 1 (Bankr. W.D. Ky. 1998) (while the determination of what constitutes a prompt cure for purposes of §365(b)(1) must be determined on a case-by-case basis, six months would be considered a baseline maximum time permissible in which to cure a lease arrearage for a consumer automobile lease).
  • In re Steaks to Go Inc., 226 B.R. 35 (Bankr. E.D. Mo. 1998) (covenants not to compete contained within franchise agreements remained enforceable following debtor/franchisee's rejection of agreements).

Journal Date: 
Monday, February 1, 1999

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