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The Propriety of Enhancing a Bankruptcy Criminals Sentence for Abuse of Judicial Orders or Process

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The increased emphasis in the past few years that the U.S. Department of Justice has placed on the prosecution of bankruptcy crimes has led to an increase of court cases in which district court judges have been called on to decide how the U.S. Sentencing Guidelines apply to bankruptcy fraud cases. Some of the guidelines clearly apply in almost every bankruptcy fraud case, such as the enhancement for amount of loss and, in most cases, the enhancement for defrauding more than one victim.

Whether, and to what extent, other guidelines apply is not so clear cut. One of the primary problems the courts are struggling with is whether, and when, the enhancement for abuse of judicial process or orders applies to bankruptcy crimes.

This article provides an analysis of the developing case law on the question of when the abuse of process enhancement is applicable to persons who are convicted of bankruptcy fraud offenses.

Base Offense Level

The U.S. Sentencing Commission's study of pre-guideline sentencing for fraud offenses revealed that the most significant factors that determined the length of a sentence for a fraud offense were the amount of loss to the victim and whether the crime was an isolated offense of opportunity, or was instead sophisticated and repeated.[2] Thus, these are the main factors upon which the guidelines for fraud offenses are based. Subsection 2F1.1 of the guidelines governs crimes in the nature of fraud and deceit. The base offense level for an offense involving fraud or deceit is a level 6 (0-6 months). However, this offense level for a fraud offense can rise quickly when required factors are considered.

Enhancement for Violations

The offense characteristic that has received perhaps the greatest degree of debate in bankruptcy fraud cases is the enhancement for violating a judicial order, injunction or process.

U.S.S.G. §2F1.1(b)(3)(B), which established the criteria for the enhancement, provides:

If the offense involved...violation of any judicial or administrative order, injunction, decree, or process not addressed elsewhere in the guidelines, increase by 2 levels. If the resulting level is less than level 10, increase to level 10.

Most courts that have considered whether this enhancement applies to bankruptcy offenses have ruled that, because bankruptcy is a judicial process, the enhancement applies to any scheme to defraud, or "violate," the system.

The first circuit court to consider the issue of when this enhancement should apply to bankruptcy crimes was the U.S. Court of Appeals for the 8th Circuit and its discussion was extremely brief. In United States v. Lloyd,[3] the Eighth Circuit held that a chapter 11 debtor "violated a judicial process by fraudulently concealing assets from bankruptcy court officers," and his conduct therefore warranted a two-level increase at sentencing under U.S.S.G. §2F1.1(b)(3)(B). The court concluded that "Lloyd abused the bankruptcy process and hindered the administration of the bankruptcy estate by concealing assets."[4] In a later case, the 8th Circuit rejected the argument that §2F1.1(b)(3)(B) should not apply because its use to the crime of bankruptcy fraud constitutes impermissible double counts due to the fact that lies to a bankruptcy court involve violation of a judicial process.[5]

The Seventh Circuit adopted, and expounded upon, the Lloyd analysis in United States v. Michalek.[6] Michalek was convicted of concealing more than $150,000 in artwork and other assets from the bankruptcy trustee. Along with other enhancements, he appealed the application of §2F1.1(b)(3)(B) to his base offense level. Judge Ripple's opinion for the 7th Circuit explained why the enhancement applied, even though Michalek had not disobeyed any specific court order. The court focused on the nature of bankruptcy:

A bankruptcy proceeding is not just another transitory cause of action that serves to adjudicate the rights and obligations of individuals. It is a special procedure by which the debtor seeks the protection of federal law from his creditors. In order to gain that protection, he must submit his property to the jurisdiction and active supervision of the bankruptcy court which acts through its trustee.[7]

Fraudulent representations to the bankruptcy court and its trustees is inconsistent with the demands of bankruptcy practice, noted the court, and therefore warrants the two-level increase.

The Eleventh Circuit reached a similar result in United States v. Bellew.[8] While the court concurred with the Eighth Circuit's opinion that §2F1.1(b)(3)(B) applies to the offense of concealing assets in a chapter 11 bankruptcy, it based its decision on the fact that the debtor's conduct violated a "judicial order." It did not adopt the abuse of "judicial process" rationale employed by the 8th Circuit. The Bellew court focused on the disclosure requirements mandated by the Federal Rules of Bankruptcy Procedure and the Official Forms. The court explained that bankruptcy cases are governed by the Bankruptcy Code, the Federal Rules of Bankruptcy Procedure and the Official Forms.[9] The Rules and Forms are prescribed by the U.S. Supreme Court, pursuant to 28 U.S.C. §2075, and Rule 9009 requires that the Official Forms "shall be used" in all bankruptcy proceedings. Rule 1007 and Form 6 order all debtors to file a schedule of assets and liabilities, which must be verified under penalty of perjury. The Eleventh Circuit concluded that the directions of the Federal Rules of Bankruptcy Procedures and Official Forms were "orders" within the meaning of the guidelines, and that violation of the disclosure requirements they compel deserves a two-level sentencing increase:

Black's Law Dictionary defines the word "order" as follows: "A mandate; precept; command or direction authoritatively given; rule or regulation." The mandate of the Bankruptcy Rules and Official Form that a debtor truthfully disclose assets and liabilities falls within this definition.[10]

The Court of Appeals observed that Bellew "necessarily knew he was violating the mandate when he signed the declarations."[11] Thus, it affirmed the two-level enhancement given by the district court.

The 9th and 10th Circuits have specifically announced their agreement with Lloyd and Michalek.[12] The 10th Circuit's explanation of why §2F1.1(b)(3)(B) should apply to bankruptcy crimes that do not involve violation of specific court orders is perhaps the most thoughtful:

[T]his view is in accord with the essence of the crime of conviction because it recognizes the importance of protecting the integrity of the bankruptcy system. Bankruptcy fraud undermines the whole concept of allowing a debtor to obtain protection from creditors, pay debts in accord with the debtor's ability, and thereby obtain a fresh start. When a debtor frustrates these objectives by concealing the very property which is to be utilized to achieve that purpose, the debtor works a fraud on the entirety of the proceeding. By obtaining protection from creditors and, at the same time, denying them of their lawful and equitable due, a debtor violates the spirit as well as the purpose of bankruptcy. This artifice strongly supports increasing the perpetrator's sentence for committing fraud upon the very source of financial refuge and salvation.[13]

To date, only the U.S. Court of Appeals for the 1st Circuit has rejected the Lloyd-Bellew approach.

In United States v. Shadduck,[14] the U.S. Court of Appeals for the 1st Circuit was called on to determine whether U.S.S.G. §2F1.1(b)(3)(B) applied to the crime committed by a chapter 11 debtor. Michael Shadduck and his wife, co-debtors in a chapter 11, failed to disclose in their bankruptcy schedules that they had no interest in pension plan, insurance policies and bank accounts. Mr. Shadduck repeated these lies when questioned under oath by the trustee at the First Meeting of Creditors, while Mrs. Shadduck sat silently as her husband lied about assets she knew about, namely their joint checking account. They were convicted and, at sentencing, given a two-level enhancement for violating a judicial order by flouting the disclosure requirements of the Federal Rules of Bankruptcy Procedure and Official Forms. On appeal, the 1st Circuit reversed.

Mr. Shadduck argued that the term "order" as used in §2F1.1(b)(3)(B) refers solely to a "specific order, such as a consent decree or an adjudicative order or mandate entered pursuant to judicial direction."[15] Insofar as neither side argued that such a specific order had been issued, the Circuit Court held that enhancement could not apply unless the "universal admonitions" of the Bankruptcy Rules and Official Forms are considered "judicial or administrative order[s]" within the meaning of §2F1.1(b)(3)(B). Basing its conclusion on Application Note 5, which advises that the enhancement focuses on violations of prior orders, injunctions or decrees, the court held that §2F1.1(b)(3) did not apply because the defendant did not act with a heightened mens rea to violate a prior court order.[16] The court did not reach the question of whether Shadduck's conduct violated a judicial process because it had not been preserved for appeal. It did, however, express its skepticism as to whether this argument had any more merit in its eyes than the judicial order argument.[17]

The Shadduck court misses the point. Not all bankruptcy crimes involve violation of the court-crafted rules of procedure, but some do. Any bankruptcy crime that is effectuated by a misrepresentation on the forms that a debtor or creditor is required by specific or general court order to complete would seem to fall within the ambit of this offender characteristic. However, lying at a §341 meeting, falsely testifying in court, receiving property from a debtor with the intent to defraud the estate, or fraudulently transferring or embezzling estate funds would not necessarily implicate a court order, and would not warrant the enhancement. These offenses would, however, seem to violate the bankruptcy process, an issue that the Shadduck court did not reach. If the 1st Circuit adheres to its narrow reading of this guideline, either the U.S. Sentencing Commission or the U.S. Supreme Court will have to resolve the split between the circuits.

The Shadduck court would probably agree wholeheartedly with the 7th Circuit's application of §2F1.1(b)(3)(B) to enhance a defendant's sentence for violating a court-approved cash collateral agreement. In United States v. Gunderson, the defendant was the secretary-treasurer of Gunderson Truck and Auto World (GTAW). Shortly after GTAW filed for chapter 11 relief, it entered into a cash collateral agreement with its primary secured creditor, Bank One. In order to allow the debtor to continue its business, the parties agreed that GTAW would deposit all proceeds from the sale of vehicles into its bank account, and could not use any of the proceeds unless Bank One, which had a first lien on the proceeds, consented. However, the debtor was allowed to use proceeds derived from its service and repairs business for ordinary operating expenses. Gunderson signed the agreement as secretary-treasurer and as a personal guarantor. The bankruptcy court approved the agreement in October 1991.

The chapter 11 failed within less than two months and the court ordered all assets of GTAW to be turned over to Bank One for liquidation by December 20, 1991. Before doing so, however, Gunderson used $33,400 of funds from the inventory account without the bank's permission. The court applied §2F1.1(b)(3)(B) to enhance his sentence because he violated the court-approved order.

Gunderson argued on appeal that the enhancement was really meant to apply only to recidivist behavior, such as when a defendant has had a prior warning that the conduct in which he engaged was wrongful.[18] Gunderson did not believe he had had such a warning. The 7th Circuit agreed with his logic, but not his factual argument. The court held that Gunderson had such a warning in the form of the cash collateral agreement. "It is completely rational" the court noted, "to determine that a person who defies a specific court-directed course of conduct shows a more 'aggravated criminal intent' than one who violates the general laws against fraudulent conduct."[19] Thus, the enhancement was upheld because the court concluded that violation of a judicially-approved agreement is more serious than other offenses that might fall within the scope of the bankruptcy crime statutes.

Conclusion

The foregoing analysis indicates that the violation of judicial order or process enhancement will, in most circuits, apply as a matter of course, resulting in an enhancement in sentencing. Almost certainly it apply in any situation in which the offense conduct can be determined to have violated a specific court order or judicial process.


Footnotes

[1] Coordinator, Bankruptcy Fraud Task Force, District of South Dakota; member, Bankruptcy Fraud Working Group of the Executive Office of U.S. Attorneys, U.S. Department of Justice. The views expressed in this article are solely those of the author and should not be attributed to any person associated with the author.[RETURN TO TEXT]

[2] U.S.S.G. §2F1.1, Background.[RETURN TO TEXT]

[3] 947 F.2d 339 (8th Cir. 1991).[RETURN TO TEXT]

[4]Id. At 340.[RETURN TO TEXT]

[5]United States v. Cheek, 69 F.3d 231, 232-233 (8th Cir. 1995).[RETURN TO TEXT]

[6] 54 F.3d 325 (7th Cir. 1995) (Ferguson, dissenting on application of the judicial process enhancement).[RETURN TO TEXT]

[7]Id. at 333.[RETURN TO TEXT]

[8] 35 F.3d 518 (11th Cir. 1994). The 7th Circuit had adopted the Bellew interpretation of §2F1.1(b)(3)(B), as well as the Lloyd interpretation. U.S. v. Michalek, 54 F.3d 325 (7th Cir. 1995).[RETURN TO TEXT]

[9]Id. at 520.[RETURN TO TEXT]

[10] 35 F.3d at 521.[RETURN TO TEXT]

[11]Id.[RETURN TO TEXT]

[12]United States v. Welch, 103 F.3d 906, 908 (9th Cir. 1996); United States v. Messner, 107 F.3d 1448, 1457 (10th Cir. 1997).[RETURN TO TEXT]

[13] 107 F.3d at 1457.[RETURN TO TEXT]

[14] 112 F.2d 523 (1st Cir. 1997).[RETURN TO TEXT]

[15] 112 F.2d at 529.[RETURN TO TEXT]

[16] 112 F.3d at 529-530.[RETURN TO TEXT]

[17] In dicta, a panel of the 2nd Circuit has also questioned the Lloyd-Bellew analysis. See United States v. Carrozzella, 105 F.3d 795, 799-802 (2nd Cir. 1997) (declining to apply enhancement to fraud connected to probate proceedings).[RETURN TO TEXT]

[18] 55 F.3d at 1332-1333. He based this argument on Note 5 and the commentary to U.S.S.G. §2F1.1.[RETURN TO TEXT]

[19]Id. at 1333.[RETURN TO TEXT]

Journal Date: 
Monday, September 1, 1997

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