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Malpractice Claims Arising Before Chapter 7 Conversion Belong to Bankruptcy Estate

By: Anna Chen

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

 

            In Cantu v. Schmidt (In Re Cantu), the Court of Appeals for the Fifth Circuit held that malpractice claims that arise during chapter 11 reorganization but before chapter 7 liquidation belong to the bankruptcy estate.[1]  In Cantu, the debtors, the Cantus, filed for chapter 11 bankruptcy.[2]  The debtors hired an attorney, Ellen Stone, to represent them in the bankruptcy case.[3]  Upon the request of a group of creditors, the bankruptcy court converted the debtors’ chapter 11 case to chapter 7 and a trustee was appointed.[4]  Following conversion, the creditors filed a complaint seeking a judgment declaring that the debtors’ debts were not dischargeable.  After a two-day trial, the bankruptcy court determined that the debtors’ debts would not be discharged.[5]  The court pointed out a number of “omissions, misstatements, and controversies” that plagued the chapter 11 bankruptcy, such as the Cantus’ failure to disclose significant assets and transactions, an improper transfer of $50,000 of what would have been estate property to a close friend during the bankruptcy case, and the Cantus’ lack of cooperation with the court and trustee.[6]  A few years later, the Cantus hired an attorney to investigate a possible legal malpractice claim against Stone for her representation during the Cantus’ bankruptcy.[7]  The trustee informed the new counsel that he believed the claims against Stone were “property of the estate and under the trustee’s sole authority to prosecute.”[8]  The bankruptcy court agreed with the trustee and authorized him to investigate the legal malpractice claims.[9]  After conducting his investigation, the trustee filed a malpractice suit against Stone in state court.[10]  After removal to federal court, Stone and the trustee settled for $281,710.54.[11]  The district court referred the case to the bankruptcy court to determine whether the settlement proceeds belonged to the debtors or the bankruptcy estate.[12]  The bankruptcy court held that the settlement proceeds belonged to the estate.[13]  On appeal, the district court and the Fifth Circuit affirmed the bankruptcy court’s decision, holding that the proceeds belonged to the debtors’ estate.[14]

            Under section 541(a)(1), property of a chapter 11 bankruptcy estate includes “all legal or equitable interests of the debt in property as of the commencement of the case,”[15] including “causes of action.”[16]  Section 1115(a)(1) of the Bankruptcy Code provides that “property” in section 541 includes “all property of the kind specified in section 541 that the debtor acquires after the commencement of the case but before the case…is converted to a case under Chapter 7.”[17]  Reading these two sections of the Code together leads to the conclusion that once a chapter 11 case is commenced and before it is converted to a chapter 7, all of the debtor’s existing and any newly-acquired property belong to the bankruptcy estate.  Thus, causes of action that belong to the debtor “at the time the case is commenced” or that are acquired after commencement of the case but before conversion are property of the estate.[18]           

            This case is significant because it implicates the rights of parties to a bankruptcy case in the context of legal malpractice.  The timing of the legal malpractice is significant.  Whether a party’s legal rights will be limited or expanded will depend on the timing of events.  If malpractice occurs before liquidation, the malpractice claim, and the proceeds flowing from it, belongs to the estate.  In this situation, the estate is expanded to include any legal claims against the bankruptcy attorney who commits fraud, misrepresentation, or any other kind of malpractice that is injurious to the value of the estate.  But if the malpractice arises during or after liquidation, such claims and proceeds belong to the debtors.[19]   

 



[1] Cantu v. Schmidt (In re Cantu), 784 F.3d 253 (5th Cir. 2015).

[2] Id. at 255.

[3] Id. at 256.

[4] Id.

[5] Id.

[6] Id.

[7] Id. at 256–57.

[8] Id. at 257.

[9] Id.

[10] Id.

[11] Id.

[12] Id.

[13] Id.

[14] Id. at 263.

[15] 11 U.S.C. § 541(a)(1) (2012).

[16] See Yaquinto v. Segerstrom (In re Segerstrom), 247 F.3d 218, 223–24 (5th Cir. 2001) (“The reference to all ‘legal or equitable interests’ includes any ‘causes of action belonging to the debtor at the time the case is commenced.’”)

[17] 11 U.S.C. § 1115(a)(1).

[18] See In re Segerstrom, 247 F.3d at 223–24; Torch Liquidating Trust v. Stockstill, 561 F.3d 377, 386 (5th Cir. 2009) (“The filing of a chapter 11 petition creates an estate comprised of all the debtor's property, including ‘all legal or equitable interests of the debtor in property as of the commencement of the case.’ We interpret ‘all legal or equitable interests’ broadly: The estate includes causes of action belonging to the debtor.”).

[19] See In re Cantu, 784 F.3d at 257–58 (“But if a cause of action is acquired at or after the time of conversion, it belongs to the individual debtor.”).