The following is a case update written by the Hon. Meredith Jury (United States Bankruptcy Judge, C.D. Cal., Ret.), analyzing a recent decision of interest:
The United States Court of Appeals for the Sixth Circuit (“the Circuit”) has weighed in on the question of who owns a legal malpractice claim – the debtor or the estate – when the malpractice occurs as a result of the filing of a bankruptcy petition. The Circuit came down on the side of the debtors and, in doing so, dramatically narrowed the application of the Supreme Court’s ruling that an asset belongs to the estate if “sufficiently rooted in the pre-bankruptcy past”, established in Segal v Rochelle, 382 U.S. 375, 380 (1966). Instead, it applied a unique element of Tennessee law to decide the case. Church Joint Venture, L.P. v. Blasingame (In re Blasingame), 2021 WL 245300 (6th Cir. 1/26/21).
To view the opinion, click here.
In July 2008 Earl and Margaret Blasingame (“the Debtors”) met with two attorneys regarding their deteriorating financial situation, one their regular counsel and the other a bankruptcy attorney brought in to assist in their filing. In August they filed a chapter 7 petition, listing assets with a value of less than $6000. As it turned out, their schedules were wildly inaccurate because they failed to disclose millions of dollars of assets they controlled through a complex web of entities and accounts, as well as a life estate in their multi-million dollar homestead. Not surprisingly, the trustee filed an adversary proceeding under section 727(a) to deny their discharge and the court granted summary judgment for the trustee in February 2011. New counsel managed to have that judgment set aside, but a trial resulted in the same outcome in 2015, which was affirmed on appeal.
Church Joint Venture (CJV), the estate’s 95% creditor, obtained derivative standing to sue on behalf of the trustee/estate and filed a malpractice complaint in the bankruptcy court against the two attorneys, asserting that their malfeasance resulted in the denial of the Debtors’ discharge. The Debtors filed a similar complaint in the Tennessee state court, asserting that the claim belonged to them, not the estate. Eventually the dispute over ownership of the claim got tee’d up in a declaratory relief action in the bankruptcy court, after the trustee had attempted to settle the matter with a Rule 9019 compromise, objected to by the Debtors. On cross summary judgment motions, the bankruptcy court ruled that the malpractice claim belonged to the Debtors, not the estate. The Sixth Circuit Bankruptcy Appellate Panel affirmed and CJV appealed to the Circuit.
Deciding an issue of first impression, the Circuit affirmed, ruling that the claim belonged to the Debtors because the final necessary element to the claim for relief, resulting damages, occurred post-petition and Tennessee law was contrary to the conclusion that an asset could be “rooted in the pre-bankruptcy past.”
The Circuit looked first at the broad definition of property of the estate found in section 541(a) but also recognized the accepted principle that although section 541 dictates what interests are property of the estate under bankruptcy law, the “nature and extent of [the] property rights…are determined by the ‘underlying [state] substantive law.’” Raleigh v Ill. Dep’t of Rev., 530 U.S. 15, 20, 120 S.Ct. 1951 (2000). Therefore, its analysis began by examining the elements necessary to a prima facie claim of legal malpractice under Tennessee law: (1) the attorney owed a duty to the client; (2) the attorney breached that duty; (3) the client suffered damages; (4) the breach was the cause of the damages; and (5) the breach was the proximate cause of the damages.
The dispute between the parties turned on whether the alleged damages accrued pre-petition or post-petition, with the Debtors arguing that it was post-petition because the damage was the denial of their discharge in 2015. CJV, to the contrary, asserted two pre-petition events damaged the Debtors: the advice to file for bankruptcy at all when they owned and controlled substantial assets and the “negligent construction” of their bankruptcy petition. However, even accepting the Debtors’ argument that the damage was the tangible act of denial of their discharge, the Circuit pondered the continued validity of the Supreme Court’s Segal “rooted in the pre-bankruptcy past” analysis since Segal was decided under the Bankruptcy Act of 1898. If that principle remained viable, a strong argument could be made that the claim belonged to the estate because both decisions – (1) to file a chapter 7 and (2) how to describe their holdings in the schedules – were made pre-petition and they started the ball rolling toward the subsequent damages.
The Circuit noted both inter- and intra-circuit disagreements on how to apply the Segal test when dealing with a claim for legal malpractice against the filing attorneys. After analyzing prior federal holdings, however, the Circuit determined it must look to Tennessee law to decide when acts constituting malpractice become a violation. The Tennessee Supreme Court had decided that a cause of action does not accrue until the client discovers or should have discovered the resulting injury. See Teeters v Currey, 518 S.W.2d 512, 517 (Tenn. 1974). Applying that test to the facts at hand, the Circuit reasoned that the Debtors could not have known of their attorneys’ misconduct until the judgment denying their discharge was entered. Therefore, at the time of the filing, the claim was not a legal interest under Tennessee law. Whether or not it was rooted in the pre-bankruptcy past, it was not property of the estate.
Although this decision comes from a federal circuit court and seems to join a growing majority of federal courts which have ruled that a malpractice claim that arises because of the filing of a bankruptcy petition belongs to the debtors, the impact of its holding is limited to claims arising in Tennessee. Rather than deciding when the legal right accrued using common law or bankruptcy law standards, the Circuit followed a unique Tennessee holding which meant there was no malpractice claim until the client knew or should have known conduct was malfeasance. It then decided these Debtors did not “know” of the misconduct until the judgment denying their discharge was entered, presumably the second time.
The Circuit considered whether the Segal standard was still viable, having been established before the definition of “property of the estate” was modified substantially by section 541(a) of the Bankruptcy Code. But then it decided not to resolve the issue of its viability, turning instead to Tennessee law. That gave it a pathway out of the dilemma facing all federal courts ruling on the ownership issue. I predict the issue will come again to the Circuit in a bankruptcy case from a different state. Perhaps then it will decide whether Segal remains valid.
I see two lessons for practitioners: first, don’t malpractice when filing a petition. Make certain you ask all the questions which will flush out what property interests your debtors might not believe they need to disclose or do not even know are “property” or “assets.” Second, if you do represent a debtor whose prior bankruptcy attorney did a less than stellar job, resulting in some tangible damages to your client, take the position the claim belongs to the debtor, not the estate. The majority of cases are trending that direction.
These materials were authored by the Hon. Meredith Jury (United States Bankruptcy Judge, C.D. Cal., Ret.) a member of the ad hoc group, with editorial contributions by Monique D. Jewett-Brewster, a shareholder with Hopkins & Carley, ALC, a member of the ad hoc group and past Chair of the CLA Business Law Section. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.