Business Law

In re Hamilton – Ninth Circuit overturns confirmation of chapter 11 plan that did not provide for sufficient payment of nondischargeable debt

The following is a case update analyzing a case of recent interest.

Summary

In Hamilton v. Elite of Los Angeles, Inc. (In re Hamilton), 803 F. App’x 123 (9th Cir. 2020) (2-1 unpublished decision), the United States Court of Appeals for the Ninth Circuit ruled that the bankruptcy court erred in confirming a chapter 11 plan where the debtor was paying only a small portion of a large non-dischargeable debt and yet enjoining the creditor from attempting to collect the rest of the debt from “property committed to the Plan” for five years. To read the full decision, click here.

Factual Summary

The chapter 11 debtor owed his former employer, Elite of Los Angeles, Inc. (“Elite”), a debt of some $2.2 million which the bankruptcy court found to be nondischargeable.  Of that amount, approximately $300,000 was secured by the debtor’s rental property.  The debtor proposed a chapter 11 plan that would pay the secured portion of the claim over 30 years with 6% interest.  The remaining unsecured $1.9 million would be paid, along with other unsecured creditors in the same class, approximately 9% over 60 months. 

The plan also provided that “enforcement of nondischargeable claims against property committed to the Plan is enjoined during the Plan period so long as Debtors are not in material default under the Plan.”  As to this injunction, “any creditor could move to modify or dissolve the injunction for cause.”

As to the absolute priority rule, the plan provided for new value of $200,000 in cash, and a promissory note of $380,000 contributed by an entity owned by the debtor’s mother which was in the same business as, and thus a competitor of, Elite.  The new value contribution was earmarked to fully pay the administrative attorney’s fees.

The bankruptcy court confirmed the plan.  The Bankruptcy Appellate Panel of the Ninth Circuit reversed.  Hamilton v. Elite of Los Angeles, Inc. (In re Hamilton), 584 B.R. 310 (9th Cir. BAP 2018). 

The BAP said:

the most challenging aspect of the Plan is the collection injunction, which the bankruptcy court approved despite the fact that the Plan makes no provision for any meaningful payment of [Elite’s] claims.  With or without the collection injunction, the Plan is not feasible.  And given that the Plan delays payment of [Elite’s] claims without any definite proposal to pay them, it essentially neuters [Elite’s] rights to be paid, and thus does not meet the good faith requirement.

The BAP noted there is no bright-line rule against such an injunction, but it must be “analyzed via a simple application of the injunctive relief standards,” in other words, a balancing of the hardships of the parties, among other factors.  A “mere delay in payment” may be considered “versus the opportunity for the debtor to pay other creditors and get a fresh start with respect to dischargeable claims.” 

The BAP found, “[t]he Plan does not merely delay payment on the nondischargeable claims over the entirety of the plan term – it fails to make any provision for the forestalled creditor ever to be paid in full.”  Rather, “at the end of the Plan term, [Elite] will be left with the same ability to collect, but from an individual who is five years older and will apparently have no increased ability or additional resources to pay the nondischargeable claims.” 

As to feasibility, the BAP noted that section 1129(a)(11) requires a finding that confirmation “is not likely to be followed by the liquidation, or the need for further financial reorganization, of the debtor or any successor to the debtor under the plan . . . .”  Here, the debtor will owe more on the debt at the end of the plan than now and therefore will necessarily require “further financial reorganization.” 

As to the absolute priority rule, the BAP ruled that the new value contribution was not “new” since the debtor’s mother’s entity had already committed to pay the debtor’s administrative attorney’s fees pursuant to an indemnity agreement with the debtor.

The debtor appealed the BAP ruling to the Ninth Circuit. 

Reasoning

In a short memorandum opinion, a Ninth Circuit panel affirmed the BAP (2-1 unpublished decision).  

As to the injunction, the Ninth Circuit simply said that there are no cases in “our court (or the BAP)” which “approved a collection injunction in such circumstances.”  It said the cases cited by the debtor authorizing an injunction anticipated that the nondischargeable debt would be paid in full during the plan, and therefore, were distinguishable. 

The Ninth Circuit also agreed that Section 1129(a)(11)’s requirement that “plan confirmation is not likely to be followed by liquidation, or the need for further financial reorganization, of the debtor’” is not supported by the record, and therefore, the bankruptcy court abused its discretion.  It agreed with the BAP that because the debtor will owe the creditor more at the end of the plan than at confirmation, “further financial reorganization” was likely. 

The Ninth Circuit also found that the bankruptcy court clearly erred in finding the plan was proposed in good faith.  Using a totality of the circumstances analysis, the Ninth Circuit stated,

[a] plan is proposed in good faith if it achieves a result consistent with the purposes of the Bankruptcy Code.  [citation omitted]  The primary purposes of Chapter 11 are to rehabilitate the debtor and maximize the value of the estate.  

Here, there were lingering, unresolved questions about the debtor’s involvement in the mother’s business that he supposedly did not own, but that was paying the attorney’s fees of the estate.  Indeed, the BAP commented, “it goes without saying that the debtor’s earnings would remain nominally controlled by his mother.” 

The Ninth Circuit agreed that the plan violated the absolute priority rule because there was no actual new value because his mother’s business was already committed to pay the administrative attorney’s fees. 

In Judge Ikuta’s dissent, she wrote, “The majority reverses the bankruptcy court’s determination based solely on its own assessment of the equities.”  As to the injunction, Judge Ikuta noted that in individual chapter 11 cases, the discharge is not entered until the plan is completed such that the automatic stay remains in effect until then.  Therefore, the proposed injunction is the “functional equivalent” of the stay that already bars Elite from enforcing collection of its nondischargeable debt anyway, and nothing more.  Further, Judge Ikuta commented that there is no requirement in the Bankruptcy Code that creditors with nondischargeable debt be paid in full during the life of a plan.  On those bases, the bankruptcy court did not abuse its discretion. 

As to feasibility, the dissent focused on the standard that “a debtor must demonstrate that the plan has a ‘reasonable probability of success’” (emphasis in original).  Judge Ikuta elaborated,

[F]easibility does not hinge on whether a debtor will be able to make certain payments after the plan has ended.  Instead, feasibility turns on the debtor’s ability to live up to the terms of the plan. (emphasis in original) 

There was no dispute whether the debtor demonstrated an ability to perform under the plan, and the bankruptcy court did not clearly err on that issue.

As to good faith, Judge Ikuta found there was no evidence that the plan was proposed in bad faith.  The dissent explained there is no rule or case that finds a plan is proposed in bad faith “merely because the debtor will only partially pay an unsecured creditor’s nondischargeable debt during the life of a plan” and reasoned that the debtor will be free of all dischargeable debt at the end of the plan, from which point on, he would be able to allocate funds to pay off Elite’s debt.  On this basis, Judge Ikuta concluded the bankruptcy court’s determination that “this strategy was an efficient and legitimate way” to resolve the debtor’s debts was not clearly erroneous. 

Judge Ikuta concluded her dissent with the following:

If this were ancient Rome, a debtor could be cut into pieces and distributed among the creditors.  See 2 W. Blackstone, Commentaries on the Laws of England 472 (1766).  Were this 13th century England, a debtor could be imprisoned.  Sturges v. Crowninshield, 17 U.S. 122, 140-41 (1819).  But today in our country, all debtors may avail themselves of the Bankruptcy Code, bad actors included.  While Elite’s nondischargeable debt is sizeable, the Code provides relief even for debtors who carry a near insurmountable amount of debt.  I dissent.

Author’s Commentary

This saga is worthy of a book or at least a complete summary in a bankruptcy journal.  The state court litigation began in late 2011, and the chapter 11 case was filed in April 2014.  The debtor here left his employer, an academic counseling business, in 2011 and began a competing business owned by his mother.  Apparently, his new business was considerably more profitable than his former employer’s business.  The employer sued the debtor in state court alleging he “absconded with the . . . lesson plans, proprietary information, and teachers.”  The employer won the $2 million judgment in state court which the bankruptcy court later found to be “willful and malicious,” because “the debtor believed that injury was substantially certain to occur as a result of his conduct.”  That, in my opinion, ignores the Supreme Court ruling in Kawaauhau v. Geiger, 523 U.S. 57 (1998).  The focus of “willful and malicious” must be based on the debtor’s actual intent to injure, as opposed to acts, done intentionally, that cause injury.  

I get the impression reading the BAP ruling and the Ninth Circuit ruling that both courts sensed that the debtor could pay a lot more than he was offering.  The administrative fees for the case were nearing $600,000, entirely to be paid by the mother’s company.  Yet, the company was paying him a fairly low salary which, in turn, justified the small payments to creditors.  There were apparently about $400,000 of other unsecured creditors, some of whom voted for the plan.  But the BAP and the Ninth Circuit saw this as a two-party dispute and a simple use of bankruptcy to “strong arm” a wronged creditor. 

To that extent, Judge Ikuta is correct.  The bankruptcy court lived with this case for three years prior to confirmation of the plan.  The Ninth Circuit simply made its “own assessment of the equities.”  I guess that is how bad faith works: it is something that offends your personal sense of fairness.  The bankruptcy judge’s decision should not be overturned unless there is clear error.

I checked the docket in San Diego to see what happened after the case was remanded to Judge Christopher Lantham.  The parties settled and the chapter 11 case was dismissed on May 21, 2020.  The amount?  Confidential.

These materials were written by M. Jonathan Hayes of Resnik Hayes Moradi LLP in Los Angeles (jhayes@rhmfirm.com)Editorial contributions were provided by Cathy Ta, who can be contacted at cathyta@cathyta.net. 

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