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In re Morabito (9th Cir. BAP) Bankruptcy court can deny remand of debtors’ state court complaint and allow dismissal by trustee when claims belong to estate and not debtors.

The following is a recent case update.

Summary

The Bankruptcy Appellate Panel for the United States Court of Appeals for the Ninth Circuit held that a bankruptcy court did not abuse its discretion in denying debtors’ motion to remand their state court lawsuit against their creditors and directing the chapter 7 trustee to dismiss the adversary proceeding.  In re Morabito, No. NV-17-1304-TaBKu, 2018 Bankr. LEXIS 3604 (9th Cir. BAP Oct. 30, 2018).  The BAP upheld the bankruptcy court’s decision that the debtors were not prejudiced by dismissal of the claims since they were claims of the estate and not the debtors.  To read the full decision, click here.

Factual Background and Procedural History

This appeal arose from the long-running dispute between chapter 7 debtors Paul Morabito and Consolidated Nevada Corporation (the “Morabito Parties”), on the one hand, and their creditors Jerry Herbst, JH Inc. and Berry-Hinckley Industries (the “Herbst Parties”), on the other [some of this background is restated from an e-bulletin dated April 4, 2018 on a prior BAP decision arising from this bankruptcy case].

A Nevada state court had awarded the Herbst Parties over $149 million in compensatory and punitive damages relating to fraudulent representations made during real estate dealings between the parties.  The Morabito Parties subsequently agreed to a settlement where they would pay the Herbst Parties more than $13 million over time and execute a confession of judgment in the amount of $85 million.  After the Morabito Parties defaulted on their settlement payments, the Herbst Parties filed involuntary Chapter 7 bankruptcies against the Morabito Parties.  A single trustee was ultimately appointed to serve in both cases.

The Morabito Parties then filed a complaint in state court against the Herbst Parties the (“Fraud Action”), alleging that the original settlement was obtained through fraud and therefore unenforceable.  The Herbst Parties removed the case to bankruptcy court.

The Morabito Parties then filed a motion with the bankruptcy court, seeking either that they be allowed to pursue the claims in the Fraud Action on behalf of the estates or that the bankruptcy court compel the trustee to abandon those claims.  After the hearing, the bankruptcy court issued detailed findings of fact relating to the weakness of the claims in the Fraud Complaint.  The bankruptcy court found that the Morabito Parties could not be authorized to pursue claims that were held to be valueless, nor was the court required to compel the trustee to abandon the claims just because they were of no affirmative value to the estates.  The bankruptcy court issued an order denying the Morabito Parties’ motion, and the BAP upheld the bankruptcy court’s order (see Morabito e-bulletin April 4, 2018).  The Morabito Parties have since appealed that BAP decision to the Ninth Circuit.

Meanwhile, the Morabito Parties moved to remand the Fraud Action to the Nevada state court, based on 28 U.S.C. § 1452(b). The Herbst Parties and the trustee opposed the remand motion.

At the hearing on the remand motion, the bankruptcy court reviewed the complaint in the Fraud Action to determine whether any of the claims therein were held by the Morabito Parties and not by the bankruptcy estate. While the bankruptcy court acknowledged that the Morabito Parties may have had standing to bring an independent action under Nevada law for “fraud on the court,” they had not pled such a claim in the Fraud Action. Upon this finding, the bankruptcy court effectively held that all the claims brought in the action were property of the estate, and therefore it denied the motion for remand to allow the trustee to dismiss the claims with prejudice. The Morabito Parties appealed the notice of dismissal that was filed by the trustee.

The BAP Ruling and Reasoning

The Trustee’s Motion to Dismiss

The trustee brought a motion to dismiss the appeal, contending that the Morabito Parties only appealed the notice of dismissal, without designating the order denying remand in their notice of appeal, and further argued that the Rule 41(a) notice of dismissal was not a “final judgment, order [or] decree” appealable under 28 U.S.C. § 158(a). The BAP observed that the remand order was interlocutory, and therefore merged into the final “judgment,” i.e., the notice of dismissal filed by the trustee.  According to Ninth Circuit precedent, an interlocutory order is ripe for appeal when a final judgment or order is entered by the court.

The Morabito Parties’ Lack of Standing

The BAP next considered whether the Morabito Parties had pled individual claims or only claims held by the estate. The Morabito Parties argued that they had brought a claim under Nevada law for “fraud upon the court.”  Under Nevada law, this could be alleged in a motion or through an independent action.  Parsing the Morabito Parties’ complaint for the Fraud Action and noting the patently ambiguous language as to which plaintiff was alleging which claim for relief, the BAP upheld the bankruptcy court’s conclusion that no independent cause of action for fraud upon the court had been pleaded by the Morabito Parties.  Therefore all that remained in the complaint were claims that were property of the bankruptcy estate and could only be pursued by the trustee.  Accordingly, the BAP held that the Morabito Parties did not have prudential standing to either litigate their claims in bankruptcy court, or to argue that Fraud Action should have been remanded to state court.

The BAP concluded by noting that since it had determined none of the claims alleged in the Fraud Action were individual claims of the Morabito Parties, then they were not at all prejudiced by the dismissal of the Fraud Action by the trustee.  They would be fully able to go back to state court and bring a new action alleging fraud upon the court.

The Morabito Parties appealed, and the Ninth Circuit affirmed the BAP decision on August 8, 2019.

Author’s Commentary

Although this case revolves on a Nevada action for fraud upon the court, the law in California is similar. Fraud upon the court is a centuries-old equitable action arising under the principle that there is no worthwhile reason to uphold a judgment that has been procured by fraud. Although the motion to remand was denied, the BAP and the bankruptcy court emphasized that this outcome did not diminish the Morabito Parties’ freedom to initiate new action in state court (on their own behalf, and not the estate’s) for fraud on the court.

These materials were prepared by ILC member Thomas B. Rupp of Keller & Benvenutti LLP in San Francisco (trupp@kellerbenvenutti.com), with editorial contributions from ILC member Michael D. Good of South Bay Law Firm in Torrance (mgood@southbaylawfirm.com).

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