In Sterling-Pacific Lending, Inc. v. Moser (In re Moser), 613 B.R. 721 (9th Cir. BAP 2020), the Bankruptcy Appellate Panel for the Ninth Circuit held that the bankruptcy court abused its discretion in declining to rule on a lender’s adversary proceeding seeking a declaratory judgment that the lender’s attempt to collect fees awarded to it in state court litigation did not violate the debtor’s chapter 7 discharge injunction. The BAP directed judgment in favor of the lender on remand because the debtor had repeatedly conceded that there was no discharge violation.
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The debtor, Dr. Moser, formed four LLCs to own and develop real property. The LLCs and Dr. Moser borrowed money from the lender, Sterling, and Dr. Moser guaranteed the LLC loans. The development projects failed. Dr. Moser and the LLCs sued Sterling in California state court.
Dr. Moser later filed a chapter 7 bankruptcy and removed the five state court actions to the bankruptcy court. However, after the chapter 7 trustee abandoned the estate’s interests in the LLCs, the bankruptcy court remanded all five cases to the state court. While those state court cases were proceeding, the trustee settled Dr. Moser’s alleged claims against Sterling for $20,000, with complete mutual releases, and dismissed Dr. Moser’s state court action against Sterling with prejudice, leaving the four LLC state court cases on file under Dr. Moser’s control. Dr. Moser received his discharge, and his chapter 7 case was closed.
Later, the LLCs—through Dr. Moser—each amended its state court complaint. Sterling reopened Dr. Moser’s chapter 7 case to file an adversary proceeding, alleging that the amended complaints really asserted Dr. Moser’s personal claims that the trustee had settled. The bankruptcy court dismissed the adversary proceeding without prejudice on the ground that it was up to the state court to determine whether the amended claims belonged to Dr. Moser or the LLCs. Eventually, Sterling prevailed in the LLCs’ state court actions, getting a judgment for well over a million dollars that included $164,000 in attorneys’ fees and costs.
Sterling then filed a new state court action against Dr. Moser and the LLCs to collect on its judgment, alleging that Dr. Moser was the LLCs’ alter ego and should therefore be held liable on the judgment.
In response, Dr. Moser reopened his chapter 7 case (for the second time), seeking sanctions against Sterling for violating the discharge injunction insofar as Sterling was attempting to collect the judgment against him on either the guaranty or as the alter ego on the loans to the LLCs. Dr. Moser also argued that the trustee’s settlement barred the collection action against him. Sterling in turn filed an adversary proceeding, offering to file a second amended complaint in state court clarifying that it was seeking to collect from Dr. Moser as the alter ego of the LLCs only for attorneys’ fees and costs incurred postpetition, and requesting from the bankruptcy court a declaration that doing so did not violate the discharge injunction.
After a lot of maneuvering by the parties, during which Dr. Moser unaccountably conceded that Sterling’s state court action did not violate the discharge injunction, the bankruptcy court again dismissed the adversary proceeding without prejudice. In the process, the bankruptcy court granted Dr. Moser’s motion for summary judgment and denied Sterling’s motion for judgment on the pleadings, which Sterling based on Dr. Moser’s failure to deny the material allegations of its complaint and, in fact, admitted that there was no discharge violation. According to the bankruptcy court, to grant Sterling declaratory relief during the pendency of the state court actions would require the court to decide an issue that was properly committed to the state court, namely who owned the LLC claims—the LLCs or Dr. Moser as their alleged alter ego. In dismissing the proceeding, the bankruptcy court declined to rule on whether Sterling could proceed with his state court alter ego claims, leaving Sterling to prosecute the state court action at its “own peril.”
Sterling appealed to the BAP, which reversed and remanded to the bankruptcy court with instructions to enter judgment for Sterling.
The BAP held that the bankruptcy court abused its discretion in refusing to clarify the scope of the discharge injunction. Criticizing the notion that Sterling should be abandoned to take its chances between giving up its claims or risking a violation of the discharge injunction, the BAP pointed to federal decisional law granting a prospective litigant’s desire for a judicial declaration clarifying the sometimes uncertain scope of the discharge injunction, particularly where a creditor believes that the debtor has “returned to the fray.” See, e.g., Boeing N. Am., Inc. v. Ybarra (In re Ybarra), 424 F.3d 1018, 1026 (9th Cir. 2005). The BAP further observed that doing so was appropriate where there is a “concrete” question about the scope of the injunction, evidently trying to steer clear of the risk of issuing an improper advisory opinion. The BAP averred that there was such a dispute because the issue of whether the discharge applied remained regardless of whether Dr. Moser was held personally liable for the judgment. Thus, the BAP concluded that the bankruptcy court had abused its discretion (and erred as a matter of law) in declining to adjudicate Sterling’s request for a ruling on the scope of the discharge injunction.
For reasons not entirely clear, Dr. Moser did not contend in Sterling’s adversary proceeding (or later on appeal) that Sterling’s prosecution of the alter ego complaint against him violated the discharge, a strategy the BAP found puzzling. Indeed, Dr. Moser admitted in his answer to the adversary complaint, in his opposition to the motion for judgment on the pleadings and at the related hearings that Sterling did not violate his discharge in pursuing the alter ego claims, instead arguing that he was not liable on the merits. Based on Dr. Moser’s judicial admissions and failure to defend the issue on appeal, the BAP not only reversed the bankruptcy court, but directed the court to enter judgment for Sterling.
This was the correct decision. Short of an impermissible advisory opinion when the dispute is purely theoretical or what exactly is at issue is opaque, it serves judicial economy and the interests of justice to enable a litigant to avoid having to choose between possibly running afoul of the discharge injunction and abandoning what may be enforceable rights. It is also wise policy to reward those who respect a court’s injunctive powers and dignity to seek judicial guidance rather than storming the fort and asking (or, rather, answering) embarrassing judicial questions later. Indeed, in a slightly different but otherwise analogous setting, litigants seeking relief from the automatic stay sometimes join such request with a prayer in the first instance that the court find that the stay does not apply to the action the litigant proposes. See, e.g., Bankr. Local R. 4001-1(b) (Bankr. N.D. Cal.) (“Every motion for relief from the stay, or order confirming that no stay is in effect, shall be filed with a completed Relief from Stay Cover Sheet”) (emphasis added).
The takeaway from this decision is that counsel should consider the prudent course of seeking a ruling from the bankruptcy court whenever there is some doubt about whether proposed action will violate the discharge injunction. Notwithstanding the added cost, it is probably better to be safe than sorry (and cited and punished for contempt). All that said, Sterling itself was not as cautious as it might have been; after all, after suing Dr. Moser post-discharge to recover on a judgment that arose in connection with related prepetition debtors, it did not seek the bankruptcy court’s intervention until Dr. Moser reopened his case to accuse Sterling of violating the discharge injunction.
One further point worth considering not addressed by the BAP: that who owned the claims asserted against Sterling might involve resolving an issue of state law does not mean that the bankruptcy court would have to defer to the state court to make that decision. Bankruptcy courts decide issues of state law all the time in the course of the exercise of their jurisdiction. Indeed, that happens at least in the offing every time the bankruptcy court decides an objection to a state law proof of claim, and often on other occasions as well.
These materials were authored by Adam A. Lewis, Senior Counsel at Morrison & Foerster, LLP in San Francisco (ALewis@mofo.com), with editorial contributions from ILC member Joseph Boufadel of Salvato Law Offices in Los Angeles (JBoufadel@salvatolawoffices.com).