Wike Final

September 19, 2024

Dear constituency list members of the Insolvency Law Committee, the following is a case update written by Hale Andrew Antico, Chief Counsel of Antico Law Firm, analyzing In re Wike, 660 B.R. 683 (B.A.P. 9th Cir. 2024) (“Wike”), a recent case of interest:

SUMMARY

In Wike, the Bankruptcy Appellate Panel of the Ninth Circuit (“BAP”) ruled that the disciplinary costs assessed against an attorney who filed for Chapter 7 bankruptcy protection were discharged under 11 U.S.C. § 523(a)(7), and the Nevada State Bar’s refusal to reinstate the debtor for failing to pay the discharged debt violated § 525(a).

To read the full published decision, click here.

FACTS

In 2020, attorney Terry Lee Wike (“Debtor”) faced two disciplinary hearings for mishandling client funds by the State Bar of Nevada (“State Bar”). The State Bar found that Debtor violated his professional duty and recommended disciplinary action. In October 2020, the Supreme Court of Nevada (“SCN”), upon reviewing the recommendations, issued two orders suspending Debtor from the practice of law. In both orders, the SCN assessed Debtor disciplinary costs: the actual costs of the hearings incurred by the State Bar, and a $2,500 fee mandated by statute. He was given two years to pay the costs.

In April 2021, Debtor filed a voluntary Chapter 7 petition, in which the Chapter 7 trustee issued a no-asset report, and the Debtor received a discharge.

The SCN then issued a Conditional Reinstatement Order, allowing Debtor to practice law again despite the fact that Debtor had not paid the disciplinary costs imposed by his suspension. Among the conditions to obtain full reinstatement was payment in full of the prepetition disciplinary costs.

Debtor argued at the SCN that any disciplinary costs owed were discharged in the subsequent bankruptcy. The SCN did not opine on the dischargeability of the disciplinary costs but stated that Debtor’s reinstatement may be conditioned on payment of the disciplinary costs, regardless of whether they were discharged. In doing so, the SCN concluded that the conditional reinstatement did not violate § 525(a). It found that the disciplinary costs were not discriminatory as they are intended to deter and protect the public and, therefore, allowed by § 525(a).

In response, Debtor reopened his bankruptcy case and filed a request for sanctions against the State Bar, arguing that conditioning his reinstatement on a debt that was discharged violated § 525(a). The bankruptcy court ruled against Debtor, finding the disciplinary costs were excepted from discharge by § 523(a)(7). Further, it found that even if the costs were discharged, the conditional order did not violate § 525(a) because the actions were not taken “solely” because Debtor filed bankruptcy. Finally, the bankruptcy

court held that it was barred from reviewing the Conditional Reinstatement Order by the Rooker-Feldman Doctrine.

Debtor appealed to the Bankruptcy Appellate Panel (“BAP”), which reversed and remanded.

REASONING

The BAP started by analyzing § 525(a), which says, in pertinent part:

“a governmental unit may not deny, revoke, suspend, or refuse to renew a license” or condition the grant of a license to a debtor ‘solely because such’ debtor “has not paid a debt that is dischargeable in the case under this title…”

The BAP noted that the legislative intent of Congress was to recognize the immense power that government organizations which perform licensing functions had over a debtor’s livelihood, and that Congress passed the statute to protect a debtor’s fresh start.

To assess the § 525(a) claim, the BAP embarked on a two-step analysis: 1) were the disciplinary costs excepted from discharged by § 523(a)(7), and if not; 2) whether the actions taken by the State Bar were taken “solely” because Debtor had not paid the outstanding costs, thus violating § 525(a).

The BAP first addressed the threshold question whether the Rooker-Feldman doctrine prevented Debtor’s appeal.

Rooker-Feldman Doctrine

The Rooker-Feldman doctrine is the result of a two Supreme Court cases that prohibit “review and rejection” by federal courts of “cases brought by state-court losers complaining of injuries caused by state-court judgments rendered before the district court proceedings commenced and inviting district court review and rejection of those judgments.” Exxon Mobil Corp. v. Saudi Basic Industries Corp., 544 U.S. 280, 284 (2005).

The bankruptcy court determined it was bound by the SCN’s holdings. The BAP disagreed, noting that in the Ninth Circuit, “it is established that state court orders that disregard or modify the discharge injunction are void, and Rooker-Feldman does not prevent federal review of such state court orders.” The BAP noted that this holding was intended to prevent Rooker-Feldman from unintentionally permitting government entities to violate the discharge injunction, rendering § 525(a) unenforceable against the very entities it was designed to enforce.

In concluding that the Rooker-Feldman doctrine does not apply to an incorrect state court interpretation of § 525(a), the BAP relied on two decisions from the Ninth Circuit Court of Appeals (“Ninth Circuit”). First, after a Chapter 13, case in which child support

arrearages were being paid, was converted to Chapter 11, the trustee stopped paying the arrears. When the debtor was then charged by the district attorney and convicted by a jury for failing to support his children, he filed a complaint in bankruptcy court asserting a violation of the automatic stay, which the bankruptcy court denied based on Rooker-Feldman. The district court affirmed the dismissal, and the Ninth Circuit reversed. In doing so, it noted that bankruptcy courts are specifically empowered to avoid state court judgments (e.g., §§ 544, 547, 548, and 549) or modify them (§§ 1129, 1325), and to discharge them (§§ 727, 1141, 1328). All of the preceding statutes are at odds with the Rooker-Feldman doctrine, which the Ninth Circuit said “is not a constitutional doctrine,” In re Gruntz, 202 F. 3d 1074, 1078 (9th Cir 2000), and that Congress “has plenary power of bankruptcy” from the Constitution. Id. at 1080.

The BAP also noted that the Ninth Circuit had valid policy reasons for the plenary power vested in the federal courts over bankruptcy proceedings:

The bankruptcy court would then be stripped of its ability to distribute the debtor’s assets equitably, or to allow the debtor to reorganize financial affairs. Such an exercise of authority would be inconsistent with and subvert the exclusive jurisdiction of the federal courts by allowing state courts to create their own standards as to when persons may properly seek relief in cases Congress has specifically precluded those courts from adjudicating. It is but slight hyperbole to say that chaos would reign in such a system

*15, citing Gruntz at 1083-1084 (cleaned up by BAP).

After finding Rooker-Feldman did not control where Congress gave bankruptcy courts exclusive jurisdiction by statute, the Ninth Circuit later extended its Gruntz holding (automatic stay) to discharge injunctions and modifications of the discharge order. In a case where notice was disputed when creditor sued a debtor after debtor’s discharge, the Ninth Circuit wrote:

Gruntz bars state court intrusions on all “bankruptcy court orders” (or other “core” bankruptcy proceedings), not just the automatic stay. As we stated in Gruntz, “state courts should not intrude upon the plenary power of the federal courts in administering bankruptcy cases by attempting to modify or extinguish federal court orders such as the automatic stay.” (emphasis added). Thus, just as “[a] state court does not have the power to modify or dissolve the automatic stay,” a state court also lacks authority to modify or dissolve a discharge order or the § 524 discharge injunction. [S]ee also Pavelich v. McCormick, Barstow (In re Pavelich), 229 B.R. 777, 782 (B.A.P. 9th Cir.1999) (“Congress has plenary authority over bankruptcy in a manner that entitles it to preclude state courts from doing anything in derogation of the discharge.”).

In re McGhan, 288 F. 3d 1172, 1179-1180 (9th Cir, 2002) (cites omitted).

After reviewing case law where the Ninth Circuit asserted that its plenary power over bankruptcy matters superseded the Rooker-Feldman doctrine, the BAP felt it was a short leap to apply the same rationale to discharge discrimination matters under § 525: “We believe the well-reasoned and thorough analyses in Gruntz, McGhan, and Pavelich equally apply to state court orders that incorrectly interpret § 525(a) because such orders undermine the discharge injunction.” Id. at *19.

In doing so, the BAP concluded that as with actions to modify the automatic stay (Gruntz) or discharge injunction (McGhan), a claim under § 525 is “core.” Further, the BAP reviewed the legislative record and found Congress intended the section as a tool to enforce the discharge injunction. The BAP then held that the reasoning of the two Ninth Circuit cases extends to state court judgments interpreting § 525. And with that, the BAP then moved on to the merits of Debtor’s § 525(a) claim.

§ 523(a)(7) Exception to Discharge

The first step in examining whether there is a violation of § 525(a) is to determine if the disciplinary costs were discharged. “Section 523(a)(7) expressly requires three elements for a debt to be non-dischargeable. The debt must (1) be a fine, penalty, or forfeiture; (2) be payable to and for the benefit of a governmental unit; and (3) not constitute compensation for actual pecuniary costs.” Albert-Sheridan v. State Bar of Cal. (In re Albert-Sheridan), 960 F.3d 1188, 1193 (9th Cir. 2020).” Id. at *22.

The BAP started with the Supreme Court’s Kelly v. Robinson, 479 U.S. 36 (1986), which analyzed whether a criminal restitution award was excepted from discharge. Despite the fact that it appeared the latter two prongs were not satisfied (as restitution compensated the victim and was not paid for the benefit of a governmental unit), the BAP noted that “Kelly essentially created an exception to the plain statutory construction of § 523(a)(7) for debts arising from state criminal statutes.” Id. at *24 (emphasis in original).

After the BAP reviewed a series of cases in the Ninth Circuit which limited or questioned Kelly, it arrived at in re Scheer, 819 F.3d 1206 (9th Cir. 2016). This case involved a fee dispute that started when an attorney took payment for a loan modification, was sanc-tioned by the California State Bar, and then filed Chapter 7 bankruptcy, naming both the former client and State Bar as creditors. While disapproving of the attorney conduct, the Ninth Circuit noted that it could not stretch the language of § 523(a)(7) to cover a fee dispute; here, the debt was “purely compensatory” and not disciplinary. Id. at 1211.

The Panel, attempting to summarize a rule of post-Kelly case law in the Ninth Circuit, found that there is no bright line and the law continues to evolve. Still, it found some general guidelines. It discerned that when the legislature amends a statute explicitly to provide that statute is enacted for a penal purpose, costs under the statutes are excepted from discharge. Id. at *33, citing in re Findley, 593 F.3d 1048, 1052-54 (9th Cir. 2010). Next, it also found that absent the criminal justice elements of Kelly, the plain text of § 523(a)(7) was analyzed. Further, it noted that each element of § 523(a)(7) is looked at – whether the debt is a “fine, penalty, or forfeiture” and whether it’s “not compensation for actual pecuniary loss.” If not both, then the debt is discharged.

Having ascertained a rule, the BAP then applied it to the facts of Debtor and the disciplinary costs. It started by reviewing the Nevada Supreme Court Rule (SCR) which mandated the $2,500 cost (and not the Conditional Reinstatement Order), to determine if it was penal in nature. (In passing, the BAP noted that in California, these rules are passed by the state legislature). After lengthy analysis, the BAP found that SCN has never analyzed SCR 120, and the rule itself has no language about penalties. The SCN’s decisions do not interpret SCR 120 as serving a penal purpose. As such, all factors pointed towards dischargeability. Id. at *41.

§ 525(a): Were actions taken “solely” because unpaid

Having found that the Rooker-Feldman doctrine didn’t prevent review, and that the disciplinary costs were discharged, the BAP finally turned to an analysis of § 525(a), and whether the Nevada State Bar’s refusal to reinstate was based “solely” on Debtor’s failure to pay the disciplinary costs. The BAP took issue with the bankruptcy court’s rationale that some of the disciplinary costs were incurred prepetition. By definition, a debt that is discharged in a bankruptcy was incurred prepetition, and an interpretation that at-tributes some causation to the bankruptcy itself is too narrow. “§ 525(a) also prohibits discrimination on the basis that a debtor ‘has not paid a debt that is dischargeable.’” *42. The BAP continued:

To the extent the bankruptcy court believes there is a causation issue because some of the debt arose before Debtor was bankrupt, the bankruptcy court’s interpretation would write § 525(a) out of existence because all discharged debts are prepetition debts. Thus, the timing issue raised by the bankruptcy court is not a basis to deny Debtor relief under § 525(a).

Id.

Lastly, the BAP took issue with the other rationale used by the bankruptcy court to deny Debtor relief under § 525(a), which is that there was a valid regulatory motive, and as such, the failure to pay wasn’t “solely” the reason for failure to reinstate.

This goes directly against the ruling from the Supreme Court in FCC v. Nextwave, 537 U.S. 293 (2003). There, the Supreme Court ruled that the regulatory motive for cancellation of a license was “irrelevant.” Id. at 301. Here, to permanently revoke Debtor’s license under § 525(a), the SCN relied on the State Bar’s regulatory motives – promoting attorneys’ rehabilitation, deterring misconduct, and protecting the public, a reliance the BAP said, under Nextwave, was in error.

AUTHOR’S COMMENTARY

The short version of all this – and let’s face it, maybe you skipped right to this part – is this: even attorneys who mishandle client funds can deserve a fresh start in bankruptcy; there’s this Supreme Court doctrine called Rooker-Feldman which has limited applicability here in the world of bankruptcy; our circuit’s body of case-law interpreting § 523(a)(7) is “evolving;” and state bar disciplinary costs can be discharged, depending on how the statute (or rule) is phrased. (Note: California amended its statute before Findley, which affirmed that it fixed it right, and costs of the disciplinary proceeding are not discharged in California.)

Once those hurdles are overcome, it becomes a bit easier to show a violation of § 525(a) than one would expect. The need to show causation is not a requirement, and, in a hit to regulatory agencies, the regulatory motive is irrelevant. This all favors debtors, and protects the fresh start to which they’re entitled. Even if they’re attorneys.

These materials were written by Hale Andrew Antico, Chief Counsel of Antico Law Firm (email). Editorial contributions were provided by Maggie E. Schroedter of Robberson Schroedter LLP (maggie@thersfirm.com).

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