How to Appoint a Trustee. Be Clear. And Be Convincing.

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 A recurring theme—one that enrages creditors—is that of a business owner who secretly transfers assets from a failing business to friendly affiliates and then files bankruptcy, leaving creditors holding the bag.

The Bankruptcy Code tries to address this by requiring that debtors open their books to the court and creditors. Where there is fraud or dishonesty, a creditor can ask the Court to appoint a trustee.  Procedurally, however, debtors have a home court advantage.

The following case illustrates just how hard it can be… and the importance of creating a strong evidentiary record, including expert testimony, even if you think you’ve caught the debtor red handed.

“Vehemence,” the court said, “is no substitute for evidence.”

What Happened Was….

Pedro Lopez-Munoz owned and operated gas stations in Puerto Rico, both individually and through a corporation that he owned. When the business fell on hard times, he sold his interests in the gas stations to his corporation and then transferred ownership of the corporation to a trust. And guess what? Pedro was the trust’s principal beneficiary.

Seven months later, Pedro filed a Chapter 11 bankruptcy case. He didn’t mention his financial interests in the gas stations.  Although he did disclose that he had transferred ownership of the gas stations to his trust, the statements he made were incomplete and misleading. Significantly, he claimed (incorrectly) that the trust beneficiaries were his children, not himself.

One of Pedro’s creditors learned about the transfers through legal discovery. It responded by asserting that Pedro had been trying to defraud his creditors, and it sought appointment of a Chapter 11 trustee.  The U.S. Trustee’s Office supported the motion. That’s important because the U.S. Trustee’s Office serves as a watchdog for bankruptcy fraud. Having their support can send a strong signal that there are real issues.

In response, Pedro rescinded the transfers and corrected his disclosures.  As for why he made the transfers?  Pedro said he was really just trying to help all of his creditors out by shielding his assets from one particularly aggressive creditor. He also submitted expert testimony from his CPA stating that the transfers had no material effect on his bankruptcy estate because all proceeds were paid over to his secured creditors.

What Did the Court Do?

The appointment of a trustee is an extraordinary act, and the moving party (i.e., the creditor) has the burden of proving the appointment is justified. This is the debtor’s home court advantage.

After a two day hearing, the Bankruptcy Court said that the bonding company had not proven that a trustee should be appointed.  The bonding company disagreed, appealed, and lost.  Why?

The appellate court believed that Pedro’s explanation for the transfers (e.g., I was trying to help my creditors!) was credible enough to overcome a presumption of fraud.

Surprised?  So was I at first.  But the appellate court pointed out that the bonding company didn’t get an expert squarely in front of the trial court. Pedro’s expert, on the other hand, testified that there was no fraud and the transfers didn’t harm creditors. Since Pedro’s expert was largely unchallenged, Pedro won.

The Legal Underpinnings

 Here’s a closer look at the court’s reasoning.  The case was heard by the Bankruptcy Appellate Court in the First Circuit.  Bankruptcy Code section 1104(a)(1) states that if a creditor requests appointment of a trustee, the court shall approve the request:

  • For cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management, either before or after the commencement of the case . . . ; or
  • If such appointment is in the interests of creditors, any equity security holders, and other interests of the estate . . . .

The appellate courts agree that there is a strong presumption against appointing a trustee.  However, they don’t agree about what a creditor must do to overcome this presumption.  Most state that the creditor must present “clear and convincing evidence.”  Some are satisfied with a preponderance of evidence.  The First Circuit hasn’t yet decided which standard to apply.

Both the bankruptcy and appellate courts hedged their answer on this issue.  On one hand, the bankruptcy court decided that the majority’s approach (“clear and convincing evidence”) was correct.  On the other hand, it stated that the standard to be applied didn’t matter because, under Puerto Rico’s fraud statute, a trustee wasn’t justified under either standard.  The Bankruptcy Appellate Court—remarking on the lack of expert testimony to support the creditor’s motion—agreed.  It held that, under either standard, the creditor had not shown a benefit to appointing a trustee that would outweigh its cost.

So Pedro avoided a trustee and it seems that the First Circuit could be falling into line with the majority rule, requiring clear and convincing evidence to justify appointment of a trustee.

United Surety & Indemnity Co. v. Pedro Lopez-Munoz (In Re Pedro Lopez-Munoz), 1st Cir. BAP No. PR16-011, Bankr. Case No. 13-08171-EAG (July 28, 2016).

View the Opinion in PDF

Mette H. Kurth

About Bankruptcy. Beer. And Blogging.

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Welcome to The Bottom Line!  A Business Bankruptcy Blog.  In Plain English.

There are few things that can clear a room faster than telling someone you are a lawyer.  Except perhaps telling them you are a bankruptcy lawyer.

I have always rejected the idea of inflicting yet another IRAC-ridden blog full of legalease and case cites onto the world.  (IRAC?  Huh?  IRAC, Issue-Rule-Analysis-Conclusion, is the formulaic rule for legal writing inflicted on first-year law students to force them to think like lawyers. IRAC is one of many things that makes legal writing, and lawyers, boring.)

Then I remembered my father and his fuzzy eggbeaters.  Few classes fill up more slowly than an 8:00 a.m. economics course.  (Or a bankruptcy class.)  But my father, a professor of economics, always had wait lists for his classes. They were popular. He did not talk about widgets.  His hypothetical businesses manufactured fuzzy eggbeaters.  His beer and pizza graphs illustrating diminishing marginal utility were famous (among economics majors).  At Halloween, he gave extra credit for the best economics-themed costumes. One very pregnant co-ed won by drawing an expectations curve on her t-shirt.  He hosted backyard barbecues for his students.  Although I wouldn’t admit it then, my dad was sort of cool.

Unfortunately, I can’t invite all of you to my house for a beer and burgers while we discuss fascinating issues of finance and bankruptcy law.  Keeping you entertained may not be easy.  But it is my pledge to you to be clear.  To be relevant.  And as much possible, not to be boring.

Cheers!

Welcome to The Bottom Line!

Mette H. Kurth

Help! I Can’t Afford a Bankruptcy Lawyer.

Going broke is not free.  The Bankruptcy Court charges a fee of $355 or more to file your case.  Bankruptcy cases involve a lot of paperwork, statutes, rules, deadlines, and legal jargon.  If you can afford to hire a reputable lawyer to help you, that is generally the best option. If you can’t, there are some alternatives that could be right for you.

There are many self-help websites that are just a Google search away.  Noll Press, for example, has been publishing  do-it-yourself legal guides since  1971.  They cover a range of topics from debt management, bankruptcy planning, costs, whether you need a lawyer, the types of bankruptcy cases, and how to file them.  They have books, forms, and free on-line articles.  They also have a referral service.   Nolo Press

The American Bankruptcy Institute also offers self-help resources. The ABI is an organization dedicated to research and education on bankruptcy matters.  Their materials are free!  They have a more academic tone, so you might find them a little less user-friendly than Nolo Press.   ABI Bankruptcy Resources

If the idea of a DIY bankruptcy is daunting , you can also find help at free legal societies and legal clinics, or a pro bono attorney might take your case free of charge.  Justia.com lists a number of legal aid societies in the Los Angeles area, including the Legal Aid Foundation, Public Counsel, Bet Tzedek, and others.   Justia.com

Outside the Los Angeles area, try a Google search like “free bankruptcy resources Chicago” to locate similar legal clinics.

Mette H. Kurth