What does Memorial Day weekend mean to you?  Perhaps it means having a nice long weekend with family and friends?  Or spending hours sitting in traffic with all the people who are getting away from it all for the weekend?  Or maybe you are a traditionalist and will spend the weekend getting all of your white clothes out of Manhattan Mini Storage.  Well, for the Weil Bankruptcy Blog, the start of Memorial Day weekend means one thing — the return of Bankruptcy Beach Reading.

Our first Bankruptcy Beach Reading post of the season tells a tale of some things not to do if an attorney does not want to get burned by Rule 9011.  Although this story focuses on events in an individual debtor’s case, one can easily see how stretching the law or the facts could apply in a chapter 11 case. 

The self-empowerment saying, “fake it ‘til you make it” can be traced all the way back to Aristotle, the philosopher who taught us that to be virtuous, one must act as a virtuous person would act and that men acquire a particular quality by constantly acting a particular way.  To be a bankruptcy attorney, one must do certain things, like say, research the relevant law, acknowledge fundamental principles of bankruptcy, take a glance or two at the Bankruptcy Code . . . things of that nature.  In re Nakhuda, a recent decision from the Bankruptcy Court for the Northern District of California, is an extreme example of what not to do if you want to pass as a competent attorney, let alone a bankruptcy attorney.  Caution: don’t try this in your courtroom.

What would have been a routine chapter 7 case in which the debtor received a prompt discharge was unjustifiably delayed and complicated due to the debtor’s counsel whose “fundamental misunderstanding of the basic principles of bankruptcy law and key provisions of the Bankruptcy Code,” “good faith belief or opinion,” which supported every position he took in the case, and “ostrich-like” refusal to “acknowledge controlling law” led to the court’s issuance of an order to show cause pursuant to Federal Rule of Bankruptcy Procedure 9011.  This mockery culminated with the court ordering the attorney’s (i) payment of $8,000 in fees to the court for his violation of Bankruptcy Rule 9011(b), (ii) disgorgement of $4,000 in attorney’s fees to the U.S. Trustee pursuant to section 329 of the Bankruptcy Code, and (iii) suspension from the practice of law in the bankruptcy courts for the Northern District of California until he has completed 24 hours of continuing legal education in bankruptcy law, three hours of continuing legal education in ethics, and ECF training.

Rule 9011 Sanctions

Bankruptcy courts commonly use the “frivolous” standard in Bankruptcy Rule 9011 to determine whether an attorney’s conduct warrants the imposition of sanctions.  The standard for frivolousness is an objective one.  An attorney’s conduct is measured against a reasonableness standard, which consists of a competent attorney admitted to practice before the presiding court.  Accordingly, attorneys have a duty to make a reasonable inquiry into both the facts and the law relevant to their case.  Shocking, right?!

Disgorgement under Section 329

Pursuant to section 329(a), an attorney representing a debtor in a bankruptcy case is required to file a statement regarding the compensation for the attorney’s services.  Section 329(b) provides that the court may cancel any such fee agreement or order the return of any payment, to the estate or the entity that made it, if the court finds the fees excessive.

Section 330 enunciates the standard by which courts are to determine whether attorney’s fees exceed the reasonable value of the services provided.  In determining the amount of reasonable compensation, courts will consider the nature, extent and value of the services rendered, taking into account all relevant factors.

By now you’re probably dying to know what this attorney did to deserve such an intense slap on the wrist.  Get ready.  The parade of horribles is a lengthy one, and we’re only giving you the highlights. By the end of this post, you’ll at least have an idea of what may cross the line of frivolity and land you in Rule 9011(c) territory . . .

Frivolous:  Taking the Position That a Debtor’s Sole Proprietorships Can Remain Open After Commencing a Chapter 7 Bankruptcy Case

Section 721 of the Bankruptcy Code provides that “[t]he court may authorize the trustee to operate the business of the debtor for a limited period, if such operation is in the best interest of the estate and consistent with the orderly liquidation of the estate.”  Accordingly, only a chapter 7 trustee, and not the debtor himself, may operate a chapter 7 debtor’s business.

In Nakhuda, the attorney improperly advised the debtor that he could continue operating laundromats as sole proprietorships during his bankruptcy case.  Prior to the section 341 meeting of creditors, the trustee advised the attorney that the debtor was required to close the businesses.  The attorney disregarded this advisement and simply responded that the issue was not so “black and white.”  By the time the meeting was held, the debtor still was operating the laundromats and using estate assets to do so.  Not surprisingly, the trustee filed an application to cease the debtor’s operations and turn over non-exempt funds and records.  The court promptly granted the application.  Rather than doing the minimal research required to understand the limitations imposed by section 721, the attorney spent months attacking the turnover order and, in so doing, squandered an unreasonable amount of the court’s and trustee’s resources.

Frivolous: Claiming that a Debtor’s Non-Filing Spouse’s Share of Community Property Is Not Property of the Estate

Section 541(a) provides that the commencement of a bankruptcy case creates an estate comprised of (1) all legal or equitable interests of the debtor in property as of the commencement of the case, and (2) all interests of the debtor and the debtor’s spouse in community property as of the commencement of the case.  All community property that is not yet divided by a state court at the time of a bankruptcy filing constitutes property of the debtor’s bankruptcy estate.

Despite the lack of ambiguity in section 541(a)(2), the attorney remained adamant that the value of the property the trustee sought to recover should be reduced by half, “based on his view” that the debtor’s spouse’s share of community property was not part of the bankruptcy estate.  Bewildered, the court noted that “[a]t no point did [the attorney] address § 541(a)(2) or even appear to be aware of its existence.”

Frivolous:  Claiming that a Debtor’s Account Receivable Is Exempt as Earnings Paid by an Employer

Pursuant to section 706.050 of the California Code of Civil Procedure, an individual debtor may exempt “disposable earnings” that are “subject to levy under an earnings withholding order.”  Earnings withholding orders only are issued to employers, because, under section 706.011(b), “earnings” is defined as “compensation payable by an employer to an employee for personal services.”

The first several versions of the debtor’s schedules listed money owed by a company for which the debtor provided consultant services as an account receivable.  The debtor even testified under oath at the 341 meeting and in his deposition that he was a consultant for and was issued a form 1099 by the company.  Not until after the trustee sought information about the account receivable did the attorney amend the schedules in order to recharacterize the account receivable as “exemptible wages” under section 706.050.   The court found this attempt to evade the trustee’s effort to collect the account receivable objectively unreasonable.

Frivolous: Claiming that a Debtor’s Bank Account Is Exempt as a “Tool of the Trade”

Under section 704.060(a)(1) of the California Code of Civil Procedure, tools, implements, instruments, and other personal property are exempt property to the extent that the aggregate equity therein does not exceed $7,625.00 and if they are reasonably necessary to and actually used by the individual debtor in the exercise of the trade, business, or profession by which the debtor earns a livelihood.

The attorney insisted that the debtor was entitled to claim as exempt funds held in a bank account because the funds were “tools of the debtor’s trade.”  Almost comically, the court assumed the attorney’s interpretation was “based on the fact that the debtor ran a business and thus needed money.”  The attorney’s claim that he had researched this issue (without citing any legal authority) was slapped down by the court – “[h]e offered nothing to support his position because there is nothing.”

Frivolous:  Claiming that Exemptions Are Automatic Based Solely on the Values Asserted in the Debtor’s Schedules

Section 542(a) of the Bankruptcy Code provides that an entity in possession, custody or control of property that the trustee may use, sell, or lease, or that the debtor may exempt under section 522 of the Bankruptcy Code shall deliver to the trustee, and account for, such property, unless such property is of inconsequential value or benefit to the estate.  The attorney interpreted the “inconsequential value” exception to mean that any asset listed on Schedule C was automatically removed from property of the estate, and, therefore, was not subject to turn over.  Remarkably, the attorney was steadfast in his argument that the laundromats and certain cash were automatically removed from the debtor’s estate because they were listed on Schedule C as having inconsequential value.   Further, the attorney argued that because these assets were automatically removed from the estate, the debtor was permitted to continue operating the businesses and using the money.

The court’s view in a nutshell: “These are patently incorrect views of the law which a moderate amount of uncomplicated research would have shown.”

Frivolous:  Launching a Campaign to Remove a Trustee Based on Your Own Misunderstanding of the Basic Principles of Bankruptcy Law

The heading pretty much says it all, but, in case there is any ambiguity, an attorney’s attempt to remove a trustee because of the attorney’s stubborn refusal to acknowledge the fundamental rules governing a chapter 7 case likely will fall into the frivolous category.

The Take-Away

You may not have learned how to fake it ‘til you make it as a bankruptcy attorney, but we hope you at least know that frivolity is not the conduit.  And, if that’s the case, then the Bankruptcy Court for the Northern District of California fulfilled the purpose of Rule 9011(c) when it laid the smack down on Mr. Nakhuda’s attorney.