“In bankruptcy, as in life, timing can be everything” – the Fifth Circuit.

Marco and Roxanne Cantu had been having a grand time buying vehicles, furs, jewelry, real estate, and $20,000 life-sized bronze horses.  Nevertheless, just like many people, 2008 was not their year.  After one bad experience (filing for chapter 11 bankruptcy) after another (hiring an incompetent attorney) after another (chapter 11 bankruptcy case converting to chapter 7), the individual debtors finally obtained a settlement for malpractice claims against their prior attorney.  Yet, then they lost that too.  In finding that the settlement proceeds from malpractice claims against the debtors’ attorney arose pre-conversion to chapter 7, the Fifth Circuit in In re Cantu held that the proceeds were property of the estate and did not belong to the individual debtors. 

A Tale of Spending and Malpractice

Having incurred substantial debt and facing foreclosure on their real estate holdings, Marco and Roxanne Cantu, along with their wholly owned corporation, filed for chapter 11.  At this time, the debtors had personally incurred over $48 million in debt and their corporation had taken on over $20.9 million in secured debt.  Approximately seven months into the complex bankruptcy case, things began to take a turn for the worse when their creditors moved to convert the case to a chapter 7 liquidation.  Finding that the debtors’ proposed chapter 11 plan was not confirmable, the court converted the case to chapter 7.

Eventually, the debtors obtained new counsel to investigate malpractice claims against their former lawyer in the chapter 11 case.  After the chapter 7 trustee asserted that the malpractice claims were property of the estate, the bankruptcy court authorized the trustee to investigate and pursue the malpractice claims.  A lawsuit was filed in state court against the debtors’ former attorney asserting, in part, legal malpractice for failing to file an acceptable plan of reorganization, vicarious liability for an associate working on the debtors’ case, and gross negligence for accepting their complex bankruptcy case despite a lack of experience.  The parties ultimately settled, and the settlement proceeds were deposited into the court registry, pending determination on whether the proceeds belonged to the debtors, personally, or to the bankruptcy estate.

Who Gets the Money?

After the bankruptcy court and district court both ruled that the settlement proceeds belonged to the estate, the Fifth Circuit considered the question on appeal.

Property of the Estate

Section 541(a)(1) of the Bankruptcy Code provides that the property of a chapter 11 bankruptcy estate includes “all legal or equitable interests of the debtor in property as of the commencement of the case.”  Section 1115(a)(1) expands the definition of property of the estate for individual chapter 11 debtors to include “all property of the kind specified in section 541 that the debtor acquires after the commencement of the case but before the case is . . . converted to a case under Chapter 7.”

When Did the Claim Arise?

To determine the ownership of the malpractice claim, the Fifth Circuit looked to when the claims arose.  The first question was which test to apply.  To determine when a claim against the debtor arises, which courts are frequently asked to do, courts have applied the “conduct test,” the “middle ground test,” and the “prepetition relationship test.”  Here, the Fifth Circuit held that these tests were appropriate only for analyzing claims asserted against a debtor.  In this case, the court was evaluating a claim brought by the debtor.  Thus, the court held that when determining whether a claim that a debtor seeks to assert arose, the “accrual approach” is the appropriate method to use.

Did the Estate Suffer a Pre-conversion Injury?

Under the accrual approach, “whenever one person may sue another a cause of action has accrued.”  Here, the conduct underlying the cause of action – the lawyer’s misconduct in handling the bankruptcy case – clearly occurred pre-conversion.  The court noted that that the timing of the injury was also important – as long as a pre-conversion injury to the estate occurred, even if additional damage occurred post-conversion, the settlement funds would belong to the estate.

In reviewing the malpractice and fraud-based claims, the Fifth Circuit held that the estate suffered a pre-conversion injury and would have been able to pursue a cause of action prior to conversion.  The court explained that the attorney’s misconduct harmed the estate by depleting the assets that could have otherwise gone to pay creditors.  By submitting an unconfirmable plan (which led directly to conversion) the attorney harmed the estate, because “ordinarily creditors are better off when the debtor is reorganized into a going concern than when a liquidation occurs.”  Additionally, to the extent that the attorney should never have filed the case as a chapter 11 bankruptcy in the first place, the court found that the delay and cost resulting from the year-long effort to create a plan harmed the estate.  Lastly, the court found that the estate suffered a pre-conversion injury in the form of fees and expenses paid to the attorney and the estate could have asserted a fraudulent inducement claim alleging that that the attorney misrepresented her qualifications.

A Correctable Injury?

The debtors’ response to any pre-conversion injury the estate might have suffered was that the injury to the estate was correctable prior to conversion.  For example, the debtors argued that even if the deficient plan injured the estate, the attorney could have submitted a second plan that would have remedied the injury.  The court rejected this argument, explaining that first, the harm of the depleted assets and spent fees could not be undone, and second, “a claim accrues when an injury occurs; that injury need not be an irrevocable one.”  Therefore, the possibility that the attorney’s later conduct could have minimized harm to the estate did not undermine the court’s conclusion that the estate had suffered sufficient pre-conversion injury to permit a lawsuit.

Conclusion

But, wait, you might say.  Didn’t I just read in the Bankruptcy Blog last week that the U.S. Supreme Court in Harris v. Vieglahn held that postpetition wages held by the chapter 13 trustee belonged to the debtor (and was not property to be distributed to creditors) upon conversion from chapter 13 to chapter 7?  Isn’t the result in that case opposite of the result here?—Yes, faithful reader, but the discrepancy can be explained.  It is based on different Bankruptcy Court provisions.  The Supreme Court case was based on section 348(f) of the Bankruptcy Code, which clearly states that postpetition pre-conversion property of the chapter 13 debtor is not property of the chapter 7 estate upon conversion.  The different result by the Fifth Circuit in In re Cantu was based on a different provision of the Bankruptcy Code (section 1115(a)(1)), which, as discussed, provides clearly that postpetition, pre-conversion property of the chapter 11 debtor is property of the estate upon conversion to chapter 7.  These decisions should caution potential debtors that conversion to a chapter 7 is not a one size fits all framework when it comes to what property belongs to the debtor—it matters what chapter the debtor started in.  Different cases breed different results, and in the Cantus’ case, it was another bad day for the debtors.