Practitioners that exclusively represent clients in large scale restructurings and chapter 11 reorganizations may be used to the debtor remaining in place with senior management continuing to oversee the day to day operations of the company and overseeing the debtor’s reorganization case.  It may seem strange then to such practitioners that, unlike in chapter 11 cases, the debtor in a chapter 7 case often has only a limited role in its own bankruptcy case after the initial debtor interview and the section 341 meeting of creditors.  In a chapter 7 case, a trustee is appointed and is charged with liquidating the assets of the estate, which is comprised of all of the debtor’s nonexempt property, and the debtor then has very little say or interest in how the trustee and the bankruptcy court administer those nonexempt assets.  The Fifth Circuit, however, recently held in In re Mandel that, despite this generally limited interest, a debtor-out-of-possession has standing to appeal from a bankruptcy court’s order allowing a claim in a chapter 7 case.

Background

The case began with a dispute between the debtor, an individual, and his business partner over a software company that they co-founded. The dispute escalated to extensive state court litigation, during which the state court appointed a receiver to ensure that the software company was properly represented in the litigation.  The parties to the lawsuit agreed to split the cost of the receiver and her law firm.

While the state court litigation was still ongoing, the debtor filed a chapter 11 petition in the U.S. Bankruptcy Court for the Eastern District of Texas.  During the chapter 11 case, the receiver and her law firm each filed claims against the debtor’s chapter 11 estate for their agreed-upon compensation.  In addition, during the course of the chapter 11 case, the receiver and her law firm, among others, filed a complaint objecting to the dischargeability of their claims, pursuant to section 523 of the Bankruptcy Code, and to the debtor’s discharge generally pursuant to section 727.  The bankruptcy court ultimately allowed the claims of the reciver and her law firm and the debtor appealed.  It is worth mentioning that the bankruptcy court had yet to rule on the dischargeability of the claims that were the subject of the appeal to the district court.

Later, the bankruptcy court appointed a chapter 11 trustee, and the parties moved to abate the appeal of the claims allowance order until the chapter 11 trustee decided whether to pursue the appeal on behalf of the estate (which he, ultimately, decided against).  The debtor’s case was later converted to a chapter 7 case, and the chapter 11 trustee became the chapter 7 trustee.  Once the chapter 11 (and later chapter 7) trustee was appointed, the debtor became a “debtor-out-of-possession.”

The U.S. District Court for the Eastern District of Texas dismissed the debtor’s appeal of the bankruptcy court order allowing the claims of the receiver and her law firm as moot, finding that the debtor did not have a sufficient interest in the order to establish standing.  The debtor appealed to the Fifth Circuit Court of Appeals.

Analysis

The issue before the Court of Appeals was whether the debtor had standing to pursue his appeal given that (1) the debt at issue in the appeal may not be discharged, thus exposing the debtor to personal liability for the balance, and (2) the bankruptcy court had yet to rule on whether the relevant debt was dischargeable.  In order to have standing to appeal a bankruptcy court order, a party must be a “person aggrieved” meaning that the appellant must show that he/she/it “was directly and adversely affected pecuniarily by the order of the bankruptcy court in order to have standing to appeal.”

The Fifth Circuit began its analysis by agreeing with the district court that “a debtor-out-of-possession will rarely have a sufficient interest to challenge a bankruptcy court order in a Chapter 7 proceeding.”  This is the case because in chapter 7, a trustee is appointed to liquidate all of the assets of the bankruptcy estate and distribute the proceeds to creditors, and “the debtor-out-of-possession typically has no concrete interest in how the bankruptcy court divides up the estate.”  However, despite a debtor-out-of-possession’s generally limited interest in chapter 7 proceedings, the Fifth Circuit held that the debtor had standing to appeal and was a “person aggrieved” by the bankruptcy court’s order.

First, the Fifth Circuit held that the debtor was a “person aggrieved” because a successful appeal of the order allowing the claims of the receiver and her law firm would have a dispositive impact on the bankruptcy court’s adjudication of the pending discharge complaint.  If the district court were to side with the debtor on the merits of the appeal of that order, there would be no claims to find nondischargeable.  Courts generally have held that “a Chapter 7 debtor qualifies as a ‘person aggrieved’ for purposes of appellate standing … if he can demonstrate that defeat of the order on appeal … would affect his bankruptcy discharge.”

Second, the Fifth Circuit found that the claims allowance order functioned as an adjudication of the claims of the receiver and her law firm against the debtor.  The Fifth Circuit reasoned that, absent the stay in the bankruptcy proceeding, the appellees could march into court with the order allowing their claims and pursue those claims directly against the debtor individually.  Courts have held that “challenges to nondischargeable debt are not moot precisely because of the possibility of future proceedings directly against the debtor.”  The Fifth Circuit also noted that several courts had extended that reasoning and stated that “a debtor’s challenge to a claim order by a bankruptcy court is not moot if the relevant debt may still be found nondischargeable.”

The Fifth Circuit disregarded the arguments of the receiver and her law firm that the appeal was moot because the relevant debt may be discharged in the future by the bankruptcy court.  The Court of Appeals commented that such an argument “puts the cart before the horse” because “the plain fact is the debt that is the subject of the Claim Allowance Order has not yet been discharged.”  The Fifth Circuit went on to state that the claims may be discharged in the future – and the debtor’s appeal may then become moot – but that did not affect the debtor’s standing at that moment.  Accordingly, the Fifth Circuit held that the debtor was a “person aggrieved” by the order of the bankruptcy court and reversed and remanded the judgment of the district court.

Conclusion

Although they may not have the capacity to represent the estate, an individual debtor-out-of-possession may still have a significant interest in the resolution or outcome of claims to be allowed against the chapter  7 bankruptcy estate as such orders may have a preclusive effect if those claims are later determined to be nondischargeable.  Accordingly, chapter 7 debtors have every incentive to remain active and informed with respect to their cases and should not simply hand the keys to their bankruptcy cases over without also keeping an eye on the trustee, the resolution of claims and the road ahead.