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Creditors Rights

Creditors Beware: Potential Pitfalls of Automatic Stay Violations

The “automatic stay” is one of the principal immediate benefits of filing bankruptcy. Upon filing a bankruptcy petition, the automatic stay springs into effect to stop any creditor’s debt collection efforts, lien enforcement actions, lawsuits and a host of other actions against the debtor and the debtor’s property. It is primarily designed to maintain the status quo while the court examines the debtor’s financial situation. The automatic stay is often likened to “closing the windows and locking the doors” to prevent any property from leaving the newly-created bankruptcy estate. As its name implies, the automatic stay is effective without any further action by the debtor or the court, and the court will eventually monitor the gathering and distribution of the debtor’s assets. However, until that time, or until the stay is lifted, creditors are generally precluded from taking any action against the debtor or the debtor’s estate.

Pursuant to the Bankruptcy Code, 11 U.S.C. 362(b), there are exceptions to the stay such as civil actions involving the establishment of paternity or the collection of a domestic support obligation. However, the exceptions outlined in § 362(b) are often narrowly construed, and the courts have broad powers to extend the reach of the automatic stay even further when necessary.

Most creditors readily acknowledge that the automatic stay applies to them, but they ask the court to lift the stay via a “motion for relief” under 11 U.S.C. § 362 of the Bankruptcy Code. Such motions commonly allege a lack of adequate protection of an interest in estate property, or lack of an adequate “equity cushion,” or, alternatively, that the debtor does not have equity in the subject property and that the property is not necessary to an effective reorganization in bankruptcy. If the court grants the creditor’s motion for relief, the creditor may repossess and foreclose upon its collateral; however, the creditor is still prohibited from pursuing any actions against the individual debtor. The stay continues until the earlier of the dismissal or the closing of the bankruptcy case, and any actions in violation of the stay are void in Texas. See In re Pierce, 272 B.R. 198, 204 (Bankr. S.D. Tex. 2001).

Not only are actions taken in violation of the stay void in Texas, but they may also be punishable by the court, particularly where the court finds that the creditor willfully violated the automatic stay. See In re Repine, 536 F.3d 512 (5th Cir. 2008). For example, Section 362(k) creates a private cause of action for a debtor to file suit against a creditor who willfully violates the automatic stay to the injury of the debtor. If the creditor is aware of the stay and intentionally acts in violation of the stay, the law provides that the debtor shall recover actual damages, including costs and attorney’s fees.

In addition to economic loss, emotional damages also qualify as actual damages. For example, in a recent appeal before the Fifth Circuit, the Court found that emotional distress damages may also be awarded in the appropriate case, but the plaintiff is required to set forth “specific information” concerning damages caused by his alleged emotional distress rather than relying only on “general assertions.” Repine, 536 F.3d at 521—522. For example, in Repine, the creditor was an attorney for the Debtor’s ex-wife in connection with a child support enforcement action wherein the family court held the debtor in criminal contempt for failure to pay child support and ordered that he be incarcerated until he paid the amounts due and owing to his wife and child. The parties eventually negotiated options for settling the child support enforcement action and securing the debtor’s release from jail, and the court entered an agreed order lifting the automatic stay to enforce the settlement terms. Specifically, the agreed order provided that attorney’s fees due and owing to the ex-wife’s attorney shall be provided for as a priority unsecured claim to be paid through the debtor’s Chapter 13 plan.

In light of the bankruptcy court’s entry of the agreed order, the family court held a hearing regarding the debtor’s release from jail, where the attorney opposed the debtor’s release, as she was concerned that her fees would not be paid. After the hearing, the debtor remained in jail since he had still not paid child support, during which time his father passed away. Also, the attorney threatened in a fax that she would refuse to appear in court to submit an agreed order releasing the debtor from jail, despite her client’s wishes, until she received “a copy of the certified checks” for her attorney’s fees. Subsequently, the attorney’s client and the debtor jointly moved to enforce the bankruptcy court’s agreed order, and the court ordered the attorney to appear and show cause why she should not be held in contempt for attempting to collect her attorney’s fees in violation of the automatic stay.

Despite being personally served with the show cause order, the attorney failed to appear, and the bankruptcy court issued a warrant for her arrest. The U.S. Marshal took the attorney into custody, and the bankruptcy court admonished the attorney to cease any and all collection efforts. Nevertheless, the attorney continued her efforts to collect her attorney’s fees and continued to refuse to consent to the debtor’s release from jail so he could attend his father’s funeral. Consequently, the ex-wife and debtor commenced an adversary proceeding seeking damages and attorney’s fees for the attorney’s willful violation of the automatic stay. After a two-day trial, the bankruptcy court awarded the plaintiffs actual damages (including $4,400.00 for emotional distress, punitive damages and attorney’s fees.) The attorney appealed; however, the district court affirmed the bankruptcy court’s decision.

Subsequently, the Fifth Circuit Court of Appeals vacated the bankruptcy court’s decision in part, finding that the debtor’s general testimony that he felt “very upset” at what his sons would think of him for being in jail and that it was “very traumatic” for him to miss his father’s funeral was insufficient evidence to support an award of emotional damages. Repine, 536 F.3d at 522. However, it is important to note that such an award is available to the plaintiff who makes specific, supportable assertions of emotional distress.

Furthermore, Section 362(k) provides that, in “appropriate circumstances,” a debtor may recover punitive damages. 11 U.S.C. 362 (k). In defining “appropriate circumstances,” the Fifth Circuit recently ruled that an “egregious” intentional misconduct is required on the violator’s part in order to impose punitive damages. Repine, 536 F.3d at 521. In Repine, the Fifth Circuit affirmed the bankruptcy court’s award of punitive damages, finding that the attorney’s violation of the stay was particularly egregious, “reckless,” and “arrogant,” especially since the attorney ignored the court’s orders and her client’s wishes, and she persisted in her collection efforts despite the bankruptcy court’s admonishment.

Accordingly, once a creditor becomes aware of a debtor’s bankruptcy filing, it is imperative that all collection efforts and communications of any kind with the debtor cease immediately in order to prevent any violation of the automatic stay. Once a creditor is aware of the stay and acts in violation of the stay, the debtor likely becomes entitled to actual damages and, in certain cases, may be awarded punitive and emotional damages. Such consequences may be easily avoided with a quick bankruptcy search of the subject obligor(s) prior to any communications, demands or other debt collection acts.

Creditors should consult with legal counsel soon after a bankruptcy filing in order to obtain advice for promptly and effectively protecting such creditors’ rights.

By David M. O’Dens and Kerry M. Hayden

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Creditors Rights

Is a Limited Liability Company Always the Right Choice?

Given the significant flexibility of a limited liability company (“LLC”) in terms of formation, corporate governance, and tax status, LLCs are emerging as the preferred entity choice for private business. However, because of a recent ruling in the case McNamee v. Department of Treasury, Internal Revenue Service 488 F. 3d 100 (“McNamee”), a careful evaluation of your business objectives, financial and tax considerations, and desired level of liability protection should be made in determining the right entity for your situation. In McNamee, the Second Circuit Court of Appeals affirmed a federal trial court’s ruling that the owner of an LLC can be held personally liable for unpaid payroll taxes of the LLC.

One of the benefits of an LLC, which also may be its Achilles’ heel in certain situations, is the ability to elect to treat the entity as a corporation or a partnership (or sole proprietorship if only one member) for federal tax purposes. An LLC exercises that option simply by filing IRS Form 8832 to elect to be treated as a corporation. In the absence of such an election, an LLC that has only one owner is disregarded as a separate entity and will be treated as a sole proprietorship for tax purposes.

According to the Treasury Regulations of the Internal Revenue Code, as discussed by the court in McNamee, if a single-
member LLC elects to be treated as a corporation, the owner will avoid tax liabilities that may otherwise fall upon him if the LLC were disregarded as an entity. However, the owner is subject to double taxation since the LLC is taxed once at the corporate level and once at the shareholder level. If a single-member LLC elects not to be treated as a corporation, either by affirmative election or by default, the owner will be liable for the tax obligations incurred by the LLC, but the owner will avoid double taxation.

Sean McNamee was the singlemember owner of the nowdefunct accounting firm W.F. McNamee & Company, LLC (“WFM, LLC”), which on average employed six persons. Mr. McNamee did not elect to have WFM, LLC treated as a corporation for tax purposes. Thus, under the Treasury Regulations, the LLC was disregarded as a separate entity and was treated as a sole proprietorship for federal tax purposes. WFM-LLC failed to make some of its required payments of payroll taxes with respect to its employees. The IRS assessed those taxes against Mr. McNamee personally and placed a lien on his property, having disregarded WFM-LLC as a separate entity. The court ruled against Mr. McNamee, and he was found personally liable for the unpaid payroll taxes. It is unclear whether the case will be appealed to the Supreme Court.

However, it is important to note that the IRS proposed Treasury Regulations in 2005 would eliminate this liability. Although the proposed regulations had no bearing on the case in McNamee, since they have not been adopted, it is a good sign of what the law may eventually be with respect to LLCs and payroll taxes. The proposed regulations would treat subchapter S subsidiaries and single-owner eligible entities that currently are disregarded as entities separate from their owners for federal tax purposes (e.g., singlemember LLCs), as separate entities for employment tax and related reporting requirement purposes. According to the proposed regulations, the Treasury Department and the IRS believe that treating the disregarded entity as the employer for federal employment taxes purposes will improve the administration of the laws and simplify compliance.

An LLC may still be an excellent choice for a business in many situations, but these developments  highlight the need for careful planning with both your attorney and CPA prior to selecting the type of entity to form for your business.

By James M. Stanford

Categories
Creditors Rights

Lease Obligations in Bankruptcy

Very few tenants enter into leases without the intent to pay all of the rent when due. But lease defaults are a reality. While nonpayment of the rent is bad enough for a landlord, in a commercial tenancy, a tenant’s default has far reaching consequences that may affect other tenants (by reducing traffic) or affect the project in general (by making a project appear less attractive). Therefore, a quick resolution to lease defaults is always in the landlord’s best interest.

Many times, after falling behind on lease payments and other financial obligations, a tenant will seek protection under the United States Bankruptcy Code in order to try and salvage the business. In recent years we have heard many horror stories about bankruptcies in general, but the good news for a landlord is that a debtor’s options in bankruptcy as toward the landlord are very limited. Below are a few important bankruptcy concepts and tenant alternatives in bankruptcy for a landlord’s use in evaluating and reacting to a tenant bankruptcy.

At the outset, the filing of a bankruptcy case imposes an “automatic stay.” Thus, although the tenant must pay all rent that is due from the date of the bankruptcy going forward, the automatic stay prevents the landlord from taking any action, including, for example, use of the landlord’s “self help” remedies. The automatic stay is designed to preserve the debtor’s estate either for reorganization or liquidation. In general, the debtor’s affairs are supervised by the bankruptcy court, and action cannot be taken against the debtor without permission of the court or obtaining “relief from the automatic stay.” Therefore, even in the circumstance where a tenant stops paying rent after filing bankruptcy, a landlord must first obtain relief from the automatic stay before exercising
any of the landlord’s normal default remedies such as lock out, taking possession of collateral securing the lease for non-payment, or suing the tenant for past due rent.

Of primary importance in a Chapter 11 reorganization bankruptcy, a lease obligation is referred to as an “executory” contract. Executory contracts are a special type of contract wherein the parties have some continuing mutual obligation to one another. So, for example, in a lease, the landlord has a continuing obligation to provide the space to the tenant, and the tenant has a continuing obligation to make rental payments. Executory contracts are subject to special rules under the Bankruptcy Code and present the Bankruptcy Court and the debtor with essentially a “binary” option. The debtor must either “accept” or “reject” an executory contract. Acceptance of an executory contract means just that — the contract is affirmed in all of its respects and the debtor is required to make all payments and perform all the actions that are required under the terms of the contract. Rejection, on the other hand, means that the debtor is refusing to continue the contract and surrendering the space to the landlord. It is important to understand from this discussion that the debtor does not have the opportunity to renegotiate a lease obligation.

With an executory contract, the debtor’s only decision is to accept or reject the lease. If the landlord elects to negotiate a “workout,” then that is the landlord’s choice. But the landlord cannot be ordered to amend or modify the lease on behalf of the debtor.

When confronted with a tenant in bankruptcy, a proper landlord’s strategy is aimed towards forcing the debtor to make the acceptance or rejection decision as early as possible in the bankruptcy process. While the Bankruptcy Code provides set deadlines for this decision to be made, in many bankruptcies, the debtor will attempt to delay the decision for some period of time. In a Chapter 11 Bankruptcy, especially, a debtor may attempt to delay the decision until confirmation of the plan. However, even if delayed for some period of time, the fact remains that at some point the debtor must accept or reject the executory contract. If the
tenant accepts the lease, the tenant must bring the lease obligations current. If the tenant elects to reject the lease, the landlord gets the property back and has an unsecured claim for unpaid rent.

While bankruptcy is often viewed as a negative event, landlords and other property owners in a leased property can take some comfort in the fact that their contracts will largely survive as is or be rejected. Bankruptcy can actually be a good event in a landlord-tenant context, because it requires the tenant to either bring the account current or give the property back. And ultimately, this is what landlords are looking for — some “closure” for a defaulted obligation.

By Cliff Wade and Barry Johnson