What Exactly Is Bankruptcy Litigation?

---

When people think of State Court litigation, they think of a lawsuit.

1. A Bankruptcy Lawsuit Is A Federal Case

Bankruptcy litigation also involves a lawsuit. However, since bankruptcy is filed under the U.S. Bankruptcy Code — which is, by definition, a federal statute — a bankruptcy lawsuit (called an adversary proceeding) is a federal case. There are different types of adversary proceedings.

2. Actions To Determine The Nondischargeability Of Particular Debts

One common type of adversary proceeding is initiated by a creditor to determine the nondischargeability of a particular debt.

The three kinds of debts that are the subject of this kind of suit are: (1) debts incurred through fraud; (2) debts incurred as a result of a breach of fiduciary duty (which does include embezzlement and larceny); and (3) debts that are the result of doing willful and malicious harm to a person or property. A creditor will initiate this kind of adversary proceeding because otherwise the debt in question will be discharged. And the creditor must file the complaint no later than sixty days after the date first set for the meeting of creditors.

Some kinds of debts are not dischargeable, without the creditor mounting a challenge to discharge. A couple of examples: (1) a debt that is a fine for some criminal act; (2) most tax debt; and (3) an obligation to pay domestic support.

3. The Litigation

When a plaintiff files an adversary complaint — sometimes the plaintiff is the debtor rather than the creditor — there is, of course, no guarantee of success. The plaintiff has to win the case. Once the plaintiff files the complaint, the adversary proceeding follows a basic structure.

• The Court issues a summons that the plaintiff includes when serving the complaint on the defendant.
• The parties must have a meet and confer session, which is typically conducted by the attorneys. In fact, most of the time the actual plaintiff and defendant don’t have much direct involvement in the prosecution of the adversary proceeding.
• The parties exchange preliminary information.
• The Court conducts a status conference, prior to which the parties file a joint status report. In essence, the joint status report tells the court the status of the dispute. At the status conference, the judge will set a timetable for the adversary proceeding. Sometimes there are multiple status conferences before trial.
• The parties conduct discovery. Each side is permitted to: (1) ask for documents; (2) ask for admissions of fact; (3) ask questions called interrogatories; and (4) conduct depositions of persons with information relevant to the case. In sum, discovery is designed to gather evidence to be used in trial.
• The Court presides at a pretrial conference. Prior to the pretrial conference, the parties submit a pretrial stipulation. Pretrial stipulations can sometimes be a hundred pages. In essence, they catalogue the facts on which the parties agree. At the pretrial conference, the Court sets the date and time for the trial.
• At the trial, each side presents its evidence to the judge, and the judge then issues a judgment.
• If either side doesn’t like the outcome, it can appeal the judgment, either to the Bankruptcy Appellate Panel, or the U.S. District Court.
• If either side doesn’t like the appellate outcome, it can appeal to the Ninth Circuit Court of Appeals.
• If either side doesn’t like the Ninth Circuit’s ruling it can appeal to the U.S. Supreme Court. However, the Supremes only take about 70 cases a year from the entire nation, and not all of those cases are bankruptcy cases. Therefore, once you’ve hit the circuit level, you’re probably not going any further unless you have something that interests the Supreme Court.
4. Jury Trials

Is a trial in an adversary proceeding a jury trial? The answer is generally, no. Adversary proceedings are what are called bench trials before a judge.

According to the U.S. Supreme Court, when a creditor files a proof of claim in the case, it submits itself to the Bankruptcy Court’s jurisdiction. As a consequence, it is not entitled to a jury trial unless it would have been entitled to a jury trial under the law in the late Eighteenth Century. However, if it has not filed a proof of claim, it may be entitled to a jury trial.

If the parties agree to having the jury trial in the Bankruptcy Court, then it will be conducted in the Bankruptcy Court. Otherwise, it will be conducted in the U.S. District Court.

5. Actions To Challenge The Entire Discharge

A creditor may also use an adversary proceeding to challenge the entire discharge of the debtor, rather than just the discharge of a particular debt. However, this kind of adversary proceeding has a danger. Even if the parties wish to settle, the other creditors must be given an opportunity to continue the adversary proceeding. Therefore, unless there is a very good reason, this sort of adversary proceeding is best avoided.

6. Actions To Avoid Fraudulent Transfers

One kind of adversary proceeding that comes up with some regularity is a fraudulent transfer avoidance action. In other chapters, the only party who has the authority to avoid a fraudulent transfer is the chapter trustee. However, since there usually isn’t a Chapter 11 trustee, the Bankruptcy Code gives debtor the authority to mount the avoidance action. (This use of the word, “avoid,” is a little unusual. It means, “to render null and void.”)

Fraudulent transfer law is vast, and has been around for over 2000 years. The ancient Romans had a well-developed bankruptcy system that was established by Julius Caesar — in part, because he had considerable debt (which may have played a role in his assassination by the wealthy senators on March 15, 44 B.C.). Included in the Romans’ laws on debt were provisions on fraudulent transfer.

There are two basic working definitions for fraudulent transfer:

The first definition captures the ancient Roman idea: A transfer is fraudulent with respect to a creditor if it’s done with the intent to hinder, delay, or defraud a creditor. However, the problem with that definition is the word “intent.” Figuring out another person intends isn’t always easy to do.

Therefore, the law has a second independent definition: A transfer is fraudulent with respect to a creditor if it’s done without getting a reasonably equivalent value in exchange for a transfer.

The basic idea underlying fraudulent transfer avoidance is: If a debtor owes money and conveys valuable assets to others, the transfer can be undone.

Since fraudulent transfer law also exists outside of bankruptcy, a creditor can avoid the transfer in State Court. However, if the debtor is in bankruptcy, only the trustee assigned to the case (or the debtor in possession in a Chapter 11 case) can do so. The trustee steps into the shoes of the creditor and inherits the right to avoid the transfer. In bankruptcy fraudulent transfer avoidance is done using an adversary proceeding.

7. Actions To Avoid Preferences

A concept somewhat related to fraudulent transfer is preferential transfer — usually referred to as “preference.” However, unlike fraudulent transfers, preferences only exist in bankruptcy.

Preference is best understood against the backdrop of the two big goals of bankruptcy.

The first big goal is to give the debtor a fresh financial start. It’s a laudable goal that has its roots in ancient times. The Code of Hammurabi (c. 1760 B.C.) had a bankruptcy law. The Law of Moses (c. 1445 B.C.) in the Bible had bankruptcy laws. And as mentioned above, the ancient Romans had a well-developed bankruptcy law. Moreover, bankruptcy is one of the enumerated powers of Congress in the U.S. Constitution. In fact, some of the people whose visages appear on our currency — including Thomas Jefferson, Abraham Lincoln, and Ulysses Grant — went through bankruptcy. In sum, bankruptcy has a long and noble pedigree.

The second big goal of bankruptcy is to make sure that all similarly situated creditors are treated equally and fairly. There are two ways in which debtors will sometimes violate this goal.

First, debtors won’t list all of their creditors in the bankruptcy papers. That’s a big no-no — perjury — that can get the debtor free room and board at the taxpayers’ expense.

Second, debtors make payments to specific creditors in anticipation of bankruptcy. Perhaps they’re hoping to curry favor with the creditor, or perhaps the creditor is a family member. That sort of prepetition payment is called a preference, or preferential transfer, because the debtor is preferring that creditor above other similarly situated creditors.

As with a fraudulent transfer, the chapter trustee (or debtor in possession in a Chapter 11 case) can avoid a preference using an adversary proceeding. Whoever avoids the preference does so for the benefit of the estate, so that all the creditors will benefit, rather than just the creditors who received the preferential largesse.

For more information on Bankruptcy Litigation, call (562) 777-9159 for a free 20 minute phone strategy session today.