The Bankruptcy Hotline

The Third Circuit reversed, stating the lower court decisions “establish a policy that fosters lawyers' abuse of their fiduciary relationships with their clients, and fail adequately to protect the justifiable reliance of clients on their lawyers' probity and trustworthiness.” The court noted that the bankruptcy court's orders had given debtor's counsel almost “exclusive control” over its assets, and court was not able to monitor use of the funds. Consequently, a jury could conclude that the debtor's decision to entrust its lawyer to safeguard its assets “was within the bounds of reasonableness.” Further, the court found that counsel's abuse of his fiduciary relationship to be “highly relevant.” The court remarked that “[w]here the wrongdoing underlying causes of action has been perpetrated by a fiduciary to the detriment of its principal, this fact militates strongly against summary judgment on the issue of whether the principal … exercised reasonable diligence in failing to discover the fiduciary's malfeasance within the applicable statutes of limitations.”

Conversion to Chapter 7 Was Proper

The Eighth Circuit has ruled that it was not an abuse of discretion for a bankruptcy court to grant a trustee's motion to convert a Chapter 11 bankruptcy to a Chapter 7, even though the debtors argued that its losses could only be realized in Chapter 11. Loop Corp. v. U.S. Trustee, No. 03-1786 (August 16).

The court was not persuaded by the debtors' argument, noting it conceded that, as liquidating entities that had ceased their business operations but continued to incur administrative expenses, the debtors had a negative cash flow. “Under the interpretation of ' 1112(b)(1) consistently used in bankruptcy courts,” the court stated, “this negative cash flow situation alone is sufficient to establish 'continuing loss to or diminution of the estate.'” In addition, the court found no abuse of discretion in the bankruptcy court's conclusion that “any speculative value which might be derived from the net operating losses in Chapter 11 was outweighed by the continuing erosion of the estate, the debtors' failure to achieve a confirmable Chapter 11 plan, and the preference of the Creditors' Committee for conversion.”

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Embezzlement By Bankruptcy Counsel Tolls Time Bar

The Third Circuit has ruled that a bankruptcy attorney who embezzled money from the estate should not be able to use the statute of limitations as a shield to his malfeasance because the trust placed in counsel may have prevented the debtor and trustee from discovering the theft. In Re: Mushroom Transportation Company Inc., No 02-3754 (August 24).

The debtor and its related subsidiaries filed a Chapter 11 bankruptcy petition that was later converted to a Chapter 7 liquidation. The bankruptcy court later authorized debtor's counsel to open an escrow account to hold the proceeds generated from the sale of the debtor's assets. Unfortunately counsel also embezzled more than $500,000 from this escrow account. The Chapter 7 trustee filed an adversary action alleging conversion, breach of fiduciary duty, breach of contract and legal malpractice, but defense counsel argued that these claims were time-barred because the debtor had failed to exercise reasonable diligence in discovering the embezzlement. The bankruptcy court agreed, finding that the debtor was not entitled to any “equitable tolling” of the statutes of limitations. The district court affirmed, finding that because the debtor had abdicated its statutory duty to preserve the estate's assets, it also could not show it had been reasonably diligent with respect to the rules of discovery.

The Third Circuit reversed, stating the lower court decisions “establish a policy that fosters lawyers' abuse of their fiduciary relationships with their clients, and fail adequately to protect the justifiable reliance of clients on their lawyers' probity and trustworthiness.” The court noted that the bankruptcy court's orders had given debtor's counsel almost “exclusive control” over its assets, and court was not able to monitor use of the funds. Consequently, a jury could conclude that the debtor's decision to entrust its lawyer to safeguard its assets “was within the bounds of reasonableness.” Further, the court found that counsel's abuse of his fiduciary relationship to be “highly relevant.” The court remarked that “[w]here the wrongdoing underlying causes of action has been perpetrated by a fiduciary to the detriment of its principal, this fact militates strongly against summary judgment on the issue of whether the principal … exercised reasonable diligence in failing to discover the fiduciary's malfeasance within the applicable statutes of limitations.”

Conversion to Chapter 7 Was Proper

The Eighth Circuit has ruled that it was not an abuse of discretion for a bankruptcy court to grant a trustee's motion to convert a Chapter 11 bankruptcy to a Chapter 7, even though the debtors argued that its losses could only be realized in Chapter 11. Loop Corp. v. U.S. Trustee, No. 03-1786 (August 16).

The court was not persuaded by the debtors' argument, noting it conceded that, as liquidating entities that had ceased their business operations but continued to incur administrative expenses, the debtors had a negative cash flow. “Under the interpretation of ' 1112(b)(1) consistently used in bankruptcy courts,” the court stated, “this negative cash flow situation alone is sufficient to establish 'continuing loss to or diminution of the estate.'” In addition, the court found no abuse of discretion in the bankruptcy court's conclusion that “any speculative value which might be derived from the net operating losses in Chapter 11 was outweighed by the continuing erosion of the estate, the debtors' failure to achieve a confirmable Chapter 11 plan, and the preference of the Creditors' Committee for conversion.”

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