'Practice By Ambush'

In re Beyond.com

In In re Beyond.com, 289 B.R. 138 (Bankr. N.D. Ca. 2003), the court refused to approve a disclosure statement where the plan proposed provisions that included the appointment of debtor's former Chief Operating Officer pursuant to an undisclosed Liquidation Manager Agreement; authorizing the disposition of estate assets upon approval of a majority of the manager and a two person committee on 24 hours notice (which the plan “deemed” approved after the 24 hours notice); to retain and pay advisors without supervision or limitation; to retain professionals without court approval; to assert the estate's rights under Chapter 5 of the Code including potential claims against the former Chief Operating Officer acting in his role as Liquidation Manager; and, to amend the Plan after its Effective Date upon ten days notice to limited parties.

In disapproving the proposed Disclosure Statement, the court initially observed the requirement of Bankruptcy Code Section 1129(a)(1) that the provisions of a Chapter 11 plan comply with all applicable provisions of the Bankruptcy Code. The proposed provisions would permit the debtor to simply ignore many provisions of the Code or Rules including abandonment (Section 554 and Rule 6007); the retention and compensation of professionals (Sections 327 and 330); amendments to plans (Section 1127); sale or use of estate assets (Section 363 and Rules 2002 and 2004); and rules regarding the settlement of controversies (Rule 9019). The court stated:

“The modifications to the applicable provisions of title 11 are not minor, ministerial or simply pragmatic. In effect, the plan affords the reorganized debtor the prerogative to comply selectively with the provisions of the Bankruptcy Code and Rules without judicial supervision. A more cynical view suggests that providing the least notice to the fewest people reduces oversight.” 289 B.R. at 144.

The court further observed that the proposal that the Plan be able to be amended after becoming effective would run afoul of Section 1127 and also violate Section 1129(a)(11) because amendment implies the need for further reorganization. The court concluded: “In its exuberance rewriting provisions of the Code, the author of the proposed plan overlooked the requirements of ' 1129(a), which provide a framework ensuring the integrity of the system. These defects cannot be cured…Having sought bankruptcy's protections, it cannot now rewrite the Bankruptcy Code to suit its purposes.” 289 B.R. at 146.

In re Consolidated Pioneer Entities

The effects of lack of oversight in a confirmed plan were dramatically illustrated by In re Consolidated Pioneer Entities, 264 F.3d 803 (Cir. 9 2001), where a granting of the United States Trustee's motion to convert was affirmed in a confirmed case where the liquidating corporation created by the plan failed to provide accountings, case information or anticipated distributions to creditors. The corporation contended that the Plan created an independent corporation which owed no specific duties to the investors or the estate, nor any reporting requirements to the bankruptcy court or anyone else.

The bankruptcy court found that: “… [the corporation's] failure to comply with its 'fundamental duty to provide an adequate accounting of financial activity constituted cause to convert.” (264 F.3d at 806). As summed up by the BAP panel: “We adhere to the fundamental notion that the … board of directors and its officers were working for the best interests of their constituency, and not for their own self interests.” (248 Bankr. at 377). The Ninth Circuit concluded: “In light of [the corporation's] attempts to prevent the appointment of an examiner and otherwise eschew its duty to account, the bankruptcy court properly determined that conversion to Chapter 7 was necessary to ensure open and full financial disclosure.” (264 F.3d at 809).

Daewoo International Corp. Creditor Trust v. SSTS America Corp.

On the other hand, in Daewoo International Corp. Creditor Trust v. SSTS America Corp., 2003 WL 21355214, the court declined to set aside a plan provision that permanently enjoined creditors from asserting rights of setoff, subrogation or recoupment against the Debtor. When the defendant was sued and sought to assert its rights, the plaintiff asserted the provisions in the confirmed plan. The only notice had been publication of the confirmation hearing notice in The Wall Street Journal, which notice did not apparently disclose existence of the provision that would enjoin the creditor from asserting the noted claims. The court found that notice by publication was adequate constructive notice. The creditor should have obtained and read the Plan: ” … because SSTS was provided with sufficient notice to object to the plan's prohibition on recoupment and because it did not do so in a timely fashion before the Bankruptcy Court, we will not allow it to do so now.” 2003 WL 21355214 at page 5.

This ruling suggests that every creditor of every plan read every line of every plan to make sure a plan does not affect the claims or defenses of a creditor. But query why creditors with minimal notice should be required to engage in such an undertaking when a reorganization plan is primarily about distributions to creditors and not about claims objections. After all, isn't a plan provision that purports to deprive creditors of defenses to claims objections effectively a claims objection? Claims objections, it should be noted, require 30 days notice to an affected creditor pursuant to Bankruptcy Rule 3007.

Motion Practice

Bankruptcy Code Section 1111(a) provides in Chapter 11 cases that claims scheduled as undisputed are “deemed filed”, dispensing with the necessity for undisputed creditors to file claims. Bankruptcy Rule 3003(b) is consistent with this provision. In In re ATD Corporation, 352 F.3d 1062 (Cir. 6 2003), the Debtor proposed in a routine ex parte motion for a claims bar date that creditors scheduled as undisputed in the schedules would be required to file a proof of claim or be barred from later asserting a claim. The Bar Date notice did not set forth this requirement, but merely referred to Bankruptcy Rule 3001. Two undisputed creditors who did not file claims were required to bring motions before the court seeking their distribution after the plan was confirmed. The bankruptcy court granted the creditors' motion because the bar date order allowed the debtor to ignore Section 1111(a), Rule 3003 and ” … permits debtor to avoid constitutionally required due process notice of objections to the scheduled claims.” The district court affirmed and added that Section 105(a), a provision that permits the court to enter orders ” … necessary or appropriate to carry out the provisions of … ” the Bankruptcy Code did not give the debtor the power to contravene Section 1111(a). The Sixth Circuit, in affirming these rulings, concluded that there had been no due process: “ We find no error in the bankruptcy court's determination that to construe the Bar Date Order as debtor urges would 'run afoul' of the due process rights of these creditors to receive adequate and meaningful notice that they were required to physically file a proof of claim before the bar date.” 352 F.3d at 1066.

The Seventh Circuit, in its recent opinion of In re Kmart, 359 F.3d 866(2004), concerning payment of pre-petition debt to critical vendors at the inception of a case, further stated of Section 105(a): “This does not create discretion to set aside the Code's rules about priority and distribution; the power conferred by ' 105(a) is one to implement rather than override.”

Chapter 13 Cases

In Chapter 13 cases, counsel have attempted to craft plan provisions purporting to discharge student loan obligations upon completing performance of the plan, without the necessity to file an adversary proceeding to determine dischargeability of the debt. The courts have rejected these efforts as inappropriate, notwithstanding the existence of case law upholding the finality of confirmed plans.

In In re Lemons, 285 B.R. 327 (Bankr. W.D. Ok. 2002), the plan attempted to discharge post-petition interest and collection expenses. The court rejected the proposed provision, along with other similar plan provisions that are designed to thwart the rights of creditors without due process, as “gamesmanship.”

In In re Whelton, 312 B.R. 508 (D. Vt. 2004), the District Court affirmed the bankruptcy court rejection of a plan provision that would have discharged over $100,000 of student loan obligations without any due process to the creditor. The discharge provision was contained in a portion of the plan entitled “Other Provisions” and was inconspicuous in the fine print. The plan was confirmed without any objection by the creditor.

The creditor later commenced an adversary proceeding to determine that the plan provision could not act to discharge the student loan. In affirming the bankruptcy court's ruling to set aside the provision, the district court found and held that: “A bankruptcy court lacks the authority to confirm a plan unless it complies with the provisions of Chapter 13 and with other applicable provisions of the Bankruptcy Code.” 312 B.R. at 514. Since the discharge provision did not comply with Section 523(a)(8) nor with the Bankruptcy Rule 7001(6) requiring a determination of dischargeability to proceed by adversary proceeding, confirmation was nugatory. In rejecting the plan provision that actively defies the Code, the Court reconciled its holding with circuit level opinions regarding the finality of confirmed plans because the provisions involved ” … a provision in a confirmation order that one-sidedly purports to resolve an issue that may only be resolved in an adversary proceeding is not entitled to preclusive effect.” 312 B.R. at 516. The court noted that notices of confirmation hearings do not provide creditors with notice of any specific plan provisions that may affect it, or which may place specific rights in jeopardy.

Due Process

At the core of these cases is a lack of due process by the moving party or plan proponent. As succinctly stated by the bankruptcy court in Whelton, supra, “Sneaking a provision in a plan, hoping no one will notice it, and then reaping the benefits of its inclusion violates the fundamental principles of due process and fair play, and threatens the heart of our legal, adversarial system.” 299 B.R. at 318. Whether the attempt to rewrite the Code takes place in a routine motion, or in the fine print of a reorganization plan, the effect is the same, to deprive parties in interest of their rights without adequate notice and disclosure. The courts and all parties in interest have a right to rely on the Code and Rules. Attempts to circumvent, defy or rewrite the Code or Rules in pleadings or plans, should be vigorously resisted by the courts. Ample means exist to curb such practices, including Section 1129(a)(1) in Chapter 11, Section 1325(a)(1) in Chapter 13, and in simply applying the Code according to its plain meaning. The alternative is to invite the parties in every case to re-write the Code to suit their desires rather than to treat all parties in interest with the consistency that results when parties can rely upon the Code and Rules that are readily accessible to everyone.

In their desire to zealously represent clients, practitioners may often attempt to rewrite the Bankruptcy Code or Rules in motions or reorganization plans. However, recent opinions have taken umbrage with these efforts to conduct “practice by ambush” that either propose provisions inconsistent with the Bankruptcy Code or seek to deprive parties in interest of due process, or both. After all, fundamental due process ” … is the cornerstone underpinning bankruptcy procedure…A creditor has the right to rely on the Bankruptcy Code and Rules and to expect to be accorded due process of law in accordance with the Bankruptcy Code and Rules, and the United States Constitution.” In re Whelton, 299 B.R. 306, 318 (D. Vt. 2004).

When a motion or plan attempts to rewrite the Code or Rules, due process is abused when parties in interest are left to the vagaries of fine print inserted into lengthy plans or seemingly routine and innocuous motions. Courts are, however, becoming more vigilant in their efforts to prevent these abuses. Several recent opinions draw attention to this issue in the context of motion practice and in Chapter 11 and 13 plans. The decisions almost uniformly reject the notion that creative counsel may dispense with the Code or Rules simply by saying so in a pleading.

Chapter 11 Plans

In re Beyond.com

In In re Beyond.com, 289 B.R. 138 (Bankr. N.D. Ca. 2003), the court refused to approve a disclosure statement where the plan proposed provisions that included the appointment of debtor's former Chief Operating Officer pursuant to an undisclosed Liquidation Manager Agreement; authorizing the disposition of estate assets upon approval of a majority of the manager and a two person committee on 24 hours notice (which the plan “deemed” approved after the 24 hours notice); to retain and pay advisors without supervision or limitation; to retain professionals without court approval; to assert the estate's rights under Chapter 5 of the Code including potential claims against the former Chief Operating Officer acting in his role as Liquidation Manager; and, to amend the Plan after its Effective Date upon ten days notice to limited parties.

In disapproving the proposed Disclosure Statement, the court initially observed the requirement of Bankruptcy Code Section 1129(a)(1) that the provisions of a Chapter 11 plan comply with all applicable provisions of the Bankruptcy Code. The proposed provisions would permit the debtor to simply ignore many provisions of the Code or Rules including abandonment (Section 554 and Rule 6007); the retention and compensation of professionals (Sections 327 and 330); amendments to plans (Section 1127); sale or use of estate assets (Section 363 and Rules 2002 and 2004); and rules regarding the settlement of controversies (Rule 9019). The court stated:

“The modifications to the applicable provisions of title 11 are not minor, ministerial or simply pragmatic. In effect, the plan affords the reorganized debtor the prerogative to comply selectively with the provisions of the Bankruptcy Code and Rules without judicial supervision. A more cynical view suggests that providing the least notice to the fewest people reduces oversight.” 289 B.R. at 144.

The court further observed that the proposal that the Plan be able to be amended after becoming effective would run afoul of Section 1127 and also violate Section 1129(a)(11) because amendment implies the need for further reorganization. The court concluded: “In its exuberance rewriting provisions of the Code, the author of the proposed plan overlooked the requirements of ' 1129(a), which provide a framework ensuring the integrity of the system. These defects cannot be cured…Having sought bankruptcy's protections, it cannot now rewrite the Bankruptcy Code to suit its purposes.” 289 B.R. at 146.

In re Consolidated Pioneer Entities

The effects of lack of oversight in a confirmed plan were dramatically illustrated by In re Consolidated Pioneer Entities, 264 F.3d 803 (Cir. 9 2001), where a granting of the United States Trustee's motion to convert was affirmed in a confirmed case where the liquidating corporation created by the plan failed to provide accountings, case information or anticipated distributions to creditors. The corporation contended that the Plan created an independent corporation which owed no specific duties to the investors or the estate, nor any reporting requirements to the bankruptcy court or anyone else.

The bankruptcy court found that: “… [the corporation's] failure to comply with its 'fundamental duty to provide an adequate accounting of financial activity constituted cause to convert.” (264 F.3d at 806). As summed up by the BAP panel: “We adhere to the fundamental notion that the … board of directors and its officers were working for the best interests of their constituency, and not for their own self interests.” (248 Bankr. at 377). The Ninth Circuit concluded: “In light of [the corporation's] attempts to prevent the appointment of an examiner and otherwise eschew its duty to account, the bankruptcy court properly determined that conversion to Chapter 7 was necessary to ensure open and full financial disclosure.” (264 F.3d at 809).

Daewoo International Corp. Creditor Trust v. SSTS America Corp.

On the other hand, in Daewoo International Corp. Creditor Trust v. SSTS America Corp., 2003 WL 21355214, the court declined to set aside a plan provision that permanently enjoined creditors from asserting rights of setoff, subrogation or recoupment against the Debtor. When the defendant was sued and sought to assert its rights, the plaintiff asserted the provisions in the confirmed plan. The only notice had been publication of the confirmation hearing notice in The Wall Street Journal, which notice did not apparently disclose existence of the provision that would enjoin the creditor from asserting the noted claims. The court found that notice by publication was adequate constructive notice. The creditor should have obtained and read the Plan: ” … because SSTS was provided with sufficient notice to object to the plan's prohibition on recoupment and because it did not do so in a timely fashion before the Bankruptcy Court, we will not allow it to do so now.” 2003 WL 21355214 at page 5.

This ruling suggests that every creditor of every plan read every line of every plan to make sure a plan does not affect the claims or defenses of a creditor. But query why creditors with minimal notice should be required to engage in such an undertaking when a reorganization plan is primarily about distributions to creditors and not about claims objections. After all, isn't a plan provision that purports to deprive creditors of defenses to claims objections effectively a claims objection? Claims objections, it should be noted, require 30 days notice to an affected creditor pursuant to Bankruptcy Rule 3007.

Motion Practice

Bankruptcy Code Section 1111(a) provides in Chapter 11 cases that claims scheduled as undisputed are “deemed filed”, dispensing with the necessity for undisputed creditors to file claims. Bankruptcy Rule 3003(b) is consistent with this provision. In In re ATD Corporation, 352 F.3d 1062 (Cir. 6 2003), the Debtor proposed in a routine ex parte motion for a claims bar date that creditors scheduled as undisputed in the schedules would be required to file a proof of claim or be barred from later asserting a claim. The Bar Date notice did not set forth this requirement, but merely referred to Bankruptcy Rule 3001. Two undisputed creditors who did not file claims were required to bring motions before the court seeking their distribution after the plan was confirmed. The bankruptcy court granted the creditors' motion because the bar date order allowed the debtor to ignore Section 1111(a), Rule 3003 and ” … permits debtor to avoid constitutionally required due process notice of objections to the scheduled claims.” The district court affirmed and added that Section 105(a), a provision that permits the court to enter orders ” … necessary or appropriate to carry out the provisions of … ” the Bankruptcy Code did not give the debtor the power to contravene Section 1111(a). The Sixth Circuit, in affirming these rulings, concluded that there had been no due process: “ We find no error in the bankruptcy court's determination that to construe the Bar Date Order as debtor urges would 'run afoul' of the due process rights of these creditors to receive adequate and meaningful notice that they were required to physically file a proof of claim before the bar date.” 352 F.3d at 1066.

The Seventh Circuit, in its recent opinion of In re Kmart, 359 F.3d 866(2004), concerning payment of pre-petition debt to critical vendors at the inception of a case, further stated of Section 105(a): “This does not create discretion to set aside the Code's rules about priority and distribution; the power conferred by ' 105(a) is one to implement rather than override.”

Chapter 13 Cases

In Chapter 13 cases, counsel have attempted to craft plan provisions purporting to discharge student loan obligations upon completing performance of the plan, without the necessity to file an adversary proceeding to determine dischargeability of the debt. The courts have rejected these efforts as inappropriate, notwithstanding the existence of case law upholding the finality of confirmed plans.

In In re Lemons, 285 B.R. 327 (Bankr. W.D. Ok. 2002), the plan attempted to discharge post-petition interest and collection expenses. The court rejected the proposed provision, along with other similar plan provisions that are designed to thwart the rights of creditors without due process, as “gamesmanship.”

In In re Whelton, 312 B.R. 508 (D. Vt. 2004), the District Court affirmed the bankruptcy court rejection of a plan provision that would have discharged over $100,000 of student loan obligations without any due process to the creditor. The discharge provision was contained in a portion of the plan entitled “Other Provisions” and was inconspicuous in the fine print. The plan was confirmed without any objection by the creditor.

The creditor later commenced an adversary proceeding to determine that the plan provision could not act to discharge the student loan. In affirming the bankruptcy court's ruling to set aside the provision, the district court found and held that: “A bankruptcy court lacks the authority to confirm a plan unless it complies with the provisions of Chapter 13 and with other applicable provisions of the Bankruptcy Code.” 312 B.R. at 514. Since the discharge provision did not comply with Section 523(a)(8) nor with the Bankruptcy Rule 7001(6) requiring a determination of dischargeability to proceed by adversary proceeding, confirmation was nugatory. In rejecting the plan provision that actively defies the Code, the Court reconciled its holding with circuit level opinions regarding the finality of confirmed plans because the provisions involved ” … a provision in a confirmation order that one-sidedly purports to resolve an issue that may only be resolved in an adversary proceeding is not entitled to preclusive effect.” 312 B.R. at 516. The court noted that notices of confirmation hearings do not provide creditors with notice of any specific plan provisions that may affect it, or which may place specific rights in jeopardy.

Due Process

At the core of these cases is a lack of due process by the moving party or plan proponent. As succinctly stated by the bankruptcy court in Whelton, supra, “Sneaking a provision in a plan, hoping no one will notice it, and then reaping the benefits of its inclusion violates the fundamental principles of due process and fair play, and threatens the heart of our legal, adversarial system.” 299 B.R. at 318. Whether the attempt to rewrite the Code takes place in a routine motion, or in the fine print of a reorganization plan, the effect is the same, to deprive parties in interest of their rights without adequate notice and disclosure. The courts and all parties in interest have a right to rely on the Code and Rules. Attempts to circumvent, defy or rewrite the Code or Rules in pleadings or plans, should be vigorously resisted by the courts. Ample means exist to curb such practices, including Section 1129(a)(1) in Chapter 11, Section 1325(a)(1) in Chapter 13, and in simply applying the Code according to its plain meaning. The alternative is to invite the parties in every case to re-write the Code to suit their desires rather than to treat all parties in interest with the consistency that results when parties can rely upon the Code and Rules that are readily accessible to everyone.