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Court Erred by Invoking Inherent Sanction Power; No Evidence of Creditor's Bad Faith

Wednesday, January 22, 2014
By Diane Davis

Jan. 17 --A bankruptcy court had constitutional authority to enter final judgment in an adversary proceeding and did not abuse its discretion in refusing to abstain from hearing the avoidance action under the mandatory abstention provision of 28 U.S.C. § 1334(c)(2); however, the bankruptcy court erred in invoking its inherent sanction power because the court failed to find by clear and convincing evidence that the appellant creditor acted in bad faith, the U.S. Court of Appeals for the Fifth Circuit held Jan. 9 (Cadle Co. v. Moore (In re Moore), 2014 BL 6284, 5th Cir., No. 13-10325, 1/9/14).

Reversing the district court's order and remanding to the bankruptcy court, Judge Emilio M. Garza concluded that notwithstanding the law firm's potential misconduct, the record does not establish that the appellant creditor abused the judicial process -- either before or after it became adverse to the trustee.

According to the court, while the law firm's nondisclosure and inconsistency justify scrutiny, they are not alone clear and convincing evidence of the creditor's bad faith or willful misconduct. Further, the bankruptcy court's “mere suspicions” do not add up to clear and convincing evidence of the creditor's bad faith, the court said.

Although the appeals court said it was “not unsympathetic” to the bankruptcy court's concerns about the “unpleasant odor” of this adversary proceeding, the evidence was not enough to sustain an inherent power dismissal, the court said. This appeal, the court said, turns on whether clear and convincing evidence demonstrates that the creditor, not the law firm attorneys, willfully abused the judicial process. “Neither imputed bad faith nor suspicion alone justifies the invocation of the inherent power,” the appeals court said. 

Case Removed to Bankruptcy Court

Appellant The Cadle Company is the largest creditor of debtor James H. Moore III's bankruptcy estate. Cadle sued Moore, Brunswick Homes LLC (Brunswick), Moore's spouse, and JHM Properties (the defendants) in state court under state law theories of fraudulent conveyance, constructive trust, and reverse veil piercing. Cadle alleged that the debtor had used Brunswick and other entities to shield assets and avoid payment of debts. The law firm of Bell Nunnally & Martin LLP (BNM) represented Cadle in this suit.

Subsequently, the debtor filed for bankruptcy protection. Cadle then removed the action to the bankruptcy court where Cadle and Brunswick each filed proofs of claim. Cadle allowed the estate's trustee to assert the company's claims and the trustee was substituted as plaintiff in the adversary proceeding (avoidance action) and engaged Cadle's counsel BNM to serve as special counsel.

Attorney Bruce Akerly of BNM filed a special employment application indicating that BNM would represent the trustee on a contingency basis and that BNM owed fiduciary duties to only the trustee, not Cadle. Subsequently, however, BNM sent Cadle a letter confirming that Cadle would pay BNM's fees for its representation of the trustee, which fees would be reimbursed by BNM in the event of a positive outcome. 

Motion to Withdraw Denied

BNM also began representing Cadle in a separate action to deny the debtor's discharge. Toward the end of this discharge action, BNM filed a motion to withdraw as special counsel to the trustee in the avoidance action. According to BNM, Cadle had refused to pay certain expenses -- fees for retaining an expert forensic accountant.

At the hearing on the motion to withdraw, a BNM attorney testified that “Cadle instructed [BNM] that they didn't want [BNM] to do anything that would benefit the trustee from a cost and expense standpoint.” The bankruptcy court denied BNM's motion to withdraw, noting the absence of any agreement obligating Cadle to pay either BNM's fees or litigation expenses, and expressing suspicion that Cadle cared more about success in the discharge action than in the avoidance action. 

Settlement in Avoidance Action

Subsequently, the trustee announced a settlement in the avoidance action. Under the agreement, the defendants would pay the trustee $37,500. Cadle, through a new attorney, objected to the settlement and offered to buy back its claim for $50,000. At a hearing on the settlement motion, a Cadle employee testified about Cadle's $60,000 fee payments to BNM for its representing the trustee. The trustee later testified that he was “shocked” at learning about the fees and promptly requested Akerly to disclose the arrangement.

Ultimately, the bankruptcy court approved the settlement and the district court affirmed. On appeal, BNM represented the trustee, and the new non-BNM attorneys represented Cadle. Akerly left BNM and a new first-year associate presented oral argument on behalf of the trustee before the panel.

The panel reversed the district court's judgment and remanded, holding that the bankruptcy court erred by refusing to consider as an available option the sale of the claims to Cadle for an amount greater than the settlement offer. On remand, the bankruptcy court permitted an auction, and Cadle acquired the claims for $41,500. 

Conflicts of Interest

At the sale order hearing following the auction, the bankruptcy court's suspicions about conflicts of interest resurfaced. Akerly sought a continuance in the adversary proceeding's trial date; however, the trustee had not instructed him to seek one. A continuance would benefit Cadle who wanted more time to prepare for trial as the new plaintiff.

The bankruptcy court approved the sale, but ordered a short continuance and requested that Cadle address the apparent conflict of interest. Later, at a hearing, a Cadle employee testified that the company continued to pay BNM's fees for about one year after becoming adverse to the trustee on the settlement issue.

The debtor and Brunswick filed a motion to dismiss on grounds of abuse of judicial process. They argued that in addition to the improper fee payments, BNM might have taken a “dive” during oral arguments on the previous appeal by having the first-year associate present oral argument.

After a hearing, the bankruptcy court dismissed the adversary proceeding based on its inherent power to sanction a party for abuse of judicial process. The district court affirmed.

Cadle appealed to the Fifth Circuit. 

Authority to Enter Final Judgment

On appeal, Cadle argued that the bankruptcy court had no constitutional authority to enter final judgment in this case. According to Cadle, under Stern v. Marshall, 2011 BL 165774, 131 S.Ct. 2594 (2011)(23 BBLR 817, 6/30/11), the bankruptcy court lacked constitutional authority to enter final judgment because the avoidance action originated from and is based entirely on state law and is wholly independent of the bankruptcy proceeding.

The Fifth Circuit disagreed with Cadle, concluding that the bankruptcy court had authority to enter final judgment because Cadle's state-law claims “would necessarily be resolved in the claims allowance process.” Cadle is a creditor who has filed a proof of claim for debts owed by the debtor, the court noted, and resolving the state-law claims is necessary to adjudicating its proof of claim. “Such claims by creditors against debtors are the very reason the claims allowance process exists,” the appeals court said.

According to the court, the state-law basis of the claims is not dispositive. While Cadle's claims rest on state-law theories and were originally brought in state court, after the debtor filed for bankruptcy, the Bankruptcy Code governed the avoidance action, the court said. 

No Mandatory Abstention

Cadle also contended that the bankruptcy court erred by not abstaining from hearing the avoidance action under the mandatory abstention provision of 28 U.S.C. § 1334(c)(2). The appeals court rejected this argument, concluding that there was no “timely motion of a party.” The filing that Cadle cited as its “motion” requesting abstention was actually a motion challenging the court's constitutional authority under Stern, the court said. In addition, timeliness is lacking, the court said.

Further, the court determined that the proceeding at issue is “core” under 28 U.S.C. § 157((b)(2) and not merely “related to” a Title 11 case; therefore, it is not eligible for mandatory abstention under §1334(c)(2), the court said. When Cadle originally removed the action to the bankruptcy court, Cadle itself represented that the proceedings were “core,” the court said. The change in the claims' ownership has no bearing on the proceedings' “core” status, the court said. 

No 'Clear and Convincing' Evidence of Bad Faith

Cadle's third argument on appeal was that the court erred in dismissing the adversary proceeding under its inherent sanction power. A decision to invoke the inherent power to sanction requires a finding of “bad faith or willful abuse of the judicial process,” the court said. In addition, the court noted that it required clear and convincing evidence.

The appeals court found that because the bankruptcy court failed to find by clear and convincing evidence that Cadle acted in bad faith, it erred in invoking its inherent sanction power. According to the court, the “record does not establish that Cadle deliberately abused the judicial process -- either before or after it became adverse to the trustee.”

The court said it was “not unsympathetic” to the bankruptcy court's concerns about the “unpleasant odor” of this adversary proceeding, but noted that Cadle's management of the avoidance action was “inept” at best. Even at its worst, however, the evidence was not enough to sustain an inherent power dismissal, the court said.

Judges W. Eugene Davis and James L. Dennis joined the opinion.

To contact the reporter on this story: Diane Davis in Washington at ddavis@bna.com

To contact the editor responsible for this story: Jay Horowitz at jhorowitz@bna.com

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