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Law Firm Sanctioned Under Rule 9011 For Filing 'Baseless' Adversary Complaint

Monday, January 6, 2014
By Diane Davis

Dec. 31 --The U.S. Bankruptcy Court for the Central District of California Dec. 11 held that sanctions of $5,000 under Federal Rule of Bankruptcy Procedure 9011 are appropriate against a law firm for filing a “baseless” and frivolous adversary complaint against a Chapter 7 debtor, and failing to conduct a “reasonable and competent inquiry” prior to filing the proceeding (Target Nat'l Bank v. Nelson (In re Nelson), 2013 BL 342730, Bankr. C.D. Cal., No. 6-12-ap-01480, 12/11/13).

Concluding that “sunlight is the best disinfectant” in cases such as this one, Judge Scott C. Clarkson determined that monetary sanctions alone would not be effective in meeting the deterrence goals of Rule 9011 and that true deterrence calls for “both a monetary sanction and for the exposure of this pattern and practice” by Weinstein, Pinson & Riley (WPR).

The court found that the adversary complaint filed by WPR against debtor Elizabeth Blanche Nelson was “baseless” within the meaning of Rule 9011 because there was no evidence that could reasonably support the adversary complaint under Bankruptcy Code Section 523(a)(2)(C), which applies to purchases of luxury goods or services prepetition.

According to the court, the adversary complaint falls below the minimum standards of competence and reasonableness and WPR failed to conduct discovery and investigate the underlying nature of the fraud charges under Section 523(a)(2)(A). There was also no evidence that could reasonably support WPR's allegation concerning the debtor's alleged “credit card kiting” under Section 523(a)(2)(A), the court said. WPR had ample time and resources to conduct an appropriate investigation, but failed to do so, the court said.

While WPR contended that the pleadings were “all filed in good faith,” Rule 9011 “makes no exception for a pure heart, empty head,” the court said, quoting Zaldivar v. City of Los Angeles, 780 F.2d 823 (9th Cir. 1986). The court also found that WPR had been sanctioned in other similar cases such that there was a pattern or practice of activity with this law firm.

Chapter 7 Filing
The debtor filed for Chapter 7 protection and listed an unsecured debt to Target National Bank of $6,659 regarding a credit card account with Target. She also listed $23,927 in additional unsecured credit card debt. According to the debtor's financial statement, she moved from New Jersey to California in the previous year.

Target referred the account to WPR and provided them with a referral sheet. The referral sheet indicated that the debtor had incurred only two charges on the account, and had made regular payments well above the minimum payments due on the account up until shortly before filing for bankruptcy. One charge was made 82 days prior to the petition date in the amount of $2,294 at a Sears Roebuck store, and the other charge was in the amount of $1,948 at a Jennifer Convertible store.

Inquiry Letter to Debtor
WPR sent a letter to the attorney representing the debtor stating that it was investigating a potential Section 523(a) proceeding (the inquiry letter) because the debtor had incurred a charge within the 90-day presumption period, and the debtor had no disposable income available to pay the minimum monthly requirement on unsecured debt.

WPR attorney Richard Ralston, who has since retired, claimed that he reviewed the debtor's statements and the account, and concluded that based on the debtor's use of the card, there was a basis to believe that the charges were nondischargeable under Section 523(a)(2).

Adversary Complaint Filed
Subsequently, Target filed a dischargeability complaint (the adversary complaint). Count I centered on the Sears charge stating that the charge may have been incurred “for goods/services not reasonably necessary for the maintenance or support of the [Debtor] … such as charges to Sears Roebuck.” Count II alleged actual fraud based on the debtor's intent. Count III alleged “credit card kiting,” stating that any payments made on the credit account appear to have been made from a cash advance from the account or from another credit card.

Ralston subsequently resigned from WPR and retired from law practice. Lourdes Slinsky, Ralston's successor, engaged in settlement negotiations with the debtor's counsel, but later resigned. Josh Harrison, Slinsky's successor, attended the status conference and the court entered a scheduling order. Harrison later moved to extend the discovery cutoff date but failed to serve any exhibits or file or serve any witness lists 14 days before trial as required by the scheduling order. As a result, the bankruptcy court denied the motion to extend.

Subsequently, Gail A. Rinaldi started working for WPR and filed an appearance on behalf of Target. She appeared on behalf of Target at the trial on the adversary complaint but the debtor did not appear. Rinaldi said she was unprepared to proceed at trial because she lacked the necessary documentation, and the court dismissed the adversary complaint.

The bankruptcy court sua sponte issued an order to show cause why sanctions should not be imposed against WPR under Rule 9011.

Authority to Sanction Attorneys
“Bankruptcy courts have inherent authority to regulate the practice of attorneys who appear before them,” the bankruptcy court said. They also “have express authority under the Bankruptcy Code and the FRBP to sanction attorneys,” the court said.

Under Rule 9011, the court explained, a bankruptcy court may impose sanctions in three situations -- “where papers are submitted demonstrate factual frivolity, legal frivolity, or where papers are submitted for an 'improper purpose.'”

'Baseless, Frivolous' Adversary Complaint
The court concluded that the adversary complaint was frivolous within the meaning of Rule 9011 because it was a “baseless” filing made without a reasonable and competent inquiry.

WPR argued that because the debtor made the Sears charge within 90 days of the petition date, a rebuttable presumption of nondischargeability under Section 523(a)(2)(C)(i)(l) applied. The court rejected this argument, saying that Section 523(a)(2)(C)(i)(l) applied to purchases for “luxury goods or services” as opposed to “goods or services reasonably necessary for the support or maintenance of the debtor or a dependent of the debtor.”

WPR failed to provide any admissible evidence substantiating that the goods purchased by the debtor for the Sears charge were “luxury goods,” the court said. At the order to show cause hearing, William Weinstein of WPR represented for the first time that the Sears charge was for a washer/dryer, but he failed to provide any admissible evidence or sufficient argument otherwise as to why a washer/dryer is a “luxury good,” the court said.

Failure to Investigate
The Ninth Circuit has adopted a “totality of circumstances” approach to determining fraudulent intent in credit card nondischargeability proceedings, the court said, citing In re Eashai, 87 F.3d 1082 (9th Cir. 1996). The facts do not support a finding that the debtor made a sudden change in buying habits, the court said. According to the court, two charges alone, incurred 50 days apart, and 131 and 82 days prior to the petition date do not appear to indicate a “sudden change in buying habits.”

The court found that WPR failed to conduct any meaningful investigation prior to filing the adversary complaint. WPR argued that the adversary complaint was justified based on purported settlement negotiations that took place with debtor's counsel after the filing of the adversary complaint. This type of “post hoc justification” for filing the adversary complaint falls below the minimum standards of competence and reasonableness set forth in Rule 9011, the court said. According to the court, WPR had several months under the scheduling order to conduct discovery to investigate the underlying nature of these charges but failed to do so.

No 'Credit Card Kiting.'
The court found that there was no evidence to support the adversary complaint's allegations of “credit card kiting.” According to the court, any payments made on the credit account appear to have been made from a cash advance from the account or from another credit card. WPR, however, provided no evidence of cash advances from other credit cards. The only evidence alluded to by WPR was the debtor's monthly budget deficit based on Schedules I and J, which WPR extrapolated retroactively to the time when the debtor incurred the two charges. Even if the extrapolation were proper, this evidence is insufficient as a matter of law to support a finding of “credit card kiting,” the court concluded.
'Dearth of Evidence.'
WPR failed to conduct a reasonable and competent inquiry prior to filing the adversary complaint, the court concluded. According to the court, WPR's failure to do so throughout each stage of litigation “constitutes woeful departure from the minimum standards of competence and diligence” set forth under Rule 9011.

Based on the “dearth of evidence,” the allegations and other factual contentions “wholly lacked evidentiary support” and were not based upon a reasonable and competent inquiry by WPR, the court said. According to the court, WPR had ample time and resources to conduct an appropriate investigation. For example, the court said, WPR could have: “(1) questioned the debtor at the 341(a) hearing; (2) sought to extend the dischargeability deadline, or (3) conducted a 2004 exam, and (4) subpoenaed records from Sears.” Instead, WPR merely sent the inquiry letter, then filed an adversary complaint and attempted to settle the matter with debtor's counsel before any trial on the merits, the court said.

The court noted that the inquiry letter threatened a 2004 examination of the debtor, which would have been appropriate, but WPR never followed up on this threat and never conducted a 2004 exam of the debtor. Further, after the adversary complaint was filed, WPR failed to propound any discovery on the debtor, despite anticipating the need for such discovery, the court said.

WPR violated Rule 9011, the court said, by filing the adversary complaint because the underlying complaint lacked an objectively reasonable basis and WPR failed to conduct an objectively reasonable investigation into the facts and circumstances surrounding the allegations contained in the adversary complaint. “While WPR contends that the pleadings were 'all filed in good faith,'” Rule 9011 makes no exception for a “pure heart, empty head” defense, the court said.

Appropriate Sanctions?
Rule 9011, the court said, provides that sanctions should be limited to what is sufficient to deter repetition of such conduct or comparable conduct by others similarly situated. The Advisory Committee Note to Rule 11 directs the court to consider nine factors in determining the appropriate amount of sanctions, the court said. One of those factors is whether the conduct was part of a pattern of activity or an isolated event, the court said. Although Weinstein of WPR told the court that this was the first time WPR had ever been sanctioned to his knowledge, the court found that WPR had been sanctioned previously in a similar case in which Ralson was involved. In another case involving Ralston, the bankruptcy court had awarded sanctions in the amount of $9,583 against WPR for facts similar to this case, the court said.

At the order to show cause hearing, WPR represented that they use a computer program called FAST (Fraudulent Activity Screening Technology) to analyze many indicia of fraud that are identical as factual elements of objective intent to commit fraud. It is unreasonable to delegate this legal decisionmaking process to a non-attorney, let alone a computer system, the court said. “No matter how advanced the FAST program has become, the Court believes that they are an insufficient substitute for due diligence in this respect,” the court said.

The court determined that “sunlight is the best disinfectant.” “[T]rue deterrence calls for both a monetary sanction and for the exposure of this pattern and practice by WPR,” the court said.

Weinstein and WPR are jointly and severally liable for $5,000 for bringing the frivolous proceeding, the court said, and Weinstein is required to report this sanction to the State Bar of California.

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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