Imposition of Sanctions Against Debtor's Attorney Engaged in Scheme Is Proper

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In re Armstrong, E.D. Tex., No. 4:11-cv-00772-RC, 9/21/12

  • Key Development: A bankruptcy court did not abuse its discretion in sanctioning a Chapter 13 debtor's counsel for attempting to abuse the bankruptcy process by discharging debts his client could not in good faith challenge.

  • Key Takeaway: A $500 sanction against debtor's counsel is appropriate because he engaged in an improper scheme to obtain the equivalent of a Chapter 7 discharge.

By Diane Davis

The U.S. District Court for the Eastern District of Texas held Sept. 21 that a bankruptcy court did not abuse its discretion in sanctioning a Chapter 13 debtor's counsel for attempting to abuse the bankruptcy process by discharging debts his client could not in good faith challenge (In re Armstrong, E.D. Tex., No. 4:11-cv-00772-RC, 9/21/12).

Affirming the decision of the bankruptcy court imposing $500 in sanctions against debtor's counsel, Judge Ron Clark concluded that debtor's counsel engaged in an improper scheme to obtain the equivalent of a Chapter 7 discharge.

The court found that the record reflected that debtor's counsel participated in, or facilitated a scheme to improperly manipulate the bankruptcy process. Despite repeated warnings, debtor's counsel refused to modify his behavior, the court said. According to the court, debtor's counsel is an experienced attorney who chose a deliberate course of action designed to obtain benefits for his client to which she was not entitled. Further, counsel did not investigate the information his client had pertaining to creditor's claims and he failed to know and observe local rules of the court, the court said.

According to the court, the bankruptcy court's findings of fact are well supported by the record and are correct. Imposition of sanctions was warranted, the court said.

Chapter 13 Filing
Debtor Diane M. Davis filed for Chapter 13 protection and was represented by attorney Gary Armstrong of Armstrong Kellett Bartholow PC. The debtor is a single, affluent debtor with no dependents. Her gross annual income is $121,760.

On her schedules, the debtor listed all of her credit card debts, and included the statement as follows: “Debtor listed the balance shown on last statement, debtor not presently able to determine if balance is correct and is uncertain if trade name is correct legal creditor.” Twelve creditors filed claims against the debtor totaling $17,400. The debtor's Chapter 13 plan proposed to make monthly payments for a period of 60 months that would result in full payment to all her general unsecured creditors.

No creditor objected to the plan, and the bankruptcy court entered an order confirming the plan.

Debtor's General Objections
The debtor then filed identical objections to the claims of each of her general unsecured creditors, stating that she had received the claim but “cannot determine that the amount stated on the claim is accurate because there are no ledgers or other accounting records attached to the proof of claim.” Due to this lack of documentation provided by the claimant, the debtor said she cannot verify the account.

Some claimants subsequently filed amended claims with additional documentation or provided debtor's counsel with additional documentation including billing statements and cardholder agreements. Debtor's counsel, however, filed seven certificates of no response to debtor's objections, notifying the court that these seven creditors had not responded to the debtor's lack of documentation objections.

Counsel Playing Games?
The bankruptcy court held a hearing to determine whether counsel was abusing the bankruptcy process by filing objections to every claim based on lack of documentation when the debtor was not denying that she had liability to these creditors. According to the court, it appeared that counsel was “playing games” by asking the court to disallow claims based on an alleged lack of “sufficient” documentation attached to the claim and not on the debtor's own knowledge of documents or statements she received, or on a belief that the claim was improper or was not actually owing.

In a second hearing, members of counsel's law firm appeared and testified that they believed the objections were sufficient because the creditors did not comply with Federal Rule of Bankruptcy Procedure 3001 and their claims were not prima facie valid. Subsequently, the bankruptcy court ruled that the proofs of claims substantially complied with Rule 3001, and sufficiently informed the debtor of the basis of the claims. The court then vacated the order confirming the debtor's plan on the grounds that the debtor acted in bad faith.

The bankruptcy court also addressed the ethical concerns raised by counsel's lack of personal knowledge of the debtor's debts, his failure to investigate, and to assure to the best of his ability that the schedules were complete and accurate before they were filed, and the failure to comply with the court's request to provide the court with more evidence in support of claim objections.

Counsel's Argument

In a show cause hearing to determine whether Armstrong's conduct violated Rule 9011(b), counsel for Armstrong argued that he was an experienced bankruptcy attorney who made an effort to comply with the Bankruptcy Code while diligently representing his client. According to counsel, the debtor provided him with the most recent statements from each credit card listed on her schedules, but she did not have the actual cardholder agreement. Armstrong said that he needed to obtain and review these cardholder agreements because they “might” provide the debtor with a substantive claim. Thus, he asserted that this justified disputing every debt on the debtor's schedules regardless of whether his client actually disputed those claims.

Armstrong also noted that courts were divided as to whether a claims objection can be based totally on lack of documentation. According to Armstrong, in Northern District practice, claimants who failed to respond to his lack of documentation objections were considered in default and his objections would be sustained. The Eastern District where this case is filed, however, does not follow this practice, the court noted. Armstrong then filed a legal brief in support of his argument that lack of documentation was a substantive objection under the Bankruptcy Code.

On Sept. 30, 2011, the bankruptcy court issued a memorandum finding that counsel engaged in an improper scheme to allow his client to obtain a quick discharge of her unsecured debt in violation of Rule 9011(b). The court then ordered Armstrong to pay a penalty of $500 to deter repetition of each conduct and comparable conduct by others similarly situated.

Armstrong appealed to the district court.

Evidence Supports Finding
Because Rule 9011 is “substantially identical to Federal Rules of Civil Procedure 11, the district court explained, courts refer to Rule 11 jurisprudence when considering sanctions under Rule 9011. According to the court, the evidence supported a finding that Armstrong's actions had an improper purpose. Armstrong filed all credit card debts as “disputed” to justify his later objections, the court said. He also objected to every single proof of claim on the grounds of “insufficient” documentation, without any evidence, or even any belief, that the debt was not owed or that a substantive defense under Texas law existed, the court said. “Attempting to manipulate the bankruptcy process is an improper purpose under 9011 and, grounds for sanctions,” according to the court.

According to the court, there was no basis to claim that Armstrong's contentions were warranted by existing law. Attorneys must abide by the conduct set forth in the court's local rules, the court explained, citing Local Rule AT-3. The Eastern District does not allow debtors to object to claims a debtor has no basis to contest, merely on the basis of “insufficient documentation,” the court said. Armstrong did not argue that the Eastern District should change its rules to comply with those of the Northern District, but even if it had, he did not provide any authority for the proposition that the Northern District encourages automatic rejection of valid claims a debtor knows are properly owed, merely because of insufficient documentation, the court said.

Sanction Is Appropriate
The $500 sanction was proper, the court concluded. “Judge Rhoades carefully considered what amount would be sufficient, but no more than necessary to achieve deterrence. She did not abuse her discretion,” the court concluded. A bankruptcy court does not have the time district courts devote to a motion, the court explained, to examine each petition, proof of claim, and objection, and the bankruptcy judge must rely on counsel to act in good faith.

A strong deterrence must be a consideration when a judge considers sanctions, the court said. After some claimants responded to counsel's demands for more and more proof, seven were left, the court noted, and the debtor attempted to obtain a Chapter 7 style discharge of their claims in the amount of $57,478. The sanction of $500 is less than one percent of that amount, the court said. “[T]he sanction will encourage counsel to conduct a proper investigation of each client's assertions, to read the Bankruptcy Rules and the local rules of court, and to refrain from pleadings that have no basis in law or fact,” the court said.

By Diane Davis

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