February 2007

Debtor/Creditor NewsMag
A publication of the Debtor/Creditor Rights Committee of the Business Law Section of the State Bar of Michigan
Articles of Interest for the
Practitioner of Debtor/Creditor Law

The Building Contract Fund Act and 523(a)(4):  An Issue Long Glossed Over
By: Thomas R. Morris of Silverman & Morris, PLLC

Bankruptcy Judge Thomas J. Tucker, in Franzone v. Ernst, (In re Ernst), 06‑4803‑TJT (Bankr. E.D. Mich., September 25, 2006) (unreported bench opinion), held that a violation by a corporate contractor of the Michigan Building Contract Fund Act, M.C.L. 570.151 et seq. (the “Act”) (also known as the “Builders’ Trust Fund Act”), does not give rise to a debt on the part of an officer or employee of the contractor that is non‑dischargeable under 11 U.S.C. § 523(a)(4).  Judge Shefferly, in Conquest Construction, Inc. v. Cicero, 06-4852-PJS (Bankr. E.D. Mich., November 30, 2006)(opinion denying motion for reconsideration), disagreed.

Applying the Sixth Circuit’s holding in In re Blaszak, 397 F.3d 386, 391‑392 (6th Cir. 2005) and the Supreme Court’s holding in Davis v. Aetna Acceptance Co., 293 U.S. 328 (1934), Judge Tucker found that in order to find a “defalcation while acting in a fiduciary capacity” on the part of the debtor, there must be an express trust in existence prior to the alleged defalcation.  The elements of an express trust were found by the court of appeals in Blaszak to include:  an intent to create a trust; a trustee; a trust res; and a definite beneficiary.  Although the Sixth Circuit, in In re Johnson, 691 F.2d 249, 252‑253 (6th Cir. 1982), found the Act to fulfill the express‑trust requirements of the Bankruptcy-Act predecessor to § 523(a)(4), in Johnson, the debtor was a sole proprietor, not an officer or other agent of a corporation or other limited-liability business organization.

The Act provides in relevant part, as follows:

In the building construction industry, the building contract fund paid by any person to a contractor, or by such person or contractor to a subcontractor, shall be considered by this act to be a trust fund, for the benefit of the person making the payment, contractors, laborers, subcontractors or materialmen, and the contractor or subcontractor shall be considered the trustee of all funds so paid to him for building construction purposes.

Thus, in Johnson the debtor was a “contractor” and therefore the “trustee” of the funds paid to him “for building construction purposes”.

The same was not true with respect to the debtor in Ernst.  In Ernst, the contractor was a corporation, and any “building contract fund” was paid to the corporation.  No trust agreement (other than that allegedly imposed by the Act) was alleged to exist between the debtor and the creditor.  (Note that in Blaszak, the issue was whether a written contract created a trust, and the court found that it had.)  Hence, there was no intent to create a trust, and therefore no express trust upon which a finding of nondischargeability under § 523(a)(4) could be made.

Judge Shefferly, in Cicero, denied the defendant’s motion for dismissal, holding that the language of the Act which imposes a trust on a “contractor” could apply to an individual in control of a corporate contractor.  The matter has not yet gone to trial, so no final order has yet been entered and the issue has not gone up on appeal.

The bankruptcy court’s holding in Ernst answers a question which appears from the reported cases since Johnson to have not been asked.  That question is whether Johnson’s determination that the Act provides for an express trust with respect to a “contractor” who is paid a “building contract fund” for “building construction purposes” applies with equal force to any agent or person in control of the corporate contractor.  In cases such as In re Englund, 20 B.R. 957 (Bankr. E.D. Mich. 1982); In re Little, 163 B.R. 497 (Bankr. E.D. Mich. 1994); and In re Collins, 266 B.R. 123 (N.D. Ohio 2000), the issue was not reached because the debtor was a sole proprietor, personally entered into the contract, and personally received payment.  In other cases such as In re Crane, 154 B.R. 60 (Bankr. E.D. Mich. 1993); In re Hickey, 1999 W.L. 33313133 (E.D. Mich. 1999); and In re Kriegish, 275 B.R. 839 (E.D. Mich. 2002), there was no distinction made between the debtor and the business entity which had entered into the contract.  In the first group of cases the question was not reached.  In the second group of cases it was not addressed.  Ernst and Cicero have now addressed the question, but their disagreement prolongs uncertainty on this point of law.

Mortgage Avoidance Update: Michigan Supreme Court Denies Certification on Mortgage Filing Issue
By Brendan G. Best of Dykema Gossett, PLLC

On October 20, 2006, the Michigan Supreme Court, in Case No. 130966, In re Certified Question From the United States Bankruptcy Court for The Eastern District of Michigan, declined the bankruptcy court’s request to answer the certified question, “when is an instrument deemed recorded when a register of deeds fails to maintain an entry book?” Justice Weaver, in her concurring opinion, questioned the Supreme Court’s constitutional authority to hear questions certified from federal courts.” See id. at 2 (citations omitted). Justices Corrigan and Young also wrote separately, concurring in the denial on the basis that “the failure of certain of our state’s registers of deeds to comply with the statutory mandate presents a political issue that must be addressed and resolved by the political branches of our state government.” Id. Justice Corrigan stated that the recording acts’ requirement to maintain an entry book was clear on its face, and “[i]t is not our role to rewrite the statute where the registers have failed to maintain entry books.” Id. at 3. Justice Young’s concurring opinion took on a decidedly libertarian strain, “alert[ing] the citizens of this state that elected officials in many counties currently do not comply” with the recording statutes, “rais[ing] serious questions about the commitment of elected officials in this state to protect basic property rights.” Id. at 4.

While picking up the libertarian drum beat, Justice Markman’s dissenting opinion was firmly rooted in federalist ideology, stating that “this Court, in refusing to answer the instant certified question, not only demonstrates a lack of comity with the certifying court but even more significantly contributes to the distortion of our system of judicial federalism by ceding responsibility for the interpretation of Michigan law and thereby diminishing the control of the people of Michigan over the development of their own law.” Id. at 5. While dismissing the claim that this case presented a political question (the question “no more constitutes a ‘political question’ than any other question of statutory interpretation”), Justice Markman also took direct aim at Justice Corrigan’s assertion that the Supreme Court was being asked to rewrite the recording statutes. “[N]o one is seeking to have this Court 'rewrite' MCR 565.24 or any other law, but simply to exercise its core judicial power and say what the present law means.” Id. at 6 (emphasis in original).

As Justice Markman pointed out, the citizens of Michigan must now rely on the rulings of federal bankruptcy judges when confronting this issue of state property law. Two cases directly on point in Michigan are Tibble v. Consumers Credit Union (In re: Koshar) (Judge Hughes), 334 B.R. 889 (Bankr. W.D. Mich. 2005) and Gold v. Interstate Financial Corp. (In re: Schmiel), Adversary Proceeding No. 04-04023 (Bankr. E.D. Mich., July 7, 2005) (unpublished) (Judge Shefferly), with both cases essentially holding that a mortgage is recorded on the date the mortgage is presented for recording, provided that the mortgagee can demonstrate compliance with the other provisions of the recording acts. Unfortunately, these opinions will probably only lead to more questions rather than answers. For example, if a county refuses to accept a recording fee until it has completed a lengthy extra-statutorial “pre-recordation” review, should the mortgagee be held not to have complied with Michigan’s recording statutes because it did not (and could not) pay the fee upon presentment? If a county received an electronic submission of a mortgage for recording but delayed several weeks before indexing the mortgage, can the mortgagee be held to have complied with the recording statutes, where electronic recording is not provided for in the statutes? Unless the courts create a bright-line test for determination of the date of recording, or the legislature revises the recording acts, the Register of Deeds office will continue to be the focal point of litigation for years to come.

The Dangers of Doing Business as Counsel for Chapter 11 Debtor:
The Disgorgement of Professional Fees in Administratively Insolvent Cases
By: Deborah Kovsky-Apap of Pepper Hamilton, LLP

“[C]ounsel is a gambler in [bankruptcy] proceedings like every other administrative creditor.”

-- Specker Motor Sales Co. v. Eisen, 393 F.3d 659, 664 (6th Cir. 2004)

Contrary to the view expressed by the Sixth Circuit in Specker, Counsel is not a gambler like every other administrative creditor in bankruptcy proceedings; rather, the deck is stacked against counsel. As a practical matter, counsel and other professionals are the only administrative creditors whose payments are subject to disgorgement to pay other administrative creditors in the event of administrative insolvency. Generally, courts agree that interim professional fees must be disgorged to make distributions to creditors with superpriority claims. Courts are split, however, on whether disgorgement of interim fees to make pro rata distributions at the same priority level is mandatory or discretionary.

11 U.S.C. §726 mandates pro rata distribution but makes no mention of disgorgement of monies already paid. Significant public policy considerations militate against mandatory disgorgement of interim fees: Mandatory disgorgement based solely on administrative insolvency exposes bankruptcy professionals to too much risk, increasing the costs of bankruptcy reorganization. Small firms may be driven from the market, and large ones may demand excessive compensation for taking the severe risk. Professionals such as those employed to deal solely with pension plan liabilities or environmental problems may not be in a position to control or even have knowledge of a debtor’s ability to reorganize, and so are unfairly penalized if it turns out that the debtor is administratively insolvent.

The issue of disgorgement is likely to come up more frequently since 11 U.S.C. §503(b)(9) has dramatically expanded the pool of administrative expense claimants in many cases, thereby increasing the probability that debtors will be unable to pay administrative expenses in full. Attorneys’ interim fees are even being attacked by § 503(b)(9) claimants before the fees are even allowed. In In re Southern Prods., Inc., No. 05-61822 (Bankr. E.D. Mo.), numerous §503(b)(9) administrative expense claimants objected to debtor’s attorney’s fees, arguing that such fees should not be allowed and paid immediately, but rather paid pari passu with all of debtor’s §503(b)(9) claimants.

Bankruptcy courts in Missouri, Massachusetts and Illinois have found that the disgorgement of interim fees is within the discretion of the court. See In re Saathoff, 2005 WL 1139893 (Bankr. W.D. Mo. Apr. 12, 2005); In re Chute, 235 B.R. 700 (Bankr. D. Mass. 1999); In re Kids Creek Partners, L.P., 220 B.R. 963 (Bankr. N.D. Ill. 1998). The Sixth Circuit, on the other hand, like bankruptcy courts in Georgia and Rhode Island, takes the mandatory approach. See Specker Motor Sales Co. v. Eisen, 393 F.3d 659 (6th Cir. 2004); see also In re Chewning & Frey Security, Inc., 328 B.R. 899 (Bankr. N.D. Ga. 2005); In re Kingston Turf Farms, Inc., 176 B.R. 308 (Bankr. D.R.I. 1995).

Bankruptcy professionals can take some steps to protect themselves. For example, a bankruptcy professional should always seek immediate approval of retainers and related security interests in those retainers under 11 U.S.C. §328. Where possible, the professional should negotiate carve-outs in cash collateral and DIP financing orders, specifying that the carve-outs are made pursuant to 11 U.S.C. §506(c) solely to pay professional fees and if not used for that purpose will be returned to the creditor granting the carve-out. See In re U.S. Flow Corp., 332 B.R. 792, 796-98 (Bankr. W.D. Mich. 2005) (distinguishing Specker and holding that a carve-out from a secured lender’s collateral is not property of the estate and not subject to disgorgement). Additionally, the final fee application should be filed early, before a Chapter 11 case actually converts. This approach seemed to work in one case in the Bankruptcy Court for the Eastern District of Michigan: Although the court in In re NM Holdings Company, LLC, 03-48939-TJT (Bankr. E.D. Mich.) did not construe or limit Specker, it did allow professionals’ final fee applications just prior to the case’s conversion. (Note, however, that at least one bankruptcy court has held that even a “final” order for compensation under 11 U.S.C. §330 is still interlocutory and subject to review while the case is pending. In re Lochmiller Indus., Inc. 178 B.R. 241 (Bankr. S.D. Cal. 1995).)

By Charles J. Schneider

It was widely assumed by the enactment of BAPCPA that domestic support orders would enjoy a priority in the distribution of payments under a Chapter 13 Plan. This priority would be ahead of the payment of debtor’s attorney fees thereby making it less likely that debtor’s counsel would represent debtors with considerable domestic support arrears. This assumption is challenged in the post-BAPCPA decision of In re Sanders, 341 BR 47 (Bankr. N.D. Ala. 2006).

The assumption arises out of the change in the scheduled priorities under 11 U.S.C. 507(a). Prior to BAPCPA, domestic support orders were given a seventh place priority under 11 U.S.C. 507(a)(7). After BAPCPA, the priority for domestic support orders were elevated to 11 U.S.C. 507(1). The priority of attorney fees was lowered from 11 U.S.C. 507(a)(1) to 11 U.S.C. 507(a)(2); thereby giving rise to the assumption.

The Sanders court began its analysis of the priority of required distributions to be made from a chapter 13 plan with pre-BAPCPA cases. The court focused on the cases, In re Aldridge, 335 B.R. 889 (Bankr. S.D. Ala. 2005), and In re Ferguson, 134 B.R. 689 (Bankr. S.D. Fla. 1991). These decisions held that nothing in 11 U.S.C. 1322 required a chapter 13 plan to provide for full payment of higher priority claims before distributions made to lower priority claims. Sanders at 50. The Sanders court noted that 11 U.S.C. 1322(a)(2) indicates that priority claims under Section 507 are required to be paid in full but there were no requirements amongst priority claims which was the equivalent of the required distributions in chapter 7 cases under 11 U.S.C. 726. This section requires that priority claims are entitled to be paid first from the property of the estate in the order specified in Section 507. 11 U.S.C. 726(a)(1).

The Sanders court further focused on the BAPCPA amendment to 11 USC 1326(b)(1). The court noted that attorney fees still enjoyed a payment priority inasmuch as the BAPCPA amended statute still required that:

         (b) Before or at the time of each payment to creditors under the plan, there shall be paid--
              (1) any unpaid claim of the kind specified in section 507(a)(2) of this title;

The amendment did not change the priority of payment to attorney fees as it substituted the former referenced attorney fees under Section 507(a)(1) to the new section under Section 507(a)(2). Congress thereby intended no change in the pre-BAPCPA payment priority of attorney fees. The court concluded that section 507(a)(2) grants priority to administrative expenses allowed under section 503(b)(2). Section 503(b)(2) provides that administrative expenses includes compensation under section 330(a)(4)(b). The debtor’s attorney fees as administrative expenses must be paid either before or contemporaneously with other claim holders, including domestic support claim holders, of a higher priority.

The court then addressed the payment of secured claims prior to the payment of domestic support obligations. It concluded that inasmuch as 11 U.S.C. 1322(b)(4) states that a chapter 13 plan may “provide for payments on any unsecured claim to be made concurrently with payments on any secured claim or any other unsecured claim”, a domestic support claim holder as an unsecured creditor could be paid concurrently with secured creditors. The court stated that there was nothing in the code that required secured creditors should receive reduced post-confirmation adequate protection payments while domestic support orders were being paid in full. Such a payment scheme would violate the equal monthly distribution payments required by Section1325(a)(5)(B)(iii).

The Sanders case was approvingly cited in another Alabama case, In re Vinnie, No. 06-80058-WRS, 2006 Bankr. LEXIS 1209, at *11 (Bankr. M.D. Ala. 2006).

The Practitioner's Dilemma
By: Martin L. Fried

We all knew it was inevitable. Give the legal profession a set of statutes capable of multiple interpretations, and that’s what you’ll get.

This article will look at various sections of BAPCPA and Michigan’s Debtor/Creditor related law to point out opposite conclusions reached by different judges on the same statutes. You may draw your own conclusions on what our legislators were thinking (or not) when passing these acts.

Michigan Exemption Statute: Available or Not?

Even the least experienced bankruptcy practitioner knows that Debtors in bankruptcy may choose between the so-called state exemptions and the federal exemptions. The state statute which contains the most - but not all - of the state exemptions is MCL 600.5451. Judge Thomas J. Tucker of the Eastern District has ruled in a unpublished bench opinion, In re Eisenberg, 05-56811, that Michigan residents who wish to take the state exemptions must take ALL of their exemptions from MCL 600.5451 since that is the exclusive set of exemptions available to Michigan residents who choose the state exemptions. To the contrary, Judge Jeffrey R. Hughes of the Western District has ruled that Michigan residents may take NONE of the exemptions in MCL 600.5451 since that statute is unconstitutional. In re Wallace, 347 BR 626 (2006).

Michigan Homestead Exemption: Available of Not?

The homestead exemption provided in MCL 600.5451(1)(n) has been held to be both constitutional and unconstitutional in the Eastern District of Michigan. Judge Thomas J. Tucker held the homestead exemption to be unconstitutional in In re Vinson, 337 BR 147 (2006) while District Court Judge Nancy Edmunds held the homestead exemption to be constitutional in the appeal of the Vinson case in Vinson v Dakmak, 347 BR 620 (2006). Judge Tucker has noted that he does not consider the Vinson appeals decision to be binding on the bankruptcy judges except in the Vinson case itself so he is free to continue holding that the homestead exemption is unconstitutional in other cases.

910 Vehicles: Surrender Deficiency or Not?

The so-called “hanging paragraph” of BAPCPA appears in §1325(a) and deals with debt secured by vehicles for personal use purchased within 910 days before filing the petition. The hanging paragraph prohibits bi-furcation of the secured debt into secured and unsecured claims. That leads to the question of whether the secured creditor could have a deficiency claim against the chapter 13 debtor who surrendered the vehicle to the secured creditor. Of the three published decisions in the Eastern District, Judge Steven Rhodes prohibited a deficiency claim in In re Evans, 349 BR 498 (2006), while Judges Phillip J. Shefferly and Thomas J. Tucker permitted deficiency claims respectively in In re Particka, — BR —, 2006 WL 3350198, and In re Evans, 349 BR 498 (2006).