Michigan Bankruptcy Blog

Timing is Everything: Sixth Circuit Reverses Bankruptcy Court and Rules that Lawsuit Settlement is Not Property of the Debtor's Estate

When someone files for bankruptcy, an estate is created that consists of, among other things, any and all assets owned by, or to which the debtor filing the bankruptcy case has a right to or interest in. This includes tangible things such as real estate, vehicles, money, clothing, and jewelry, as well as rights to property such as litigation claims.

In a Chapter 7 case, all assets belong to the trustee on the date a case is filed unless an exemption is claimed, and the trustee gets to keep, sell or otherwise administer assets for the benefit of creditors.

When it comes to determining "property of the estate," timing is important. Generally speaking, a debtor gets to retain property acquired after the bankruptcy filing occurs.

Recently, the U.S. Court of Appeals for the Sixth Circuit reversed a bankruptcy court in a case involving the analysis and determination of whether an asset was acquired before or after a debtor filed for bankruptcy.[1]

Robert and Beth Underhill filed for Chapter 7 in 2010, listing their ownership in Golf Chic Boutique LLC, a small retail operation they owned and operated, as an asset. After the Underhills received a discharge and the case was closed, Golf Chic sued a competitor for tortious interference and settled the case for an $80,000 payment to Beth Underhill.

The lawsuit was filed after the Underhills discovered that a competitor had complained to a mutual supplier about Golf Chic's prices and requested that the supplier end its relationship with Golf Chic. The competitor sent emails to this effect to the supplier in 2010. After the supplier severed ties, Golf Chic went out of business.

After learning of the settlement a creditor, Huntington National Bank ("Huntington"), moved to have the Underhills' bankruptcy case reopened to allow the trustee to distribute the settlement proceeds to creditors. Huntington argued that the settlement proceeds were property of the estate because the cause of action "arose in 2009," while the Underhills countered that the cause of action did not arise until after the threats made by Golf Chic's competitor caused the supplier to sever ties, which was after their case closed.

The bankruptcy court, while acknowledging that the harm occurred post-petition, nonetheless concluded that the cause of action was property of the estate because it was "sufficiently rooted in the [Underhills'] pre-bankruptcy past" because the record "ma[d]e clear that events relating or giving rising to the Claim occurred as early as April of 2009."

The Underhills appealed to the Bankruptcy Appellate Panel, which affirmed the bankruptcy court's decision because the record reflected that "the events giving rise to Golf Chic[]'s claim for tortious interference began in 2009." The Underhills then appealed to the Sixth Circuit.

In its reversal, the Sixth Circuit explained that "most courts apply Segal v. Rochelle, 382 U.S. 375 (1966) -which defined pre-petition assets under a previous version of the Code as those 'sufficiently rooted in the pre-bankruptcy past' of the debtor - to the current version of the Code." It went on to explain that "pre-petition conduct or facts alone will not 'root' a claim in the past; there must be a pre-petition violation." That is, the claimant must have suffered a "pre-petition injury."

The Sixth Circuit stated that the record lacked evidence of a pre-petition violation or injury, explaining that the evidence pointed to by the bankruptcy court was insufficient, and didn't amount to a "wrongdoer's intentional procurement of [a] contract's breach" as required intortious-interference-with-contract cases such as this. The Sixth Circuit held that the violation or injury occurred post-petition, when the competitor sent the cease-sales demand to the supplier. Accordingly, the Underhills were permitted to keep the settlement proceeds.

One judge dissented, arguing that because the Underhills failed to list this litigation claim as a contingent interest in their bankruptcy schedules, they deprived Huntington and other creditors of their shares of the settlement proceeds to which they were entitled.

While this case involves a very fact specific inquiry, there are a couple of broader lessons to learn from it.

• There is a lot of line drawing in bankruptcy. While bankruptcy is an equitable process, there are still many firm deadlines, dates and procedures that must be adhered to. The petition date - the day a case is filed - is very important in determining when rights arise and obligations accrue.

• Don't overlook the 341. Every bankruptcy debtor must attend a meeting of creditors (called a "341 meeting"). Creditors may attend and ask the debtor questions, but most don't. In this case, had more probing questions been asked at the 341 by Huntington or other creditors, then the potential cause of action may have come to light and been added to the debtor's schedules.

Categories: 6th Circuit Court of Appeals, Chapter 7