Archive for the ‘ Procedure ’ Category

My client (“Wolfgang”) ran a small construction business in the summer of 2007. He hired an attorney (“Attorney David”) to help him foreclose on mechanics’ liens he had recorded, because one of his customers didn’t pay him $50,000 for a construction job. The attorney helped him, but the litigation turned very ugly: the customer countersued for $250,000 in completion damages.

The legal bills mounted. From May 2007 to November 2007, Attorney David charged more than $100,000 in attorney fees. Wolfgang settled the countersuit by paying $40,000. He never expected that result: he had hoped to collect $50,000, not pay $40,000.

The recession hit too. Construction started to tank in the San Gabriel Valley in the spring of 2007; by the summer of 2007, Wolfgang had no new jobs, and realized he needed to sell his house and take other financially-protective actions. The bills that Attorney David was piling up? Wolfgang couldn’t keep up with them, but kept promising he’d pay Attorney David.

He and his wife discussed the situation over the fall. If we’re going to sell the house and move, his wife said, I want to go back to Luxembourg (where she came from) with the children.

His wife moved back to Europe in January 2008. Wolfgang sold his house the next month. He had also invested in a Pollo Loco franchise, and he tried to keep that going. He moved in with his mother in Calabasas for five months, then moved to Luxembourg to be with his wife and children.

Attorney David felt betrayed. Stiffed. Resentful. He sued Wolfgang for the fees and interest, now more than $150,000. Not finding Wolfgang in the US, Attorney David found an attorney and process server in Luxembourg. Wolfgang didn’t answer the lawsuit, and Attorney David figured out how to garnish Wolfgang’s Luxembourgish wages.

Somehow Wolfgang found me. I filed a bankruptcy case for him, and got him discharged of his debts. Even though Wolfgang lived in Luxembourg, there was enough reason to have the case administered in Southern California. The discharge would extend to the debt to Attorney David.

But Attorney David had other ideas: he sued Wolfgang in the bankruptcy court for nondischargeability of the debt, now more than $200,000. Specifically, he claimed that Wolfgang had defrauded him; he alleged that Wolfgang had misrepresented himself and case at the time he hired Attorney David, and had never intended to pay the attorney’s fees. A debt for services procured by fraud is not dischargeable under 11 USC Sec. 523(a)(2).

Attorney David’s case was weak. Wolfgang clearly breached the contract, but contract breach isn’t fraud. Fraud requires elements of knowledge (Attorney David would need to prove that Wolfgang knew he couldn’t or wouldn’t pay at the time he hired the attorney) and reliance (Attorney David would need to prove that he justifiably relied on Wolfgang’s promises). Nonpayment of fees is an occupational hazard for attorneys; we guard against this hazard by asking for fee deposits and making it clear that nonpayment is grounds to withdraw. Jay Foonberg, a coach for attorneys, memorably holds that it’s better to not work and not get paid than it is to work and not get paid, so don’t get stuck in the latter; he calls this “Foonberg’s Rule.”

Wolfgang was going to win, but the process could take months if not years. To try to settle the case, we went to mediation.

In mediation, a neutral party – here, another bankruptcy attorney – meets with both sides and tries to see if there is any ground on which to resolve the case. The case only settles if both sides agree to the terms of the settlement; otherwise, they leave the mediation and continue on to trial.

Attorney David made the first presentation in mediation: he reiterated the same settlement demand he had made six months earlier – payment of $5,000 a month for 20 months, a total of $100,000. My client rejected it out of hand because he could not commit to the payment schedule. I pointed out to the mediator that he had a tough job: Attorney David didn’t have a fraud case, and Wolfgang didn’t have assets. Wolfgang had little incentive to find a lot of money to pay for settlement, because he expected to win; and even if he lost, then Attorney David would be left with a piece of paper saying he was owed $200,000 or more, but no way to collect more than a fraction of that money.

Wolfgang did not display a compromising mindset. He found it unjust to pay one red cent to end the litigation: the truth was that he had not defrauded Attorney David.

Many people think that the justice system exists to find the truth, and then to act on it. Not so. The justice system exists to resolve disputes; it is a beautiful thing when our system of justice reaches a just and true result, but it’s entirely unnecessary that it do so.

If the justice system exists to resolve disputes, someone who is in a legal bind should recognize that he needs to think strategically and not expect the judge to find truth and vindicate him. Strategic thinking is as useful, if not more so, in a legal setting as in any other life interaction.

Wolfgang had a difficult situation: he had few assets to fight with. He had me, but my willingness to team up with him would evaporate when I had used up the $12,000 retainer I held in my trust account. His opponent was a retired attorney who showed himself willing – like Javert in Les Miserables – to follow Wolfgang back to the Old World. “Justice” doesn’t enter into the equation.

While he was dogged, Attorney David also showed himself to be a poor negotiator. After his presentation, he said that he was busy, and really wanted to settle this case because he had more important work to do than prepare for this trial. Not a good idea to back himself into a corner.

The parties ultimately settled for a payment of $20,000 by Wolfgang: half on signing the settlement agreement, and two payments of $5,000 each in 12 and 24 months.

Had the case gone to trial, it could have cost Wolfgang at least $20,000. He really faced the question of whom to pay: his attorney to defend him, or his former attorney turned tormentor. I have worked for clients who lived by the motto “millions for defense, not a cent in tribute.” However, when you are bankrupt, that motto is generally unhelpful.

Attorney David will need to question whether his effort was worth it. He spent untold hours attempting to get paid, drove Wolfgang into bankruptcy, and ended up with less than 10 cents on the dollar. That doesn’t look like a win to me.

On the other hand, Wolfgang had to pay up to get out of an almost frivolous lawsuit after filing bankruptcy. That does not look like much of a win to me, either.

Debtor’s often have Notices of Federal Tax Liens outstanding at the time they file bankruptcy. How are these handled?
First, a properly-noticed lien survives bankruptcy. It continues to attach to any property owned at the time of the bankruptcy. It does not attach to any property acquired after the petition date.
1. Lien on real property. If the bankrupt debtor owns a house and the IRS has filed a Notice of Federal Tax Lien against the debtor’s real property (in the county records), the IRS will generally keep that notice in place after bankruptcy. The house may be underwater and the IRS lien thus worthless, but if the house appreciates in value, the IRS is entitled to the new value.
If, however, the debtor acquires a new piece of land after filing bankruptcy and discharging his taxes, the IRS lien won’t attach to the new piece of land.
2. Personal property. If there is a Notice of Federal Tax Lien filed against personal property, it attaches to everything the debtor owns on the day of the bankruptcy petition. Once the debtor discharges the underlying tax, the IRS still has the right to seize all your personal assets (even those exempted) to satisfy its lien, but it just won’t. Imagine: you, as a debtor, file for bankruptcy, go through the entire process, get your debts including your tax debts discharged, and then they send the Asset Recovery Team to your house to seize your car and sofas – for which it could get how much at auction? Also, the lien doesn’t attach to newly-acquired property, so it would need to investigate whether the bracelet it proposes to seize and sell came from Aunt Tammy as a birthday gift after the bankruptcy petition was filed. The IRS long ago figured out that the PR and legal problems here are huge, so they’ll go ahead and release the lien.

“You Had Me at Discharge”

There’s an almost rapturous feeling that my clients feel when they hear “discharged” about their debts in a Chapter 7 bankruptcy case. It’s a feeling like that which Renee Zellweger’s Dorothy Boyd feels in Jerry Maguire when Tom Cruise’s Jerry finally admits he loves her. However, Tom’s character is the ultimate fantasy – a fairy tale – someone who rescues Dorothy from the accumulated problems of her life.

Don’t fall into the same trap of believing that bankruptcy will be a fairy-tale happy ending. There are many reasons to avoid bankruptcy: legal cost, hit to your credit rating and, for many people, a decline in self-esteem. Yet many clients come to me after having avoided debt problems for years – which inevitably makes them worse.

Start by confronting your debts. It’s never a good strategy to avoid or deny problems that will surely catch up with you. At least half of my chapter 7 clients contact me but do nothing (other than trying to avoid debt collection calls) for years, hiring me only after they’re finally sued by a creditor and served with a summons. Many could have avoided bankruptcy by confronting and paying off their debts earlier or, when paying off debts isn’t possible, by getting organized and either seeking debt reductions or filing for bankruptcy sooner rather than later and getting on with their financial lives.

Do us both a favor by taking the following steps: (1) Pay off your debts, if at all possible. (2) Attempt to negotiate a reduction in your debt from your creditors (particularly credit card companies) if you don’t have the means to pay the full amount; there’s usually no reason to hire someone like me or a debt collector to do this for you or, if you’re unsure whether this will work in your particular situation, call me and I can advise you whether it’s feasible to self-negotiated and give you tips on how to do so. (3) Contact me or another bankruptcy attorney when you start to have issues with paying your debts. Most attorneys offer a free half-hour consultation, and if you look for someone in the Central District Consumer Bankruptcy Attorneys Association, you’re reasonably likely to find someone who is both competent and not self-interested – they’ll advise you correctly.

Remember: your best (and cheapest) recourse almost always is to confront your debt issues head-on and quickly, rather than denying their existence.

Large local business files chapter 11

I often ride my bike past the headquarters for THQ, a large video-game company in Agoura Hills, California.  In fact, it’s the third-largest employer in the city, after Bank of America and the local school district.   Two days ago, it filed for bankruptcy protection under Chapter 11 of the code (click here to view the LA Times article).  The debtor’s attorneys listed on the filing are Gibson, Dunn, and Crutcher in Los Angeles, and Young Conaway Stargatt & Taylor, a local firm in Wilmington, Delaware, where the corporation filed its case.

Even though world headquarters for this company are down the street, the Delaware filing is a reminder that the venue provisions for bankruptcy courts allow a filing in the debtor’s district of (1) residence, (2) domicile (residence and domicile are not the same thing), (3) principal place of business in the United States, (4) principal site of assets in the United States, or (5) incorporation.  The first four work for people as well as corporations: I once filed a case for a U.S. citizen residing in Switzerland by showing that he owned a bank account and shares in a corporation doing business in Agoura Hills.

THQ’s president spins the chapter 11 filing as an opportunity, and I admire that.  The company faced undeniable problems (which, having almost no interest in video games, I am happily ignorant of) and had lost $2 billion in market capitalization over the last six years.  That’s a lot of mojo down the drain.  If, as the company and the LA Times report, the company found an investor to purchase its assets, bankruptcy will be a great vehicle for it to strip off the liens attaching to those assets and allow it to continue doing business and catering to the tastes of hard-core action gamers.  We’re probably all better off in that case, because those guys will stay off the streets, to blow up zombies on their electronic screens, rather than interact with the rest of society.

Where can you file a bankruptcy case?

I had a client who lived in Europe – Luxembourg, of all places.  He went there because his business ventures in the US were going bad, so he took time away from this country.  His wife was a national of Luxembourg, so he moved his whole family to a house in the shadow of his inlaws.

But one creditor in the US didn’t like this.  The creditor sought a judgment and managed to get the Luxembourgish authorities to garnish the debtor’s wages for a prospective US judgment.  So the debtor contacted me and asked me to file a bankruptcy petition in the US.

There is a statute (28 USC 1408, if you’re interested) that tells us what bankruptcy courts have jurisdiction over a case.  The debtor may file in any judicial district in the U.S. in which he has had his residence, his domicile, his principal place of business in the U.S., or his principal assets in the U.S., for the greater part of the 180 days preceding the case filing.

My debtor had moved into his mother’s house in Simi Valley prior to moving to Luxembourg two years earlier.  He intended to move back to his mother’s house when his children finish high school in another five years.  He had two failed businesses in Canoga Park, both of which were now-inactive corporations.

The debtor didn’t have residence.  The trustee and I fought over whether he had domicile: that tricky concept requires physical presence in a spot in which you have the intent to live permanently; having created domicile, you can move around, so long as you don’t change your mind about where you want to end up.  The trustee said it wasn’t clear that my client intended to come back to California.

We also argued over whether his principal assets were in California.  He owned an overencumbered house in Luxembourg, but had a bank account with $600 and stock in a corporation owning a breakfast café in Woodland Hills (he was essentially a silent partner in that one, and it had no value).  The statute refers to “principal assets in the United States;” I argued that since he had no assets anywhere else in the U.S., his Luxembourg assets were irrelevant, and the court in the Central District of California had jurisdiction.

But the trustee finally agreed that the debtor had a principal place of business in the Central District.  He had opened and closed businesses here; he was a wage slave in Luxembourg, thus that wasn’t a “principal place of business.”  So the trustee agreed to no longer challenge jurisdiction, and my client in Luxembourg could file his bankruptcy case in Woodland Hills.

The trustee’s concession created new problems, because now the debtor had to show up at a meeting of creditors.  Sometimes the trustee will allow an out-of-country debtor to submit to the meeting of creditors by telephone or by written interrogatories; here, the trustee insisted that the debtor be present in the U.S. for the meeting of creditors. She would have been okay with the debtor landing in New York and sitting at a U.S. Trustee’s office and answering questions by phone; my debtors decided that since they needed to fly to the U.S. anyway, why not just go all the way to California?

Section 523(a)(1) of the bankruptcy code distinguishes the nondischargeable taxes from those that may be discharged in bankruptcy.

In most cases, the analysis is pretty simple.  Generally, nondischargeable taxes are those where the return was due less than three years ago, where the return was actually filed less than two years ago, or where the tax was actually assessed less than 240 days ago (assuming the debtor is filing a bankruptcy petition today).  This is, in the end, numerical.

If the debtor made a “fraudulent return,” the taxes are not dischargeable.  This is also very easy to determine: did the IRS assert the fraud penalty and win?  It’s a rare case when a debtor files a bankruptcy petition and the first allegation of fraud comes when the debtor wants to discharge taxes.

But there is one phrase that invites interpretation, and that can trip up the most conscientious practitioner: 523(a)(1)(C) says that “A discharge . . . does not discharge an individual debtor from any debt for a tax with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”

There are two main functions to the IRS: audit and collection.  Audit determines how much tax you owe; collection ensures that you actually pay it.  This subsection implicates both functions, and they have very different standards of bad behavior.

Because the subsection starts with the “fraudulent return” element, it’s a reasonable assumption to believe that fraudulent intent extends to the element of “willful attempt to evade or defeat tax.”  Not so.

“Willful evasion” includes both a conduct element (an attempt “in any manner”) and a mental state element (“willful” means “voluntary, conscious, and intentional”).  The conduct may be an affirmative act, such as transferring property to another family member for no consideration while tax debts hang over the owner’s head, or an omission, such as failure by a law partner’s failure to tell the accounting gal to withhold taxes.

The mental state is satisfied where the taxpayer had a duty to pay tax, knew he had that duty, and voluntarily and intentionally violated that duty.  Did your taxpayer pay $3,000 to help his son’s college tuition one year while he owed $100,000 in tax?  That payment would suffice for evasion in “any manner.”

This issue can arise at the last minute in a case.  A good bankruptcy practitioner will file an adversary proceeding, that is, a separate lawsuit in the bankruptcy, to get a judgment stating that the debtor’s taxes are discharged.  The IRS may never say anything about dischargeability of these taxes until it answers the lawsuit.  I had a case where the bankruptcy specialist told me she would discharge the debtor’s taxes “according to the formula,” suggesting she would only look at the three-year, two-year, and 240-day rule mentioned above, but then the IRS answered the dischargeability proceeding by denying dischargeability and showing me the 100-page history from the collection department.

If the government says that the tax is not dischargeable, the debtor can continue to prosecute the action and hope that the judge will render a decision in his favor.  That litigation will cost tens of thousands of dollars, however.  The debtor can also get out of bankruptcy and submit an offer in compromise to the IRS; that contract between the IRS and the debtor can deal with taxes and penalties due to fraud, and also taxes that the now-compliant taxpayer tried to evade in the past.  Sources tell me that this program has gotten much easier in the last six months, as well.

Who is the Bankruptcy Trustee?

When you file a bankruptcy, you no longer own your own goods. They pass into a bankruptcy estate owned by a trustee, who is supposed to act for the good of your creditors.
This means that a debtor generally does not have the right to sell his own assets between filing bankruptcy and getting a discharge.
In chapter 7, or liquidation, bankruptcies, the trustee has the duty to investigate your assets and determine what he may sell off to satisfy creditor claims. Usually, because of the exemptions provided by state law, there is nothing to sell off. The debtor continues on his or her way by shedding debts but not goods. We call these “no-asset cases.”
In chapter 13 bankruptcies, which involve a personal reorganization, there are two trustees: the debtor himself, and the chapter 13 trustee. Here, the bankruptcy estate includes the next five years of the debtor’s income. The debtor keeps legal title to goods, and the chapter 13 trustee ensures that the debtor is making his best efforts toward paying into the plan.
In chapter 11 bankruptcies, the debtor is also the trustee, a position known as the “debtor-in-possession.” In corporate cases, the company’s former management may continue to serve as the debtor-in-possession; in cases of willful mismanagement, the court may oust the former management and install a new trustee.

Can I keep my car in bankruptcy?

California and federal law allows a person to bring some assets through bankruptcy, by allowing exemptions. We the people want citizens to be able to make a fresh start without needing to go begging on the streets; but if we are going to stiff creditors, we don’t want the debtors to gorge on expensive assets while shedding debt. You get to keep your 10-year-old beat-up Toyota; you don’t get to keep the brand-new Lexus that your sugar daddy gave you. How do the courts enforce this difference?
California has two exemption schemes. Under Type 1, at California Civil Code Section 704, a debtor may exempt a motor vehicle to the extent of $2,725. This means that, once the debtor files bankruptcy, the trustee may sell the debtor’s car, but only if the trustee will realize some dividend for the creditors after paying the exemption amount of $2,725 to the debtor. If the trustee can’t do this, or convince the judge she can do it, the debtor keeps the car.
If the car is used as a “tool of the trade,” for instance, because it belongs to a realtor who uses it only to ferry clients to house showings, the exemption increases to $4,850. If both spouses have business cars, the exemption is $9,700.
If the debtor chooses this Type 1 exemption scheme, he’s stuck with the entire scheme. The main advantage to Type 1 exemptions is that a married couple may claim a $100,000 exemption in their homestead. The main disadvantage is that there is no “wild card” exemption.
Type 2 exemptions allow a debtor to exempt $3,525 in any single car. In addition, the debtor may exempt up to $2,200 in tools of the trade. So the realtor’s car could conceivably have an exemption of $5,725.
Type 2 exemptions also allow a debtor to exempt up to $24,425 in any kind of property, the “wild card” exemption. Using this exemption, the debtor could protect almost $30,000 of value in a car, if he wanted to keep nothing else.

Bankruptcy and the self-employed worker

Self-employed persons face special challenges in filing bankruptcy. When I hear that a potential debtor has a business, a slew of questions come up: is the business incorporated, a partnership, or a sole proprietorship? Does the debtor want to reorganize and continue, or just let the business fold? Is the business a service business catering to walk-in customers? What kind of insurance does the business have? What kind of debts is the debtor discharging?
One solution – incorporation
One debtor had a computer repair shop that wasn’t doing well, but he wanted to keep it running. He had so little income he could qualify for a chapter 7 bankruptcy; however, a chapter 7 trustee might have required that he shut the business.
In this case, the debtor incorporated the business prior to the bankruptcy, and put all the business assets into the corporation. He then reported this transfer of assets on his bankruptcy schedules, and reported the corporation’s stock (rather than the individual assets, such as motherboard diagnostic stations) as his asset. Here, the trustee was convinced that the business had no value if sold as an ongoing business, and that the business assets and liabilities transferred into the corporation canceled each other out such that there was no value.
Another solution – shutting down
If the business does something dangerous, or caters to walk-in clientele, the trustee will probably shut it. One debtor had a business filling propane tanks for people living in the hills above Santa Barbara and Goleta. After I filed the case, the trustee called me and said: “John, this business scares the s*** out of me.” He was much relieved to hear that the debtor had stopped his activities, and would give him the keys to his warehouse at the creditors’ meeting.
The secret solution – ignoring the trustee
Another client had a consulting firm he ran from an office, advising people how to market their business. He spent most of his time meeting clients at their offices and working on their matters at his own office; no walk-in traffic. The business was a sole proprietorship (no corporation, no partners), and he used a fictitious name (for instance, “Aardvark Advertising”). The trustee told him in public that he needed to shut it down right away. I called the trustee back and asked what that would look like: does he have to stop visiting his office? His home office? May he mail out the billing statements he has ready? Does he have to swear not to turn on his computer, or make a phone call? The trustee replied that, under local guidelines, he has to tell people to shut down their businesses, but no one would be able to enforce this, so he should continue to work. And so I advised the client.
Had any of these clients filed bankruptcy on their own, they might not have been able to reach the discharge they eventually got. Using an attorney for a bankruptcy is just a very wise decision.

Getting rid of taxes in bankruptcy

People often believe that they cannot discharge income taxes through bankruptcy. Wrong! It is more difficult to discharge income tax than other debts, but debtors can sometimes meet the requirements for dischargeability. First, the income tax must be from a period where the tax return was due more than three years before the bankruptcy filing. Second, the debtor must have actually filed the tax return more than two years prior to the bankruptcy filing. Third, the tax cannot have been assessed within the last 240 days before the bankruptcy filing (this might occur if the debtor had an audit determining more tax due than reported).
These rules give the I.R.S. a chance to collect from the debtor before the bankruptcy. As an example: You file your return for the 2010 tax year on April 15, 2011. The IRS then has three years to try to collect the taxes that are due from that return. But say that you file your return late. If you file you 2011 return in 2013, then the IRS has 2 years from the date you filed to collect, and then you can discharge it in bankruptcy. Finally, if the IRS does an audit and assesses a higher amount of tax on your 2010 return, then it has 240 days to collect the taxes before you file bankruptcy and discharge taxes.
(As an aside, I try to use the term “tax year” as opposed to the vacuity appearing in the Internal Revenue Code: “taxable year.” The government taxes income, not time.)
Additionally, your return cannot be fraudulent, and you cannot have “willfully” attempted to evade payment of the tax. If a court determines that you owe a fraud penalty on your taxes, then you cannot discharge the penalty nor the underlying tax. This rule gives citizens yet another incentive – in addition to avoiding jail time, a 75 percent civil penalty, and other harsh treatments – to file an honest tax return.