by Jodi L. Hause, Esq.

A recent bankruptcy decision out of the Third Circuit Court of Appeals hit home for lots of law firms and creditors alike.  In the wake of higher scrutiny of mortgage companies and lenders and the enforcement of strict Proof of Claim standards, the case of In re Taylor is a cautionary tale. 

Much like the Nosek case a few years ago in the 1^st Circuit, Taylor involved a bankruptcy court issuing Rule 9011 sanctions against a mortgagee, the law firm acting on the creditors’ behalf, and individual attorneys at the law firm.  Taylor highlights the problems inherent in high volume practices and mortgage servicing where too much emphasis is placed upon computerized practices.   Like many large mortgage companies, the creditor in this case used a third-party vendor to service its loans and to provide financial information and payment records to its law firms in bankruptcy and foreclosure proceedings. 

The Taylors filed a Chapter 13 bankruptcy case in the Eastern District of Pennsylvania.   Their mortgage company filed a proof of claim and subsequently filed a motion for relief from the automatic stay in the Debtor’s Chapter 13 case, alleging that the Debtors were not current on their post-petition contractual mortgage payments.   Prior to the commencement of the bankruptcy case and after the filing date, the Debtors made only partial mortgage payments because they disputed the need for flood insurance on the property.   In disputing this, the Debtors paid the amount of their mortgage payment minus the component of the payment for flood insurance.  One law firm filed the proof of claim, while another law firm filed the motion for relief from the automatic stay.   The vendor did not convey the payment dispute to either firm.  Unfortunately, the proof of claim and the motion for relief contained glaring inconsistencies with regards to the amount of the monthly payment and the value of the real estate.  The Bankruptcy Court found (and the 3^rd Circuit ultimately agreed) that a reasonable inquiry by the filing attorney would have identified those inconsistencies and remedied them before making misleading representations in the pleadings.     To make matters worse, the attorneys who appeared on behalf of the creditor at the hearings made misleading and inaccurate verbal representations to the Court.   The Court was not impressed by the attorneys’ exclusive reliance on information provided by the mortgage company’s vendor.    The misrepresentations and the inaccurate pleadings caused the Bankruptcy Judge to investigate the practices employed by the creditor and its agents and attorneys in this case to determine whether Rule 9011 sanctions were warranted.

Rule 9011 of the Federal Rules of Bankruptcy Procedures require that representations and allegations made to the court are based on evidentiary support or are likely to have evidentiary support.   In making this conclusion, the party must conduct an “inquiry reasonable under the circumstances.”  It is not necessary that a party act in bad-faith to violate Rule 9011.  Rather Rule 9011 sanctions are implicated when a party makes representations without having taken reasonable steps to inquire into the truth of the allegations.  The 3^rd Circuit in Taylor recognized that lawyers “constantly and appropriately rely on information provided by their clients, especially when the facts are contained in the client’s computerized records.”   In this opinion the Court did not suggest that lawyers must independently verify and investigate all factual allegations made by their clients.  However, the Court found that the law firm’s actions in this case were unreasonable in light of the circumstances.

Essentially, the law firm should have investigated the cause of the delinquency and should have identified the inconsistencies between the information it received from the vendor when it was assigned the task of filing a motion for relief and that which was already contained in the Proof of Claim.   These errors were warning signs that should have caused the attorney to contact the client to clarify and provide accurate information.   Instead, the law firm did not take the steps to review the referral information and ask necessary questions.  It essentially continued with the automation and filed the motion for relief in autopilot.    Computerized databases may be appropriate, but the ultimate responsibility and accountability when the information derived from the database is inaccurate falls to the attorney.   Material misrepresentations are made when a law firm relies on inaccurate records contained in a database which may have been inaccurately transmitted by the creditor.   The fact of the matter is that it is the attorneys who certify to the court that the representations are grounded in law and fact.  

Courts want accountability and rightfully so.  This decision is unsettling for lawyers because we must rely on the information that is provided to us by our clients.   We usually do not have access to our client’s internal records that would allow us to somehow independently audit their records, nor would we be equipped to do such an audit in most cases.   On the other hand, creditors’ lawyers are on egg-shells right now because we know that our clients are heavily scrutinized in bankruptcy and foreclosure cases.    

At the Bernstein Law Firm, we are fortunately ahead of the game in this regard.   We are on heightened alert in that we take the time to review our pleadings before they are filed to ensure that they are accurate.   For example, we are careful to file proofs of claim with accurate figures and complete supporting documentation.   Correct and accurate pleadings are important because material errors will cause deeper scrutiny.  We have a reputation for zealous representation and we are well-respected for our attention to detail.   (A sloppy reputation is like wearing a target on your back).

In the end, we can take away several lessons from Taylor.         First, do it right the first time.  Take the necessary steps to ask additional questions and get clarifications before a pleading is filed to avoid even an inadvertent material misrepresentation.  Second, creditors and attorneys must be prepared to adjust their own procedures and systems to fit the rules and requirements of the courts.   One cannot simply rely on “screen prints” as the firm did in the Taylor case when a reasonable inquiry would reveal a material inaccuracy.  Third, when mistakes happen correct them.  Errors will occur because no system is infallible.  Taking responsibility for the error and taking the steps to correct it immediately will go a long way in both the specific case where an inaccurate representation is discovered and in maintaining a reputation that will enable the courts and adverse parties to give you the benefit of the doubt in future cases.          

The citations for the opinions discussed are below:

In re Nosek, 406 B.R. 434 (D. Mass. 2009) aff’d in part, modified in part, 609 F.3d 6 (1st Cir. 2010)

In re Taylor, 655 F.3d 274 (3d Cir. 2011)

by Scott Schuster, Esq.

Unfortunately, the Code does not require that the administrative claim be paid in full immediately after the Court allows the claim. Instead, the Code only sets the relative priority of the claim.  In Chapter 11, a requirement for the confirmation of a Plan is that administrative expense claims be paid “in full and in cash.” If the case is ultimately declared “administratively insolvent” – i.e. the debtor does not generate sufficient cash to pay its administrative claims – then 503(b)(9) creditors will probably not receive the full amount of their claims.

While the court can order immediate payment of these claims, they often decline to do so. The courts have tended to be very debtor friendly on this issue. In two recent cases, In Re Bookbinders and In Re Global Home Products, LLC, creditors attempted to force immediate payment of 503(b)(9) claims. In both cases, creditors urged the court to order immediate payment of the claims, arguing that there may not be enough assets left at the end of the bankruptcy to pay the 503(b)(9) claims in full. In both cases, the courts’ reasoned that the Code did not explicitly provide for immediate payment. The courts in both cases denied the creditors’ request for immediate payment of their 503(b)(9) claims. Unfortunately, in the Global Home Products case, 503(b)(9) creditors ultimately received less than 50 percent of their claims under the debtor’s Plan.

While a 503(b)(9) creditor appears to face an uphill battle, it is not all bad news. In fact, section 503(b)(9) has greatly increased the potential for recovery for large numbers of unsecured creditors nationwide. Notwithstanding the difficulties of allowance and payment that 503(b)(9) creditors face, they stand in a better position than a general unsecured creditor. Section 503(b)(9) claims are given the same priority status as the debtors’ attorneys’ and other professionals’ fees. In the grand scheme of the bankruptcy system, this is about the best position in which a trade creditor can sit.

Since many 503(b)(9) motions are lightly contested, they can be handled by experienced creditors’ rights counsel at a modest price. In fact, a valid 503(b)(9) claim is often stipulated to by the debtor early in the case. Often the debtor will agree to allow the claim in full, if the creditor agrees to forego payment until a plan can be confirmed. This system benefits all parties because if all 503(b)(9) creditors demanded immediate payment in full, many debtors would not have sufficient cash flow to meet those demands, and would terminate operations shortly after entering bankruptcy. Since debtors rarely enter bankruptcy with significant cash reserves, such an outcome would likely result in 503(b)(9) creditors receiving far less than 100 percent of their claims.

If a creditor is willing to accept a reduced amount on its 503(b)(9) claim, then it should consider “claim traders” – companies that purchase bankruptcy claims from creditors. Claim traders are often very interested in 503(b)(9) claims and, depending on the circumstances of the particular debtor and its prospects for reorganizing, are often willing to pay a very large percentage of the claim.