non-bankrupt third party.
If a bankrupt debtor largely prevails in a dispute over a contract requiring the borrower to pay the lender’s counsel fees, California law requires the lender to pay the debtor’s counsel fees, according to an Oct. 1 opinion from the Ninth Circuit.
Section 1717(a) of the California Civil Code turns a unilateral obligation to pay attorneys’ fees into a reciprocal liability. In other words, if a contract imposes counsel fees on one party, California law imposes the obligation on both. The law is applicable, among other situations, to cases in which a security agreement requires the borrower to pay the lender’s counsel fees incurred in collection suits.
The case entailed a chapter 13 debtor with a $26,000 car loan that included $7,000 in so-called negative equity from an auto that was traded in to buy the new vehicle. The debtor went all the way to the Ninth Circuit to establish that her plan properly bifurcated the lender’s claim into a $19,000 secured claim and a $7,000 unsecured claim. The prior litigation revolved around the hanging paragraph in Section 1325(a) of the Bankruptcy Code.
Having prevailed, the debtor invoked California’s Section 1717(a) and sought to recover the $245,000 in fees she incurred in the bifurcation litigation. She lost in bankruptcy court and on a first appeal in district court.
In the Ninth Circuit, she won a reversal in an opinion by Circuit Judge Paul J. Watford.
For counsel fee obligations to become reciprocal, state law requires the underlying dispute to involve a contract. The lower courts believed state law was inapplicable because the litigation turned on federal bankruptcy law, not the contract. Judge Watford disagreed.
He said that the contract gave the lender a security interest to cover the negative equity in the car that was traded in. According to Judge Watford, the debtor eventually won a judgment preventing the lender “from fully enforcing the terms of the contract.” Consequently, the debtor satisfied the statutory requirement that the dispute pertain to a contract.
Judge Watford could see nothing in the California law to make Section 1717 inapplicable when a contract dispute turns on federal bankruptcy law.
The decision should have “application in states other than California where there are similar statutes on the books,” said Kenneth N. Klee in a phone interview. Klee, with Klee Tuchin Bogdanoff & Stern LLP in Los Angeles, was counsel for the debtor in the Ninth Circuit case.
The Ninth Circuit’s ruling might have greater utility in corporate bankruptcies, where secured lenders typically have a contractual right to recovery of attorneys’ fees after default. Section 1717(b) provides that “the party who recovered a greater relief in the action on the contract” is entitled to recover fees. The state statute has many unanswered questions where it applies to a corporate reorganization.
The decision is not all good news for debtors. In states like California, they can become liable for an adversary’s counsel fees when a contract has liability only for the other party.