If a chapter 7 debtor sues her bankruptcy counsel for legal malpractice allegedly committed during the bankruptcy proceedings, the bankruptcy court at minimum has “related to” jurisdiction, does it not?
Wrong!
The Ninth Circuit Bankruptcy Appellate Panel held in a nonprecedential opinion on April 25 that there was no related to jurisdiction because the postpetition claim belonged to the chapter 7 debtor.
The case was like a hot potato that no court wanted to handle.
The woman filed a chapter 11 petition to stop foreclosure and refinance her home prior to a sale intended to capture substantial appreciation, preserve her equity and pay creditors in full. After a year in chapter 11 without a confirmed plan, the bankruptcy court converted the case to chapter 7.
Despite what the BAP called the debtor’s “scorched earth” litigation tactics, the chapter 7 trustee eventually sold the home, paid creditors in full, and turned over a surplus of almost $600,000 to the debtor, including her $175,000 homestead exemption.
After discharge, the debtor sued her attorney for malpractice in state court, alleging that he failed to bring facts to the attention of the bankruptcy court that would have blocked the trustee’s sale and allowed her time to sell the property for considerably more. She sought $2.5 million in compensatory damages, not including punitive damages.
The state court dismissed the suit under the Barton doctrine, faulting the debtor for not having obtained the bankruptcy court’s approval to sue her attorney, who had represented her in both chapters 11 and 7. The state court ruled that the bankruptcy court had exclusive jurisdiction over the malpractice claims.
Next, the debtor next sued her former attorney in bankruptcy court for fraud under state law because the statute of limitations by then had lapsed for malpractice claims. The bankruptcy court dismissed the suit with prejudice, saying that the allegedly withheld information would not have changed the court’s mind about approving the trustee’s sale.
The debtor appealed to the BAP and won the battle but probably lost the war on jurisdictional grounds.
According to the BAP, the debtor’s postpetition claims for fraud or malpractice under state law did not “arise under” title 11.
With regard to “arising in” jurisdiction, the BAP construed Schultze v. Chandler, 765 F.3d 945 (9th Cir. 2014). Under Schultze, the lawsuit in bankruptcy court did not pertain to an “administrative” matter and therefore was not “core,” because the case did not involve a court-appointed attorney. Rather, the suit dealt only with counsel’s services as a “chapter 7 private attorney.”
Consequently, there was no “arising in” jurisdiction because the claims were under state law, did not involve the administration of the estate, could exist outside of bankruptcy and could have been (and were) brought in state court.
Similarly, the BAP said, the case lacked “related to” jurisdiction because there was no “conceivable effect” on the bankruptcy estate, for several reasons.
The claims belonged to the debtor and were not property of the estate, the BAP said. Creditors already had been paid in full, so the estate would have received no assets even if the suit were successful.
Consequently, the BAP held that the bankruptcy court lacked subject matter jurisdiction.
The BAP therefore vacated the bankruptcy court’s dismissal with prejudice and remanded with instruction to dismiss without prejudice for lack of subject matter jurisdiction.
The question arises: Would there have been “related to” jurisdiction if creditors had not been paid in full?
The answer: Possibly not, because the BAP said the claim belonged to the chapter 7 debtor and was not estate property because the claim arose after filing. On the other hand, the malpractice claim may have been estate property if creditors were shortchanged.
The holding of the case may therefore only apply to cases with a 100% distribution. However, the trustee, not the debtor, would have been the proper party to sue if the estate stood to make a recovery. In that event, the debtor’s suit would have been dismissed for lack of standing unless the trustee abandoned the claim.
These tough questions may explain why the BAP made its opinion nonprecedential.
A final question: Was there any court where the debtor could sue after having been tossed out of bankruptcy court?
The dismissal order in state court was final, suggesting that the debtor could not sue a second time in state court, even though the BAP opinion plainly says that the state court was wrong about Barton and the bankruptcy court’s exclusive jurisdiction. Because there were no claims under federal law and the parties likely were both California residents, the debtor probably could not sue in federal district court under diversity jurisdiction.
What does the opinion teach us apart from the ruling on the absence of “related to” jurisdiction?
To avoid being left out in the cold, it may have been advisable for the debtor to act first in bankruptcy court, perhaps to seek a declaration regarding Barton and thus ensure that the state court would find jurisdiction.