Is the ‘Accrual Test’ for the Existence of a Claim Alive and Well after Grossman’s?

The Third Circuit’s infamous Frenville decision, like drug-resistant bacteria, is taking on new life in the Sixth Circuit, even though the Third Circuit sat en banc in 2010, overruled Frenville and sided with seven other circuits. See Jeld-Wen Inc. v. Van Brunt (In re Grossman’s Inc.), 607 F.3d 114 (3d Cir. 2010), overruling Avellino & Bienes v. M. Frenville Co. (In re M. Frenville Co.), 744 F.2d 332 (3d Cir. 1984).

In Frenville, the Third Circuit had held that a claim was not discharged in bankruptcy if it had not arisen under state law before bankruptcy.

In Grossman’s, the Third Circuit sat en banc, overruled Frenville unanimously, lined up with seven other circuits, and held that an asbestos claim is presumptively discharged if exposure occurred before bankruptcy, even though injury was not manifest until years later. The en banc court reasoned that Frenville was contrary to the broad definition given to the word “claim” in the Bankruptcy Code.

The New Sixth Circuit BAP Case

Both before and after filing for chapter 7 relief, attorneys for a couple allegedly committed malpractice resulting in the loss of the debtors’ discharges. On behalf of the estate, a creditor mounted a malpractice suit in bankruptcy court against the debtors’ lawyers. After discharge, the debtors sued the lawyers in state court. Both malpractice suits were based on the same allegations.

The creditor filed a declaratory judgment action in bankruptcy court to determine who owned the malpractice claim. The creditor contended that the malpractice claim arose before bankruptcy and was therefore estate property.

Simplified, the bankruptcy court ruled that the claim was the debtor’s property because the claim did not arise under state law until after filing, when the debtor sustained injury by the denial of discharge.

The BAP’s Affirmance

On appeal, the Sixth Circuit Bankruptcy Appellate Panel upheld the bankruptcy court, finding that the case was governed by Underhill v. Huntington National Bank (In re Underhill), 579 F. App’x 480 (6th Cir. 2014).

The April 5 opinion by Chief BAP Judge Daniel S. Opperman recited several principles of black letter law: (1) Property interests are defined by state law, citing Butner v. U.S., 440 U.S. 48, 55 (1979); (2) federal law, not state law, determines when a debtor’s property becomes property of the estate, citing Underhill; and (3) again citing Underhill, property belongs to the estate if it is “sufficiently rooted in the prebankruptcy past,” a concept laid down by the Supreme Court under the former Bankruptcy Act in Segal v. Rochelle, 382 U.S. 375, 380 (1966).

Judge Opperman said that Underhill rejected the notion that pre-petition conduct by itself makes the claim “sufficiently rooted” in the pre-bankruptcy past. He said that Underhill requires a pre-petition injury.

Because there was no pre-petition injury, Judge Opperman held for the BAP that “the malpractice cause of action arose post-petition and is not property of the bankruptcy estate.”

Underhill

What, exactly, did Underhill rule, and is it at odds with Grossman’s and similar authorities from other circuits? Underhill was a 2/1 decision overruling the BAP.

A couple in Underhill filed a chapter 7 petition. An asset included ownership of a closely held corporation. In their schedules, the couple stated that neither they nor the corporation held any claims. The trustee reported there were no assets.

Three months after the bankruptcy case was closed, a supplier canceled a supply contract with the couple’s corporation. The couple discovered that a competitor had been complaining to the supplier since before bankruptcy that the couple were selling the supplier’s goods at a discount.

The couple filed a tortious interference claim against the competitor. The suit culminated in a settlement where the couple received $80,000. A creditor learned about the settlement and reopened the couple’s bankruptcy. Ultimately, the bankruptcy court ruled that the settlement proceeds were estate property. The BAP affirmed.

Interpreting Segal v. Rochelle, the Sixth Circuit reversed the BAP in an opinion for the majority by Circuit Judge Deborah L. Cook.

Citing post-Segal authority from the Sixth Circuit, Judge Cook said that “‘[p]re-petition conduct or facts alone will not “root” a claim in the past; there must be a pre-petition violation.’” In other words, she said, “a cause of action qualifies as bankruptcy estate property only if the claimant suffered a pre-petition injury.”

Judge Cook cited the Eleventh Circuit for the proposition that a claim for legal malpractice belongs to the debtor who suffered no injury until after filing.

In the case at bar, Judge Cook said, there was no pre-petition “violation or injury.” Although the competitor lodged some complaints before bankruptcy, she said that the first interference occurred after bankruptcy, when the competitor demanded that the supplier cut off the debtor’s corporation. She therefore reversed the BAP and held that the claim belonged to the debtors.

Dissenting, Circuit Judge Bernice B. Donald said the debtors were aware of the competitor’s conduct before filing but did not list any contingent or unliquidated claims. She that the tortious interference claim was based in part on pre-petition conduct of which the debtors were aware.

Consequently, Judge Donald believed that the claim was “sufficiently rooted” in the pre-bankruptcy era to qualify as estate property.

Under Sixth Circuit precedent, Judge Donald said it was of “little significance” under Ohio law whether a tortious interference claim requires actionable damages. She said the majority “misplaced” reliance on the fact that the tortious interference claim was not actionable until after bankruptcy.

Observations

There is a big, whopping factual distinction between Grossman’s and Underhill: Grossman’s involved a claim against the debtor, while Underhill dealt with a claim by the debtor.

To benefit the debtor by discharging more debts, Grossman’s has claims arising at an earlier point in time, so long as constitutionally adequate notice was given. Also to benefit the debtor, Underhill has claims by the debtor arising at a later time.

In the definition of “claim” in Section 101(5), the Code does not distinguish between claims by the debtor from claims against the debtor. Is there nonetheless one test when the claim is against the debtor and a different test when the claim is by the debtor? Does the existence of a claim depend on whether the debtor is or is not benefitted? Is the existence of a claim for bankruptcy purposes a question of advancing the debtor’s fresh start?

The new case in the BAP makes good sense from the standpoint of equity. The debtors were malpracticed, resulting in the loss of discharge. If the debtors at least owned the malpractice claim, they might recover some of their damages.

If the estate instead owned the claim, creditors could realize a double recovery: Their claims were not discharged, and they might share from a recovery of damages against the attorneys whose malpractice resulted in loss of discharge.

Rather than making separate rules for claims by or against a debtor, we believe that equity calls for courts to make special rules covering malpractice claims where injury does not result until after filing. Having different rules lacks statutory rationale.

Underhill, however, did not involve malpractice. Indeed, the debtors realized a windfall when the court ruled that the claim was not estate property. We submit that the Sixth Circuit ought to reconsider Underhill and decide whether the majority or the dissent properly interpreted Segal, assuming Segal remains good law after adoption of the Code.

Given that the circuit had reversed the BAP in Underhill, we understand why the BAP didn’t relish the idea of being reversed a second time and therefore decided that Underhill was controlling when a similar issue arose later.