Different Rules Govern When Claims Accrue By or Against an Estate

Recently, courts have been holding that the accrual of claims by and against an estate are not governed by the same rules. An appeal on the way to the Sixth Circuit will perhaps give some clarity to the issue.

Frenville

To determine whether a claim accrued before bankruptcy and was therefore discharged, there is no longer a circuit split.

In Avellino & Bienes v. M. Frenville Co. (In re M. Frenville Co.), 744 F.2d 332 (3d Cir. 1984), the Third Circuit had held that a claim was not discharged in bankruptcy if it had not arisen under state law before bankruptcy. 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).

In Grossman’s, the Third Circuit 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.

When the tables are turned, the rules recently are different in deciding whether a claim belongs to the estate or to the debtor. In those cases, the result has turned on whether the claim by the debtor accrued under state law before or after filing. In other words, the discredited Frenville concept still holds water in deciding whether a claim is property of the estate.

Legal Malpractice Claims

In April, we reported Church Joint Venture LP v. Blasingame (In re Blasingame), 598 B.R. 864 (B.A.P. 6th Cir. April 5, 2019). There, the Bankruptcy Appellate Panel for the Sixth Circuit held that a legal malpractice claim leading to the loss of the debtors’ discharges belonged to the debtors, not to the estate. 

Because there was no pre-petition injury, the BAP held that “the malpractice cause of action arose post-petition and is not property of the bankruptcy estate.” The case is on appeal to the Sixth Circuit. Church Joint Venture LP v. Blasingame (In re Blasingame), 19-5505 (6th Cir.). To read ABI’s discussion of the BAP’s Blasingame opinion, click here.

In June, Bankruptcy Judge Elizabeth D. Katz of Worcester, Mass., dealt with a case where the debtor’s pre-bankruptcy attorney advised his client to make a transfer of valuable property before filing. The attorney advised the client that the transfer might be attacked as a fraudulent transfer.

That’s exactly what happened. The chapter 7 trustee sued the transferees to set aside the pre-bankruptcy transfer. The trustee also sued the debtor’s pre-bankruptcy counsel, contending that the advice was malpractice.

In her June 28 opinion, Judge Katz held that the legal malpractice claim belonged to the debtor, not to the trustee. She therefore dismissed the malpractice suit in bankruptcy court for lack of jurisdiction.

Judge Katz held that the “plain language” of Section 541(a) required dismissal, because the claim did not arise under state law until after bankruptcy when the debtor suffered injury. Knowledge of potential injury before bankruptcy was “not dispositive,” she said.

The opinion by Judge Katz raises a question: Did Segal v. Rochelle, 382 U.S. 375 (1966), decided under the former Bankruptcy Act, survive adoption of the Bankruptcy Code? Segal held that a claim by the debtor belonged to the estate if it was “sufficiently rooted in the prebankruptcy past.”

Judge Katz followed Thomas L. Perkins of Peoria, Ill., who held in May that Segal no longer determines whether an asset is estate property. The two judges are of the view that property of the estate is governed by state law, following Butner v. U.S., 440 U.S. 48 (1979), which, by the way, was also decided under the former Bankruptcy Act. 

Judge Perkins’ opinion is In re Brown, 18-81242, 2019 BL 168813 (Bankr. C.D. Ill. May 9, 2019). Brown was not appealed. To read ABI’s discussion of Brown, click here.

The Search for a Unified Theory

The concept of the accrual of property interests is evidently different when dealing with claims by the estate, as opposed to claims against the estate. The difference makes sense in terms of viewing the Bankruptcy Code as a statute primarily for debtor relief.

Grossman’s ensures that more, not fewer, claims will be discharged. Decisions like those by Judges Katz and Perkins let debtors keep more intangible property. The decisions by those two judges make even more sense when the debtors have malpractice claims. 

In the case of malpractice leading to the loss of discharge, debtors would suffer twice if malpractice claims belong to the trustee. The debtors will have lost their discharges and also find themselves without a suit against the lawyer who caused the damage in the first place.

So, the diverging rules make sense when the debtors are individuals. But what if the debtor is a corporation?

Assume that a chapter 7 corporate debtor has a claim that will not accrue under state law until after filing. If accrual is the only test, then the chapter 7 trustee will be unable to pursue the claim on behalf of creditors. Instead, the claim will remain property of the corporate debtor. 

But the corporate debtor in chapter 7 does not receive a discharge. 

So, what happens with a corporate chapter 7 debtor? Will shareholders pursue the claim and hope the trustee and creditors never find out? Will the target of the late-accruing claim escape liability? Can a creditor pursue the claim? Can the chapter 7 trustee somehow use strong-arm powers to lay claim to the lawsuit?

Perhaps Segal and Frenville reflect a policy that answers this hypothetical question. In the case of a corporate debtor, maybe the claim is sufficiently rooted in the prebankruptcy past so that the trustee could bring the claim on behalf of all creditors. Perhaps the rules are the same for claims by and against a corporate debtor in chapter 7. But does it make sense if the results are different for corporate chapter 7 debtors than for individual debtors?

If any of our readers have answers to these questions, please pass them along. We are flummoxed.