The Third Circuit’s long-vilified Frenville opinion is experiencing a rebirth in the Sixth Circuit, at least with regard to legal malpractice claims committed against the debtor. On January 26, the Cincinnati-based appeals court held that a malpractice claim belonged to the debtors, not to the chapter 7 estate, because the claim did not accrue under state law until the debtors lost their discharges.
The Malpractice Claim
A couple consulted with counsel about their financial problems. The lawyers recommended filing a chapter 7 petition.
In their schedules, the debtors listed $6,000 in assets. The trustee later determined that they had million in assets in a web of trusts and shell companies. Eventually, the debtors lost their discharges for failure to disclose assets.
The Sixth Circuit’s opinion by Circuit Judge Bernice Bouie Donald did not say whether the debtors contributed to their own loss of discharge by failing to disclose assets to their attorneys. The opinion also does not state whether the lawyers knew about the potential nondisclosed assets and advised their clients not to schedule them, or even told them about the risk of nondisclosure.
The debtors filed a legal malpractice suit against their lawyers in state court after losing their discharges. Having received derivative standing, a creditor filed a malpractice suit in bankruptcy court. On cross motions for summary judgment, the bankruptcy court applied Tennessee law and granted summary judgment in favor of the debtors, holding that the malpractice claim belonged to them. The bankruptcy court reasoned that the malpractice claim accrued under state law after bankruptcy because damage did not occur until the debtors sustained injury when the court denied their discharges.
The Bankruptcy Appellate Panel affirmed in April 2019. Church Joint Venture LP v. Blasingame (In re Blasingame), 597 B.R. 614 (B.A.P. 6th Cir. April 5, 2019). Because there was no pre-petition injury, the BAP ruled that “the malpractice cause of action arose post-petition and is not property of the bankruptcy estate.” Id. at 619. To read ABI’s report on the BAP opinion, click here.
Frenville
There is no longer a circuit split regarding the test to determine when a claim arose against a bankruptcy estate and was therefore discharged. As we shall see, there is less clarity in knowing whether a claim against a third party belongs to the estate or the debtor.
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.
As shown by the Sixth Circuit’s new decision, the discredited Frenville concept still holds water in deciding whether a claim belongs to the estate or the debtor.
Is Segal v. Rochelle Still Good Law?
Typically, an analysis of estate property begins with a concept laid down by the Supreme Court under the former Bankruptcy Act. In Segal v. Rochelle, 382 U.S. 375 (1966), the Court ruled that an intangible claim is estate property if it is “sufficiently rooted in the prebankruptcy past.” Id. at 380.
Judge Donald observed that the “sufficiently rooted” language “has a long and disputed history.” She noted that the statutory definition of estate property changed with the adoption of the Bankruptcy Code in 1978.
Generally speaking, the Code attempted to broaden the concept of estate property. Judge Donald said that some circuits believe that the definition of estate property in Section 541 codified Segal, while others question whether the “rooted” concept survived the Code.
“There is little agreement” among the circuits, Judge Donald said, on how to apply Segal to a malpractice claim against a debtor’s attorneys. Some apply the test “expansively,” allowing the estate to capture contingent and unripe claims. Others rely on accrual under state law, thus allowing a debtor to retain a malpractice claim.
Although Sixth Circuit precedent did not answer the question on appeal, Judge Donald found guidance in Tyler v. DH Capital Mgmt. Inc., 736 F.3d 455 (6th Cir. 2013). In Tyler, the occurrence of a pre-petition violation was one indicia of a claim belonging to the estate.
Judge Donald asked, “when did the violation occur?” Did the violation occur on the breach of duty or when damage was incurred? For the answer, she looked to Tennessee law.
Tennessee had changed its rule. Now, a malpractice claim accrues when a patient discovers or should have discovered injury.
Weaving Segal together with Tennessee law, Judge Donald said,
[W]hile it remains difficult to determine whether, if ever, an unaccrued claim can be “sufficiently rooted” in a debtor’s past, it is clear that at the very least there must be some awareness of the claim in order for it to exist as a legal interest and be properly included in the debtor’s bankruptcy petition.
Judge Donald said that “Tennessee courts have likewise applied this same reasoning to their accrual rule, seeking to ameliorate the unjust results caused by treating a claim as accrued prior to a plaintiff’s knowledge of the injury.”
Applying the facts to the law, Judge Donald held that “the malpractice cause of action could not have become a legal interest under Tennessee law until after the judgment denying the [debtors’] discharge was entered because the [the debtors] were unaware of the filing attorneys’ conduct, which allegedly constituted malpractice.”
When the debtors filed their chapter 7 petition, “the malpractice claims were not a legal interest under Tennessee law such that they could be considered as property of the bankruptcy estate under federal law,” Judge Donald said. She therefore affirmed the BAP and held that the malpractice claim belonged to the debtors.
Observations
Crucial facts are missing that could have affected the result.
Did the debtors tell counsel about their trusts and ownership interests? Did the debtors only tell counsel about the $6,000 in assets that ended up in the schedules, withholding information about other assets? Did counsel advise the debtors that their web of ownership interests need not be disclosed? Did counsel advise the debtors about the risk of nondisclosure? Did counsel know about the additional assets but omit them from the schedules at the direction of the debtors?
The trustee should have been able to discover answers to the foregoing questions because the trustee presumably controlled the debtors’ attorney/client privilege.
If the debtors were responsible for nondisclosure, the lawyers may have a defense regardless of who owns the claim. Or, the lawyers may have a defense to a claim by the debtors but no defense to a claim by the trustee if the lawyers violated their obligations under Rule 9011. After all, nondisclosure caused the trustee and the surrogate to incur additional costs in discovering and recovering nondisclosed estate property.
If the debtors were responsible in part for nondisclosure, equitable principles might preclude them from owning the claim, assuming no bar under Law v. Siegel, 571 U.S. 415 (2014). It is also conceivable that a full revelation of the facts might show that the debtors and the trustee could assert different claims with different measures of damages.
Judge Donald’s Dissent in Underhill
In her opinion, Judge Donald six times cited the nonprecedential Sixth Circuit opinion in Underhill v. Huntington National Bank (In re Underhill), 579 F. App’x 480 (6th Cir. 2014). Judge Donald dissented in Underhill. She mostly cited her own dissent. The BAP decision relied heavily on Underhill.
In Underhill, a couple filed a chapter 7 petition, claiming that their closely-held corporation had no claims. The trustee reported “no assets.”
As it turned out, the corporation had a tortious interference claim. The couple sued and received an $80,000 settlement. A creditor learned about the settlement and reopened the couple’s bankruptcy. The bankruptcy court ruled that the settlement proceeds were estate property, and the BAP affirmed.
Interpreting Segal, the Sixth Circuit majority reversed the BAP. Judge Donald dissented, saying that the debtors were aware of the claim before filing but did not list any contingent or unliquidated claims. She said 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 in Underhill that 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.
Had the facts been fully developed, Judge Donald might have been able to resuscitate her Underhill dissent. If the debtors were aware of the failure to disclose assets, her Underhill dissent would suggest that she could have found the malpractice claim to be estate property.
Overview
Should “claim” have a different meaning, depending on whether the claim is by or against the estate? On one level, two definitions make sense.
With regard to claims against an estate, a broad definition of claim makes sense. Companies could not reorganize in chapter 11 if they were to be sued after bankruptcy based on claims that did not manifest until after discharge.
Even with an expansive definition of “claim,” creditors are protected by the Due Process Clause if unmanifested claims are discharged. Why? Because, debtors must create trusts to satisfy claims that do not manifest until after bankruptcy.
In the case of claims by a debtor, a broad definition can be unfair. The issue arises with regard to medical malpractice claims that do not manifest until after bankruptcy. Should a trustee swoop down and snatch away a malpractice claim that did not manifest until years after bankruptcy? Should debtors lose the fruits of a claim when malpractice caused actual pain and suffering or necessitated subsequent surgeries?
Having one definition is appealing but doesn’t account for laudable human sympathies. Is the bankruptcy court still essentially a court of equity or an institution that unthinkingly applies a vaguely written statute?
The Third Circuit’s long-vilified Frenville opinion is experiencing a rebirth in the Sixth Circuit, at least with regard to legal malpractice claims committed against the debtor. On January 26, the Cincinnati-based appeals court held that a malpractice claim belonged to the debtors, not to the chapter 7 estate, because the claim did not accrue under state law until the debtors lost their discharges.
The Malpractice Claim
A couple consulted with counsel about their financial problems. The lawyers recommended filing a chapter 7 petition.
In their schedules, the debtors listed $6,000 in assets. The trustee later determined that they had million in assets in a web of trusts and shell companies. Eventually, the debtors lost their discharges for failure to disclose assets.
The Sixth Circuit’s opinion by Circuit Judge Bernice Bouie Donald did not say whether the debtors contributed to their own loss of discharge by failing to disclose assets to their attorneys. The opinion also does not state whether the lawyers knew about the potential nondisclosed assets and advised their clients not to schedule them, or even told them about the risk of nondisclosure.
The debtors filed a legal malpractice suit against their lawyers in state court after losing their discharges. Having received derivative standing, a creditor filed a malpractice suit in bankruptcy court. On cross motions for summary judgment, the bankruptcy court applied Tennessee law and granted summary judgment in favor of the debtors, holding that the malpractice claim belonged to them. The bankruptcy court reasoned that the malpractice claim accrued under state law after bankruptcy because damage did not occur until the debtors sustained injury when the court denied their discharges.
The Bankruptcy Appellate Panel affirmed in April 2019. Church Joint Venture LP v. Blasingame (In re Blasingame), 597 B.R. 614 (B.A.P. 6th Cir. April 5, 2019). Because there was no pre-petition injury, the BAP ruled that “the malpractice cause of action arose post-petition and is not property of the bankruptcy estate.” Id. at 619.