Benchnotes March 2025

By Christina Sanfelippo, Aaron M. Kaufman and Bradley D. Pack1

California District Court Finds that Certain PAGA Penalties Are Subject to Discharge

As a matter of first impression for the court, the U.S. District Court for the Eastern District of California recently ruled that while 25 percent of the recovery awarded to employees under the California Private Attorneys General Act (PAGA)2 was penalties and for the benefit of a governmental unit, such amount was not “payable to” a governmental unit under the plain meaning of the discharge exception in 11 U.S.C. § 523(a)(7), and were therefore subject to discharge.

In Patacsil, former employees of the debtors, who owned and operated nursing homes for the disabled, had filed a pre-petition suit against the debtors, bringing claims under (among other things) the PAGA.)3 Following a trial, the district court awarded damages and attorneys’ fees to the former employees, including $79,524.53 in PAGA penalties awarded to the former employees and the state of California. A few months later, the debtors filed for chapter 7, and the former employees filed an adversary proceeding seeking a determination of the dischargeability of their damages and attorneys’ fees recovered in the district court case.

On appeal, the parties did not dispute that PAGA penalties satisfied the first and third elements of § 523(a)(7), which require that a nondischargeable debt be “a fine, penalty, or forfeiture” and “not compensation for actual pecuniary costs.” The court explained that PAGA plaintiffs are private attorneys’ general who, stepping into the shoes of California’s Labor and Workforce Development Agency (LWDA), bring claims on behalf of the state agency and recover civil penalties on its behalf. Further, the penalties under the PAGA are calculated to punish employers for wrongdoing and deter violations.

The question before the court was whether all of the awarded PAGA penalties could be considered “payable to and for the benefit of a governmental unit” to satisfy the second element of § 523(a)(7). Beginning its analysis with the text of the statute, the court explained that the LWDA meets the definition of “government unit” under § 101(27) because it is an executive branch agency of the state of California. The court also found that the PAGA penalties are “for the benefit of a governmental unit” because 75 percent of the penalties awarded in a PAGA action are distributed to the LWDA for the enforcement of labor laws and related education efforts. The remaining 25 percent benefits the LWDA by decreasing its enforcement costs while expanding its enforcement powers.

However, the court concluded that the 25 percent of PAGA penalties recovered by aggrieved employees could not be considered “payable to” a governmental unit. The court explained that courts have consistently applied the “payable to” analysis to the end recipient of a debt when considering whether that debt is dischargeable under § 523(a)(7). Under the PAGA statute, the state statutorily relinquished its claim to 25 percent of the PAGA penalties and has no ability to recover those funds.

Thus, 25 percent of the PAGA penalties had been collected and would be retained by private parties. While the court acknowledged that its holding is in tension with the California legislature’s stated goal in enacting PAGA of incentivizing aggrieved employees to bring employment actions in return for a share of the PAGA penalties, the court concluded that it is bound by the plain language of § 523(a)(7). Accordingly, the court affirmed the bankruptcy court’s order and held that only the 75 percent of the PAGA penalties payable to the LWDA were nondischargeable under § 523(a)(7).

Eleventh Circuit Resolves Priority Dispute over Debtor’s Settlement Payment from Class Action

The Eleventh Circuit was recently tasked with determining when, under Article 9 of the Uniform Commercial Code (UCC) as adopted by Florida, a commercial tort claim converts to a contract. In Payroll Management Inc.,)4 the debtor was a member of a certified class of economic-loss plaintiffs in multidistrict litigation arising from the Deepwater Horizon oil spill. In 2012, the parties entered into a settlement agreement, thereby settling thousands of economic-loss lawsuits against British Petroleum Inc. (BP). As a result of the settlement, BP created a settlement fund in which a neutral claims administrator would evaluate and pay the valid claims of class members. Class members who did not opt out of the settlement were bound by its terms and released BP from further litigation in spill-related economic-loss lawsuits. The settlement agreement was approved in December 2012 and went into effect two years later.

To be entitled to a recovery from the settlement fund, a class member was required to submit a claims form with supporting documentation for review by a neutral claims administrator. All parties’ appellate rights with respect to a claim and the review process then had to be exhausted. The class member had to sign an individual release releasing BP from any further liability related to the oil spill before issuing payment. The debtor did not opt out of the settlement agreement with BP and was therefore bound by its terms. The debtor submitted its claims form and supporting documentation to the claims administrator in 2012.

A few years later, the debtor’s financial situation deteriorated. The debtor granted a security interest in its assets to an insurance company in exchange for workers’-compensation insurance to cover its employees, and the security agreement was recorded in November 2015. The debtor also became delinquent on its federal employment tax payments, and in March 2017, the Internal Revenue Service (IRS) filed a $23 million federal tax lien notice against the debtor with the Florida Secretary of State.

The debtor filed a chapter 11 petition in March 2018, subsequently agreeing to settle its BP claim with the neutral claims administrator for $1,070,330.23 and obtaining bankruptcy court approval of the settlement. The debtor’s insurer initiated an adversary proceeding against several other creditors, alleging that it held a perfected first-priority security interest in the $1,070,330.23 payment. While the insurer did not hold a security interest in the debtor’s commercial tort claims, it held a security interest in the debtor’s contracts.

The insurer argued that the BP claim had converted to a contract before the security agreement was recorded in 2015 because the debtor had submitted its claims form and supporting documentation to the claims administrator in 2012, and the settlement agreement became effective in 2014. The IRS disagreed, arguing that the BP claim was a commercial tort claim — not a contract — when the federal tax lien notice was filed in March 2017, and its tax lien therefore attached automatically to the commercial tort claim and was perfected upon filing. The narrow issue on appeal was whether the debtor’s BP claim was a commercial tort claim in March 2017.

The Eleventh Circuit explained that a commercial tort claim converts to a contract when the claim has been “settled” and “reduced to a contractual obligation to pay.”)5 The court explained that the BP claim was not “reduced to a contractual obligation to pay” before the insurer’s security agreement was recorded because neither the settlement agreement, nor the submission of the debtor’s BP claim, gave the debtor an automatic right to payment; rather, BP’s contractual obligation to pay arose after the claims-review process had ended, with a signed individual release that stated the amount to be paid. As of March 2017, the claims-review process remained unfinished because the debtor and claims administrator had not agreed on a certain payment amount, BP had not exhausted its right to appeal, and the debtor had not signed an individual release.

For similar reasons, the court rejected the insurer’s argument that the settlement agreement’s release provision automatically extinguished the debtor’s commercial tort claim. The release provision in the settlement agreement did not automatically obligate BP to pay the debtor a certain amount. However, the individual release that the debtor had been required to sign prior to receiving any settlement payment provided that BP was obligated to pay a certain amount and that the debtor was not entitled to any further payment for its claim. The debtor’s individual release was signed post-petition.

BP had no contractual obligation to pay the debtor as of March 2017, so the debtor’s BP claim was still a commercial tort claim. Since the insurer did not hold a security interest in the debtor’s commercial tort claims, the IRS’s tax lien had first priority in the $1,070,330.23 settlement payment.

Miscellaneous

• In re Klemkowski, 2024 WL 4625644 (Bankr. D. Md. Oct. 30, 2024) (mortgage-servicer’s unilateral termination of chapter 13 debtor’s ability to make payments through online portal was violation of automatic stay; debtor established that she had a contractual right to use online portal at time of bankruptcy filing, and servicer’s termination of that right amounted to exercise of control over property of estate in violation of § 362(a)(3); while debtor failed to request monetary damages under § 362(k) or to demonstrate entitlement to such damages, court would allow parties to brief issue of what form of relief was appropriate, including whether court should order servicer to restore debtor’s access to online portal).

Christina Sanfelippo is an associate with Cozen O’Connor in Chicago. Aaron Kaufman is a partner with Gray Reed in Dallas. Bradley Pack is a shareholder with Engelman Berger, PC in Phoenix.