Credit Bid Rights at 363 Sales: Have the Ground Rules Changed?

Regina Stango Kelbon

The following is a summary of a paper prepared for the Pennsylvania Bar Institute.

Regina Stango KelbonThe decisions by the Bankruptcy Court for the District of Delaware in In re Fisker Auto. Holdings, Inc., and the Bankruptcy Court for the Eastern District of Virginia in Free Lance-Star Publ’g Co., have sparked discussions as to the circumstances justifying the curtailment of a secured creditor’s credit bid rights in a sale conducted pursuant to Section 363 of the Bankruptcy Code.

The In re Fisker Auto. Holdings, Inc. case represents the first major case in a post RadLAX world limiting a secured creditor’s credit bidding rights under section 363(k) of the Bankruptcy Code. Following the court’s lead in Fisker, the Bankruptcy Court for the Eastern District of Virginia in In re Free Lance-Star Publ’g Co. limited a secured creditor’s right to credit bid because the secured creditor did not hold valid liens on all of the assets being sold, and because the secured party engaged in a loan-to-own strategy and inequitable conduct that the court found resulted in the depression of the sale price for the debtors’ assets.

While the Fisker and Free Lance decisions have provoked discussions regarding limitations on a secured creditor’s credit bid rights, a careful review of these cases highlight that they arise out of unique fact patterns and, therefore, may be of limited utility in attempting to limit a secured creditor’s credit bid rights. In each of the cases, 1) there were unencumbered assets that were being sold as part of the auction process; 2) the secured creditor had purchased the claims at a deep discount with a stated intention to implement a loan-to-own strategy; and 3) each auction was proposed on a very fast track designed to depress market participation and the value of the debtor’s assets. As such, secured creditors seeking to embark on loan-to-own strategies need to assess the applicability of these decisions and proceed cautiously to avoid any unwanted limitation on credit bidding rights in a Section 363 sale context.

Lenders’ risk: Who really owns the collateral?

Nikolaus J. Caro

F8E56703A48C584BA41E613723A92DB7Unlike real estate transactions where a lender can obtain title insurance, secured lenders are often relying upon the representations and warranties in their loan agreement and the borrower’s audited financial statements, if and when determining whether the collateral securing their loans is owned by the borrower or another pledgor.  After default, a lender may find itself in a precarious position whereby it is unable to foreclose on the collateral because it is not owned by its borrower and it does not have a pledge from the person that actually does own the property.  According to the Third Circuit, however, certain oversights may not affect the lender’s position as a secured creditor.   In In re WL Homes 534 Fed. Appx. 165 (3d Cir. 2013), the court dealt with the issue of whether or not a deposit account owned by a wholly-owned subsidiary of the debtor was properly pledged despite the fact that the owner of the deposit account did not sign a pledge agreement.

In 2007, WL Homes LLC (“WL Homes”) and Wachovia Bank (“Wachovia”) entered into a transaction pursuant to which Wachovia extended a $20 million revolving line of credit to WL Homes secured by among other things various deposit accounts, including a $10,000,000 deposit account opened at Wachovia after the loan closed and owned by and in the name of JLH Insurance Corp., a wholly-owned subsidiary of WL Homes (“JLH”).  JLH was formed as a pure captive insurance company—it’s sole purpose was to pay claims brought against WL Homes by insuring the risk of WL Homes.   The purpose of the deposit account was to meet a requirement under Arizona law dealing with captive insurance companies.  Although the JLH account was owned by and in the name of JLH, WL Homes transferred all of the funds into that account.  The two entities had separate books and records and organic documents, but there was significant overlap in their board compositions, and the President of JLH was also the CFO of WL Homes and had negotiated the loan documents with Wachovia in such capacity.  The WL Homes balance sheet treated the deposit account as an asset of WL Homes.

In early 2009, WL Homes filed for Chapter 11 bankruptcy, which was subsequently converted to Chapter 7, in the Bankruptcy Court for the District of Delaware.  Promptly thereafter, Wachovia filed an action with the court seeking a declaratory judgment that it had an enforceable security interest in the pledged JLH deposit account.  The Bankruptcy Court granted Wachovia’s motion for summary judgment, finding that (i) Wachovia had use and control over the deposit account and (ii) JLH had consented to the pledge of the deposit account as collateral.  After the District Court for the District of Delaware ruled that Wachovia did not in fact have use and control over the account, but nonetheless affirmed the outcome in the Bankruptcy Court on the grounds that JLH had consented to the pledge, the case was appealed to the Third Circuit.

In ruling in favor of Wachovia under California Law, the Third Circuit first opined that the debtor need not fully own the property that it pledges in a secured transaction, but it may only pledge the rights that it actually has in that property—a security interest attaches to the debtor’s rights, which need not amount to full ownership.  Furthermore, the court opined that consent of the owner of the property is one way in which the debtor may obtain rights in such property, and thus the defining issue became whether or not JLH had consented to the pledge of its deposit account; in order to consent, it first had to have knowledge of the pledge.

In applying certain principles of the law of agency, including the “doctrine of imputed knowledge”, the court held that an agent’s knowledge, in this case the President of JLH, will be imputed to the principal, JLH, if knowledge of the fact is material to the duties to the principal.  Such knowledge must be acquired in the scope of the agent’s duties to the principal, and only knowledge that is actually material to such duties will be imputed.  Furthermore, even knowledge obtained in a different capacity can be imputed if such knowledge is present in the mind of the agent while acting for the principal.  In applying these principles to the facts, the court held that JLH had sufficient knowledge because its President was the CFO of WL Homes and he had sufficient knowledge when acting in his capacity as an agent of JLH.  Because it had sufficient knowledge, JLH was deemed to have consented to the pledge, thus giving WL Homes rights in the deposit account and resulting in an enforceable security interest in favor of Wachovia.

The cases cited by the Third Circuit were situations where a lender would be hard pressed to know which company or individual owned a particular piece of equipment.  In those cases, courts would impute the consent of the owner, who generally owned the borrower and signed the documents, to granting a lien as well.  This case extends the concept because here the account was not in the name of the borrower and the lender had knowledge of that fact.

Despite the fact that the lender overcame what could have been a deleterious mishap, it nonetheless could have saved itself from the risk of being an unsecured creditor, as well as the high cost of litigation, had the parties set up the account at closing and properly identified the source of all collateral being pledged.  In addition to properly identifying the owner or rights-holder of all collateral, ensuring that an express consent is acquired or adding such party as a signatory to the loan documents helps mitigate the likelihood that the debtor will challenge the enforceability of a lender’s security interest.

“Loss Payee” v. “Lender Loss Payee”: How the Difference of One Word Can Prevent a Secured Lender’s Recovery on Insurance Proceeds

Jason I. Miller

8FB7E8F1756E711AD4F5ACD73289F034As a secured lender, you take a security interest in your borrower’s inventory and/or equipment and then perfect under applicable law.  To further protect the value of the collateral supporting your loan, you confirm your borrower has adequate insurance and obtain an endorsement as “loss payee” on the policy.  What happens when the collateral is stolen or destroyed and your borrower misrepresents to the insurance company that there are no liens on the collateral?  The above facts are virtually identical to those in Westfield Ins. Co. v. Talmer Bancorp, 2013 WL 5812027 (6th Cir. 2013), a case where the Sixth Circuit  ruled that because the secured party was listed as “Loss Payee” rather than “Lender Loss Payee,” the secured party was barred from recovering any insurance proceeds.  This case highlights the small but very important distinction between “Loss Payee” and “Lender Loss Payee” endorsements.  While the terms differ by a single word, the designations make a critical difference in determining whether a secured party can recover insurance proceeds under the borrower’s insurance policy after a loss.  A secured party receives far greater protection when its rights are endorsed as “Lender’s Loss Payee”.

In the Westfield case, Milan 2000 Furnishings, Ltd. (“Milan”) obtained a business-property insurance policy from Westfield Insurance Co. (“Westfield”). Peoples State Bank (“Peoples”) obtained a lien on Milan’s real property and a security interest in Milan’s inventory and required Milan to obtain insurance on the collateral. Milan obtained the policy and named Peoples as a loss payee under the policy.

Subsequently, Milan submitted an insurance claim alleging that burglars had stolen inventory from its warehouse.  Westfield requested executed proof-of-loss (“POL”) statements for Milan for both the warehouse and the inventory.  Although Milan listed Peoples on the warehouse POL, it did not identify Peoples as a loss payee on the inventory.  In fact, Milan admitted to affirmatively indicating to Westfield that no party held a security interest in its inventory.  After conducting an investigation, Westfield issued a joint payment to Milan and Peoples to cover the property damage and a separate payment to solely Milan to cover the stolen inventory.

Bancorp, as successor-in-interest to Peoples, objected to Westfield’s failure to pay insurance proceeds to the bank to cover the lost inventory.  Westfield refused and sought a declaratory judgment that it did not owe Bancorp any insurance proceeds due to Milan’s fraud.  The District Court for the Eastern District of Michigan entered a consent judgment in favor of Westfield in the amount paid to Milan, and declared the insurance policy void.  On appeal, the Sixth Circuit affirmed that Bancorp, as a loss payee, was ineligible to share in insurance proceeds when the insurance policy was voided due to Milan’s fraudulent POL.  As the court explained, “Milan’s admitted fraud forecloses Bancorp’s right to recovery under Michigan law because, unlike mortgagees, the policy gives loss payees such as Peoples no independent right of recovery if the insured breaches the policy’s terms.  Instead, under the policy’s loss payable provisions, ‘the lienholder is simply an appointee to receive the insurance fund to the extent of its interest…’” In sum, Bancorp’s lesser status as a loss payee (as opposed to a lender loss payee) prevented it from recovering any insurance proceeds after the actions of the named insured voided the underlying policy.

The Westfield case and the antecedent cases cited by the Westfield court, illustrate the harsh results that can ensue when an insurance policy is voided and a secured creditor is listed as a “Loss Payee”, as opposed to “Lender’s Loss Payee”.  There are a number of reasons why insurance companies may have the right to void a borrower’s policy (e.g., fraud, failure to timely file a proof of loss and intentional destruction of personal or real property).  Despite the similarity between the two terms, a secured party who is a loss payee rather than a lender’s loss payee cannot enforce the insurance policy after the policy is voided due to any of the circumstances listed above.  Lenders should be mindful of the difference between the two endorsements and always insist on obtaining a Lender Loss Payable endorsement.  In addition, Lenders should carefully read the provisions of that endorsement as well as the enumerated circumstances that can give rise to the insurer’s ability to void the policy.

What’s “Commercially Reasonable” for Article 9 Foreclosure Sales?

Ramesh Dhanaraj

dhanarajr1 (2)Since the financial crisis, sales under Section 363 of the Bankruptcy Code have provided an increasingly popular way for secured creditors of distressed businesses to recover their loans.  However, despite the advantages of Section 363 sales, the significant expense and time required to conduct a Bankruptcy sale has caused secured creditors to pursue less comprehensive solutions.  One alternative for recouping value from a troubled loan is an Article 9 foreclosure sale under the Uniform Commercial Code (UCC).

Article 9 (Part 6) of the UCC provides certain statutory remedies to all secured lenders, whether or not such remedies are expressly provided by the security agreement entered into by the lender and the borrower in a lending transaction.  If a borrower defaults under its loan agreement, Article 9 entitles a secured lender to pursue certain rights and remedies with respect to the lender’s collateral (for which a lien may be perfected under Article 9) as set forth in the parties’ security agreement and in Article 9 itself.

However, unlike a Section 363 sale where a Bankruptcy Court approves the process and the sale of a debtor’s assets itself, the UCC provides foreclosing creditors with procedural guidelines for selling collateral assets under Article 9.  This leaves an opening for others to attack the sale process after it is completed.

Such an attack occurred in the recent case of Edgewater Growth Capital v HIG Capital in Delaware.  In Edgewater, a private equity fund, Edgewater Growth Capital (“Edgewater”), acquired a company called Pendum which was in the business of servicing automatic teller machines.  Pendum became highly leveraged due to the significant debt financing that was required to consummate the acquisition.  Soon after Edgewater’s acquisition, Pendum began experiencing serious financial difficulty and became in default under its credit agreement with its lenders.  After numerous amendments to Pendum’s credit agreement were allowed, HIG Capital, another investment fund, purchased a majority of Pendum’s senior debt at a discount.  When Pendum requested yet another amendment from its creditors, its ninth in only about a year and a half, HIG agreed to approve it only under the condition that Pendum’s Edgewater-appointed board members resign from the board.  Consequently, Edgewater’s board members resigned and were replaced with a new board consisting of experienced restructuring consultants.  HIG then negotiated an agreement with the new board under which Pendum’s assets would be sold under Article 9 (the “Foreclosure Sale Agreement”).  Under this Foreclosure Sale Agreement, Pendum’s new board would first be allowed 55 days to attempt to sell the company independently outside of the Article 9 foreclosure sale context.  If no buyer was found during this so called “market check”, it was agreed that HIG would immediately commence an Article 9 foreclosure sale of Pendum’s assets.  As part of the Foreclosure Sale Agreement, HIG agreed to fund both the costs of finding a buyer and the operations of Pendum during the market check.  It also provided the board with a fiduciary “out” which allowed the board to continue to seek potential buyers for the business even after the allotted time for the market check expired.

Pendum conducted an extensive effort to sell itself which included hiring an investment bank and contacting 67 potential bidders.  Despite its considerable efforts, Pendum’s board was unable to secure a buyer for the business during the allotted 55 days.  Shortly thereafter HIG moved forward with the foreclosure sale.  HIG contacted 60 potential bidders and provided public notice of the sale by running advertisements in the Wall Street Journal.  In the end, no outside buyers arose on the day of Pendum’s auction and an affiliate of HIG purchased the company’s assets.  Edgewater then brought suit against HIG in the Delaware Court of Chancery contending that HIG’s acquisition of Pendum was not commercially reasonable under the UCC and was a prohibited private sale.

Edgewater alleged, among other claims, that HIG failed to conduct Pendum’s foreclosure sale in a commercially reasonable manner because the Foreclosure Sale Agreement discouraged competition by allotting too short a time period for properly marketing and selling the company.  The Edgewater Court disagreed.  It found that “commercial reasonableness” for Article 9 sales must be analyzed through the lens of the type of collateral being sold.  The court reasoned that, in the case of a distressed business, the analysis should turn on whether the secured party sold the collateral in conformity with the practices of a seller of “distressed entities”.  It went on to point out that any commercially reasonable process must take into account the “stark reality of the company’s economic facts, not based on the assumption that the foreclosing party must prop up [a] failing entity for the lengthy period that a healthy going concern could use to test the market.”  Specific factors that supported HIG’s actions and the timing as being commercially reasonable were that HIG (i) financed the company’s operations and independent efforts to find a buyer prior to commencement of the foreclosure sale, (ii) provided the board with a fiduciary “out” to continue to seek potential buyers even after the market check deadline, and (iii) allowed for a robust sale process which ultimately provided 83 days for marketing a highly distressed company and included discussions with over 60 potential bidders.

Additionally, Edgewater claimed that HIG’s sale of Pendum’s assets was private, and thus improper under Article 9, since Pendum’s assets were marketed and sold under agreements privately negotiated by Pendum’s board and HIG.  The Edgewater Court clearly points out that under Article 9 a secured party may purchase its own collateral, but it must do so at a “public” disposition not a “private” disposition.  A public sale under the UCC is one in which the public has had a meaningful opportunity for competitive bidding.  The Court disagreed with Edgewater’s argument and found that HIG’s efforts to include Pendum’s board in the sales process, which HIG took even though it had no contractual obligation to do so, was a manifestly positive one.  In dismissing Edgewater’s contention, the court asserts that if it were to deem a sale “private” whenever a borrower negotiates contractual concessions from a foreclosing party in order to give the borrower a greater chance to find a more favorable buyer, it would only be creating counterproductive incentives for secured creditors to exercise their rights in a way that would be adverse to borrowers.

The takeaway from Edgewater is that in cases where secured creditors are faced with the so-called melting ice cube scenario, the extent to which a borrower’s business is deteriorating may be balanced against the robustness of the foreclosure sale process making an Article 9 sale an attractive option for creditors when time is of the essence.

Creditor Didn’t Look Before It Leaped: Loses Right To Stop 363 Sale and Credit Bid

Linor Shohet

shohetl (2)A June 2013 decision from the United States Bankruptcy Court for the Eastern District of North Carolina Greenville Division, In re L.L. Murphrey Company, 2013 WL 2451368 (Bankr. E.D.N.C. June 6, 2013), highlights the importance of due diligence in connection with assignments of security interests.

L.L. Murphrey Company (the “debtor”) filed a voluntary Chapter 11 petition on June 8, 2000.  In 2000, the debtor was in default to Wachovia Bank, N.A. (“Wachovia”) for approximately $12,800,000 secured by the debtor’s real property and personal property by appropriate loan documents (“PreBankruptcy Loan Documents”).

In July 2001, the court confirmed a plan of reorganization, which restructured the debt  into two notes and provided that:

  1. The debtor and Wachovia will enter into amended and restated loan documents consistent with the plan of reorganization;
  2. The debtor shall execute and deliver such additional agreements, instruments and documents as may reasonably be requested by Wachovia;
  3. The Reorganization required that amended and restated loan documents be executed consistent with the confirmation of the plan; and
  4. All liens in favor of any creditor would be deemed released upon confirmation of the plan.

Post confirmation, Wachovia didn’t redocument the loan. Wachovia sold the loans and assigned the PreBankruptcy Loan Documents to CadleRock Joint Venture, L.P. (“CadleRock”) and CadleRock subsequently sold the loans and assigned the PreBankruptcy Loan Documents to D.A.N. Joint Venture Properties of North Carolina (“DAN”).  DAN relying on the assigned documents filed the requisite notices of assignment, amendments and continuation statements.  When the debtor filed a voluntary Chapter 7 petition in 2012, DAN filed a proof of claim for over $6,000,000 and claimed that over half of such amount was a secured claim.

In January and February 2013, the trustee filed motions requesting the court’s approval to conduct a sale of the debtor’s real and personal property pursuant to Section 363 of the Bankruptcy Code, free and clear of liens, with any such liens transferred to the proceeds of the sale.  DAN tried to block  the trustee’s sale motion, arguing that the trustee failed to establish any of the five separate grounds required under Section 363(f) which would permit a sale free and clear of liens. The Trustee argued that he met the requirements of 363(f)(4), which permits the sale of property free and clear of any interest in the property if the interest is in “bona fide dispute.”

DAN argued that its security interest was not subject to a legal or factual dispute because there were no pending objections to its proof of claim and because the debt underlying its claim and the related liens was explicitly reaffirmed by an order entered by the court in a related proceeding. Further, DAN argued that the confirmed plan only required delivery of amended and restated loan documents reasonably requested by Wachovia, and Wachovia never made any such requests of the debtor.

The court disagreed, determining that the trustee had established the existence of a bona fide dispute as to the validity of DAN’s liens because the confirmed plan explicitly required the parties to execute amended and restated loan documents as a condition precedent for setting the implementation date of the new notes.  Therefore, the court permitted the trustee to sell the property free and clear of any liens pursuant to Section 363(f)(4) of the Bankruptcy Code.

Having allowed the 363 sale, the court then turned to the issue of whether DAN could credit bid at the public sale.  The trustee asserted that the questionable validity of DAN’s liens constituted the requisite cause for the court to revoke DAN’s right to credit bid under Section 363(k) of the Bankruptcy Code and the Bankruptcy Court agreed. In re L.L. Murphrey Company serves as a reminder to debt purchasers that as they rarely get any representations from debt sellers they need to undertake appropriate e due diligence before purchasing.   DAN may well end up with an unsecured claim for the entire amount due. That result could have been avoided  had it performed the proper diligence.

Purchasers of Bankruptcy Claims Beware: “Disabilities” of Purchased Claims Could Limit Your Recovery

Josef Mintz

Josef W. MintzRecently, a Delaware bankruptcy court denied a purchaser of claims its recovery because of judgments against the original holders of the claims from whom the claims were purchased.  The case, In re KB Toys, Inc., et al., 470 B.R. 331 (Bankr. D. Del. 2012), held that section 502(d) of the Bankruptcy Code applies to claims purchasers and original claim holders alike.  Section 502(d) disallows a claim against a debtor until the claimant first pays any money owed to the debtor as a result of certain bankruptcy recovery actions such as turnover, avoidance and setoff.  For example, if a claimant files a claim for $10,000, but the claimant owes the debtor $5,000 on account of a preference, the court should disallow the $10,000 claim under 502(d) unless and until the preference liability is satisfied.  According to KB Toys, a hypothetical purchaser of that $10,000 claim will face the same disallowance as the original holder of the claim unless and until the hypothetical $5,000 judgment is paid.  KB Toys thus held that the “disability” of the $10,000 claim travels with the claim to subsequent holders.

KB Toys is an important case for at least two reasons.  First, the case created a new rule of law concerning disallowance of bankruptcy claims in Delaware.  Second, KB Toys’ holding differs from the current view on the same issue in New York.  In New York, under Enron Corp. v. Springfield Assocs. (In re Enron), 379 B.R. 425 (S.D.N.Y. 2007), whether a disability travels with a transferred claim depends upon whether the transfer is structured as a sale or an assignment.  According to Enron, a claim purchaser who buys a claim at a sale will generally take the claim free from any disability that would affect the seller, but an assignee will stand in the shoes of the assignor and will take the claim with the same limitations of the assignor.  KB Toys criticizes Enron’sdistinction between a sale and assignment of a claim, finding that such a distinction is not contemplated by the Bankruptcy Code.  Instead, according to KB Toys, the Bankruptcy Code employs a simpler concept of a “transfer” to uniformly describe both sale and assignment transactions, thus erasing the distinction.

Additionally, KB Toys reached several other conclusions that should serve as cautionary tales to entities engaged in the bankruptcy claims trading business.  First, the court found that the claim purchaser did not undertake sufficient diligence before purchasing the claims in question because it had knowledge of the possibility of disallowance at the time of its purchases.  Specifically, the claim purchaser had notice of potential and actual avoidance action liabilities by virtue of the publically available court filings in the case.  Also, the claim purchaser included indemnification language in some of its transfer agreements, which demonstrated its capacity to negotiate around this very issue at the time of purchase.  Second, the court was not persuaded by the purchaser’s argument that it had purchased the claims in good faith.  Instead, the court noted that the purchase of claims in bankruptcy carries inherent risk and, as a result, purchasers of bankruptcy claims are not entitled to the traditional protections of a good faith purchaser that might be available in non-bankruptcy contexts.

“Robo-Signing” Gets Sanctioned: Mortgage Foreclosure Law Firm’s Reliance on Third-Party Computer Records Does Not Amount to Reasonable Inquiry Required by Rule 11

Michael Trainor

In In Re: Niles C. Taylor, 2011 U.S. App. Lexis 17651 (March 22, 2011), the U.S. Court of Appeals for the Third Circuit considered whether two lawyers, their law firm, the managing partner of the law firm, and their client could be sanctioned for the lawyers’ decision to rely on information provided by a client’s third party computer system in pursuing creditor claims in a bankruptcy matter.

Niles and Angela Taylor filed for a Chapter 13 Bankruptcy in 2007 wherein they listed, among other things, a mortgage on their home.  The bank on the mortgage filed a proof of claim and retained counsel to seek relief from the automatic stay.   Counsel for the bank was retained through a third party computer service which assigned cases to firms who handled high-volume foreclosure work.  Relying solely on the information provided by the third party computer system and failing to take any steps to verify the accuracy of the information provided by the third party computer system with its client, the bank’s counsel filed a motion for relief so that the bank could pursue foreclosure.  The bank’s attorney also filed a response to the debtors’ objection to the bank’s proof of claim.

The proof of claim contained several errors, including a misstatement of the debtors’ monthly mortgage payment and a misstatement of the value of the debtors’ home.  Debtors subsequently provided written evidence to support the fact that the monthly payment on the proof of claim was incorrect.  Yet, despite clear evidence to the contrary, the bank’s counsel maintained in its response to the debtors’ objections that the bank’s proof of claim was accurate.  The bank’s counsel also moved for the admission into evidence of requests for admissions due to the debtors’ failure to submit timely responses.

The bankruptcy court held a hearing on the motion for relief and claim objection, during which counsel for the bank urged the court to grant relief and to admit the requests for admissions.  Counsel made these requests even though counsel had been given information to show that the motion and admissions contained falsehoods.  It was only upon probing by the court that counsel acknowledged that the debtors had made every payment on the underlying mortgage and that, therefore, the proof of claim and motion for relief were inaccurate.  The court denied counsel’s motion for the admissions to be entered into evidence, remarking that the firm and its attorneys “closed their eyes” to the fact that there was evidence that conflicted with the admissions and to evidence that proved that the assertions in the motion for relief were inaccurate.

The bankruptcy court then issued an order to show cause upon the bank and its attorneys as to why the motion, the response to the claim objection, and the requests for admissions were submitted without investigation into the proper and correct facts surrounding the debtors’ mortgage loan.  After four hearings held over several days, the bankruptcy court issued sanctions on the bank, the law firm, the managing partner of the law firm, and two individual attorneys at the firm based, in large part, on the fact that representations were made to the court without first making a reasonable inquiry as to their validity.

The law firm and its attorneys appealed the sanctions order to the District Court, which ultimately overturned the order.[1] The United States Trustee then appealed the District Court’s decision to the Third Circuit Court of Appeals, which upheld the sanctions as to the bank, the law firm and its attorneys but overturned the ruling as to the managing partner of the firm.  In maintaining its imposition of sanctions against the individual attorneys and the law firm, the court stated, in part, as follows: “We appreciate that the use of technology can save both litigants and attorneys time and money, and we do not, of course, mean to suggest that the use of a data base or even certain automated communications between counsel and client are presumptively unreasonable. However, Rule 11 requires more than a rubber-stamping of the results of an automated process by a person who happens to be a lawyer.  Where a lawyer systematically fails to take any responsibility for seeking adequate information from her client, makes representations without any factual basis because they are included in a “form pleading” she has been trained to fill out, and ignores oblivious indications that her information may be incorrect, she cannot be said to have made reasonable inquiry.”  The sanctions against the managing partner of the firm were overruled, in part, because the managing partner did not have hands on contact with the subject case or any of the incorrect filings submitted to the bankruptcy court.  The sanctions against the bank were upheld because the bank did not appeal the bankruptcy court’s original order of sanctions.


[1] Appellant United States trustee appealed an order of the District Court for the Eastern District of Pennsylvania that reversed sanctions originally imposed in a bankruptcy court on the law firm.