Kathy Bazoian Phelps
Senior Counsel in Ponzi Scheme Litigation
and Bankruptcy Matters

Kathy is a senior business trial attorney with more than 30 years experience prosecuting and defending claims for high net worth clients involved in Ponzi scheme matters and in bankruptcy proceedings. Kathy’s practice includes recovering assets for clients in complex fraud cases under standard fee and alternative fee arrangements. She also handles SEC and CFTC whistleblower claims. Kathy also serves as a mediator in bankruptcy matters, in complex business disputes, and in matters requiring detailed knowledge about fraud or Ponzi schemes.

Kathy’s Clients in Ponzi Scheme Cases and Bankruptcy Matters
Equity Receivers
Bankruptcy Trustees
High Net Worth Investors
Debtors in Bankruptcy
Secured and Unsecured Creditors

Friday, January 4, 2013

Taking Advantage of Stern v. Marshall in a Ponzi Scheme Case

Posted by Kathy Bazoian Phelps

   Clawback actions in Ponzi scheme cases may be a dime a dozen these days, but the issues now raised by the Supreme Court decision in Stern v. Marshall, __ U.S. __, 131 S. Ct. 2594 (2011), can become quite costly for those involved. In Stern v. Marshall, the Supreme Court held that bankruptcy judges do not have the constitutional authority "to enter a final judgment on a state law counterclaim that is not resolved in the process of ruling on a creditor’s proof of claim," even though Congress designated it as a core claim in 11 U.S.C. § 157(b)(2)(C). Id. at 2620.

   Whether you are representing the trustee plaintiff or a clawback defendant, the issue commands immediate attention and can impact the tenor of the entire case. Following Stern v. Marshall, two circuit courts have stated that Stern v. Marshall prohibits bankruptcy judges from entering final judgments in fraudulent transfer actions, at least when the defendant has not filed a proof of claim that is related to the trustee’s fraudulent transfer claim. Executive Benefits Insurance Agency v. Arkison (In re Bellingham Ins. Agency, Inc.), 2012 WL 6013836 (9th Cir. Dec. 4, 2012); Waldman v. Stone, 698 F.3d 910 (6th Cir. 2012).

   On the other hand, in Onkyo Europe Electronics GMBH v. Global Technovations Inc. (In re Global Technovations Inc.), 694 F.3d 705, 722-23 (6th Cir. 2012), the Sixth Circuit held that a bankruptcy court can enter a final judgment on a fraudulent transfer action that is related to the defendant’s proof of claim.

   In light of Stern v. Marshall and its progeny, a Ponzi scheme clawback defendant therefore must move quickly and carefully in evaluating whether to seek to transfer the case to the district court, and the trustee must thoughtfully respond. What are the available options and what strategic considerations parties should think about in evaluating those options? And, if the best choice for your client is to seek to transfer the case to the district court, what are the steps to get that accomplished?

Selecting the Court to Hear Fraudulent Transfer Claims

   The choice of courts comes down to two - the bankruptcy court or the district court. Determination of which court is the right court or better court is a multi-step process, with several variables to consider.

Step One: Who Filed a Proof of Claim?

   The first question is whether the defendant has filed a proof of claim in the bankruptcy case. Or, if you are representing the defendant, whether the defendant should file a proof of claim (probably for purposes of participating in any distributions from the assets that the trustee collects, including the clawback actions). As noted, at least the Sixth Circuit has held the filing of a proof of claim gives the bankruptcy court jurisdiction over a fraudulent transfer claim when it is related to the defendant’s proof of claim. Onkyo Europe Electronics GMBH v. Global Technovations Inc. (In re Global Technovations Inc.), 694 F.3d at 722 -23. In the clawback situation, this relationship likely cannot be contested because both the proof of claim and the trustee’s clawback claim most probably arose out of the same series of transactions.

   If there is a group of clawback defendants, how many of them filed proofs of claims? If none of the clawback defendants have filed proofs of claim, then an analysis must be undertaken to determine which court is the better court (see Step Two below). If all or nearly all of the defendants have filed claims, then the chances are that the cases will remain in the bankruptcy court for final resolution. But what if some of the defendants did file proofs of claim and others did not, for whatever reason? Then the district court may still be an option, and the party seeking to move the case to district court might argue that there are common issues in the actions – insolvency, the Ponzi presumption, and possibly good faith. The argument, therefore, would be that all of the cases involving all defendants, whether or not the defendants have filed claims, should be tried in the district court that has jurisdiction over all of the actions. The resulting efficiencies would be the "cause" for withdrawal of the reference under 28 U.S.C. § 157(d).

   Another possible path to getting all of the cases to the district court would be, of course, to withdraw the proofs of claim, if such an action is otherwise advisable. This would remove the basis for keeping the clawback actions in the bankruptcy court. However, defendants must fully understand the consequences of withdrawing their claims before they do so. A trustee, on the other hand, should pay close attention to the withdrawal of a defendant’s proof of claim. If a defendant withdraws a proof of claim in order to pursue a Stern v. Marshall issue in the district court, the trustee should make sure the withdrawal papers explicitly bar re-filing the claim and bar any distribution from the estate. The trustee could consider seeking that such a bar apply even to any claim that might otherwise arise from any recovery that the trustee might obtain against the defendant on the clawback claim. The trustee would also be prudent to insist on the defendant's signature on the withdrawal, not just the lawyer's.

Step Two: The Strategic Considerations

   If representing the clawback defendant, there are many factors to consider when deciding whether to push for removal to the district court or to stay in the bankruptcy court.

   First is the "know your judge" factor. It is fair to say that very few clawback actions ever go to trial. Most are either dismissed by the court or settled. Whether you are likely to do better for your clients on your dismissal motion or in your settlement with the trustee in the district court or the bankruptcy court depends at least in part on the judges involved. So if you are unfamiliar with them, you would serve your clients well to inquire about them in an effort to get some local knowledge. The unknown variable here, however, is that, although you know which bankruptcy judge is assigned, you will not know which district judge is assigned until you actually file a motion to withdraw the reference, unless your district has only one district judge.

   Second, from a litigation tactic standpoint, give some consideration to which court your opponent would likely prefer and then consider pushing for the opposite if it otherwise makes sense. The trustee and the trustee’s attorney are likely more comfortable in the bankruptcy court if only because that is where they more regularly practice. Withdrawal of the reference or even the threat of going to the district court could potentially impact the posture of the case and settlement value.

   Third, the speed at which the different courts can get a case to trial may also be a consideration that can sway the decision. In many districts, experience suggests that the district court takes longer to set a matter for trial than in the bankruptcy court. Either the trustee or the defendant may feel more or less pressure to resolve the case expeditiously and such variables should be considered.

   Fourth, if the case proceeds in bankruptcy court and the defendant either has not filed a claim or has withdrawn it, and that court eventually enters a money judgment against the defendant, the defendant might then be able to argue that the judgment is void under Stern v. Marshall. This is questionable because the cases are split on whether the Stern v. Marshall issue can be waived. In In re Bellingham Ins. Agency, the Ninth Circuit held that the issue could be waived, and even implicitly so by conduct. But in Waldman v. Stone, the Sixth Circuit held that, because of the institutional concerns on which Stern v. Marshall relied, the issue cannot be waived.

   Finally, one more factor could influence which court will hear the clawback. A defendant could file a jury demand and then refuse to consent to a trial in the bankruptcy court under 28 U.S.C. § 157(e). In Granfinanciera S.A. v. Nordberg, 492 U.S. 33, 109 S. Ct. 2782 (1989), the Supreme Court held that there is a right to a jury trial in a fraudulent transfer action, at least when the defendant has not filed a proof of claim. This would also take the case into district court, at least for trial.

The Process

   If you decide that it is in your client’s better interests for the clawback case to go to the district court, the process is relatively straightforward. You file a motion to withdraw the reference for cause under 28 U.S.C. § 157(d). Under Rule 5005(a), Fed.R.Bankr.P., the motion is filed with the bankruptcy clerk, but under Rule 5011(a), it is heard by a district judge. That judge is selected when the bankruptcy clerk transmits the motion to the district court. Under Rule 5011(c), the motion does not stay the proceedings in the bankruptcy court unless the bankruptcy court so orders.

   The district judge may then grant the motion, deny the motion, or defer it until the matter is ready for a dispositive motion or trial.

   A trustee may resist a motion to withdraw the reference on the grounds that there is not cause for the withdrawal until the case is ready for trial and there is no reason why the bankruptcy judge can't supervise all of the pretrial proceedings. The trustee may hold out hope that, by the time the matter is ready for trial (if it hasn't settled), the defendant might be prepared to consent to the bankruptcy court.

   Although potentially costly, both Stern v. Marshall and Granfinanciera provide your clawback defendants with potentially valuable strategic options. If considered carefully, they could offer advantages that could change the tenor and momentum of a case.

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