Source: https://www.hestonlaw.com/recent-ninth-circuit-bankruptcy-decisions---in-re-zafar-david-khan
Timestamp: 2019-04-21 12:38:59+00:00

Document:
Debtors and Barton, who founded RPost International, Ltd (“RIL”), received an initial distribution of RIL stock in consideration of “unreimbursed expenses and compensation” in 2001. After suffering a stroke, Barton took a leave of absence from RIL. In 2007, the Debtors cancelled Barton's shares of stock and returned them to the RIL treasury. Barton brought a suit against Debtors for the stock conversion. The Superior Court found that Debtors fraudulently forged corporate resolutions and misplaced or destroyed the shareholder registry. Debtors separately filed Chapter 13 bankruptcy petitions after the Superior Court found the Debtors liable but before the court assessed damages. The Debtors listed the claims as having a value of $100,000 with a “[remainder] unliquidated; pending [the Superior Court] proceeding”. The Superior Court awarded Barton a judgment for approximately $3.5 million. Debtors did not amend their petitions accordingly.
Barton filed proofs of claims in both cases and the Debtors both objected to the claims. The Debtors argued that Barton's claims were subject to mandatory subordination under §510(b) and that the claims should be disallowed. Debtors also filed adversary actions for subordination and disallowance which were dismissed by the court. Barton filed motions to convert both cases to Chapter 7 on the basis of bad faith.
The Court held that Barton's claims were not subject to mandatory subordination under §510(b) since they were not “for damages arising from the purchase or sale of… a security.” Rather, the Court found that the claims were based on the Superior Court justment for fraud and conversion that occurred well after the purchase of the stock. The Court dismissed the Debtors' objections to disallow the claims as lacking any legal basis. The Court also granted Barton's motion to convert to Chapter 7 for bad faith. The Court found bad faith in that the timing of the filing was intended to defeat the State Court action due to the fact that the award of damages would likely cause Debtors to be above the chapter 13 unsecured debt ceiling. The Court also found that Debtors manipulated the bankruptcy process and concealed assets.
The BAP affirmed the Court's determination that Barton's claims were not subject to mandatory subordination. The BAP reached this conclusion without addressing whether the claim “[arose] from the purchase or sale of securities” because they found that §510(b) does not apply in an individual case. The BAP affirmed the dismissal of the disallowance as it found there was no basis for such. Lastly, the BAP found no abuse of discretion in the finding of bad faith and subsequent conversion to Chapter 7.
Is Barton's claim subject to mandatory subordination under Bankruptcy Code §510(b)?
Did the court abuse its discretion in finding that Debtors filed their cases in bad faith when it converted their cases to Chapter 7?
The Ninth Circuit disagreed with the BAP and held that §510(b) does apply to individuals. However, the Court also held that the claim did not “arise out of the purchase or sale of securities”, and thus the claim was not subject to mandatory subordination under §510(b). Although the courts have given broad interpretation to the phrase “arising from”, this stops short of applying to every transaction involving stocks. While the Superior Court did relate back to the initial purchase of the stock, it did so purely as a means to assess the award of damages. The claim itself did not relate to this purchase of stock or the risks that entail such a purchase, but rather to the fraud and conversion that occurred many years later.
The Court then looked at whether the trial court abused its discretion in converting the cases to Chapter 7 for bad faith. The debtors cited to the factors set out in In re Leavitt for finding bad faith: 1) whether the debtors misrepresented facts in petition or plan, unfairly manipulated the Bankruptcy Code, or otherwise filed his Chapter 13 petition or plan in an unequitable manner; 2) the debtor's history of filings and dismissals; 3) whether the debtor only intended to defeat state court litigation; and 4) whether egregious behavior is present.
The Court found that: Debtors manipulated the bankruptcy proceedings; intended to interfere with the state court litigation; and that their behavior was egregious to say the least. The Court did not that the third Leavitt factor, prior filings/dismissals, did not cut against them. Debtors argued that under the third factor, they did not only intend to defeat the state court litigation. The Court noted that the Leavitt factors are just factors that should be considered, but that the true test is the totality of circumstances. Under the totality of circumstances there was no abuse of discretion.
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