Opinion
Case No.: 8:14-bk-11729-MW Adv No: 8:16-ap-01123-MW
2019-11-15
IN RE: Richard Clark FARRELL, Debtor(s). Karen Sue Naylor Plaintiff(s), v. Betty Farrell Defendant(s).
Robert P Goe, Goe & Forsythe, LLP, Irvine, CA, for Plaintiff. D Edward Hays, Laila Masud, Marshack Hays LLP, Irvine, CA, for Defendant.
Robert P Goe, Goe & Forsythe, LLP, Irvine, CA, for Plaintiff.
D Edward Hays, Laila Masud, Marshack Hays LLP, Irvine, CA, for Defendant.
MEMORANDUM DECISION AND ORDER
Mark S. Wallace, United States Bankruptcy Judge
This adversary proceeding came on for trial on October 22, 2019 to determine whether Betty Farrell ("Ms. Farrell"), defendant herein, breached her fiduciary duties while she was a member of the Official Committee of Holders of Unsecured Claims (the "Committee") in the main bankruptcy case of Richard C. Farrell.
The Court has subject matter jurisdiction over this proceeding pursuant to 28 U.S.C. § 1334 and General Order 13-05, filed July 1, 2013, of the United States District Court for the Central District of California. This is a core proceeding under 28 U.S.C. § 157(b)(2)(A), (B). Venue is proper pursuant to 28 U.S.C. § 1409.
Each of Plaintiff and Defendant have consented to this Court's final determination of the matters here in controversy under the rule of Stern v. Marshall , 564 U.S. 462, 131 S.Ct. 2594, 180 L.Ed.2d 475 (2011) and Wellness Intern. Network, Ltd. v. Sharif , 575 U.S. 665, 135 S. Ct. 1932, 191 L.Ed.2d 911 (2015). Joint Status Report, Docket No. 46, filed March 7, 2017 at page 4 item F.
FINDINGS OF FACT
Richard C. Farrell ("Debtor") filed a voluntary chapter 11 petition and commenced this bankruptcy proceeding on March 19, 2014 (the "Petition Date"). Prior to the Petition Date, Debtor had been married to the defendant herein, Ms. Farrell. The couple separated on January 14, 1999, Ms. Farrell filed for dissolution of the marriage, and the marriage was terminated on May 23, 2000.
As of the Petition Date, the California family law court with jurisdiction over the marital dissolution proceeding had not yet divided the community property nor made a determination whether retroactive or permanent spousal support would be awarded to Ms. Farrell. (Ms. Farrell had, however, been awarded temporary spousal support).
Ms. Farrell applied to the Office of the United States Trustee (the "UST") for membership on the Official Committee of Holders of Unsecured Claims (the "Committee") on or about April 3, 2014. On the UST's form, Ms. Farrell estimated her claim at $6 million. The UST agreed that Ms. Farrell should be on the Committee and appointed her to the Committee on April 8, 2014 along with David J. Harter and James T. Burnes. Ms. Farrell executed the Committee's By-Laws on April 27, 2014. These By-Laws recited that "[e]ach Member of the Committee is aware of the fiduciary duty it has to all unsecured creditors of the Debtor ..." By-Laws, Article V(1).
It is undisputed that Ms. Farrell was a very active member of the Committee over the course of her tenure (approximately April 2014 through November 2015). She provided information to the Committee and its professionals regarding Debtor's real and personal property, including condominiums in Newport Beach, California, a 1999 Harley Davidson and an Ansel Adams print. Such information eventually led to the liquidation of these and other assets, greatly augmenting the amount of cash held by the bankruptcy estate.
Ms. Farrell filed a proof of claim on May 29, 2014, which the Court designated as Claim No. 9-1 (the "Claim"). The Claim asserts unsecured claims including a first-priority domestic support obligation in an "unliquidated, pending" amount arising from the dissolution of Ms. Farrell's marriage with Debtor.
Ms. Farrell filed a motion for relief from the automatic stay on May 13, 2014. Her motion requested the Court to lift the stay so that she could proceed in California family court to determine her rights to community and separate property and domestic support. The Debtor and the Committee opposed the motion, and the dispute went into mediation. The mediation resulted in the execution by the Debtor and Ms. Farrell of a Binding Mediation Term Sheet. This Court approved the Binding Mediation Term Sheet by order entered October 14, 2014.
The Binding Mediation Term Sheet provides, in relevant part, as follows: "To the extent that, after reservation of funds sufficient to pay community claims and any administrative claims determined by the bankruptcy court to be payable from community property, any excess property will be awarded to both Debtor and [Ms. Farrell] as their separate property ... The family law court shall equally divide the community property pursuant to California law but the court shall not offset creditor claims held by [Ms. Farrell] by awarding her a larger amount of property as her separate property." Binding Mediation Term Sheet at numbered paragraphs 1 and 6.
Debtor signed a declaration supporting the Committee's motion for appointment of a chapter 11 trustee. The Court granted the motion on December 11, 2014 and four days later approved the UST's appointment Karen Sue Naylor, plaintiff herein ("Ms. Naylor"), as chapter 11 trustee.
After taking office as chapter 11 trustee, Ms. Naylor became very concerned about the magnitude of Ms. Farrell's claim in the case and its potential first-priority status in whole or in part. A telephone conference ensued among Ms. Naylor, Ms. Farrell's attorneys and Ms. Naylor's attorney. One of the major issues that was discussed during this conference was the scope, extent and priority of Ms. Farrell's claims. Reporter's Transcript ("R.T.") at 76, lines 17-20. There was extensive discussion on these points. R.T. at 76, line 20. Ms. Naylor repeatedly emphasized that she did not want to administer a case where only one priority creditor gets paid and none of the other unsecured creditors receives any money. R. T. at 76, lines 21-25, 77, line 1. She specifically advised Ms. Farrell's counsel that she "would not administer disputed assets solely for the benefit of [Ms. Farrell]." Trial Declaration of Karen Sue Naylor, Docket No. 131, filed September 16, 2019 ("Naylor Declaration") at 2 of 5, lines 17-19.
Other meetings between Ms. Naylor and Ms. Farrell's attorneys ensued. Ms. Naylor kept asking for an understanding of Ms. Farrell's claims and, despite these multiple inquiries, was never given a straight answer. Instead, she was told by Ms. Farrell's professionals that "it would all work out." Naylor Declaration at 2 of 5, lines 18-19.
While these events were occurring, Ms. Naylor was making arrangements for locating buyers of bankruptcy estate assets, bringing sale motions and performing various other tasks associated with reducing bankruptcy estate property to cash for later distribution to unsecured creditors. Naturally, expenses were run up during this process, including sizable professional fees.
After a long period of time of dodging Ms. Naylor's questions about the nature and scope of her claims (while at the same time actively demanding that Ms. Naylor and the Committee take aggressive action to obtain and liquidate estate assets), Ms. Farrell finally showed her hand. Interim fee applications were filed by Ms. Naylor's attorneys, the Committee's attorneys and other professionals on October 9, 2015. Ms. Farrell filed an Omnibus Response on October 21, 2015 (Docket No. 346) to these interim fee applications. The Omnibus Response states: "It is entirely possible it will ultimately be adjudicated that Debtor has little to any remaining interest in community property and that Betty's pre-petition support claim which has the highest priority for payment will consume the property that remains in this estate. As such, on this record, it is impossible for this Court to authorize payment for any allowed fees at this time. Betty is cognizant that Applicants have a right to be paid for their services; however, they do not have a right to be paid from her property or from funds that should be payable to her on account of domestic support." Omnibus Response at page 2 of 36, lines 18-24. Ms. Farrell then resigned from the Committee on November 1, 2015.
The Court granted the applications in part, allowing the fees and expenses requested on an interim basis but withholding authorization from Ms. Naylor to pay the approved fees and expenses.
The Committee filed a complaint against Ms. Farrell on May 2, 2016, commencing this adversary proceeding. This case was converted to chapter 7 on May 6, 2016, and Ms. Naylor substituted in as plaintiff. The first amended complaint filed September 30, 2016 states a cause of action for equitable subordination of Ms. Farrell's claim, a cause of action for breach of fiduciary duty by Ms. Farrell, and a cause of action for two declaratory judgments relating to the community sub-estate within the main bankruptcy estate. Specifically, the first amended complaint asked the Court to determine that (1) the Binding Mediation Term Sheet has a binding effect upon the liability and equal division of the community property sub-estate, and (2) the "interest of justice" within the meaning of 11 U.S.C. § 726(c)(1) requires that all administrative expense claims against the Estate be paid from the community property sub-estate.
Ms. Naylor and Ms. Farrell entered into a Joint Pretrial Stipulation on April 19, 2019 (Docket No. 108) which the Court later approved. As mentioned earlier, this adversary proceeding was tried on October 22, 2019.
As of this writing, the California family law court has not yet determined whether Ms. Farrell will be awarded permanent and/or retroactive domestic support. Thus, Ms. Farrell's section 507(a)(1) first priority claim based upon a domestic support order remains unliquidated. However, pursuant to a Judgment filed July 19, 2019 (the "July 2019 Judgment"), the California family law court determined, among other things, that Ms. Farrell has no ownership in the business C3 Lighting, that there is no community interest in real property located at 3322 and 3324 Via Lido, 125 Star Crest and 516 West Ocean Front, and that the 2009 Jeep is Debtor's sole and separate property.
Even apart from this adversary proceeding, the waterfall of distributions by Ms. Naylor from bankruptcy estate property pursuant to 11 U.S.C. § 726 remains unknowable at this point in time. First, there is uncertainty concerning the amount of permanent and/or retroactive support that the California family law court will award to Ms. Farrell. Second, uncertainty may exist as to whether community claims will exceed the value of community property held by the estate for the payment of such claims pursuant to 11 U.S.C. §§ 541, 726.
CONCLUSIONS OF LAW
Breach of Fiduciary Duty
A member of a creditors' committee has a fiduciary duty to all the creditors they represent. In re County of Orange, 179 B.R. 195, 202-03 (Bankr. C.D. Cal. 1995). In the context of corporations and partnerships, being under a fiduciary duty to others generally is regarded as consisting of a duty of care and a duty of loyalty. Pfeffer v. Redstone , 965 A.2d 676, 684 (Del. 2009) (corporate director's fiduciary obligations); Davenport Grp. MG, L.P. v. Strategic Inv. Partners, Inc. , 685 A.2d 715, 722 (Del. Ch. 1996) (general partner's duties generally are parallel to those of corporate directors). Arising from the duties of care and loyalty is a duty of disclosure. Pfeffer v. Redstone, supra, 965 A.2d at 684. A duty of disclosure can be breached by omitting the disclosure of material facts. Id. The Court concludes that the fiduciary duties owed by creditor committee members to their constituencies include a duty of care, a duty of loyalty and a duty of disclosure.
Fiduciary duties are generally strict and uncompromising in nature: "Many forms of conduct permissible in a workaday world for those acting at arm's length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the ‘disintegrating erosion’ of particular exceptions [citation omitted]. Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd. It will not consciously be lowered by any judgment of this court." Meinhard v. Salmon , 249 N.Y. 458, 464, 164 N.E. 545, 546 (N.Y. 1928) (Cardozo, C.J.)
Ms. Farrell correctly points out that although creditor committee members owe fiduciary duties, they are hybrids who serve more than one master. Each creditor committee member is by definition a creditor and therefore is in competition with other creditors for a piece of a shrinking pie. If a creditor committee member's claim is disputed by the debtor either as to amount or priority, it is not a breach of fiduciary duty for such committee member to assert the rights such member is entitled to under the bankruptcy law, even though allowance of the claim almost inevitably will have the result of diluting distributions to other creditors. Rickel & Assoc. Inc. v. Smith, 272 B.R. 74, 80 (Bankr. S.D.N.Y. 2002) ; In re Microboard Processing, Inc. , 95 B.R. 283, 285 (Bankr. D. Conn. 1989).
Although Ms. Farrell had and has the full right to seek allowance of domestic support awarded to her by the family law court as a first priority unsecured claim under 11 U.S.C. § 507(a)(1), she does not and did not have the right to actively conceal her intentions with respect to such claim by dodging Ms. Naylor's repeated inquiries on that subject. Her fiduciary duties required her to disclose at the outset of the case what she waited until October 21, 2015 to disclose in the Omnibus Response, namely, her position that the bankruptcy estate's professionals (and, by implication, general unsecured creditors) "do not have a right to be paid from her property or from funds that should be payable to her on account of domestic support." She should have disclosed at the outset of the case, in a full and fair response to Ms. Naylor's pointed inquiries, that she was planning to lure the estate's professionals into possibly working for free and, when it came time for them to paid on an interim basis, to oppose payment on the grounds successfully asserted by her in the Omnibus Response. Thus, Ms. Farrell seriously breached her fiduciary duties, including the duty of disclosure and the duty of loyalty, by refusing to answer Ms. Naylor's questions, concealing her true intentions and using the stock phrase "it will all work out" to lure Ms. Naylor and the estate's professionals into performing work and administering the estate for what might end up being her sole benefit. In the Court's view, the fiduciary duty of disclosure with respect to specific information is best analyzed by asking, "is this information something the persons or entities for whom I am acting as a fiduciary would have an interest in knowing?" Here, there is no doubt whatsoever that unsecured creditors would have wanted to know if there was a possibility that estate resources would be expended solely for Ms. Farrell's benefit and if Ms. Farrell intended to rely upon her priority creditor position to advocate for this result. If general unsecured creditors had known at the case's outset what they did not learn until October 21, 2015, it seems likely that they would have pressed either for dismissal of the case – leaving it to Ms. Farrell to spend her own money to recover assets to which she had a claim – or alternatively to have requested Ms. Naylor to negotiate with Ms. Farrell to establish a carve-out for estate professionals and general unsecured creditors. Ms. Farrell's concealment of her knowledge and intentions concerning her claim deprived general unsecured creditors of the opportunity to negotiate to obtain a distribution of a piece of the bankruptcy estate's assets through a carve out agreement.
See In re Covington, 368 B.R. 38, 41-42 (Bankr. E.D. Cal. 2006) (discussing the impropriety of a trustee's liquidation of estate property for the benefit of "just one creditor" holding a domestic support obligation); cf. Williams v. California First Bank , 859 F.2d 664, 666-67 (9th Cir. 1988) (improper for trustee to liquidate claims that benefit only select creditors with the only benefit to the estate being the recoupment of administrative costs).
Equitable Subordination
A proponent of the equitable subordination of all or part of an allowed claim bears the burden of proving three elements: (1) the claimant engaged in some type of inequitable conduct; (2) the misconduct injured creditors or conferred an unfair advantage on the holder of the claim sought to be subordinated and (3) subordination would not be inconsistent with the Bankruptcy Code. In re First Alliance Mortg. Co. , 471 F.3d 977, 1006 (9th Cir. 2006) ; In re Filtercorp, Inc. , 163 F.3d 570, 583 (9th Cir. 1998). The remedy of equitable subordination is remedial rather than punitive in nature. Schubert v. Lucent Tech. Inc. (In re Winstar Communications, Inc.) , 554 F.3d 382, 411 (3d Cir. 2009). A claim should be subordinated only to the extent necessary to offset the harm suffered. In re USDigital, Inc. , 443 B.R. 22, 49 (Bankr. D. Del. 2011).
Here, Ms. Farrell's breach of her fiduciary duties as a member of the Committee as described above rises to the level of inequitable conduct. It was inequitable for Ms. Farrell to push hard for the liquidation of estate assets while at the same time knowing that she intended to assert rights that might enable her to gain all the benefit from such asset liquidation while paying for none of it. Further, her concealment and nondisclosure of her position and intentions was likewise inequitable.
Turning to the third element of equitable subordination, Ms. Farrell's argues that subordination of her claim would be inconsistent with the Bankruptcy Code because it would deprive her of the priority position to which she is entitled under 11 U.S.C. § 507(a)(1). If this were the law, then no priority claim could ever be subordinated, and 11 U.S.C. § 510(c) would be a dead letter as to this class of claims. The whole point of an equitable subordination of an allowed claim under section 510(c) is to change the order of distribution otherwise required under 11 U.S.C. § 726 (assuming a chapter 7 case) to the extent necessary to offset the harm suffered. The Bankruptcy Code expressly permits this: " ... after notice and a hearing, the court may ... subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim ..." 11 U.S.C. § 510(c). Thus, Ms. Farrell retains her first-priority position allowed claim for domestic support, but pursuant to section 510(c) the order of payment of that first-priority under section 726 is altered in such a way as to offset the harm done to creditors resulting from her inequitable conduct. The alteration is that other creditors are paid before her to the extent of the harm. There is nothing inconsistent with the Bankruptcy Code in all this. Indeed, section 510(c) expressly provides for it.
Turning to the second element of equitable subordination, the Court at this point in time is unable to determine the precise extent to which the unsecured creditor body was harmed by Ms. Farrell's inequitable conduct. This inability is due partly to the fact that the family law court has not yet determined Ms. Farrell's entitlement to retroactive and/or future domestic support.
Damages for wrongful conduct are sometimes determined by analyzing what likely would have happened if such wrongful conduct had not occurred. Here, if Ms. Naylor had known soon after her appointment of Ms. Farrell's true intentions with respect to her claim, she likely would have declined to administer the estate. Naylor Declaration at 2 of 5, lines 17-19. In the absence of estate administration (and a likely dismissal of Debtor's case), professional fees would not have been incurred after Ms. Naylor made a decision not to administer bankruptcy estate assets. For this reason, the Court determines that Ms. Farrell's claim in its entirety is equitably subordinated to all professional fees for work perform by Ms. Naylor's professionals and the Committee's professionals from and after fifteen (15) days after Ms. Naylor's appointment as chapter 11 trustee on December 15, 2014.
Damages to non-administrative priority creditors (other than Ms. Farrell) and general unsecured creditors are more difficult to determine. Such creditors may have been able to collect from Debtor after his bankruptcy case was dismissed, but this is very speculative. Alternatively, such creditors may have benefited from a carve-out agreement negotiated by Ms. Naylor as consideration for keeping the case in bankruptcy. This also is speculative. Further, if the numbers are such that no assets of value in the estate remain after payment of Ms. Naylor's trustee fee and the payment of professional administrative claims, the issue of any payment to non-administrative priority creditors and general unsecured creditors would be moot. Therefore, the Court reaches no determination on this matter at this time and invites further briefing on the issue. Ms. Naylor and Ms. Farrell shall each file opening briefs on or before December 15, 2019 and a responsive brief on or before January 15, 2020.
Declaratory Judgments
The Court determines that the Binding Mediation Term Sheet has a binding effect in this court upon the liability and equal division of the community property sub-estate. After all, the Court approved the Binding Mediation Term Sheet, and there is simply no reason why it would be unenforceable here. The enforceability or non-enforceability of the Binding Mediation Term Sheet in the California family law court is a matter entirely in the hands of the California family law court.
Ms. Naylor requests a declaratory judgment that all administrative expense claims be paid from the community property sub-estate pursuant to the "interest of justice" rule of 11 U.S.C. § 726(c)(1). Ms. Farrell counters that this relief is moot by virtue of the July 2019 Judgment of the California family law court (unless such judgment is reversed on appeal). Ms. Farrell contends that under the July 2019 Judgment community claims exceed community property and so it is certain that all allowed administrative claims will be paid from community property. Defendant's Trial Brief, Docket No. 1235, filed September 16, 2019 at 13-14 of 19.
Had Ms. Farrell not argued as she has, the Court would be reluctant to reach the conclusion that the "interest of justice" standard in 11 U.S.C. § 726(c)(1) requires all administrative expenses to be allocable to community property. Rather, it would seem that any administrative expense costs allocable to work done to reduce the Debtor's separate property to cash for later distribution to creditors should be allocable under the "interest of justice" standard to the Debtor's separate property and not to community property. 6 Collier on Bankruptcy ¶ 726.05[2] (16th Ed.) Administrative expense costs allocable to work done for reducing community property to cash would be allocable to community property.
Ms. Farrell's argument, however, seems to concede that (1) under the facts as they now stand it is inevitable that all administrative expenses will be paid from community property, and (2) Ms. Farrell does not consider this result to be objectionable.
The Court disagrees with Ms. Farrell that the sought-after declaratory relief is moot. The Court still needs to decide how allowed administrative claims are allocated between (i.e., paid from) community property and separate property. The parties' seeming agreement that all administrative claims should be paid from community property in the estate would appear to be beneficial because it will spare Ms. Naylor from the somewhat onerous task of trying to figure out mathematically how much money was spent dealing with community property and how much dealing with separate property. An elimination of expenses associated with an unnecessary mathematical analysis would seem to be in the interests of justice under 11 U.S.C. § 726(c)(1). For all these reasons, the Court will require Ms. Naylor to first apply all allowed administrative expenses against community property in the estate and, if such property is fully consumed, to then apply them against Debtor's separate property. To that extent, the Court grants Ms. Naylor's request for a declaratory judgment on this point, subject to modification by the Court in the event that the July 2019 Judgment is reversed on appeal.
SUMMARY AND CONCLUSION
As the Court envisions it, the Debtor and Ms. Farrell will return to the California family law court to obtain a ruling on Ms. Farrell's entitlement to domestic support. Concurrently, if she is currently holding the 2000 Porsche referred to in the July 2019 Judgment, Ms. Naylor will convey the vehicle to Ms. Farrell based upon the California family law court's determination that it is Ms. Farrell's sole and separate property. The Court is uncertain whether the California family law court determined that Ms. Farrell's sole and separate property includes a $204,000 interest in the 3328 Via Lido condominium or, alternatively, that Ms. Farrell merely has a $204,000 community property interest in the 3328 Via Lido condominium. If the former is the case, and if Ms. Naylor is currently holding these funds, then Ms. Naylor would convey $204,000 to Ms. Farrell because Ms. Farrell's sole and separate property is not included in the bankruptcy estate. 11 U.S.C. § 541. If the $204,000 interest is a community property interest held by Ms. Farrell, Ms. Naylor would use this property interest to pay community claims as discussed above.
Also concurrent with the California family law process, Ms. Naylor would distribute to her professionals and the Committee's professionals all fees and expenses for services performed by them on or after December 30, 2014 and that are allowed by this Court on a final basis. She would also distribute to non-administrative priority creditors an amount equal to the subordination of Ms. Farrell's claims to the claims of these creditors after this Court determines such amount (see references to the briefing schedule above). If funds remain after making these distributions, she would make a distribution to general unsecured creditors. Throughout this process she would create a reserve for the payment of her own fees. If there is an insufficiency of funds to make these distributions and create the reserve, Ms. Naylor is authorized to adjust downward the amounts distributed to professionals (and any other creditors entitled to payment under the waterfall described above) so that there is a pro rata distribution among the professionals (and, if applicable, priority creditors and/or general unsecured creditors) and Ms. Naylor.
If at that point there is still remaining property to distribute (and assuming the California family law court has by that time determined the amount of Ms. Farrell's permanent and/or retroactive domestic support), the parties will return to this Court for a determination of a waterfall of distributions consistent with the provisions of bankruptcy law. The Court will need to address the effect, if any, of 11 U.S.C. §§ 507(a)(1)(C), 726(a), (b), (c)(1)-(2) on any remaining distributions required to be made by Ms. Naylor.
The Court recognizes that the distribution procedures described above are intricate and complicated. Ms. Naylor and/or other interested parties may return at any time to this Court for additional guidance by filing a pleading to that effect.
The Court sets a status conference for this adversary proceeding for Wednesday, March 11, 2020 at 9:00 a.m. An updated status report shall be filed on or before February 27, 2020.
IT IS SO ORDERED.