Conflicting Chapter 7 Rulings: Revisiting Administrative Freezes

by Lesley Anne Hawes March/April 2015

Lesley Anne Hawes dissects two Chapter 7 bankruptcy-related cases centered on temporary administrative freezes on debtor funds in bank accounts and their dramatically different outcomes.

Lesley Anne Hawes,
Partner,
McKenna, Long & Aldridge

Within the last six months, two decisions have been published regarding temporary administrative freezes on debtor funds in bank accounts, with dramatically different outcomes. One decision by the Court of Appeals for the Ninth Circuit, In the Matter of Mwangi (Mwangi v. Wells Fargo Bank, N.A.), 764 F. 3d 1168 (9th Cir. 2014) rejected a damage claim by the debtor based on a bank’s temporary freeze of funds in a Chapter 7 debtor’s bank account. Another decision by the Bankruptcy Court for the Southern District of New York, In re Weidenbenner, 521 B.R. 74 (Bankr. S.D.N.Y. 2014), held the same bank had willfully violated the automatic stay and was liable to the debtors for damages based on its imposition of a five-day administrative “pledge” or hold on the Chapter 7 debtors’ bank account, causing a check to bounce.

Filing a bankruptcy petition creates an estate, which includes all property in which the debtor has a legal, equitable or beneficial interest as of the petition date. See 11 U.S.C. §541. The Bankruptcy Code imposes a broad automatic stay of any action by a creditor or other third party to assert or continue prosecution of claims against a debtor that arose prior to the petition date, to enforce liens on the debtor’s assets or to exercise “control” over property of the estate after the petition is filed. See 11 U.S.C. §362(a). It also imposes an affirmative duty on third parties who are holding property of the bankruptcy estate to turn over that property to the trustee when they receive notice that a bankruptcy petition has been filed. See 11 U.S.C. §542. These provisions collectively allow property of the debtor to be gathered into the estate in an orderly fashion to be administered by a trustee or in Chapter 11 by a debtor-in-possession, providing a breathing spell free from creditor action until the assets of and claims against the estate can be sorted out.

Creditors are not without protections for their rights and interests upon the filing of a bankruptcy petition. Among other provisions, the Bankruptcy Code grants creditors a right of set-off for mutual debt obligations. A creditor who holds a pre-petition claim against a debtor and who also owes the debtor or holds property of the debtor at the time the petition is filed has a mutual debt obligation that may be offset. See 11 U.S.C. §553. Creditors cannot exercise set-off rights after a bankruptcy petition is filed, however, without first obtaining relief from the automatic stay.

However, there are practical realities that bring the application of these provisions into conflict when an individual debtor files for Chapter 7 protection. Notice of the bankruptcy is generally not instantaneous; there may be delays between the filing and the time the creditor learns of the petition and can take action regarding the debtor’s property in its possession. Second, the Chapter 7 trustee, who may have dozens or sometimes hundreds of pending cases to administer at the same time, neither has the ability nor desire to instantaneously take physical possession and control of all of the debtor’s property, particularly in an individual case in which the debtor can designate property as exempt, removing it from the estate upon the passage of the time for objection to the claims of exemption. Chapter 7 trustees would be overwhelmed if physical possession of all funds and property of those Chapter 7 debtors were immediately transferred to the Chapter 7 trustee upon filing the petition. Third, for a creditor who may have a right of set-off, the creditor must retain physical possession of the property or funds to preserve that right but as a practical matter needs time to file pleadings to obtain an order for relief from the stay to permit it to exercise the set-off rights under the Bankruptcy Code.

Two decades ago, the United States Supreme Court addressed the practical conflict between the automatic stay provisions, the turnover provisions and the set-off provisions of the Bankruptcy Code in its landmark Strumpf v. Citizens Bank of Maryland, 516 U.S. 16 (1995) decision. The court held that a bank in possession of a debtor’s bank account and with a claim against the debtor was entitled to place an administrative freeze on the account of limited duration while the bank diligently pursued an order for relief from stay and the right to exercise its set-off rights. The decision took a practical approach to the application of these seemingly conflicting provisions of the Bankruptcy Code to give effect to the creditor’s rights while protecting the debtor and the estate.

The two recent administrative freeze decisions reached different outcomes in part because only the creditor in the Ninth Circuit’s Mwangi decision had an offset claim and therefore could rely on the rule articulated by the Supreme Court in Strumpf, which “forgives” the creditor from its temporary violation of the stay and failure to turn over estate property immediately where the creditor is doing so to preserve its set-off right and acts diligently. More important, the decisions diverged in their analysis of the debtor’s rights in funds before the time to object to the debtor’s claims of exemption has expired and the interpretation of the Bankruptcy Code provisions, which permit a debtor to assert a claim for damages for violation of the stay, with the Weidenbenner decision purporting to address the “practical realities” faced by a debtor while seemingly expanding the availability of a damage remedy for debtors for violation of the stay even if only the estate has an interest in the funds at the time of the violation.

In the Mwangi case, the debtors’ schedules listed the bank as an unsecured creditor with a claim substantially larger than the amount of total funds in the debtors’ accounts with the bank. The Ninth Circuit also held the debtor had no claim for violation of the stay. The court reasoned that initially after the petition was filed, the account funds constituted property of the estate, not of the debtor, and the funds only revested the funds in the debtors after the expiration of the deadline for objections to the claim of exemption. During that period, the debtors could not demonstrate their interests were injured since they did not have an interest in the funds during that time period, only the estate had the interest.

When the funds revested in the debtors automatically after the expiration of the exemption objection period, the funds automatically became property of the debtors, not of the estate, and the stay provisions of §362(a)(3), which prohibit obtaining or exercising control over “property of the estate,” were not violated by the bank since the funds at that point were property of the debtors, not the estate. Further, the court found that under §542(b), the bank properly sought direction from the Chapter 7 trustee as to the disposition of the funds in the account since the funds in the bank account were in the nature of a debt owed to the estate rather than a tangible asset to be physically turned over. Recognizing the apparent “catch 22” in which the debtors were placed by this analysis, the Ninth Circuit concluded that the debtors’ remedy was to make a motion to compel the trustee to distribute or abandon the estate’s interest in exempt property if the trustee fails to act timely to provide instructions to the creditor or distribute the exempt property to the debtor.

In contrast, in Weidenbenner the debtors owed no debt to the bank, and the debtors could demonstrate actual injury from the five-day freeze as one of their checks drawn on the account bounced and a penalty fee was imposed on them by the party to whom the check was issued. The court rejected all arguments raised by the bank in defense of the debtors’ stay violation claims, including the argument that it complied with §542(b) through its request to the trustee for instructions on the disposition of the funds. The court rejected that argument in part because the bank in that case acknowledged that where account funds total less than $5,000, the bank did not impose an administrative pledge to hold the funds in the account pending instructions, a line unilaterally drawn that the court found no justification for in the provisions of the Bankruptcy Code. The court rejected the argument, accepted by the Ninth Circuit and other courts, that the debtors did not have standing to assert a claim for the alleged stay violation since the funds were property of the estate, not of the debtors, at the time the alleged violation occurred.

Instead, the court relied on the language of §362(k) of the Bankruptcy Code permitting recovery for stay violations and the “practical realities of debtors’ lives” to support the court’s interpretation that the debtors had standing to seek damages for violations of the stay that affected the estate but where the debtors themselves suffered injury, in that case a $25 penalty imposed by the check recipient for the bounced check.

There is an undercurrent of concern by the court in Weidenbenner that the bank’s policies were unilaterally crafted by the institution in apparent disregard of the provisions of the stay and other protections for the debtors and the estate under the Bankruptcy Code. Ironically, had the bank immediately turned over the funds in the account to the Chapter 7 trustee, the check issued by the debtors on the account would still have been rejected, the debtors would still have incurred the penalty that was the basis for their stay violation damage claim, but the bank would have been able to escape liability because of its compliance with §542(b) through the transfered funds. That practical reality was not addressed in the reported decision.

The court in Weidenbenner recognized the decision conflicted with Mwangi from the Ninth Circuit but reconciled the outcome because the creditor in Weidenbenner had no offset claim that would allow the creditor to retain the funds under §553 and Strumpf. But there is no reasonable way to reconcile the divergent analysis of the right of a Chapter 7 individual debtor to assert a damage claim for a stay violation that occurred at a point where only the estate had an interest in the property subject to the violation. That conflict may require further review by the courts of the Second Circuit.

Lesley Anne Hawes, a partner in the Los Angeles office of McKenna Long & Aldridge, specializes in the representation of secured and unsecured creditors in bankruptcy proceedings and in the representation of federal equity receivers appointed in civil enforcement actions by federal agencies such as the FTC and SEC.

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