Bankruptcy is often a refuge for individuals or businesses whose assets are threatened by pending litigation or judgments. While access to the bankruptcy court has been severely restricted in recent years by congressional changes to the U.S. Bankruptcy Code, the bankruptcy option remains for those defending civil lawsuits who subsequently require the benefits and protections afforded under bankruptcy law.
But what happens when the debtor is the one prosecuting a civil action, and he or she fails to disclose the pending or even potential civil action in the context of the bankruptcy proceeding? The result of this oversight or deception can be drastic, including the ultimate sanction: dismissal of the civil action.
When an individual or entity files a petition for bankruptcy protection under chapters 7, 11, or 13 of the Bankruptcy Code, a bankruptcy estate is created. Pursuant to Section 541(a)(1) of the code, the bankruptcy estate is composed of "all legal or equitable interests of the debtor in property as of the commencement of the case."1
The scope of Section 541(a)(1) is broad, encompassing both tangible and intangible property.2 Included within the wide sweep of "intangible property" under the section are prepetition causes of action held by the debtor.3 The bankruptcy estate encompasses all property of the debtor, even what is needed for a fresh start.4 As the U.S. Supreme Court has recognized, "[A]n estate in bankruptcy consists of all the interests in property, legal and equitable, possessed by the debtor at the time of filing, as well as those interests recovered or recoverable through transfer and lien avoidance provisions."5
The Bankruptcy Code affords debtors the right to exempt certain property from the bankruptcy estate.6 Section 522 of the Bankruptcy Code directs what property a debtor may exempt. In chapter 7 proceedings, nonexempt property in a debtor's bankruptcy estate is subject to administration by the trustee for the benefit of creditors--and this property includes pending lawsuits. As one court has explained, pursuant to Section 541, "a trustee in bankruptcy succeeds to all causes of action held by a debtor at the time a bankruptcy petition is filed."7
Subject to the specific exemption rules, the Bankruptcy Code seeks to ensure that all property of the debtor is included in the debtor's bankruptcy estate for administration by the bankruptcy trustee. To accomplish that purpose, Bankruptcy Code Section 521(1) requires the debtor to file a schedule of assets and liabilities, a schedule of current income and expenditures, and a statement of financial affairs.8 A debtor has an "affirmative duty to disclose all of its assets to the bankruptcy court."9 The required documents must be executed under penalty of perjury.
In completing the schedules, debtors have an absolute duty to report any and all interest they hold in property, even if they believe their assets are worthless or unavailable to the bankruptcy estate. Schedules must be complete, thorough, and accurate so that creditors are able to judge for themselves the nature of the debtor's estate.10 The disclosure obligations of debtors are at the very core of the bankruptcy process. In fact, courts have said that meeting these obligations is part of the price that debtors must pay for receiving a bankruptcy discharge.11 As one court has noted:
The dual purposes of a Chapter 7 bankruptcy case are to grant the honest debtor a discharge of his or her pre-petition debts, and to provide a mechanism for the fair and orderly distribution of the debtor's assets that are subject to administration by the Trustee. These purposes are fully realized when a debtor complies with the requirement that he or she submit accurate and complete information concerning the identification of creditors and assets.12
When an individual files for bankruptcy protection but fails to disclose an existing cause of action in his or her bankruptcy filings, such as the statement of financial affairs, and later receives a discharge, courts have held that the debtor possesses no standing to pursue the civil claim, because it was--and would have been--the property of the trustee prior to discharge.13 According to decisional law, a debtor is disallowed to assert title to or pursue an undisclosed claim simply because a trustee, without knowledge of the claim, took no action regarding it before the bankruptcy proceeding was closed.14 Accordingly, a debtor/plaintiff will lose the right to pursue a civil claim by either failing to disclose it in his or her bankruptcy proceeding or intentionally concealing it from the court, trustee, and creditors in the bankruptcy proceeding.
Judicial estoppel is an equitable doctrine that precludes a party from asserting one position and then later seeking advantage by taking a clearly inconsistent position.15 In recent years, the doctrine of judicial estoppel has been asserted with increasing frequency as a defense to various claims. In New Hampshire v. Maine,16 the U.S. Supreme Court applied the doctrine to bar the State of New Hampshire from taking a different position from that taken by the state during litigation in the 1970s. It explained that "under the judicial estoppel doctrine, where a party assumes a certain position in a legal proceeding, and succeeds in maintaining that position, he may not thereafter, simply because his interests have changed, assume a contrary position, especially if it be to the prejudice of the party who has acquiesced in the position formerly taken by him."17 The Court further noted that the "purpose of the doctrine is to protect the integrity of the judicial process by prohibiting parties from deliberately changing positions according to the exigencies of the moment."18
In New Hampshire, the Court set forth several factors for courts to consider in determining whether to apply judicial estoppel. First, the later position must be clearly inconsistent with the earlier position. Second, if a party succeeds in persuading a court to accept that party's earlier position, the judicial acceptance of an inconsistent position in a later proceeding would create the perception that either the first or the second court was misled. Third, the party seeking to assert an inconsistent position would derive an unfair advantage or impose an unfair detriment on the opposing party if not estopped from attempting to assert it.19 Implying greater application of the doctrine, the Court noted that these factors are not "inflexible prerequisites."20
The doctrine's specific applicability to bankruptcy proceedings is illuminated in Hay v. First Interstate Bank.21 The debtor, Hay, filed a chapter 11 bankruptcy petition in 1986. During the course of the proceeding, Hay discovered information leading to potential claims that he ultimately brought against First Interstate and others in a federal civil action in 1989. However, Hay never brought the information he discovered to the attention of the bankruptcy court at any time before the bankruptcy proceeding was closed in 1988.22
First Interstate moved for summary judgment in the civil action, contending Hay was judicially estopped from asserting any claims against it because the events that led to his claims arose during the course of Hay's prior bankruptcy proceeding. The trial court granted First Interstate's summary judgment motion, which was unanimously affirmed on appeal.23
The Ninth Circuit initially recognized that while not all of the facts underlying Hay's claims against First Interstate were known during the pendency of the bankruptcy proceeding, Hay knew enough information to require him to notify the bankruptcy court of the existence of the potential asset. Citing precedent, the Ninth Circuit noted that a debtor "must disclose any litigation likely to arise in the non-bankruptcy context." The court held that the failure to give this notice estopped Hay and justified the summary termination of his civil action.24
Similarly illustrative is Hamilton v. State Farm Fire and Casualty Company,25 in which the plaintiff asserted a questionable claim with his insurer, State Farm, for water intrusion at a home Hamilton owned but rented to others. Following an investigation of the claim, State Farm concluded Hamilton intentionally caused the water intrusion, that he vandalized and stole property from the house, and that he violated the antifraud/concealment provisions of the insurance policy at issue. Consequently, State Farm denied the claim.26
Prior to State Farm's decision, Hamilton hired lawyers to pressure the insurer to pay the claim. In correspondence from the lawyers to the carrier, Hamilton emphasized the importance of promptly settling his claim because he was facing a November 10, 1997, foreclosure deadline on his house due to the unremedied property damage and corollary absence of income generated by a renter. Nevertheless, State Farm denied the claim on November 3, 1997.27
Before receiving State Farm's denial letter, Hamilton filed for chapter 7 bankruptcy protection on October 31, 1997. In the schedules he filed with the bankruptcy court, Hamilton listed a $160,000 loss against his estate, but he failed to disclose his corresponding claim against State Farm as an asset of the estate. The bankruptcy trustee noticed the large loss Hamilton listed and inquired on several occasions if he was pursuing any insurance claims to recover on the loss. Hamilton's repeated failure to respond led to a successful motion by the trustee in July 1998 to dismiss the bankruptcy case, which also vacated any impending discharge of Hamilton's debts.28
Three months later, in October 1998, Hamilton filed a bad faith lawsuit against State Farm based on the denial of his insurance claim. State Farm brought a motion for summary judgment, contending, among other things, that the case was barred by the doctrine of judicial estoppel because Hamilton failed to list his insurance claim (and impending lawsuit) as assets in his chapter 7 bankruptcy schedules. The trial court agreed with State Farm, concluding Hamilton's contradictory positions in the bankruptcy case and his subsequent civil action estopped him from pursuing his lawsuit against State Farm.29 As the court declared:
[W]e must invoke judicial estoppel to protect the integrity of the bankruptcy process. The debtor, once he institutes the bankruptcy process, disrupts the flow of commerce and obtains a stay and the benefits derived by listing all his assets. The Bankruptcy Code and Rules "impose upon the bankruptcy debtors an express affirmative duty to disclose all assets, including contingent and unliquidated claims." The debtor's duty to disclose potential claims as assets does not end when the debtor files schedules, but instead continues for the duration of the bankruptcy proceeding.30
The court of appeal thus concluded that Hamilton's dishonesty in his bankruptcy case judicially estopped him from asserting claims--which constitute previously undisclosed assets--in his subsequent civil action.
A decision in the same vein is Burnes v. Pemco Aeroplex, Inc.31 The debtor in Burnes filed a chapter 13 bankruptcy petition in July 1997. Six months later, the debtor filed a discrimination charge with the Equal Employment Opportunity Commission against his employer. Almost a year later, while his bankruptcy proceeding was pending, the debtor filed an employment discrimination suit against his employer in federal district court. The debtor never amended his bankruptcy schedules or the statement of financial affairs to include the lawsuit. In October 2000, the debtor converted his bankruptcy case from chapter 13 to chapter 7. At that time, the debtor filed new, updated schedules but again did not include the discrimination lawsuit. In January 2001, the debtor received a "no asset" discharge of over $38,000 in debt. Neither the chapter 7 trustee nor any of the debtor's creditors knew about the lawsuit. The defendant employer moved for summary judgment in the district court on the basis of judicial estoppel, and the court granted the motion, concluding that judicial estoppel barred the debtor from pursuing his claims.32
On appeal, the Eleventh Circuit held that the doctrine of judicial estoppel precluded a party from "asserting a claim in a legal proceeding that is inconsistent with a claim taken by that party in a previous proceeding." Moreover, the doctrine is "an equitable concept intended to prevent the perversion of the judicial process" and "protect the integrity of the judicial process by prohibiting parties from deliberately changing positions according to the exigencies of the moment."33 The court concluded that the first part of the two-part analysis had been satisfied because the debtor had signed his bankruptcy schedules and statement of financial affairs under oath.34
Although the court recognized that judicial estoppel should not be applied if the inconsistencies are the result of "a good faith mistake rather than…part of a scheme to mislead the court," the court determined that a "debtor's failure to satisfy [his or her] statutory disclosure duty is inadvertent only when, in general, the debtor either lacks knowledge of the undisclosed claims or has no motive for their concealment."35 In so holding, the court rejected the debtor's contentions that his failure to place the cause of action on his schedules was inadvertent error.
The court held that the debtor clearly demonstrated his knowledge of the undisclosed cause of action because he had filed the discrimination lawsuit during the pendency of his chapter 13 bankruptcy proceeding and continued to pursue the claim when he converted the case to a chapter 7 proceeding. The court also determined that the debtor had a motive to conceal the cause of action because he probably would not have received a "no asset" discharge of his debts if the trustee, the bankruptcy court, and his creditors had known about the cause of action. Therefore, the court held that the district court did not err in determining that the debtor was judicially estopped from pursuing his discrimination lawsuit against his former employer.36
When to Notify, Correct, or Attack
For defendants, the issue of timing in notifying the court in a civil action of potential bankruptcy fraud committed by a debtor/
plaintiff in a bankruptcy proceeding is crucial. If the bankruptcy proceeding is still ongoing, the debtor/plaintiff still has the opportunity to revise or amend the statement of financial affairs that was filed in the bankruptcy court to "correct" a prior nondisclosure of a pending civil action. Once the bankruptcy proceeding is concluded, however, the opportunity to correct the nondisclosure virtually evaporates, and the plaintiff is exposed to critical scrutiny by the civil court to explain away the objective appearance of fraud and deception.
The recent decision of an Indiana appellate court in Morgan County Hospital v. Maria Upham is instructive.37 Maria Upham, the surviving spouse and personal representative of the estate of her decedent husband, claimed that her husband died as a result of malpractice committed by a hospital and its staff physicians. Before instituting the malpractice action, Upham first brought an administrative claim in 1998 with the Indiana Department of Insurance against the same defendants. During the course of the prelitigation administrative claim, Upham responded to interrogatories under oath that she had never filed for bankruptcy.
Following an adverse ruling and dismissal of her prelitigation administrative claim in 2001, Upham filed for chapter 13 bankruptcy protection in June 2002. Five months later, she initiated the malpractice action. In January 2005, Upham filed an amended declaration in bankruptcy court concerning her financial affairs, in which she did not disclose the ongoing malpractice action.
In September 2006, during her deposition in the malpractice action, Upham testified about the bankruptcy petition she had filed three years earlier in 2002. At the time of her testimony, the bankruptcy proceeding was still open and ongoing. One month later, Upham was successful in a motion to have the bankruptcy court issue an order specifying that any sums recovered in the malpractice action would be reported to the court and trustee for distribution to Upham's creditors.
Subsequently, the defendants in the malpractice action brought summary judgment motions on the grounds that Upham did not possess standing to sue and that she was judicially estopped from pursuing the action based on her failure to disclose it in her filings with the bankruptcy court. The court granted the motions, agreeing with the defense that Upham was judicially estopped from pursuing her malpractice suit based on the nondisclosure issue.
Upham then brought a motion in the trial court for reconsideration and to correct the error. The motion was granted, thereby nullifying the summary judgments in favor of the defendants, and the order was affirmed on appeal. Citing Robson v. Texas Eastern,38 the court of appeal in Morgan initially noted the applicability of judicial estoppel when a debtor/plaintiff fails to disclose a cause of action as an asset in bankruptcy proceedings and then pursues the omitted cause of action in a subsequent civil lawsuit.39 The court then noted how an inference of bad faith arises when the party asserting judicial estoppel demonstrates that the plaintiff had knowledge of an unscheduled claim and a motive for concealment, notwithstanding the duty to disclose it.
The court recognized that if the party asserting judicial estoppel establishes knowledge of a claim and motive for concealment by the debtor/plaintiff, the plaintiff then has the "burden of coming forth with evidence indicating that the nondisclosure was made in good faith." However, the court also emphasized that while knowledge and motive are important in establishing judicial estoppel, "the inquiry does not end there if the debtor/plaintiff comes forward with evidence indicating that the non-disclosure was made in good faith."40
Applying these principles to the facts of the case, the appellate court in Morgan concurred with the trial court that Upham sufficiently explained her failure to amend her filings with the bankruptcy court to denote the existence of the malpractice action prior to her deposition in that action. The explanation, concomitant with the fact that her bankruptcy proceeding was still open and ongoing, militated in favor of Upham and against the defendants' judicial estoppel argument. The trial court's order reversing the defendants' summary judgment motions was thus proper and affirmed on appeal.
Considering the present economic climate, it is incumbent on defense lawyers to perform a bankruptcy background check on plaintiffs. Arguably more important is the same background check performed by the attorney representing the plaintiff, to ensure that no undisclosed pending or even former bankruptcy proceeding is omitted from the intake history by counsel. This due diligence is critical, considering no plaintiff's lawyer wants to risk an involuntary dismissal of a civil action due to a client's deceptive acts or conduct.
Whether by mistake or intention, a debtor/plaintiff who conceals a pending civil action in the context of a bankruptcy proceeding may lose any legal or equitable right to pursue the civil action as a consequence of the nondisclosure. While the timing of an attack by the defense can be determinative of success on a dispositive motion brought in the trial court, eventually the issue must be addressed with the court by counsel.