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Trustee Needs to Value Assets During Pendancy

By: Myron A. Bloom

As most bankruptcy practitioners know, Section 554(c) of the Bankruptcy Code provides generally that property that is properly scheduled under Section 521 of the code and not administered at the time of closing of a case is abandoned to the debtor. What happens, however, if a trustee does not investigate the value of a scheduled asset and, post closing, determines that the asset was worth well in excess of the value set forth in the schedules (assuming no debtor fraud)?

This situation was presented to the Bankruptcy Appellate Panel of the 10th U.S. Circuit Court of Appelas in Russell v. Tadlock, et al. (In re Tadlock). A rather unusual set of facts gave rise to the panel's opinion. Tadlock and his wife filed for bankruptcy and listed as one of their assets their home, which they valued at $99,000. The Tadlocks claimed that the home was encumbered by two liens, the total of which exceeded the home's stated value.

During the pendency of the case, the junior lien creditor obtained relief from the automatic stay to proceed with foreclosure. The motion for relief was granted without opposition. Shortly thereafter, the Chapter 7 trustee filed a report of no distribution and the case was closed.

Now, two important facts. First, at no time during the pendency of the case did the trustee attempt to determine the value of the home. Second, for reasons unknown, the senior lienholder released its lien on the home just before the case was closed. When the home was ultimately sold at a sheriff's sale sometime after the case was closed, the proceeds were sufficient to pay off the secured creditor, provide funds for the Tadlocks (who had claimed a homestead exception) and generate a surplus of $37,000.

The trustee, upon learning of the existence of a surplus, filed a motion in bankruptcy court to reopen the Tadlocks' case for the limited purpose of administering the $37,000 surplus. The motion was granted, and the fund was placed with the clerk of court. The trustee then filed an interpleader action in bankruptcy court in which she disavowed any interest in the fund. The bankruptcy court "suggested" that the trustee brief the issue of who was entitled to the surplus, and for the first time, in her brief, the trustee argued that she had committed excusable neglect by not retaining the estate's interest in the property. Interestingly, the trustee did not amend her complaint to allege she had such an interest, nor did she seek relief from the original order closing the case (which by operation of law constituted an abandonment of the surplus).

The bankruptcy court did the following: First, it found that the order closing the case should be revoked under Rule 60(b) of the Federal Rules of Civil Procedure, made applicable to bankruptcy cases by virtue of Rule 9024 of the Federal Rules of Bankruptcy. It reasoned that at the time of the filing of the report, the trustee had no reason to know that the senior lienholder had released, or would release, its lien, nor did the trustee have any reason to believe that the debtors would attempt to gain control of any proceeds assumed to be encumbered by a lien.

Second, the court took up the issue of who was entitled to the surplus. Again, the trustee took no position. The bankruptcy court dealt with the matter as if it were properly brought before it as a motion for summary judgment, and it concluded that the surplus was property of the estate because the debtors' interest in a possible surplus after a foreclosure "was a right the debtors owned on the date they filed their petition and that right belongs to the estate."

In the process of so concluding, the bankruptcy court sua sponte amended the trustee's complaint to include a claim for declaratory judgment as to the estate's interest in the surplus vis-a-vis the Tadlocks. The Tadlocks appealed, and in a 2-1 decision, the panel reversed.

The majority first took up the question of whether it was an error for the bankruptcy court to reopen the case, thereby revoking the deemed abandonment. The majority stated that the trustee in this case had two options before making her report of no distribution - she could have obtained an accurate valuation of the asset, e.g., by appraisal, or she could have sought to except any equity in the property from the order of abandonment. She did neither, simply allowing the property to be abandoned.

Citing to Collier on Bankruptcy, the majority stated that it is a trustee's duty to investigate valuations, and the code imposes no duty on a debtor to inform the trustee of changes to value that may occur post petition; changes in value after the petition date is not cause to reopen a case. Thus, the majority stated, neither the lack of investigation on the part of the trustee nor the Tadlocks' failure to disclose post-petition events were cause to reopen the case to vacate the order of abandonment. "Abandonment is irrevocable even if it is subsequently discovered that the abandoned property had greater value than previously believed," the court stated, citing the 9th Circuit in In re Adair. Only if the trustee is misled by false or incomplete information will this result be altered (something not alleged in this case).

The second issue the majority dealt with was whether invocation of Federal Rule of Civil Procedure 60(b) and Federal Rule of Bankruptcy Procedure 9024 (excusable neglect) was appropriate. The panel stated that it was not. The only case offered in support of the use of rules 60(b) and 9024 in this context involved a Chapter 11 case that was inadvertently closed while a sale of assets was pending, where the trustee had filed his report at the urging of the court, and where equity was necessarily invoked to give a debtor property to "the considerable detriment of a good faith purchaser." Moreover, in that case, the trustee was authorized to sell all of the debtor's assets pursuant to a confirmed plan and revocation of the abandonment was necessary to carry out the terms of the confirmed plan.

Accordingly, the majority reversed and directed the clerk of the court to pay the surplus to the Tadlocks.

The dissent expressed its disagreement with the standard of review utilized by the majority. The majority stated that in reviewing a grant of summary judgment it would utilize a de novo standard. The dissent, however, took the position that the correct standard was an abuse of discretion standard. Under that standard, an appellate court should not reverse a decision based on sound discretion, especially when it comes to orders granting motions to reopen cases and revoke orders of abandonment. On this basis alone, the bankruptcy court's ruling should not be disturbed. Moreover, stated the dissent, the orders were most likely interlocutory and the standards for permitting an interlocutory appeal were not considered.

This result may seem harsh, but the majority found that the policy of finality underlying the decision was an important one. As the majority stated, " [w]e also recognize the need for finality in bankruptcy cases and the need for debtors to rely on the conclusiveness of bankruptcy proceedings as they move beyond bankruptcy."

However, one may question why the policy of finality would trump another policy, that of ensuring that nonexempt assets should be liquidated with the proceeds going to creditors with valid claims. That result would be especially apt here, where a different result would not prejudice the debtors. In any event, the case provides an important lesson for not only trustees but also creditors. Both have an interest in maximizing dollars to pay creditors. To achieve that end, both must be diligent in making sure that assets are not just identified, but valued properly. Unless that occurs, a debtor might get not only the discharge he or she seeks, but a monetary windfall as well.

This article is reprinted with the permission from the May 19, 2006 issue of The Legal Intelligencer.  Copyright 2006 ALM Properties, Inc.  Further duplication without permission is prohibited.  All rights reserved.