Bankruptcy is nearly always about allocation of losses among disappointed parties. In addition to enforcing the usual rules about allowed claims and priority, bankruptcy courts are called on with increasing frequency to decide when a lender has stepped out of line, either in its collection efforts or in its pre-bankruptcy arrangements with the now-defunct debtor. Two recent cases have offered interesting takes on what lenders can and can't do vis-à-vis debtors and vis-à-vis other creditors. The combination breaks some new ground and raises some central questions about the debtor-creditor game.

Rambo Negotiates?

We always thought that so long as you didn't lie, you could pretty much say anything in a negotiation. We were wrong. The I-want-what-I-want-no-matter-what quality of negotiations in the context of a bankruptcy discharge received a real setback in the First Circuit recently. The First Circuit ruled that once a party is in bankruptcy, certain threats are off the board—even in out-of-court negotiations. In re Diamond, 346 F.3d 224 (1st Cir. 2003).

For 17 years, Mr. Diamond had made his living in the real estate industry. Premier Capital, a creditor, claims that he concealed assets and made false oaths as part of his bankruptcy filing. During settlement negotiations to resolve a claim of non-dischargeability under §727, Premier Capital's attorney told Mr. Diamond's attorney that if the dischargeability issue was not resolved in Premier's favor, he would take action at the New Hampshire Real Estate Commission to revoke Mr. Diamond's real estate broker's license. Mr. Diamond caved on the proposed settlement, but the bankruptcy court rejected the settlement and denied the creditor's complaint on all grounds.

The hook was a stay violation: attempting to collect in violation of the stay. The First Circuit found that although negotiations regarding discharge were not per se violations of the automatic stay (!), the statement by defendants could "reasonably be deemed tantamount to a threat" of immediate action against the debtor. The court made an interesting point: Premier's statement functionally forced the debtor to treat a professional license as collateral, which the court believed was beyond the permissible bounds of routine negotiations in bankruptcy. This is a different way to frame what is often a question about whether using threats for their in terrorem value is permissible when the action will yield no tangible return for the debtor. The First Circuit frames this instead as a stay violation through the device of a creditor's efforts to reach something valuable to the debtor that is not properly property of the bankrupt estate.

We're reminded of Leo Katz's book, Ill-Gotten Gains: Evasion, Blackmail, Fraud and Kindred Puzzles of the Law, in which he poses the central conundrum: The law of blackmail says that it is unlawful to threaten to do things that are in fact lawful to do. So, for example, threatening to tell someone's spouse about an infidelity can be blackmail, even though telling the spouse is legally permissible. In this case, we assume Premier could tell the real estate commission about Mr. Diamond, but they could not use the threat to tell as a way to extract more money from him. Violation of the stay is a convenient hook, although perhaps unnecessary.

The court remanded the case to the district court to figure out damages. So far as we can tell, there was never a factual inquiry into whether or not Mr. Diamond had misbehaved—just a slap upside the head to the creditor for overreaching in negotiations.

In Furtherance of a Fraud

In this case, lender MBNA tested the bounds of creditor behavior as well—this time, long before the debtor filed for bankruptcy. Computer Personalities Systems sold computers at retail under an arrangement by which MBNA would be the exclusive supplier of financing to the debtor's customers. Computer Personalities had some troubles, resulting in systematic difficulties with failure to ship some of the computers ordered. The company ended up in bankruptcy. In re Computer Personalities Systems Inc., 284 B.R. 415 (Bankr. E.D. Pa. 2002).

Judge Weiss found that MBNA was an arm's-length creditor, not a co-venturer with Computer Personalities. She also determined that MBNA is not an insider, a characterization that would have required MBNA to prove that the transaction was fair. As an outsider, MBNA was off the hook unless the trustee could show more egregious conduct, such as fraud or overreaching. The trustee managed to do just that.

The court described MBNA's activities toward the debtor as "looting" and its continued funding of "unwitting" customers as "conduct that could be viewed as egregious." If these facts are proven at trial, said the court, MBNA's claim will be equitably subordinated.

Lehman Brothers and Lehman Financial Paper Inc. also wound up in bankruptcy court over its role in financing debtor scams. It seems that a few years ago First Alliance figured out a way to sell sub-prime mortgages: It scoured the real estate records to find mostly older people who had owned their homes for a long time and had built up substantial equity. It then descended on these folks with high pressure, deceptive sales practices (persuading them that they should ignore "amount financed" and the "APR" in the disclosure documents because they were meaningless numbers that regulators made them put in). Sweet.

The wheels of justice turn slowly (and lots of old folks lost their houses while those wheels were turning), but First Alliance eventually ended up in bankruptcy. In re First Alliance Mortgage Co., 298 B.R. 652 (C.D. Cal. 2003). Of course, the assets still on hand won't compensate those who claim they were cheated. They will have to look elsewhere.

So what happened to Lehman, the secured creditor that financed these shenanigans? According to specific findings of fact, supported by Lehman's own internal memoranda, Lehman knew a lot about the business plan going in and it found out even more about the complaints while it financed the business. Lehman monitored the customers' litigation against First Alliance, continuing to fund the company to go sell mortgages to some more old folks even as others were filing suit. Now that First Alliance is in bankruptcy, the trustee claimed that Lehman engaged in inequitable conduct that should result in equitable subordination of its otherwise secured claims.

The trustee argued that Lehman "aided and abetted" First Alliance as it defrauded customers. The court bought the factual assertion: Lehman's financing constituted significant, active and knowing participation by Lehman in the First Alliance fraud, thereby substantially assisting First Alliance in its fraudulent lending practices. At this point, it looks like the trustee will get some money for those who were defrauded.

But the court isn't through. It points out that Lehman's activities didn't hurt the business. Indeed, the fraudulent lending practices were quite profitable for First Alliance. Lehman didn't lie to anyone, the court said. Indeed, the court describes Lehman's activities as "arm's-length, in the ordinary course of business." Goodness. We didn't realize that Lehman was ordinarily in the business of substantially assisting in fraudulent lending practices.

As you can guess by now, the district court let Lehman keep its claim. Without Lehman, the business would have been forced to engage in honest lending practices or shut down, a fact that did not trouble the court. Instead, this court seems to take a no-one-got-hurt view, carefully ignoring folks who lost their homes, the creditors who thought the business was straight up, and the investors in the business (if there were any) who didn't know what was going on. We understand the case is on appeal.

It is always possible to highlight factual differences in an effort to distinguish cases, but we believe the courts' attitudes toward MBNA and Lehman illustrate fundamentally different approaches to risks taken by creditors who knowingly assist a debtor as it defrauded third parties. The California court in Lehman took the position that its only responsibility in measuring fraudulent conduct was to see if the debtor itself was injured and to define injury to others within a very narrow scope—complete with a full set of blinders. The Pennsylvania court inverted that approach, going straight to MBNA's assistance to the debtor as the debtor hurt more customers. The latter case obviously offers greater system-wide policing, as it tells the MBNAs of the world that they bear responsibilities when they finance fraudulent schemes.

We confess that we believe the Pennsylvania court has the stronger position. As we see it, a bankruptcy court dispenses justice to multiple parties; it does not exist solely to protect the debtor from its creditors. Part of what makes bankruptcy so special is that creditor-vs.-creditor quality of many of the disputes. These cases are a reminder that courts need to watch out for overreaching on the part of one creditor that affects all the others.

The split between the cases is a good reminder, however, that equitable subordination, with slippery criteria such as "egregious" and "overreaching," ultimately depends on judgment, which really means the good sense of the presiding judges—or perhaps the good judgment of the lawyers advising their clients long before anyone ends up in bankruptcy court.