Bankruptcy case resembles Hollywood movie plot

Over the past century technological advancements have brought untold benefits to our society. Computers and electronic information have made life easier and faster and have increased productivity. They have changed the way businesses operate by making obsolete paper libraries and traditional file management processes. In fact, it is hard to imagine any facet of modern life that is not in someway affected by electronic devices and electronic media. The dangers of over-reliance on computers and electronic devices have been the subject of many films during the past half-century, from Stanley Kubrick’s “2001: A Space Odyssey,” to “The Terminator” trilogy, to “The Matrix” trilogy, and so on. The dangers presented in these fictional works have typically centered on humanity’s over-reliance on machines to do work, with the resulting effect that the machines take over and even assume more human-like personas. With the issuance of the opinion in In re Taylor, 2011 U.S. App. LEXIS 17651 (3rd Cir. August 24. 2011), these fictional works provide real-life examples of the dangers of over-reliance on machines.

In In re Taylor, the Third Circuit Court of Appeals imposed sanctions on a creditor, HSBC, and its outside counsel for not checking into the accuracy of computer data generated by HSBC and blindly relied upon by outside counsel in its representations to a bankruptcy court. The computer-generated data contained numerous errors and was not reviewed by anyone to verify its accuracy. Instead, each party in the chain of command blindly relied upon the information produced by the computer system. The Court found that false and misleading information was not only submitted to the Bankruptcy Court in a proof of claim and motion for relief, but was also argued in open court at hearings despite clear evidence that the information was erroneous. Under Rule 9011 of the Bankruptcy Rules of Procedure, which is the equivalent of Rule 11 of the Federal Rules of Civil Procedure, the Court found that HSBC and its attorneys had made false representations to the Bankruptcy Court and were sanctionable regardless of whether those statements were intentionally designed to be false. Instead, the Court stated that the key requirement is only a showing of “objectively unreasonable conduct.”

Case Facts and Trial Court Disposition

The Taylors (“Debtors”) filed a Chapter 13 bankruptcy case and, in their bankruptcy schedules, listed HSBC as a secured creditor holding a mortgage on their residence. At the time of the filing, the Debtors and HSBC were in a dispute over “forced placed” insurance because HSBC believed the Debtors’ home to be located within a flood zone. The dispute resulted in increased monthly payments and, ultimately, led to the bankruptcy filing. HSBC retained two sets of outside counsel to represent it in the bankruptcy case. One set was retained by HSBC to file a proof of claim generated from information compiled by HSBC’s computer software program. Shortly after filing the proof of claim, HSBC, through email correspondence, retained different outside counsel to move for relief from stay (the “Stay Relief Counsel”). All contact between HSBC and Stay Relief Counsel was through email, with all the documents and loan histories emailed by HSBC to Stay Relief Counsel. HSBC failed to ever mention that there was a dispute over the flood zone determination and forced placed insurance, and Stay Relief Counsel made no attempt to review the proof of claim filed by other counsel on behalf of HSBC.

The Debtors objected to the proof of claim, arguing that the amounts stated by HSBC were incorrect due to “escrow” charges relating to the flood insurance dispute and forced-placed insurance, incorrect supporting documentation attached to the proof of claim including the wrong note, and a severely understated value of the home by approximately $100,000.00. It is worth noting that the Debtors had continued to make the regular monthly payment without the additional $180 per month flood insurance charge, but HSBC did not acknowledge these payments and treated each payment as a “partial” payment, thereby reflecting an increased mortgage arrearage each month. It was ultimately determined that the Debtors’ home was not in a flood zone, and the account was, in fact, current, yet both HSBC and Stay Relief Counsel failed to acknowledge and correct this error.

HSBC never spoke with Stay Relief Counsel, never advised Stay Relief Counsel of the flood insurance dispute, and never advised Stay Relief Counsel of the accounting issue. Rather than verifying the information it had asserted in the motion for relief, Stay Relief Counsel continued to rely solely upon the computer-generated information in the preparation and subsequent litigation of the motion for relief. The Debtors objected to the motion for relief, arguing that all payments had been made, and attached copies of their payment checks, some of which had already been cashed by HSBC.

During the litigation phase, and after the Debtors’ objection to the motion for relief, Stay Relief Counsel issued requests for admissions to the Debtors, which they failed to answer resulting in the requests for admissions being deemed as true. Normally, this would be a favorable occurrence, but not in this instance. The Debtors’ objection clearly refuted the requests for admissions, going so far as to present documentary evidence establishing their position. Despite this discovery, Stay Relief Counsel made no attempt to verify the Debtors’ allegations with anyone at HSBC, and continued to assert the flawed position.

At the hearing, Stay Relief Counsel continued to represent the flawed position to the Bankruptcy Court relying upon the computer-generated information and the unanswered requests for admissions. When the Bankruptcy Court took issue with the arguments by Stay Relief Counsel, no explanation could be given. Again, instead of admitting the error, Stay Relief Counsel moved forward. At the conclusion of the stay relief hearing, the Court informed Stay Relief Counsel that it was issuing a “show cause” order as to why HSBC and Stay Relief Counsel should not be sanctioned for violations of Rule 9011, finding that both HSBC and Stay Relief Counsel had made misleading statements to the Bankruptcy Court. After four separate hearings on the matter, again without any contact between HSBC and Stay Relief Counsel, the Bankruptcy Court ordered sanctions against both HSBC and Stay Relief Counsel.

Only Stay Relief Counsel appealed the order to the District Court, which overturned the order. The United States Trustee then appealed the District Court’s decision to the Third Circuit Court of Appeals, which reinstated the Bankruptcy Court’s order for sanctions.

The Opinion

In determining that sanctions were warranted, the Court first discussed Rule 9011’s intended purposes and requirements, stating that Rule 9011 “requires that parties making representations to the court certify that ‘the allegations and other factual contentions have evidentiary support or, if specifically so identified, are likely to have evidentiary support.’” Taylor, 2011 U.S. App. LEXIS 17651, at *16 (quoting, Fed. R. Bank. P. 9011(b)). Rule 9011, the Court states, does not necessarily concern the truth or falsity of the representation but rather whether the party making the representation reasonably believed it to have evidentiary support at the time the representation was made. Id. at *17. Rather than finding that the party made false statements, the standard in determining whether Rule 9011 has been violated requires “only a showing of objectively unreasonable conduct.’” Id. (quoting Felheimer, Eichen & Braverman, P.C. v. Charter Tech., Inc., 57 F.3d 1215, 1225 (3d Cir. 1995).

After setting for the standard to measure whether Rule 9011 had been violated, the Court next applied this standard to the facts. Stay Relief Counsel argued that the statements made to the Bankruptcy Court, both in the form of the motion and in open court, were “literally true” statements, therefore no violation had occurred. They relied upon the information given to them by HSBC through the computer-generated data. However, the Court disagreed, citing the numerous errors contained in the information supplied to Stay Relief Counsel including the incorrect value of the home, the number and amount of payments made, and the erroneous flood zone determination. Moreover, the Court stated that literally true but misleading statements, i.e., half-truths, presents no “safe harbor” from Rule 9011’s wrath.

The Court then reviewed whether or not the “literal truths” represented to the Court were done so after a reasonable inquiry by Stay Relief Counsel and HSBC. If, after a reasonable inquiry was made, the statements were made as a result of some unknown error or technical issue, then, while still faulty and wrong, the representations would not be violative of Rule 9011. Taylor, at *20-*23. Several factors play into making up a reasonable inquiry including the amount of time available to investigate the factual and legal information; the necessity of the parties in relying upon the information provided to them (e.g., summaries of information in extraordinarily large matters versus gleaning information by reviewing each item); the plausibility of the asserted position; and the degree of complexity of the matter as a whole. Taylor, at *23 (relying upon Mary Ann Pensiero, Inc. v. Lingle, 847 F.2d 90 (3d Cir. 1988)).

Ultimately, the reliance on the computer-generated information by Stay Relief Counsel and HSBC was determined to be unreasonable. First, Stay Relief Counsel was unreasonable in relying on the information because they made no attempt to verify the information with any live individual, instead blindly accepting the information as true even when presented with inconsistencies raised by the Debtors. HSBC was unreasonable because no one with HSBC could be found to have any responsibility about the underlying case. Essentially, HSBC had ceded all control over the case and the information to a database, using only minimal controls to send information. In fact, no one ever responded to any emails related to this case that were sent by Stay Relief Counsel. The Court succinctly and pointedly framed these issues when it rhetorically asked, “[w]ho, precisely, can be held accountable [for these factual errors]” if HSBC’s records are inadequately maintained, inaccurately transferred to a database, and/or a law firm relies on this information without any investigation, and material misrepresentations are made to the court? Taylor, at *26-*27.

The Impact

Accounting issues are frequently encountered both in big and small cases with debt balances and account histories provided by our clients, usually generated by computerized accounting systems, that cannot be reconciled with hard facts and documentary proof that we can use in court. Many hours are spent vetting numbers and asking clients for documents and calculations that are supported by those documents. The main reason we do this is to avoid the issues raised in the Taylor opinion. By doing it correctly, i.e., investigating the data, not only does this ensure that sanctions are avoided, but also that possible collateral damage is avoided by substantiating the facts of a case.

We, as attorneys, and you, as creditors, can take no action to "enforce" any obligation unless the debt can be proven: with copies of any contracts, statements, invoices, etc. For banks, it must be proven that the bank is the noteholder or has servicing rights (with original notes, endorsements, allonges, servicing agreements, powers of attorney, etc.). After proving the contract, noteholder, and/or servicer status, the debt calculations must be established as true and accurate. This entails more than simply accepting the data provided from a computer database. Like the Taylor case, oftentimes the data does not tell the whole story. Establishing the accuracy of the data requires more than blind reliance.

Part of the proof required often includes, for example, the ability to prove that products were shipped or funds advanced, that variable interest rates have been reset at proper times and tied to the proper indexes, that payments were properly applied upon receipt, and that any "suspense" or "dispute" balances have been properly applied or explained in a reasonable fashion. Judges do not like "suspense" balances and are highly suspicious of any fees or charges other than principal, interest, taxes, and insurance (PITI). When asked why a particular fee or charge appears in a proof of claim calculation or loan history, and Judges routinely ask, any response akin to "the computer won't allow partial payments to post" or "that's a routine inspection or appraisal fee" will be met by the Judge much like a teacher's response to "the dog ate my homework" excuse. Diligent outside counsel may be annoying, and we will almost certainly cost more than a high-volume, high speed debt collection "mill." The Taylor case is a prime illustration of how "you get what you pay for" even if the dispute seemingly involves "at best a $540 dispute." See Taylor at *16. Paying on the front end to get the documentation and the numbers right may seem like a waste a money if 99% of cases are undisputed, but the expense pays for itself in spades when regional and national lender or vendor reputations are called to the mat by the very public litigation that arises in that 1% of cases which increasingly is causing Judges, trustees, and consumer attorneys alike to dispute far more than 1% of creditor claims in this uncertain economy.

In the end, machines are only as good as the people that use them. Blind reliance on them may result in unexpected problems and severe consequences. There is no substitute for the human factor in truly verifying the accuracy of what has to be proven at trial. Mistakes may still occur, but hey, we’re only human after all.