Prior bankruptcy case might mean plaintiff has no claim

“Karen Auday had a bad week.” So began a recent opinion by the Sixth Circuit Court of Appeals that amounted to a bad day in court for Ms. Auday, due to her failure to disclose a discrimination claim in a prior bankruptcy case. The Sixth Circuit’s opinion in Auday v. Wet Seal Retail, Inc., -- F.3d --, 2012 WL 5259002 (6th Cir. 2012) confirms the oft-quoted maxim that bankruptcy exists only for the honest but unfortunate debtor. In Ms. Auday’s case, her failure to disclose the existence of her discrimination suit in her bankruptcy case meant that she could not personally bring the suit later. Auday serves as a reminder that when one finds oneself on the wrong end of a lawsuit, it pays to analyze whether the plaintiff’s actions in a prior bankruptcy can result in an early dismissal of the case.

A Bankruptcy Debtor’s Disclosure Obligation

A request for bankruptcy relief obligates the bankruptcy debtor to lay bare his or her personal assets to satisfy creditor claims. This obligation requires the debtor to file schedules listing all asset and liabilities, and courts routinely state that filing accurate and complete schedules is at the core of a bankruptcy debtor’s disclosure duty. The failure to do so can even result in a denial of a debtor’s discharge from his or her debts, the chief benefit to be gained from filing bankruptcy in the first place.

The Bankruptcy Estate and Ownership of a Lawsuit

The Bankruptcy Code operates to create an “estate” when a bankruptcy petition is filed, consisting of all of a debtor’s interests in property existing at the time of the filing. When the estate is created at the beginning of the case, all such property formally belonging to the debtor becomes property of the estate, which is broadly defined in order to capture all types of property. It even includes a claim or causes of action that a debtor might have against somebody else. Thus, as soon as a person files a bankruptcy petition, they no longer own that claim and it may only be prosecuted for benefit of the estate. The estate, in turn, is represented by a trustee acting for the benefit of the debtor’s creditors, and the only way for the debtor to regain the right to bring the claim is to have it formally “abandoned” by the trustee.

In Ms. Auday’s case, she failed to disclose her discrimination claim in the schedules she filed when she initiated her bankruptcy case, and because the claim was never scheduled, it could not be abandoned. In fact, when she attempted to bring the claim herself after receiving her bankruptcy discharge, her bankruptcy case had not even been closed. Because the claim still belonged to the bankruptcy estate, Ms. Auday lacked “standing” to bring the claim. Standing is conferred only upon those whose rights are at stake in the litigation, and a lack of standing is a constitutional bar to bringing a suit. Thus, when a claim belongs to a bankruptcy estate, it is the trustee, and not the debtor, that has standing to litigate the claim. The Sixth Circuit affirmed this rule, and held that only Ms. Auday’s bankruptcy trustee had standing to bring the suit.

Judicial Estoppel

But what happens if the bankruptcy case is closed and the trustee has been relieved of his or her duties? May the debtor bring the previously undisclosed claim then? The answer, correctly, is no. If the claim was never disclosed then it was never “administered” in the bankruptcy case and remains property of the bankruptcy estate, meaning the debtor still lacks standing to bring the claim. Moreover, the Debtor who receives a discharge in bankruptcy while concealing a cause of action will likely be “judicially estopped” from bring the claim at all.

Judicial estoppel is a court-created doctrine that “generally prevents a party from prevailing in one phase of a case on an argument and then relying on a contradictory argument to prevail in another phase.” New Hampshire v. Maine, 532 U.S. 742, 749 (U.S. 2001). The doctrine is by no means limited to bankruptcy law, but in this context courts reason that a debtor who receives a discharge while concealing a potentially valuable claim should be held to have forfeited that claim. This rule is premised upon the deep-rooted conviction that the integrity of the bankruptcy systems itself depends upon full disclosure. If a debtor were permitted to conceal a cause of action while in bankruptcy only to assert it later, then the bankruptcy goal of fairly distributing assets to meet liabilities would be undermined.

Exceptions to Judicial Estoppel

Because bankruptcy law favors the honest but unfortunate debtor, there are exceptions to the judicial estoppel rule, which could otherwise be applied harshly. First, if a debtor’s failure to disclose the claim as an asset resulted from the debtor’s mistake or inadvertence, the doctrine will not apply. Mistake or inadvertence is typically a valid excuse when the debtor lacked factual knowledge at the time of the bankruptcy filing to determine whether or not a claim existed. If the debtor had no way of knowing about the claim when the bankruptcy is filed, then the courts will not punish the debtor by applying judicial estoppel. Second, if the debtor makes a good-faith effort to disclose the claim during the bankruptcy, then judicial estoppel will not apply.

This is what in fact appears to have happened in Ms. Auday’s case. Prior to receiving her bankruptcy discharge, Ms. Auday’s lawyer wrote to her bankruptcy trustee to alert the trustee to the existence of the claim. The trustee then retained a lawyer to pursue the claim but ultimately failed to do so. Thus, although Ms. Auday was turned from the courthouse for lack of standing, the Sixth Circuit expressly refrained from ruling on the judicial estoppel issue. Instead, the Court remanded the case back to the district court to allow the claim to be pursued by the trustee. And litigation with a bankruptcy trustee is often preferable because trustees are usually more realistic about the value of a case and are motivated to settle the case quickly and efficiently.

Conclusion

Although most bankruptcy debtors live up to their disclosure obligation, there are those who do not, and their concealment can work against them in a subsequent lawsuit. If you find yourself in the unfortunate position of having been named in a lawsuit, one of the first things you should do is research whether the plaintiff has filed a prior bankruptcy case. It just may be that the plaintiff has no right to pursue the claim at all.