Friday, February 26, 2010

The American bankruptcy system exists for the “honest but unfortunate” debtor, not for those who would use bankruptcy strategically to rewrite obligations just to get a better deal than they could outside bankruptcy.

Indeed, just a few years ago, Congress passed bipartisan bankruptcy reform legislation that tightened the bankruptcy laws to crack down on fraud and abuse. Yet loopholes remain. The U.S. Court of Appeals for the 9th Circuit is primed to rule any day on one of the biggest potential loopholes - the ongoing Bleak House-style efforts of the late Anna Nicole Smith to obtain the fortune of deceased Texas oilman J. Howard Marshall. Although the specific facts are unique, the 9th Circuit’s ruling could impact the finality of every trust or will in America by providing disgruntled claimants with an opportunity to contest every will in the bankruptcy court of their choice.

In 1994, Marshall married former stripper-Playboy centerfold Smith, only to die 14 months later. During their brief courtship and marriage, Marshall showered Smith with millions of dollars in gifts, from jewelry to expensive gowns. After a 95-day jury trial with dozens of witnesses (including six days of testimony from Smith) the Texas probate court ruled that those gifts were the full extent of Marshall’s generosity and dismissed Smith’s charge that she had been defrauded out of a larger share of Marshall’s estate. Before the Texas court could rule, however, Smith rushed into bankruptcy court in California, persuading a federal bankruptcy judge to award her a total of $474 million (after a five-day court hearing) which was later reduced to $88 million on appeal.

The subsequent series of court cases has lasted almost 10 times longer than the Marshalls’ star-crossed marriage. According to the federal district judge, the case has generated more paperwork than any other case in that district’s history - and legal fees that may even exceed Smith’s jewelry bill. The case has been up to the Supreme Court once already to determine a narrow issue of law. After ruling on that issue, the Supreme Court sent the case back to the lower court to resolve one other issue with far-reaching importance - essentially, who should decide the validity of Smith’s challenge to Marshall’s will, the Texas probate court or the Hollywood bankruptcy court?

Common sense tells us that the probate court is the place to resolve such issues. And although the issues are technical, relevant law tells us the same thing. According to federal law, bankruptcy courts have authority to resolve only “core” issues related to the bankruptcy case itself. In particular, bankruptcy law is designed to provide a set of procedures to coordinate an orderly distribution of the bankrupt’s assets, not to encourage “forum-shopping” into bankruptcy merely to rewrite contracts and strategically evade creditors - or, as in Ms. Smith’s case, simply to relitigate her failed state court suit.

If allowed to stand, Smith’s case demonstrates the ease by which savvy litigants can game the bankruptcy system and manufacture jurisdiction by a bankruptcy court to get a second bite at the apple. Smith’s asserted need for bankruptcy was based on a default judgment in a sexual harassment suit filed by her housekeeper - a dubious story rendered still more so by a subsequent settlement that smells of collusion - and a profligate lifestyle that led Smith to spend Marshall’s fortune before she inherited it.

The ease by which Smith manufactured her bankruptcy case combined with the activism of the hair-trigger bankruptcy judge offer someone in Smith’s position a veritable “heads-I-win-tails-you-lose” proposition. If the state court appears hostile, she can rush into bankruptcy court with a trumped-up bankruptcy filing. On the other hand, if things look promising in the state court, she can take her chances there - unless someone else decides to file bankruptcy for the same reason. In short, every trust or will could be susceptible to challenge by a strategic bankruptcy filing leading to years of expensive and acrimonious litigation.

Critics of bankruptcy reform argued that it was unnecessary because judges could be trusted to police abuse of the bankruptcy laws by wealthy filers. Will the 9th Circuit prove this proposition right?

Todd J. Zywicki is professor at the George Mason University School of Law.

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