|April 19, 2005|
Previously published on April 2005
The United States Court of Appeals for the Seventh Circuit, in In re A.G. Financial Service Center, Inc., recently examined a creditor's ability to pursue a prepetition claim for punitive damages against a chapter 11 debtor. The Seventh Circuit held that there is no federal law prohibiting creditors from seeking allowance of a punitive damages claim in a chapter 11 bankruptcy case. The Seventh Circuit ruled that creditors are entitled to pursue punitive damages against a debtor if state law allows punitive awards against insolvent parties. The Seventh Circuit concluded, however, that although a bankruptcy court cannot categorically disallow a claim for punitive damages if such a claim is available under state law, a bankruptcy judge may exercise discretion and equitably subordinate any punitive damages award to other allowed claims against the debtor's estate.
Punitive Damages Claims in Chapter 11 Cases
Many courts have struggled with how to deal with punitive damages claims in chapter 11 bankruptcies. The Bankruptcy Code does not address whether punitive damages claims shall be disallowed in chapter 11 cases. Because the amount of punitive damages claims in a chapter 11 case often constitutes a significant portion of the total claims against a debtor, numerous bankruptcy courts have disallowed these claims in chapter 11 cases. These bankruptcy courts have used their broad equitable powers to disallow punitive damages claims, reasoning that (i) punitive damages claims frustrate a debtor's ability to reorganize, (ii) punitive damages claims punish innocent creditors for the debtor's wrongdoing by reducing their recovery, and (iii) the punitive and deterrent purposes of punitive damages are not served in bankruptcy. Other bankruptcy courts have concluded that the disallowance of punitive damages claims in chapter 11 cases is no longer a viable means of handling punitive damages claims in chapter 11 cases, reasoning that (i) disallowance of punitive damages claims can unfairly deprive some creditors of their right to receive payment for compensatory claims against the debtor, (ii) disallowance can be inequitable, and (iii) a punitive damages claim that would have been paid under chapter 7 as a fourth priority claim cannot be disallowed in chapter 11. Prior to the A.G. Financial Service Center decision, only one court of appeals addressed this issue. The United States Court of Appeals for the Eleventh Circuit held that punitive damages claims are not available in bankruptcy.
A.G. Financial Service Center Inc. ("A.G.") issued private-label credit cards to over 280,000 borrowers, which consumers used to purchase goods and services from single merchants. Some of A.G.'s merchants were distributors of satellite television systems. Many borrowers complained that they had been misled about the terms of credit or the costs of satellite television. A.G. experienced high delinquency rates and approximately 500 cardholders sued the company.
One lawsuit in Mississippi against A.G. resulted in a $167 million judgment, almost all of it comprised of punitive damages. A.G. responded by filing a petition for chapter 11 relief. Other than $2 million in cash, A.G.'s principal asset was a tort claim against its corporate parent based on the legal theory that the parent had induced A.G. to mislead the consumer cardholders.
To settle A.G.'s claim, the nondebtor parent company offered a global settlement to satisfy all of A.G.'s debts in full except for punitive damages awards. Almost all of A.G.'s actual and contingent creditors agreed to accept specified sums from the parent. To the non-settling creditors, A.G. offered a choice between $5,500 cash (less any unpaid balance on the account) and an opportunity to prove actual damages in court. Wanting to maintain the ability to pursue punitive damages, eight cardholders objected to these options, three of which filed claims in the chapter 11 case.
A.G. filed a plan of reorganization with the bankruptcy court. The plan of reorganization provided for payment in full for all claims other than punitive damages claims. The plan categorically disallowed all punitive damages claims. The plan also included a release of the parent in exchange for the cash settlement with A.G. and an injunction forbidding A.G.'s creditors from suing the parent.
The bankruptcy court confirmed A.G.'s plan of reorganization over the objection of five creditors who argued that the rejection of all punitive damages claims and the injunction against the debtor's parent were unwarranted. The district court upheld the plan on appeal, ruling that punitive damages are unavailable in bankruptcy proceedings. The objecting cardholders then appealed to the United States Court of Appeals for the Seventh Circuit, arguing that the plan provisions categorically denying punitive damages claims were impermissible and asked the court to reverse and direct the bankruptcy court to allow them jury trials to collect punitive damages.
The Seventh Circuit's Decision
The Seventh Circuit considered the issue of whether the cardholders were entitled to pursue punitive damages. The Seventh Circuit observed that both the bankruptcy court and the district court summarily concluded that punitive damages are unavailable in bankruptcy proceedings because their award would be unfair to other creditors. The Seventh Circuit noted that neither court attempted to identify any Bankruptcy Code provision supporting categorical disallowance of punitive damages claims. The court stated that "[b]ankruptcy law enforces non-bankruptcy entitlements, unless they are modified according to the Code." Accordingly, the Seventh Circuit reasoned that the lower courts lacked authority to alter state law, or depart from the Bankruptcy Code, to implement their own views of wise policy.
In considering whether punitive damages are available in bankruptcy, the Seventh Circuit noted one appellate decision from the Eleventh Circuit which upheld a bankruptcy court decision striking a creditor's claim for punitive damages. In Novak v. Callahan (In re GAC Corp.), the Eleventh Circuit held that the purposes of punitive damages, to punish and deter the tortfeasor, are not served in bankruptcy. In a single paragraph, the Eleventh Circuit ruled that allowance of punitive damages claims in bankruptcy is inequitable because innocent creditors would be forced to pay for the debtor's wrongdoing. The Eleventh Circuit concluded that future wrongful conduct will not be deterred when the punitive damages are paid from the wrongdoer's estate rather than from his own pocket.
The Seventh Circuit also looked to United States v. Noland, a United States Supreme Court decision, to determine whether punitive damages are available in bankruptcy. In Noland, the Supreme Court held a bankruptcy court may not use its equitable power to subordinate tax penalty claims on a categorical basis in derogation of Congress's scheme of priorities. Moreover, the Supreme Court strongly implied that case-by-case administration of the Bankruptcy Code's authority for equitable subordination of claims is the proper way to deal with all punitive financial claims.
Relying on Noland, the Seventh Circuit ruled that if state law deems punitive damages unavailable against an insolvent defendant, bankruptcy courts should enforce the prohibition if the defendant files for bankruptcy. The Seventh Circuit concluded, however, if punitive damages claims against insolvent parties are allowed under state law, there is no federal law prohibiting punitive damages against a debtor "though whether a punitive award should be subordinated to other claims is open to independent consideration under the terms of the Bankruptcy Code." Nevertheless, the Seventh Circuit affirmed confirmation of A.G.'s plan of reorganization in part because the district court judge made it clear that any punitive awards would be equitably subordinated to all other claims. Moreover, the Seventh Circuit observed that appellants adduced no facts or circumstances that supported a right to punitive damages. Indeed, appellants failed to allege any facts concerning A.G.'s purported misconduct and failed to identify the governing state law. The Seventh Circuit concluded that any claim against A.G.'s parent company was settled and released and there was no claim for the creditors to pursue individually.
The court's holding in A.G. Financial Service Center is significant because the Seventh Circuit, unlike the Eleventh Circuit, is the first court of appeals to conclude that there is no federal bar against punitive damages claims in chapter 11 cases. Although debtors in the Seventh Circuit may no longer categorically disallow punitive damages claims in a chapter 11 plan, bankruptcy courts may still have the ability and discretion to equitably subordinate such claims to foster a successful restructuring. It remains to be seen whether other courts of appeal will reach the same conclusion as the Seventh Circuit or follow the Eleventh Circuit in concluding that punitive damages are unavailable in bankruptcy.
In re A.G. Fin. Serv. Ctr., Inc., 395 F.3d 410 (7th Cir. 2005).
United States v. Noland, 517 U.S. 535 (1996).
Novak v. Callahan (In re GAC Corp.), 681 F.2d 1295 (11th Cir. 1982).