Chapter 8 Property of the Estate

• Jurisdiction: United States

Chapter 8 Property of the Estate

§ 8.1 ~ Introduction: The heart of the matter

The primary role of the bankruptcy trustee is to collect and distribute the property of the estate.¹ It is therefore of the highest importance to know what constitutes property of the estate. The basic rule is set forth in § 541(a), which provides that the commencement of the case "creates an estate." It says this estate comprises "all legal or equitable interests of the debtor in property as of the commencement of the case."² So, as elsewhere, we are thrust back on non-bankruptcy law: That which is property for purposes of bankruptcy distribution is whatever would have been property had bankruptcy not intervened. For federal bankruptcy law purposes, we do not defer to state law labels of what is a "property interest" or "property"; rather, what is "property" is a federal bankruptcy law question. However, if something is found to constitute "property," its attributes will be defined by state law.³

§ 8.2 ~ Pre-Bankruptcy

The definition says "as of the commencement of the case." This means that the debtor may lose anything that was his at the time of the filing, but he gets to keep whatever he acquires later. So, for example, in Segal v. Rochelle,⁴ the debtor's pre-petition tax loss carryforwards were recognized as transferable property that became property of the debtor's estate.⁵

You can see the tension in Wheeler v. Magdovitz, where the debtor sued his lawyer for malpractice.⁶ Magdovitz, the lawyer, prepared a petition and schedules declaring that Wheeler, the debtor, had no assets.⁷ Wheeler signed them, Magdovitz filed them, and Wheeler got his discharge. But five years later he was indicted and convicted for concealing assets. He thereupon sued Magdovitz for malpractice. But the question arose: Who owned the cause of action? If it was the property of Wheeler "as of the commencement of the case," then it belonged not to Wheeler himself but to his trustee. If it arose later, then it belonged to Wheeler.

Wheeler argued that the action was his because it did not "accrue" under state law until injury occured — and the injury, per Wheeler, was his indictment five years after bankruptcy. The court accepted the assumption that the question was in fact, When did the claim accrue? But it held that there was a "relationship" between Wheeler and Magdovitz dating prior to the bankruptcy sufficient to date the claim from that time. The court also said that Wheeler knew, or should have known, about the misconduct all along because it was his own property that was at issue. Wheeler asserted that he was an uneducated person who simply relied on the advice of his attorney, but the court was not persuaded.

§ 8.3 ~ Earnings and Human Capital

The general rule is that the debtor's property passes to the trustee. Inevitably, there are exceptions. Perhaps most important, the Code provides that — at least in a chapter 7 case — earnings from personal services performed by an individual debtor after the commencement of the case are not property of the estate.⁸ This exception helps to explain the traditional bankruptcy strategy: The best time to file bankruptcy is the day before you start work on the good new job. That way, you would discharge all your past debts while insulating your future earnings.⁹

This was never any more than a crude oversimplification, but prior to the BAPCPA amendments in 2005, it harbored a large grain of truth. Under those amendments, it is a lot less true. Most notably, Congress amended the Code to mandate the notorious "means test," which bars some debtors from chapter 7 bankruptcy relief on the premise that they can expect to have post-bankruptcy earnings that should remain available to creditors.¹⁰The idea seems to be to force these debtors into chapter 13 (or, if they exceed the debt limits, perhaps chapter 11), where they will have to repay at least some of the debts, and where post-petition income is an estate asset.¹¹

The exception for personal services may create some anomalous results. The difficulty is that "earning power" may be a capital asset. Normally, if I own a capital asset, it becomes an asset of the estate — for example, 100 shares of General Motors stock. My wit, my energy and my learning may count as "human capital." But they do not pass to the trustee because the Code says so.

A dramatic instance is Ryan v. Lynn.¹² Ryan and Lynn married while Lynn was in medical school. Later, when they divorced, the New Jersey divorce court found his medical degree to be "property" with a value of some $300,000 subject to division under New Jersey's equitable distribution law. Lynn later filed for bankruptcy in Connecticut. Ryan and her attorney sought to block his discharge on the grounds that he concealed an asset by failing to list the medical degree as "property" subject to administration by the bankruptcy court.

On the face of things, there is a lot to be said for this argument. If we believe that property for purposes of bankruptcy is whatever counts as property under non-bankruptcy law, then the medical degree clearly qualifies. Moreover, if we believe that the creditors should have the first crack at the proceeds of the debtor's investments, then the medical education would seem to qualify quite well.

However, the bankruptcy judge held that Ryan's earning capacity was more akin to wages and thus excluded under § 541(a)(6). This is surely acceptable under the statute as it stands. But to get a sense of just how close the case might be, consider the case of Harold and Wilma, proud parents of Jed and Jeffrey. Jed is a clever child with good test scores, so Harold and Wilma spend $100,000 to buy him two years' worth of education toward board certification as an ophthalmologist. Jeffrey is not so good at the books — but he is a hard worker — so they buy him a bulldozer. Both Jed and Jeffrey come upon hard times and file for bankruptcy. Nothing can take away Jed's new learning, but Jeffrey will very likely lose the bulldozer.¹³

Prior to the enactment of § 1115 in 2005, the exclusion of earnings applied in chapter 11, just as it does in chapter 7. The point is illustrated by a Ninth Circuit case involving FitzSimmons, a lawyer who sought relief in his personal chapter 11.¹⁴ The trustee sought to reach his earnings from his law practice. FitzSimmons resisted, holding that they were "earnings from personal services" and thus not part of the chapter 11 estate. The circuit acknowledged that some earnings were excluded. But the court held that the interpretation protected only earnings from "personal services" and not "practice earnings." The court remanded to let the lower court sort things out.

§ 8.4 ~ Intangibles

As trustee or DIP, do not overlook the fact that "property" includes intangible property such as accounts receivable, causes of action, patents, copyrights, goodwill, tax attributes, etc. Receivables are familiar stuff: Many trustees sue and collect on the debtor's receivables all the time. Rights of action may be less common but are likewise an estate asset, at least if they accrued pre-petition. For example, the estate might include an "unfair competition" lawsuit against the villain who put the debtor out of business.

Patents, trademarks and copyrights are property of the estate to the extent that they were property of the debtor as of the date of the bankruptcy filing. This category of property seems to be expanding. For example, the Federal Circuit has held that it is possible to patent "business methods."¹⁵

The best advice is to think as expansively as possible when looking for intangible property of the estate, lest you miss something that may have value.

§ 8.5 ~ Cyberproperty, Technoproperty, etc.

It is a cliche that we live in an era dominated by new species of wealth generated from cyberspace, biotechnology, court-created rights of privacy, etc. Inevitably, we can anticipate litigation over the nature of these rights. Some of this litigation may directly implicate the question of what constitutes "property." Our own guess, however, is that most of it will raise the property interest issue indirectly.

For example, there is already a small body of case law on issues of priority and perfection of security interests in technology-related intangibles. We also suspect that courts will get entangled in trying to figure out the distinction between the "property" right in some of these new items and the rules governing executory contracts. And of course, there are complex multi-jurisdiction issues, since it can be difficult to determine exactly where some of these "techno assets" are located. Perhaps surprisingly, not a lot of this sort of litigation has come to our attention. But the future is young.¹⁶

§ 8.6 ~ The Bankruptcy Clause (a.k.a. Ipso Facto Clause)

Although § 541(a) purports to preserve non-bankruptcy rights, § 541 arms the trustee with a bankruptcy trump card to play against one kind of interest that would otherwise exist under non-bankruptcy law. This section invalidates a bankruptcy clause.¹⁷ A bankruptcy clause (sometimes known as an "ipso facto" clause) is a contract clause that purports to trigger rights in the nondebtor or obligations on the part of the debtor in the event of the debtor's bankruptcy.

As a practical matter, the Code has to include a clause trumping contractual ipso facto provisions. Otherwise, the nondebtor could use the bankruptcy clause in the private contract to negate the ability to obtain effective bankruptcy relief or, at a minimum, to alter the statutory priority scheme.

The practicing lawyer will see ipso facto clauses in many contexts, broadly drafted to terminate all kinds of rights in the event of a bankruptcy filing. Most of these are unenforceable. One assumes they were tucked into the form file long ago when they were enforceable under the prior Bankruptcy Act and persist through a kind of inertia. They probably continue to be used in order to have some in terrorem ...