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In re Sann

United States District Court, D. Montana, Missoula Division

October 17, 2017

In re STEVEN VINCENT SANN, Debtor.
v.
MICHAEL J. SHERWOOD and Michael J. Sherwood, P.C., Defendant and Appellant. Christy L. Brandon, Plaintiff and Appellee,

          ORDER

          DANA L. CHRISTENSEN, CHIEF JUDGE

         Appellant Michael J. Sherwood ("Sherwood") and his law firm Michael J. Sherwood, P.C. (together "Appellants") appeal the judgment entered against them by the United States Bankruptcy Court for the District of Montana[1] in favor of the Plaintiff/Trustee Christy L. Brandon ("Trustee") for the Chapter 7 estate of Steven Sann ("Sann"). The Trustee brings this action to collect $53, 532 in funds transferred to Sann from an IOLTA trust held by Sherwood on Sarin's behalf. These funds were subject to an asset freeze, though Sann retained an allowance of $17, 844 for living and business expenses. The funds at issue are three monthly draws, distributed after the case was converted under Chapter 7 of the Bankruptcy Code. The Trustee contends that the funds were property of the estate, and the Chapter 7 conversion prohibited Sherwood from making these transfers. Appellants argue these transfers were proper because the IOLTA trust was not property of the estate subject to the bankruptcy proceedings. Judge Kirscher determined the funds were estate property, improperly transferred, and entered judgment in favor of the Trustee. This appeal follows. This Court has jurisdiction over this appeal under 28 U.S.C. § 158(a)(1). For the reasons stated below, this Court affirms Judge Kirscher's ruling.

         Factual Background [2]

         This case arises from the juncture of a civil action against Sann by the Federal Trade Commission ("FTC") and Sarin's subsequent bankruptcy. On January 8, 2013, the FTC filed a civil complaint against Sann and his related business operations seeking injunctive and equitable relief. The Complaint alleged Sann had engaged in deceptive business practices referred to as "cramming;" the unauthorized addition of charges onto a consumer's monthly telephone bill, in violation of 15 U.S.C. § 45(a). The Complaint alleged the scheme netted profits of more than $26 million, and cost consumers more than $70 million.

         The Court entered a Stipulated Preliminary Injunction ("SPI") freezing Sann's assets pending the outcome of the FTC litigation. The SPI had a carve-out provision allowing Sann to receive $17, 844 per month to pay his mortgage, personal and business expenses. Sann's attorney, Appellant Michael J. Sherwood, received permission from the FTC to take possession of $648, 352.20 from the sale of an apartment complex and distribute monthly draws from these funds. Sherwood placed the proceeds in an IOLTA trust and began issuing the monthly draws in November 2014.

         Unrelated to the FTC litigation, Sann and his wife, Terry Sann, filed for bankruptcy under Chapter 11 in late September 2014. As residents of Nevada, they filed in Las Vegas. On the bankruptcy schedules the Sanns listed numerous accounts, including one ending in 6474. They included the money held in the IOLTA trust, claimed no exemptions, and listed the SPI's allowance of $17, 844. On the Statement of Financial Affairs, the Sanns listed the pending FTC action.

         In December, the FTC successfully transferred the case to the District of Montana, and Sherwood became involved in the bankruptcy case as well. In March, the United States Trustee filed a motion to convert the bankruptcy case under Chapter 7. The FTC joined the motion to convert, while the Sarins opposed it. At a hearing, the FTC's counsel stated that if a trustee were appointed to oversee all assets, the FTC would stipulate to Sarin's request to modify the freeze.

         The Court converted the case under Chapter 7, appointing Brandon as the Trustee. From the date of conversion, Sann was no longer entitled to draws from the IOLTA trust. Sherwood was sent official notice of the conversion, but stated he "was not up to speed on bankruptcy law" at the time. (Doc. 3 at 9.)

         The day following the Trustee's appointment, Sherwood sent Sann a check for $17, 844. Sherwood made two further transfers, on June 2 and July 1.

         During this time, Sherwood was advised not to continue paying the monthly draws. In mid-May, Sherwood received an email from the Sarins's Nevada bankruptcy attorney, Samuel A. Schwartz ("Schwartz"), stating they should attempt to carve-out funds for Sarin's FTC defense, but that "[otherwise], [he did not] believe there [was] a basis to object to the Chapter 7 trustee holding the funds." (Doc. 3 at 10.) Sherwood testified that the Sarins's Montana bankruptcy attorney, James A. Patten ("Patten"), told him not to make any further transfers from the trust. Sherwood did not share Patten's opinions, and continued to send the monthly draws, fearing he would be held in contempt if he failed to comply with the SPI.

         In early June, the Trustee sent Sherwood a demand to turn over the remaining funds in the IOLTA trust. In mid-June, the Trustee sent Sherwood a demand letter stating that the trust funds were property of the estate. Sherwood disagreed that the funds were property the estate, and informed the Trustee he would continue to pay the monthly draws according to the SPI. The Trustee then filed a motion for turnover in the bankruptcy case. While the motion was pending, the Trustee filed a Complaint against Sherwood citing violations of 11 U.S.C. §§ 542 and 543. As a result of the litigation, coupled with advice from Patten, Sherwood decided not to issue the August 1 payment.

         On August 4, the Bankruptcy Court granted the Trustee's motion for turnover, ordering Sann to transfer to the Trustee all funds in the IOLTA trust as of the date of conversion, which was April 29. This demand included the request for $626.05 from account 6474. In addition, the Bankruptcy Court ordered the turnover of $53, 532 for the three disbursements paid by Sherwood after conversion, deeming these funds property of the bankruptcy estate.

         Sann complied in part, turning over $80, 248.75 from account 6474. The Trustee credited that transfer against her demand, including account 6474. The Trustee did not apply any of the funds towards the $53, 532.

         As a result of the Bankruptcy Court's order and a related hearing, Sherwood mailed the remaining funds, $487, 756.20, to the Trustee and asked the Trustee to dismiss the adversary proceeding. The Trustee declined, seeking to enforce the $53, 532 against Sherwood under § 542(a). Trial was conducted and judgment was entered for the Trustee.

         Legal Standing

         When considering an appeal from a bankruptcy court, a district court applies the same standard of a review that a circuit court would use in reviewing a decision of a district court. SeeFordv. Baroff(in reBaroff), 105 F.3d 439, 441 (9th Cir. 1997). A district court reviews a bankruptcy court's legal conclusions de novo and factual findings for clear error. In re Leavitt, 171 F.3d 1219, 1222 (9th Cir. 1999) (citations omitted). Mixed questions of fact and law are reviewed de novo. Miller v. United States, 363 F.3d 999, 1004 (9th Cir. 2004). While the determination to award equitable relief is reviewed for abuse of discretion. Traxler v. Multnomah Cty., 596 F.3d 1007, 1014, n.4 (9th Cir. 2010); King v. Stanton (In re Stanton), 38 B.R. 746, 751 (B.A.P. 9th Cir. 1984).

         Discussion

         Appellants raise two issues on appeal and argue that Judge Kirscher erred by (1) finding that the $53, 532 transferred from the IOLTA trust was property of the bankruptcy estate and not exempted; and (2) rejecting Appellant's equitable defense of double recovery upon finding that Sherwood failed to heed the warnings of the Bankruptcy Court and bankruptcy counsel instructing him to cease distributing the monthly draws. This Court will address these issues in that order.

         I. Property of the Bankruptcy Estate

         The commencement of a bankruptcy case creates an estate as a matter of law. 11 U.S.C. § 541(a). The estate is comprised of "all legal or equitable interests of the debtor ... wherever located and by whomever held." Id. Estate property is broadly construed and includes "[a]ny interest in property that the estate acquires after the commencement of the case." § 541(a)(7); United States v. Whiting Pools, 462 U.S. 198, 204-05 (1983). Thus, property "is not outside of [the estate's] reach because it is novel or contingent or enjoyment must be postponed." Harsh Investment Corp. v. Bialac (In re Bialac), 712 F.2d 426, 431 (9th Cir. 1983). This includes property to which the debtor has a future interest.

         The policy of the Bankruptcy Code is to promote inclusion to maximize a creditor's distributions. In re McCullogh, 259 B.R. 509, 518 (Bankr. D.R.I. 2001). However, property can be excluded from the estate under various provisions. Section 541(c)(2) is such a provision and exempts valid state spendthrift trusts and ERISA approved pension plans. Patterson v. Shumate, 504 U.S. 753, 760 (1992).

         Appellants argue that the $648, 352.20 recovered from the sale of an apartment complex owned 99% by Sann is subject to exclusion from the bankruptcy estate under § 541(c)(2). They argue the exclusion applies because the property was held in an IOLTA trust on Sarin's behalf, and like spendthrift trusts, the SPI's asset freeze placed a restriction on those funds. Judge Kirscher disagreed and determined the property was not exempted and fell under the broad scope and plain meaning of § 541(a).

         On appeal, this Court is asked to consider whether the SPI created a valid spendthrift trust, precluding the bankruptcy court from exercising jurisdiction over those funds. For the reasons cited below, Judge Kirscher's ruling is affirmed.

         A. The IOLTA funds were included within the ...


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