Wednesday, December 7, 2011

Recent Decisions Related to Bankruptcy and Foreclosure in the First Circuit (Nov.2011) Part 2 of 3

Sanctions against debtor’s counsel upheld on appeal as the assessment of his frivolous arguments below were properly measured against an objectively reasonable standard:
HERMOSILLA (IN RE HERMOSILLA) v. BAKER, 2011 Bankr. LEXIS 4285 (1st  Cir. BAP 11/14/11)(Not for Publication).
PROCEDURAL POSTURE: Appellant attorney sought review of an order from the United States Bankruptcy Court for the District of Massachusetts, which imposed monetary sanctions against him for violations of Fed. R. Bankr. P. 9011 and denied his motion to alter or amend that order by reducing the sanctions amount.
OVERVIEW: Prior to filing for bankruptcy and prior to a divorce, the debtor severely beat his wife and was found guilty of assault and battery with a dangerous weapon. The bankruptcy court held that the ex-wife's personal injury claim was nondischargeable under
11 U.S.C.S. § 523(a)(6). The court also imposed sanctions on the debtor’s attorney for advancing arguments not warranted by fact or law in the adversary proceeding. On appeal, the attorney argued that the court acknowledged that he had some basis for the arguments he made and thus, imposition of the sanctions was an abuse of discretion. The panel determined that most of the quotations from the record cited by the attorney were presented out of context with key portions of the court’s reasoning missing. The bankruptcy court properly employed an objectively reasonable standard. The attorney was trained in the law and well traveled in the bankruptcy court. His advancement of arguments that directly contradicted the Bankruptcy Code, that were contrary to well-established legal precedent, and that were foreclosed by a pre-trial order and pre-trial statement could not be excused. The amount of the sanction was not grossly excessive.
OUTCOME: The panel affirmed both
orders.

In affirming the Courts below, the First Circuit gave a thorough analysis of abandonment and the specificity (or lack thereof)needed to schedule assets and abandon assets:

(IN RE: FURLONG)DONARUMO; MURRAY SUPPLY CORPORATION, Appellants, Cross-Appellees, v. FURLONG, Appellees, Cross-Appellants, 660 F.3d 81; 2011 U.S. App. LEXIS 22072 (1st Cir. BAP 1/1/11).
PROCEDURAL POSTURE: Appellants and cross-appellant debtors challenged a decision of the U.S. District Court for the District of Massachusetts, which affirmed bankruptcy court decisions, ruling that the trustee had abandoned all claims in the debtors' personal and corporate bankruptcy cases by operation of law under 11 U.S.C.S. § 554(c), but not the stock of the corporate debtor.
OVERVIEW: The debtors bought the assets of a company from one of the appellants. With the assets, the debtors formed the corporate debtor, but the business failed. In the individual and corporate bankruptcies, the debtors listed a claim against appellant. The court held that the trustee was on notice to investigate the extent of the claim against appellant, was able to complete his investigation into the value of the claims before making the decision to abandon the claims. Therefore, the corporate debtor's claims against appellant were properly scheduled under
11 U.S.C.S. § 521(a)(1) and were abandoned by operation of law under § 554(c) when the corporate bankruptcy case was closed. Also, the lower courts correctly found that the trustee's intent to abandon all claims under § 554(a) in its notice of intention to abandon in the personal bankruptcy case was clear and unequivocal. The stock of the corporate debtor owned by the debtors was never formally abandoned under any provision of § 554 and continued to be property of the personal bankruptcy estate because the trustee never filed a notice of intent to abandon the stock, and the personal bankruptcy estate remained open.
OUTCOME: The court affirmed the district court's decision.
STANDING: Though none of the parties raised the issue of standing before the district court, the Furlongs here argue that neither Donarumo nor Murray Supply has standing to appeal the ruling on the abandonments, while Donarumo and Murray Supply challenge the Furlongs' standing to cross-appeal the stock issue. Where the issue of standing was not raised below, this Court must undertake the inquiry without remanding. Spenlinhauer v. O'Donnell, 261 F.3d 113, 118 (1st Cir. 2001). Standing to appeal a bankruptcy order is limited to "persons aggrieved," that is, persons whose pecuniary interests are adversely affected by the challenged order. Id. at 117-18. All parties here meet the "persons aggrieved" standard and therefore have standing to appeal the various parts of the bankruptcy court's order.
Corporate Claims abandoned: Like any other property, claims that are disclosed by the debtor to the bankruptcy court may be abandoned by the trustee to the debtor. A debtor has a duty to disclose all assets to the bankruptcy court on a schedule, including legal claims. If an asset has been formally scheduled under § 521(a)(1) but has not been administered by the trustee when the estate is closed, the asset is abandoned to the debtor by operation of law. 11 U.S.C. § 554(c). However, property that is neither administered nor abandoned (including property not properly scheduled that was never administered) remains property of the estate. 11 U.S.C. § 554(d). Property may also be abandoned after notice and hearing under § 554(a), which is the manner in which the Trustee abandoned the claims in the personal bankruptcy estate here, or by court order under § 554(b).  While a legal claim that is totally unscheduled may not be abandoned by operation of law under § 554(c), a partially-scheduled claim requires a more careful inquiry into whether the requirements of § 521(a)(1) were met. Once an asset is referenced on a schedule, § 521(a)(1) does not specify the level of detail with which that asset must be described.
§ 704,"  a debtor is required only to "do enough itemizing to enable the trustee to determine whether to investigate further." Here, the Trustee was not only on inquiry notice as to the extent of the asset, he was on actual notice. The Trustee was able to conduct his investigation into the value of the claims with the help of the sixteen-count draft complaint before determining that it would not be cost-effective to pursue the claims. Additionally, creditors attending the § 341 creditors' meeting were on actual notice of the claims after they were described by Mr. Furlong in greater detail than on the Schedule B. Here, the Furlongs described their claims with reasonable particularity and it is common knowledge that business tort claims and claims under Mass. Gen. Laws ch. 93A might arise out of the same underlying facts as a claim for breach of contract; therefore, the Trustee was on inquiry notice to investigate the extent of the asset. Moreover, the Trustee, having actual knowledge of the contents of the draft complaint, was able to complete his investigation into the value of the claims before making the decision to abandon the claims from the estate. Therefore, all of Drew's II's claims against Donarumo were properly scheduled under § 521(a)(1) and were abandoned by operation of law under § 554(c) when the corporate bankruptcy case was closed. We do not address the claims for negligent and intentional infliction of emotional distress in the context of the corporate bankruptcy, as those claims appear to be brought by the Furlongs in their individual capacities.

While a "debtor has a duty to prepare schedules carefully, completely, and accurately," generally, an asset is adequately scheduled if its description exhibits "reasonable particularization under the circumstances. "It would be silly to require a debtor to itemize every dish and fork . . . ."  As "investigation is part of the Trustee's duties under 11 U.S.C. § 554(a).  Section 554(a) provides that "[a]fter notice and a hearing, the trustee may abandon any property of the estate that is burdensome to the estate or that is of inconsequential value and benefit to the estate." 11 U.S.C. § 554(a). However, a hearing is unnecessary if no party in interest requests one. Id. § 102(1). In this case, the Trustee filed a Notice of Intention to Abandon in the personal bankruptcy case on November 6, 2007. No parties in interest objected or requested a hearing, and the bankruptcy court approved the Notice on November 30, 2007.  Donarumo and Murray Supply argue that only the claims specifically named in the "Reasons for Abandonment" section of the Notice were abandoned under § 554(a). It is true that a trustee's intent to abandon an asset must be clear and unequivocal, but here, the Notice stated the Trustee's clear intent "to abandon a cause of action against Andrew Donarumo et al." While the Trustee's description of the contours of the cause of action in the "Reasons for Abandonment" section could have been crisper, his intent to abandon all the claims held by the personal bankruptcy estate was obvious.  Despite only referring specifically to "misrepresentation" and "other business related tort[s]" in his "Reasons for Abandonment," the Trustee made clear that the cause of action involved multiple theories of recovery "ar[ising] from the purchase of a business known as Drew's Plumbing and Heating, Inc. II." As the bankruptcy court ably recited: [A]s painful as [the Notice] is to read, its meaning is unambiguous: The estate holds claims against Donarumo and perhaps others, arising from the purchase of a business that came to be known as Drew's Plumbing; and the Trustee notices parties in interest of his intention to abandon those claims, based on his determination, made after investigation, that the claims have no or negligible value to the estate. The lower courts were correct in finding that the Trustee's intent to abandon all state court claims under § 554(a) was clear and unequivocal, and that all of the claims were therefore abandoned when the bankruptcy court approved the Notice. Therefore, regardless of the schedule, the Trustee's intent to abandon all of the claims is dispositive, especially where the creditors had prior notice of the extent of the claims after the § 341 creditors' meeting.
The Trustee's intent to abandon all claims is also evidenced in later statements. In an affidavit submitted to the bankruptcy court, the Trustee stated that "all ownership and control of the claims," which included "a range of business tort claims as well as breach of contract claims," in both bankruptcy estates was "relinquished" to the Furlongs and Drew's II. In a second affidavit, the Trustee made clear his intent to abandon, via the Notice, "the Donarumo litigation." At the April 14, 2010 hearing on the Motion to Verify before the bankruptcy court, the Trustee stated that he considered the various theories of recovery, as well as the corporate and personal bankruptcies, interchangeable. However, none of these statements affects our conclusion that the Notice of Intention to Abandon itself was sufficient to abandon all claims against Donarumo that were held by the personal bankruptcy estate.

The Automatic Stay:  Donarumo and Murray Supply challenge the holding below that the transfer of Drew's II's claims to the Furlongs personally was not a violation of the automatic stay. To review, before Drew's II filed for bankruptcy, it surrendered to its secured lender, Key Bank, its tangible and intangible assets. Key Bank then sold those assets to Gem Plumbing. Because of the possibility that Drew's II's "general intangibles" included the claims against Donarumo, Gem Plumbing assigned any rights in the claims back to the Furlongs and Drew's II. The Furlongs, acting as directors at a meeting of the board of Drew's II at which they were the only attendees, assigned Drew's II's interest in these claims back to themselves personally.  Donarumo and Murray Supply argue that this transfer of Drew's II claims was a violation of the automatic stays in both the corporate bankruptcy and the personal bankruptcy. Both of these arguments fail. A pending bankruptcy petition "operates as a stay . . . of . . . any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate."
11 U.S.C. § 362(a)(3). However, the stay ends when the bankruptcy estate is closed, id. § 362(c)(2)(A), and the stay is inapplicable to property that has been removed from the estate, id. § 362(c)(1). At the time of the transfer of the claims from Drew's II to the Furlongs individually, the Drew's II corporate bankruptcy case had long been closed, and thus the automatic stay on transfers of its assets was dissolved under § 362(c)(2)(A). Though the automatic stay in the personal bankruptcy estate was still effective, we agree with the bankruptcy court that an automatic stay "does not extend to the assets of a corporation in which the debtor has an interest, even if the interest is 100% of the corporate stock."

Personal Bankruptcy Abandonment:  Donarumo and Murray Supply challenge the lower courts' determinations that the state court claims held by the personal bankruptcy estate that were not specifically named in the Notice of Intention to Abandon were in fact abandoned under

Donarumo and Murray Supply also argue that the automatic stay in the personal bankruptcy was violated because the Furlongs "used" the Drew's II stock in transferring to themselves the claims against Donarumo, Drew's II's sole remaining asset. See

Drew's II Stock:  The Furlongs challenge the holding that the Drew's II stock remains a part of the personal bankruptcy estate, as never having been abandoned. The Furlongs scheduled their 100% stock ownership in Drew's II as an asset in their personal bankruptcy. As a part of the Motion to Verify, the Furlongs moved to compel abandonment of the stock under
§ 554(b). While the bankruptcy court never directly addressed the § 554(b) motion, it did conclude that "there may yet be value in the stock of Drew's Plumbing,"11 and that the stock remained property of the estate. Additionally, the Trustee never filed a notice of intent to abandon the stock under § 554(a), and the personal bankruptcy estate remains open, so the stock was never abandoned by operation of law under § 554(c). Therefore, the stock was never formally abandoned under any provision of § 554 and continues to be property of the personal bankruptcy estate.
11 U.S.C. § 363(b)(1); In re Consol. Auto Recyclers, Inc., 123 B.R. 130, 140 (Bankr. D. Me. 1991) (voting of shares constitutes "use" under § 363). We disagree. Though Massachusetts law requires shareholder approval of the transfer "of all, or substantially all, of [a corporation's] property," see Mass. Gen. Laws ch. 156D, § 12.02(a), the Furlongs were acting in their capacity as directors of Drew's II, not shareholders, when they effectuated the transfer. Because they took no actions as shareholders, they did not attempt to vote or use the Drew's II stock in any way. There was no violation of the automatic stay. Because, as discussed below, the stock remains within the personal bankruptcy estate, the Trustee may be able to bring a derivative action in state court against the Furlongs for improper transfer of the claims. However, that is for another court to decide on another day.

Creditors attempt to persuade the state court to allow execution against debtor’s assets, arguing they were not assets of the estate, was a willful violation of the automatic stay:

(IN RE: ORTIZ) ORTIZ v. PEREZ, 2011 Bankr. LEXIS 4491 (Bankr. D.P.R. 11/10/11).
This proceeding is before the Court upon Plaintiff's unopposed motion for summary judgment for willful violation of the automatic stay pursuant to 11 U.S.C. § 362. For the reasons set forth below, Plaintiff's motion for summary judgment is GRANTED in part. The commencement of this bankruptcy case triggered the stay of an order for the execution of a judgment issued against the debtor. Co-defendants, filed a motion for the execution of the Judgment in state court. In this renewed request for execution of judgment Defendants acknowledge that Plaintiff had initiated a bankruptcy case and that the state court had dictated the stay of the proceedings. The state court denied Defendants' request for execution by referring the parties to the stay order of January 29, 2008.  On June 1, 2009, Defendants filed a second motion for the execution of the Judgment reasserting their previous arguments. Defendants also asserted that the automatic stay was not applicable. On June 10, 2009, the state court resolved that the stay provisions of Section 362(a) of the Bankruptcy Code involve all actions from creditors against any property of the bankruptcy estate and that pursuant to Section 541 this includes property owned by a debtor in community or property in which a debtor has an interest. Defendants' second request for execution of judgment was denied accordingly. Plaintiff filed the present adversary proceeding claiming costs and damages as a result of Defendants' attempts at the execution of the Judgment to collect against the Property in violation of the automatic stay afforded by 11 U.S.C. §362.

Even if a party fails to address a motion for summary judgment, it does not mean that summary judgment should automatically follow.
VĂ©lez v. Awning Windows, Inc., 375 F.3d 35, 42 (1st Cir.2004). "[W]hen faced with an unopposed motion for summary judgment, a court still has the obligation to test the undisputed facts in the crucible of the applicable law in order to ascertain whether judgment is warranted.  Because in Puerto Rico when one spouse files for bankruptcy, the personal property of the filing spouse and community property become property of the estate by operation of § 541(a)(2)(A), the Property at hand is now part of the bankruptcy estate.  In the case at bar, it is clear that Defendants violated the automatic stay pursuant to 11 U.S.C. § 362(a)(1), (a)(2) and (a)(6), which prohibits post-petition collection efforts for claims that arose prior to the commencement of the case, including the enforcement or collection of a judgment against property of the estate. Because Defendants' had knowledge of the automatic stay, its ensuing violation is deemed intentional. As such, this Court finds Defendants to have committed a willful violation of the automatic stay.
The time frame in which to challenge the debtor’s discharge is strictly construed, is jurisdictional, and equitable tolling does not apply to it:

(In re ANDERSEN, Debtor) CADLE COMPANY AS GENERAL PARTNER FOR D.A.N. JOINT VENTURE, L.P., v. ANDERSEN, 2011 Bankr. LEXIS 4440 (Bankr. D. Mass. 11/21/11).
PROCEDURAL POSTURE: Plaintiff creditor brought an adversary proceeding against debtor seeking revocation of the debtor's discharge alleging that the debtor improperly refused to answer questions concerning potentially concealed assets during an examination. The debtor moved to dismiss the complaint for lack of jurisdiction based on the creditor's failure to timely seek revocation under 11 U.S.C.S. § 727(e).
OVERVIEW: The creditor prevailed in an appeal of an order denying the creditor's motion to reopen the debtor's bankruptcy case to seek revocation of the debtor's discharge, the debtor's case was reopened, and the creditor then filed the action seeking revocation. The creditor contended that the period during which the creditor's appeal was pending tolled the statutory periods for filing the complaint for revocation. The bankruptcy court held, however, that the deadlines for filing a complaint for revocation of discharge were jurisdictional in the nature of statutes of repose and were not subject to equitable tolling based on the appeal. Further, the motion to reopen the debtor's case to seek revocation was not a substitute for a revocation complaint since revocation required an adversary proceeding, and reopening the debtor's bankruptcy case was not a prerequisite to filing the revocation complaint. Thus, the creditor's lack of diligence was the only basis for the creditor's failure to seek revocation in a timely manner. In any event, the debtor's refusal to answer questions at the examination was not a ground for revocation since the questions were not ordered or approved by the court.
OUTCOME: The debtor's motion to dismiss the complaint, treated as a motion for summary judgment, was granted.
The time frame in which to challenge the debtor’s discharge is strictly construed, is jurisdictional,  and equitable tolling does not apply to it.

Lender’s mortgage not avoided due to post-petition perfection, applying the laws of Puerto Rico:

SOTO-RIOS v. BANCO POPULAR DE PUERTO RICO, 2011 U.S. App. LEXIS 23503 (1st Cir. 11/23/11).
PROCEDURAL POSTURE: Chapter 11 debtors sought to avoid creditor bank's mortgages, and to prevent any post-petition actions that would perfect them under 11 U.S.C.S. §§ 362(a), 544(a), 547(b). On summary judgment, the bankruptcy court rejected the debtors' efforts. The U.S. District Court for the District of Puerto Rico affirmed. The debtors appealed.
OVERVIEW: The presented mortgage deeds were pending recordation when bankruptcy was filed three years later. The bank attained a pre-petition "interest in property" within the meaning of
11 U.S.C.S. §§ 362(b)(3), 546(b)(1)(A). P.R. Laws Ann. tit. 30, § 2256 (2005)'s relation back provision established the moment of presentment as the priority marker. Nothing suggested the documents were defective or that the bank had any responsibility for the lengthy delay. The bank obtained a concrete, pre-petition debt, and presenting the mortgages for recordation gave notice to any bona fide purchaser, of the acts to preserve priority. The exceptions to the automatic stay and the trustee's strong arm power applied. Under P.R. Laws Ann. tit. 30, § 2256, the transfers were "perfected" for purposes of § 547 upon presentment well outside the 90-day preference window -- because only a bona fide purchaser presenting earlier documents could have acquired a superior interest under § 547(e)(2). The debtor's arguments failed.
OUTCOME: The district court's judgment was affirmed.

Failure to object to an 11 U.S.C. §363(b) sale is implied consent to the sale under § 363(f)(2):

(In re Grassi) BAC HOME LOANS SERVICING LP, Servicer for Deutsche Bank National Trust, Trustee on Behalf of HSI Assets Securitization Corporation Trust 2007-HE1 v. GRASSI,  2011 Bankr. LEXIS 4362 (1st Cir. BAP 11/2/11)(NOTICE: NOT FOR PUBLICATION).PROCEDURAL POSTURE:  Debtors, a husband and wife, filed Chapter 7 bankruptcy and subsequently converted their case to one under Chapter 13 of the Bankruptcy Code. The husband sought permission to sell a condominium he owned, free and clear of all liens, and the U.S. Bankruptcy Court for the District of Maine granted the husband's motion and denied a loan servicer's motion for reconsideration. The loan servicer appealed.
OVERVIEW: Thirteen months after the bankruptcy court confirmed an amended Chapter 13 bankruptcy plan the debtors filed in March 2009, which provided that the husband would surrender a condominium he owned to a home loan company, the husband sought an order under
11 U.S.C.S. § 363(f) which allowed him to sell the condominium to two individuals who offered to purchase it for $137,300, free and clear of all liens. A loan servicer did not object to the husband's motion by the deadline set by the bankruptcy court; however, it filed an objection after the court approved the sale, claiming that the sale should not have been approved because the sale price was substantially below the amount of debt the husband owed on the property and that the property could have been sold at a foreclosure sale for substantially more than the buyers offered. The bankruptcy appellate panel affirmed the bankruptcy court's orders approving the sale and denying the loan servicer's motion for reconsideration. The loan servicer gave its implied consent to the sale, for purposes of § 363(f)(2), when it failed to file a timely objection after it was notified that the husband sought permission to sell his condominium.
OUTCOME: The bankruptcy appellate panel affirmed the bankruptcy court's order granting the husband's motion to sell his condominium and the bankruptcy court's order denying the loan servicer's motion for reconsideration.

Using formula approach to interest rate, objecting creditor received the indubitable equivalent of its claim, thus its objection to confirmation of Chapter 11 Plan was overruled:

In re: SW BOSTON HOTEL VENTURE, LLC, et al., Debtors, 2011 Bankr. LEXIS 4384 (Bankr. D. Mass. 11/14/11).
PROCEDURAL POSTURE: Debtor businesses filed petitions under Chapter 11 of the Bankruptcy Code and operated their businesses as debtors-in-possession, and after the court ordered joint administration of the debtors' bankruptcy estates, the debtors filed a Modified First Amended Joint Plan of Reorganization and asked the court to confirm their plan. An insurance company filed an objection to the debtors' plan.
OVERVIEW: The debtors declared bankruptcy in 2010 and filed a Modified First Amended Joint Plan of Reorganization in June 2011 which divided creditors and other interests into nine classes and proposed to pay all allowed claims filed against their bankruptcy estates by non-insiders in full, using income generated by their operations and the sale of condominiums one of the debtors owned. The debtor's largest creditor, an insurance company, filed an objection to the debtors' plan, claiming that it could not be confirmed because it did not meet the requirements of
11 U.S.C.S. § 1129, including the requirement that it provide fair and equitable treatment of the company's secured claim. The court found that the debtors' plan met the requirements of § 1129 and could be confirmed even though it allowed the debtors to act in unison, pursuant to 11 U.S.C.S. § 1123(a)(5)(C), in reorganizing their businesses and paying claims. The court used the formula approach adopted by the U.S. Supreme Court to evaluate the rate of interest the debtors proposed to pay the insurance company on its debt and found that the plan provided the insurance company with the indubitable equivalent of its claim.
OUTCOME: The court overruled the insurance company's objection to the debtors' Modified First Amended Joint Plan of Reorganization and stated that it would enter an order which confirmed the debtors' plan.

Choice of law provision in security agreement governed validity, not perfection;
Failure to vacate default was an abuse of discretion:

(IN RE SUPPLIES & SERVICES, INC.) SUPPLIES & SERVICES, INC., and BANCO POPULAR DE PUERTO RICO, v. NACCO INDUSTRIES, INC., NACCO MATERIALS HANDLING GROUP, INC., and YALE MATERIALS HANDLING CORPORATION, 2011 Bankr. LEXIS 4404 (1st Cir. BAP 11/23/11).
PROCEDURAL POSTURE: Appellant, a creditor asserting a first perfected security interest in the inventory and related assets of appellee debtor, appealed from orders of the United States Bankruptcy Court for the District of Puerto Rico, that denied the creditor's motions for summary judgment and to set aside a default judgment and granted summary judgment in favor of the debtor and intervenor bank, a competing creditor.
OVERVIEW: The creditor failed to file a timely answer to the debtor's adversary complaint, which alleged that the security agreement was ineffective under the five year lapse provision of North Carolina law,
N.C. Gen. Stat. § 25-9-515, and that the security interest was void under 11 U.S.C.S. § 544. The creditor had provided floor plan financing to the debtor. The parties agreed that, despite the North Carolina choice of law provision, that Puerto Rico law governed perfection. The parties' choice of law related to the validity, construction and enforcement of the agreements, and it was honored by the appellate panel. However, the issue was the lapse in perfection, an issue that did not affect the validity of the underlying agreements. The application of North Carolina law by the bankruptcy court was thus erroneous. Just cause existed for the bankruptcy court to set aside the default. The creditor's filing of a summary judgment motion at the direction of and within the time period set by the bankruptcy court satisfied the "otherwise defend" clause of Fed. R. Civ. P. 55(a). Good cause therefore existed to vacate the default.
OUTCOME:  The order granting summary judgment filed by the debtor and intervenor bank were reversed. The order denying the creditor's motion to set aside the default was reversed. The bank's motion to strike portions of the creditor's reply brief was denied. The case was remanded for further proceedings.

The Choice of Law Issue
: The parties' dispute centers around the question of whether Puerto Rico law or North Carolina law applies to the perfection of NACCO's security interest. Under North Carolina law, perfection by financing statement is limited to five years unless it is renewed. The effective period under Puerto Rico law is ten years.  The bankruptcy court applied North Carolina law pursuant to the choice of law provision in the security agreement, and granted summary judgment to the Debtor and Banco Popular because the five-year perfection period had lapsed prior to the commencement of this case. NACCO argues that the bankruptcy court erred because  Puerto Rico law governs perfection and the validity of the agreements is not at issue. If it is correct, its security interest would have been perfected when the case was commenced. We conclude that Puerto Rico law governs perfection and that the bankruptcy court erred in applying North Carolina law.

The Choice of Law Clause:  As noted above, section 9 of the security agreement contains the following choice of law provision: “INTERPRETATION. The validity, construction and enforcement of this Agreement are determined and governed by the laws of the State of North Carolina. All terms not otherwise defined have the meanings assigned to them by
Articles I and IX of the Uniform Commercial Code. . .” The parties' choice of law in this case relates to the "validity, construction and enforcement" of the agreements, and it will be honored because it has not been challenged. As discussed below, the concern here is over the lapse in perfection, an issue that does not affect the validity of the underlying agreements.  Under North Carolina law, perfection is generally governed by the law of the jurisdiction where the debtor and/or collateral is located. Further, as noted above, the parties agreed in section 1.03(c) of the floor plan agreement that Puerto Rico law would govern perfection.
Validity vs. Perfection:  Perfection of a security interest governing the type of collateral present in this case is achieved by the filing of a financing statement. Perfection relates to the interest of third parties in the collateral; it does not affect the validity of the security agreement between the debtor and the secured party. "[A] defective financing statement does not affect the validity of the security interest between the parties." Validity and perfection are entirely independent. "The attached security interest is valid as between the parties, has priority over a general creditor, but, unless perfected, is subject to the rights of many others acquiring interests in the property." On the other hand, "[t]o acquire rights valid against third parties, it is necessary that the security interest be perfected." Id. at § 4:6. A security agreement's validity is based upon attachment and enforceability, but not perfection. "While 'attachment' relates to the creation and enforceability of a security interest between the parties to the transaction, 'perfection' is an additional step which makes the security interest effective against third  parties." Thus, a security agreement can be valid between the parties without being perfected.

Allowing a financing statement to lapse does not invalidate  the security interest," but rather upon lapse the security interest becomes unperfected. Therefore, as a lapse of a financing statement relates solely to the perfection of the security interest, and in no way implicates the validity of the security agreement, the laws of the jurisdiction governing the perfection of the financing statement should apply to a lapse of the financing statement. In this case, Puerto Rico law governs perfection. Due to the bankruptcy court's erroneous application of North Carolina law, we conclude that the bankruptcy court erred in: (1) granting summary judgment in favor of the Debtor and BPPR and against NMHG; (2) holding that NMHG's security interest had lapsed and "is now expired, ineffective, unperfected and shall be considered a general unsecured claim"; and (3) determining that BPPR "has a senior secured priority interest over Debtor's entire inventory of equipment and parts."

Order Denying Motion to Vacate Default:  NACCO argues that the entry of default was erroneous and that the bankruptcy court abused its discretion when it refused to vacate the default.
Rule 55(a) provides: "when a party against whom a judgment for affirmative relief is sought has failed to plead or otherwise defend, and that failure is shown by affidavit or otherwise, the clerk must enter the party's default." Fed. R. Civ. P. 55(a) (emphasis supplied). According to NACCO, entry of default was not appropriate because it had otherwise defended against the adversary proceeding by filing its motion for summary judgment as instructed by the bankruptcy court. NACCOclaims that "just cause" existed for the bankruptcy court to set aside the default. We agree.
The First Circuit has held that setting aside an entry of default under
Rule 55(c) is a case-specific inquiry, and the court should consider a number of factors, including: "(1) whether the default was willful; (2) whether setting it aside would prejudice the adversary; (3) whether a meritorious defense is presented; (4) the nature of the defendant's explanation for the default; (5) the good faith of the parties; (6) the amount of money involved; and (7) the timing of the motion."
Banco Popular's Motion to Strike Portions of NACCO's Reply Brief:  Banco Popular filed a motion seeking to strike portions of NMHG's reply brief on August 5, 2011, nine days after this case was submitted for review on the briefs and almost eleven weeks after the subject brief was filed. As those portions of NMHG's reply brief did not factor into our decision today, we deny the motion to strike.

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