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In re Khan

United States Court of Appeals, Ninth Circuit

January 23, 2017

In re Zafar David Khan, Debtor,
v.
Kenneth Barton; Thomas Burke; Nancy K. Curry, Chapter 13 Trustee, Appellees. Zafar David Khan, Appellant, In re Terrance Alexander Tomkow, Debtor, Terrance Alexander Tomkow, Appellant,
v.
Kenneth Barton, Appellee. In re Terrance Alexander Tomkow, Debtor, Terrance Alexander Tomkow, Appellant,
v.
Kenneth Barton, Appellee. In re Zafar David Khan, Debtor, Zafar David Khan, Appellant,
v.
Kenneth Barton, Appellee. In re Terrance Alexander Tomkow, Debtor, Terrance Alexander Tomkow, Appellant,
v.
Kenneth Barton, Appellee. In re Zafar David Khan, Debtor, Zafar David Khan, Appellant,
v.
Kenneth Barton, Appellee.

          Submitted November 9, 2016 Pasadena, California

         Appeal from the Ninth Circuit Bankruptcy Appellate Panel Nos. 14-1021, 14-1060, 14-1020, 14-1041, 14-1061, 14-1062 Taylor, Dunn, and Kirscher, Bankruptcy Judges, Presiding Argued and

          Lewis R. Landau (argued), Calabasas, California, for Appellants.

          Patrick C. McGarrigle (argued) and Michael J. Kenney, McGarrigle Kenney & Zampiello APC, Chatsworth, California, for Appellees.

          Before: Diarmuid F. O'Scannlain, Ferdinand F. Fernandez, and Johnnie B. Rawlinson, Circuit Judges.

         SUMMARY[*]

         Bankruptcy

         On appeal from the Bankruptcy Appellate Panel, the panel affirmed (1) the bankruptcy court's decision that a creditor's claims were not subordinated and (2) the bankruptcy court's conversion of the debtors' Chapter 13 bankruptcy proceedings to Chapter 7 proceedings.

         11 U.S.C. § 510(b) requires that claims for damages arising from the purchase or sale of a security of the debtor or an affiliate of the debtor be subordinated to certain other claims or interests. Disagreeing with the BAP, and following Liquidating Tr. Comm. of the Del Biaggio Liquidating Tr. v. Freeman (In re Del Biaggio), 834 F.3d 1003 (9th Cir. 2016), the panel held that § 510(b) applies when debtors are individuals. Nevertheless, the panel agreed with the bankruptcy court that the creditor's claims did not arise out of a purchase or sale of securities, but rather were based upon a judgment entered against the debtors on account of their actions in fraudulently converting the creditor's stock.

         The panel held that the bankruptcy court did not clearly err when it found bad faith and did not abuse its discretion when it converted the debtors' Chapter 13 proceedings to Chapter 7 proceedings.

         Concurring in part, Judge Rawlinson agreed with the majority that the bankruptcy court acted within its discretion when it converted the proceedings from Chapter 13 to Chapter 7. She also joined the majority's conclusion that 11 U.S.C. § 510(b) applies to debtors who are individuals. Judge Rawlinson dissented from the conclusion of the majority that § 510(b) was inapplicable because the creditor's claims did not arise from a purchase or sale of securities.

          OPINION

          FERNANDEZ, Circuit Judge.

         Zafar David Khan and Terrance Alexander Tomkow (collectively "Debtors") appeal the judgment[1] of the Bankruptcy Appellate Panel of the Ninth Circuit ("BAP"), which affirmed the decision of the bankruptcy court that the claim of Kenneth Barton was not subordinated pursuant to the provisions of 11 U.S.C. § 510(b), [2] and converted[3] the Debtors' Chapter 13 bankruptcy proceedings[4] to Chapter 7 proceedings.[5] We affirm the decision of the bankruptcy court.

         BACKGROUND

         In 2013, Barton obtained a Superior Court of the State of California ("Superior Court") judgment against the Debtors and RPost International, Ltd. ("RIL") for conversion, fraud, breach of fiduciary duty, and violation of California Business and Professions Code Section 17200, based upon Barton's allegations that the Debtors fraudulently converted his 6, 016, 500 shares of common stock in RIL.

         The Superior Court found that after Barton and the Debtors founded RIL, they each received an initial distribution of RIL stock in 2001. The consideration for the stock "was stated to be unreimbursed expenses and compensation."

         After suffering a stroke, Barton took leave from RIL. Thereafter, the Debtors cancelled Barton's shares of stock and returned them to the RIL treasury in June or July of 2009. The Superior Court held that the Debtors fraudulently converted Barton's stock in 2009 and determined that they had forged corporate resolutions in an attempt to support their fraud and either "misplaced or destroyed" the shareholder registry, which was "the best evidence of the issuance of [the] stock." The Superior Court then ruled that Barton should recover damages and that his 6, 016, 500 shares should be reinstated. After further hearings, the Superior Court determined Barton should, instead, receive the value of the converted stock. Therefore, it fixed damages for the conversion at $3, 850, 560, based upon the value of the RIL stock as of June 30, 2009, the date of conversion, which was $0.64 per share. After adjustments, a judgment including $3, 840, 060 for the converted shares was entered in Barton's favor.

         A few days before the Superior Court intended to determine the value of the RIL stock for the award of compensatory and punitive damages, each of the Debtors had separately filed a Chapter 13 petition for bankruptcy. At the § 341 (creditors meeting) hearing, the Debtors did not give meaningful information regarding their companies' business transactions, stock valuation, and settlements. And, in their Chapter 13 Schedules, they each reported their RIL stock as having a $0 value and listed Barton's conversion judgment as having a value of only $100, 000 with a "[remainder] unliquidated; pending [the Superior Court] proceedings." Neither Debtor filed amended schedules or an amended Plan that included the full value of the judgment after it was rendered.

         Barton filed a proof of claim in each case and the Debtors objected. They argued that the claims should be mandatorily subordinated under § 510(b), which, they said, would render the claim unenforceable and subject to disallowance under § 502(b)(1). The Debtors also filed separate actions for mandatory subordination and disallowance on the same grounds as those alleged in their objections. The bankruptcy court dismissed the separate actions after the parties litigated the claim objections to resolution because the same result would apply to those actions.

         Barton had filed separate motions to convert each case to Chapter 7, arguing that the Debtors acted in bad faith, which was cause to convert under § 1307(c).

         After a hearing, the bankruptcy court ruled on the Debtors' claim objections based on subordination and disallowance and on Barton's motions to convert. It held that Barton's claims were not subject to subordination because they were not "for damages arising from the purchase or sale of . . . a security." § 510(b). Rather, the bankruptcy court determined that Barton's claims were based upon the Superior Court judgment for fraud and conversion. The bankruptcy court did not specifically address the disallowance issue, but did dismiss the Debtors' separate objections related to that issue. Finally, the court granted Barton's motions to convert. As to each of the Debtors, it found that "the timing of the filing was intended to defeat the state court action . . . [because] it was likely that there was going to be an award of damages that would have put these Debtors outside a Chapter 13." It also found that the Debtors manipulated the bankruptcy process and concealed assets. The Debtors then appealed to the BAP.

         The BAP affirmed the bankruptcy court's subordination determination, but on different grounds. It determined that § 510(b) did not "apply in an individual debtor case." Khan I, 523 B.R. at 183. The BAP also affirmed the bankruptcy court's refusal to disallow Barton's claims because they were not subject to subordination and, even if they were, "there [was] no basis for claims disallowance under § 502(b)(1)." Id. at 182. Lastly, the BAP held that the bankruptcy court did not abuse its discretion when it found bad faith and converted the cases from Chapter 13 proceedings to Chapter 7 proceedings. Id. at 185-87. These appeals followed.

         JURISDICTION AND STANDARDS OF REVIEW

         We have jurisdiction pursuant to 28 U.S.C. § 158(d)(1).

         "We review decisions of the BAP de novo." Aalfs v. Wirum (In re Straightline Invs., Inc.), 525 F.3d 870, 876 (9th Cir. 2008). "This court independently reviews the bankruptcy court's rulings on appeal from the BAP." Miller v. Cardinale (In re DeVille), 361 F.3d 539, 547 (9th Cir. 2004). "'Because we are in as good a position as the BAP to review bankruptcy court rulings, we independently examine the bankruptcy court's decision, reviewing the bankruptcy court's interpretation of the Bankruptcy Code de novo and its factual findings for clear error.'" Id. "[We] accept findings of fact made by the bankruptcy court unless [those] findings leave the definite and firm conviction that a mistake has been committed by the bankruptcy judge." Aalfs, 525 F.3d at 876 (internal quotation marks omitted).

         "We review for abuse of discretion the bankruptcy court's ultimate decisions . . . to convert [the cases] from Chapter 13 to Chapter 7." Rosson v. Fitzgerald (In re Rosson), 545 F.3d 764, 771 (9th Cir. 2008). A court abuses its discretion when it makes "a factual finding that was illogical, implausible, or without support in inferences that may be drawn from the facts in the record." United States v. Hinkson, 585 F.3d 1247, 1263 (9th Cir. 2009) (en banc). We "review the bankruptcy court's finding of bad faith for clear error." Leavitt v. Soto (In re Leavitt), 171 F.3d 1219, 1222-23 (9th Cir. 1999).

         DISCUSSION

         We will first consider the Debtors' assertion that the bankruptcy court and the BAP erred when they determined that § 510(b) did not apply.[6] Thereafter, we will consider their argument that those courts should not have determined that the conversion of their proceedings from Chapter 13 to Chapter 7 was appropriate.

         I. Subordination of Barton's Claims

         Section 510(b) requires that claims for damages "arising from the purchase or sale" of a "security of the debtor or of an affiliate of the debtor" shall be subordinated to certain other claims or interests.[7] As already noted, the bankruptcy court determined that the section did not apply because Barton's claims did not arise from the purchase or sale of a security. The BAP affirmed the bankruptcy court on the basis that the section did not apply because the Debtors were individuals. See Khan I, 523 B.R. at 183-84. However, after the BAP ruled, we held that § 510(b) does apply when debtors are individuals and in doing so we specifically disagreed with Khan I. See Liquidating Tr. Comm. of the Del Biaggio Liquidating Tr. v. Freeman (In re Del ...


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