In re Moore (Cadle v. Moore), 2014 U.S. App. LEXIS 470 (5th Cir Jan. 9, 2014):

The Cadle Company ("Cadle") is a creditor of the bankruptcy estate of James H. Moore, III ("Moore"). Cadle originally brought suit against Moore in state court. After Moore filed for bankruptcy, Cadle removed its action to the bankruptcy court and allowed the estate's trustee to assert its claims. Over Cadle's protests, the trustee sought to settle the claims, and Cadle ultimately re-acquired them at auction. But the bankruptcy court then found that Cadle had paid the trustee's attorney's fees even after the two had become adverse over the settlement issue, and dismissed the adversary proceeding based on its inherent power to sanction a party for abuse of judicial process. The district court affirmed, and Cadle appeals. We reverse the district court, vacate the order of dismissal, and remand to the bankruptcy court.***

IV

Cadle finally contends that the court erred in dismissing the adversary proceeding under its inherent sanction power.

"We review de novo a district court's invocation of its inherent power and the sanctions granted under its inherent power for an abuse of discretion." Positive Software Solutions, Inc. v. New Century Mortg. Corp., 619 F.3d 458, 460 (5th Cir. 2010) (citation omitted). A decision to invoke the inherent power to sanction requires a finding of "bad faith or willful abuse of the judicial process," which finding we review de novo. Gonzalez v. Trinity Marine Grp., Inc., 117 F.3d 894, 898 (5th Cir. 1997) (citation omitted).⁶

6   See also In re Yorkshire, LLC, 540 F.3d 328, 332 (5th Cir. 2008) (court must find "bad faith conduct" before imposing sanctions under inherent power); Goldin v. Bartholow, 166 F.3d 710, 722-23 (5th Cir. 1999) (same).

"[T]he finding of bad faith must be supported by clear and  convincing proof." Crowe v. Smith, 261 F.3d 558, 563 (5th Cir. 2001). In sum, we uphold a lower court's decision to invoke its inherent sanctioning power only if clear and convincing evidence supports the court's finding of bad faith or willful abuse of the judicial process.⁷

7   At the October 2011 hearing on the motion to dismiss, the bankruptcy court suggested that certain cases apply lower thresholds to the application of inherent power sanctions, such as a finding that the "very temple of justice has been defiled," Bartholow, 166 F.3d at 722-23, or that a party shows "callous disregard of its responsibilities" to the court, Smith v. Smith, 145 F.3d 335, 344 (5th Cir. 1998). In fact, these standards are not more lax; we explained in those same cases that a sanctioning court must find bad faith. Bartholow, 166 F.3d at 722-23; Smith, 145 F.3d at 344.

If this high threshold for invoking inherent powers is surmounted, we review the substance of the sanction itself more deferentially, for an abuse of discretion. See Chambers v. NASCO, Inc., 501 U.S. 32, 55, 111 S. Ct. 2123, 115 L. Ed. 2d 27 (1991) (concluding that sanction of attorney's fees was not abuse of discretion).

We hold that because the bankruptcy court failed to find by clear and convincing evidence that Cadle acted in bad faith, it erred in invoking its inherent sanction power. Crowe, 261 F.3d at 563. Akerly and BNM's potential misconduct notwithstanding, the record does not establish that Cadle deliberately abused the judicial process--either before or after it became adverse to the trustee.

First and foremost, the bankruptcy court faulted Cadle for BNM's inadequate and inconsistent fee disclosures early on in the adversary proceeding. The parties do not dispute that BNM never disclosed to the court in its employment application Cadle's commitment to paying BNM's fees. The employment application claimed that any fees from the trustee would be contingent in nature, but just months later, BNM memorialized its fee arrangement with Cadle in the "smoking gun" November 2006 letter. Additionally, the bankruptcy court noted that BNM's claim at the May 2007 motion to withdraw hearing that Cadle had promised to cover litigation expenses--not fees--was "inconsistent" with both BNM's employment application, which did not mention Cadle's role, and with Cadle's (then undisclosed) commitment to paying only BNM's fees.

Yet BNM's nondisclosure and inconsistency, while justifying scrutiny, are not alone clear and convincing evidence of Cadle's bad faith or willful misconduct. Cadle account officer Jeanne Isler specifically testified that she had no knowledge of any separate fee agreement between BNM and the trustee. Moreover, at this stage in the proceeding, the interests of Cadle and the trustee had not yet become adverse, so Cadle's fee payments were not yet problematic. See Mims, 608 F.3d at 256 (noting that Cadle "advanced over $60,000 in attorneys' fees to the trustee's attorneys" after the trustee took over Cadle's claims). Even under Moore and Brunswick's premise that Cadle had an affirmative duty to disclose the trustee's attorney's potential conflict of interest, the record bears out no clear and convincing evidence of any bad-faith violation of this duty. To the contrary, Cadle representatives candidly testified about fee payments to BNM at hearings in 2007 and 2008. In fact, during the sale order hearing, the bankruptcy court even recalled its earlier knowledge of the fee arrangement.

The bankruptcy court next took issue with BNM's 2007 attempt to withdraw as counsel to the trustee in the avoidance action. Suggesting that a conflict between Cadle and the trustee had materialized even at this early stage, the court cited a BNM attorney's testimony that "Cadle instructed [BNM] that they didn't want [BNM] to do anything that would benefit the trustee from a cost and expense standpoint . . . ." The bankruptcy court noted its suspicion that Cadle, like many large creditors, cared only about the discharge action and not the trustee's success in the avoidance action.

Again, the bankruptcy court's mere suspicions do not add up to clear and convincing evidence of Cadle's bad faith. Cadle's "instructing" BNM not to incur certain litigation expenses suggests disagreement between Cadle and BNM regarding litigation strategy and expense allocation in the avoidance action, but does not constitute clear and convincing evidence of Cadle's bad faith. At this time, Cadle and the trustee were aligned in their objective of recovering assets for the estate. In fact, Cadle continued to pay BNM's fees in connection with motions and trial preparation; the company refused only to pay for an expert forensic accountant.

The bankruptcy court further suggests that bad faith can be deduced from evidence of the benefits reaped by Cadle after it became directly adverse to the trustee. The court suggests that the company sabotaged BNM's representation of the trustee and purposefully obtained privileged information revealing the trustee's litigation strategy. But both allegations find insufficient support in the record. As to the first claim that Cadle influenced BNM's representation of the trustee, the court relies only on the facts that Akerly left BNM, that the firm had no definite plans for identifying his replacement, and "a decision was made" to allow a first-year associate to present arguments. None of these facts indicates that Cadle "willful[ly]" tainted the judicial process. Trinity Marine Grp., 117 F.3d at 898. Neither does the bankruptcy court substantiate its suggestions that Cadle purposefully obtained privileged information appearing on BNM's bills for its work for the trustee. Finally, the bankruptcy court's narrative is factually inconsistent. Cadle indeed continued to pay BNM's fees after Cadle became adverse to the trustee on the settlement issue, but far from obtaining any benefit, Cadle actually lost in the bankruptcy court and then again in the district court. Cadle ultimately prevailed on the previous appeal before us, but Cadle's payments to BNM had stopped well before the appeal was filed; no clear and convincing evidence links the victory to Cadle's fee payments or influence.

Finally, the bankruptcy court imputes  BNM's alleged misconduct to Cadle. The court's theory is that because the company is a "sophisticated party that regularly hires lawyers to monetize assets," Cadle was accountable for "its" lawyers, who represented the trustee. Thus, the nondisclosures and conflicts of interest are "attributable" not only to BNM, but also to Cadle.

The bankruptcy court's approach controverts well-established rules of agency law. An agent's acts and mental states are imputed to his principal when the agent acts on behalf of the principal. See U.S. ex rel. Vavra v. Kellogg Brown & Root, Inc., 727 F.3d 343, 348 (5th Cir. 2013). Here, at all relevant times in the avoidance action, BNM was the agent of the trustee, not of Cadle. In both BNM's employment application and its November 2006 letter to Cadle, the law firm explained to Cadle that the trustee was its sole client in the avoidance action. No clear and convincing evidence shows that Cadle had somehow appropriated BNM as its own agent. BNM's attempt to withdraw from representing the trustee in the avoidance action, in fact, manifested the tension between its fiduciary duty to the trustee and its reliance on Cadle's payment of litigation expenses.  And the fact that BNM received fees from Cadle, unbeknownst to the trustee, did not destroy this agency relationship and transform BNM into the agent of Cadle. Rather, under agency principles, an agent must account to his principal for any gains beyond the agent's agreed-upon compensation.¹⁴ Thus, BNM should have relinquished any fees received from Cadle, but the agency relationship between BNM and the trustee--established when BNM became the trustee's special counsel--remained intact. Cf. 11 U.S.C. § 328(c) (enabling court to require disgorgement of fees arising from conflict of interest).

After Cadle and the trustee became adverse on the settlement issue, there is even less basis for construing BNM as Cadle's agent. BNM continued to represent the trustee in directly opposing Cadle and was successful in these efforts until our decision on the last appeal. Thus, because BNM was not acting as Cadle's agent before or after the settlement dispute arose, we cannot impute the firm's acts or mental states to Cadle.¹⁵ Cf. Payne v. C.I.R., 224 F.3d 415, 420 (5th Cir. 2000) (refusing in civil tax fraud case to impute fraud, reviewed under same "clear and convincing evidence" standard).

 

15   The agency principles outlined here are relevant to our rejection of Cadle's additional claim that as a matter of law, nondisclosure is insufficient to establish fraud on the court and thereby cannot warrant outright dismissal. Cadle relies on Fierro v. Johnson, 197 F.3d 147 (5th Cir. 1999), for the proposition that fraud on the court is established only with "an unconscionable plan or scheme . . . designed to improperly influence the court in its discretion," and that "less egregious misconduct, such as nondisclosure to the court of facts allegedly pertinent to the matter before it, will not ordinarily rise to the level of fraud on the court." Id. at 154 (citation omitted). However, there, we held that because a nondisclosure in a state criminal case was neither actually nor constructively known to the government's attorneys in the later federal habeas case, there was no fraud on the court in the latter case. Id. at 155. We reasoned that we could not impute the police officer's and prosecutor's knowledge of the perjury and the tainted evidence in the state court trial to the government attorneys in the habeas case because the "relationship [between the parties] is too attenuated." Id. In short, the decisive factor in Fierro for our analysis of fraud on the court was the imputation of knowledge (and resultant bad faith), not simply whether a nondisclosure was at issue.

We are not unsympathetic to the bankruptcy court's concerns about the "unpleasant odor" of this adversary proceeding. The record suggests that BNM made several miscommunications about fee arrangements. And after Cadle became adverse to the trustee, it should have recognized immediately the conflict of interest and ceased all fee payments to BNM. Cadle's management of the avoidance action was inept, at best. But even at its worst, the evidence is not enough to sustain an inherent power dismissal. This appeal turns on whether clear and convincing evidence demonstrates that Cadle, not the BNM attorneys, willfully abused the judicial process. Neither imputed bad faith nor suspicion alone justifies the invocation of the inherent power. In sum, all of the bankruptcy court's theories fall short of the stringent standard of clear and convincing evidence of bad faith.¹⁶ Crowe, 261 F.3d at 563.

16   Because the bankruptcy court had no legal authority in the first place to invoke its inherent sanction power, we have no occasion to review the substance of the sanction for abuse of discretion.