A Texas court has recently carved out an exception to the Supreme Court’s ruling in United Student Aid Funds, In. v. Espinosa, 559 U.S. 260 (2010), on the finality of confirmed bankruptcy plans.  In Oklahoma State Treasurer v. Linn Operating, the United States District Court for the Southern District of Texas held Espinosa’s rule that a confirmed plan cannot be collaterally attacked post-confirmation does not apply to unclaimed royalty proceeds that a debtor had been holding for third parties and thus that the Oklahoma State Treasurer could object post-confirmation to a plan provision allocating such unclaimed property to the reorganized debtor.  Concluding that these proceeds were never property of the estate, the court reasoned that, although the Treasurer never objected to the debtor’s reorganization plan, the Treasurer could, nonetheless, object post-confirmation to the treatment of that property because it was never property of the estate in the first place.

To understand the district court’s ruling, it is important first to understand the holding in Espinosa –

In Espinosa, a student, Espinosa, took out several federal student loans and later filed for relief under Chapter 13 of the Bankruptcy Code.  Normally, such loans would be non-dischargeable in bankruptcy unless the student could show that not discharging the loans would create “undue hardship,” which can be determined only in an adversary proceeding.  Espinosa sought to discharge the interest payment obligations under his student loans and included provisions to that effect in his proposed plan.  However, Espinosa never filed the requisite adversary proceeding to do so.  United Student, as the manager of Espinosa’s loans, received notice of the proposed plan, but did not object to the proposed discharge of the student loan interest and the plan was subsequently confirmed.  United Student did not file an appeal.

Years later, United Student came to its senses and filed a motion to have the plan declared void based on the procedural deficiency that Espinosa never filed an adversary proceeding, which United Student claimed deprived it of due process.  After the bankruptcy court ruled in favor of Espinosa, the district court ruled in favor of United Student and the Ninth Circuit ruled in favor of Espinosa, the Supreme Court took up the case and affirmed.  The Court noted first that confirmed plans of reorganization constitute final judgments of the bankruptcy court and cannot be overruled except in the case of a void order, which can result from a jurisdictional error or a violation of due process, which is what United Student asserted.  The Court ultimately ruled that because United Student received actual notice of the plan confirmation process and chose to sit quiet without objection and then, following the order confirming the plan, continued to sit quiet without appeal, it received proper notice of the treatment of the student loans, but waived any objection to that treatment by not voicing that objection during the confirmation process.  Although Espinosa should have brought an adversary proceeding, United Student could not claim to have been deprived due process so as to deny it the opportunity to be heard.

Returning to Linn Operating –

The Oklahoma State Treasurer filed proofs of claim in Linn’s bankruptcy, seeking possession of certain unclaimed royalties under Oklahoma’s statutes on unclaimed property.  These statutes require an oil and gas operator to pay certain unclaimed royalties from production into an escrow account held by the Treasurer.  The Treasurer did not object during the plan confirmation process, but rather, after the plan was confirmed, filed an adversary proceeding, seeking to recover the royalties from the estate.  Linn countered, among other things, that the Treasurer’s efforts were barred by Espinosa because the Treasurer had notice of Linn’s proposed plan but did not object until after the plan was confirmed.  The bankruptcy court agreed with Linn and dismissed the Treasurer’s claim.

On appeal, the district court reversed.  The court first distinguished the facts from those in Espinosa.  Specifically, the court characterized the royalties as being similar to property subject to a bankruptcy constructive trust, which put them outside of the bankruptcy estate, and thus, outside the jurisdiction of the plan.  Under section 541(d) of the Bankruptcy Code, when the debtor holds only legal, but not equitable title, to property, that property is included in the estate only to the extent of the debtor’s legal title.  The consequence of this is that the debtor/trustee cannot use its avoidance powers to avoid transfers of property that it held in trust for another because it never had equitable title to the property to begin with.

The district court noted that the Treasurer was akin to a debtor acting as trustee over a constructive trust in that the Treasurer was effectively a trustee over the escrowed funds for the unknown beneficiaries.  Thus, stated the district court, the Treasurer was not a “true creditor” as defined by section 101(10)(A) of the Bankruptcy Code even though it filed a proof of claim.  The court further reasoned that the unclaimed royalties were never properly capable of being adjudicated by the bankruptcy court because they were not part of the bankruptcy estate.  The court ruled that Espinosa did not apply because the bankruptcy court’s confirmation of the plan was void for lack of jurisdiction insofar as it related to the unclaimed royalties and thus fit within one of the two exceptions stated in Espinosa to the prohibition against attacking a confirmed plan post-confirmation.  The district court’s reasoning why this defect was a jurisdictional one is opaque and should not be read too broadly.  If there is a colorable claim that the proceeds could be property of the estate (for example, if there is a dispute whether the proceeds belong to a royalty owner or instead the debtor), then this reasoning falls flat.

It is worth noting that the district court ruled the Treasurer to be the trustee of the constructive trust as opposed to Linn, the debtor.  With this ruling, the district court sidestepped a tricky issue.  Under the constructive trust doctrine, the debtor is treated as the trustee of the constructive trust, not the party asserting a claim to the property.  If the court had ruled that the Oklahoma statutes create a constructive trust over which the debtor is the trustee, it would not necessarily follow that the Treasurer could pursue any post-confirmation claims.  Although the debtor may have had legal title over the royalties, it would have held them in trust for whoever the unknown beneficiaries of the royalties were and, thus, would not have had equitable title.  This is more in line with the holdings of cases to which the district court cited, including Matter of Haber Oil Co., Inc., 12 F.3d 426 (5th Cir. 1994), and Begier v. I.R.S., 496 U.S. 53 (1990).  In both cases, the debtor was held to be trustee of a constructive trust, created under applicable nonbankruptcy law.  But the Treasurer is in the same position for any proceeds it holds: it has only legal, and not beneficial, title to such proceeds; the Treasurer is not free to spend those proceeds as part of Oklahoma’s government spending.

Thus, while the bankruptcy court perhaps lacked the authority to convey equitable title to these proceeds to Linn, it seems that the bankruptcy court nonetheless would have jurisdiction to address the debtor’s legal title to these proceeds.  Thus, it seems that the bankruptcy court could have allowed the debtor to continue holding these proceeds post-confirmation, at least if the Treasurer did not timely object.

This decision acts as a reminder that Espinosa is not the end of the story.  It is still generally true that once a plan is confirmed and the appeal period has run, that plan cannot be attacked thereafter.  However, creditors and debtors alike should be aware that issues remain over the extent to which state law controls what property is even subject to the plan to begin with.