Debtor Improperly Colludes with Buyers, then Sues Them; Complaint Dismissed on In Pari Delicto Defense

Kwok v. Li (In re Kwok), No. 22-1152 (9th Cir. BAP May 23, 2023)

On May 23, 2023, the U.S. Bankruptcy Appellate Panel for the Ninth Circuit issued an opinion agreeing with a bankruptcy court’s dismissal of an action based on the defense of in pari delicto but remanding for further findings to support an award of sanctions.

The opinion involves an adversary proceeding brought by the debtor and the defendants’ motion to dismiss the complaint under Rule 12(b)(6) of the Federal Rules of Civil Procedure, incorporated in Rule 7012 of the Federal Rules of Bankruptcy Procedure.

The Debtor, namely David Kwok, operated a company, namely Shorb DCE, LLC, which owned 100% of the equity interests in an apartment building. After Shorb filed a chapter 11 bankruptcy petition in 2017 and had its case converted to chapter 7, the bankruptcy court approved the sale of the apartment building to the Buyers, who were the sole bidders, for approximately $2.5 million. This property held significant equity.

Unbeknownst to Shorb’s chapter 7 trustee, Kwok and his girlfriend were promised payment under a $150,000 “Secret Note” signed by the Buyers.

In less than a year, Kwok filed a chapter 13 bankruptcy petition that was later converted to chapter 7. When Kwok’s chapter 7 trustee learned of the Secret Note, an adversary proceeding was initiated against the Buyers. Despite this, Kwok’s attorney failed to amend Kwok’s schedules to include the Secret Note. The Kwok trustee subsequently moved to abandon the Secret Note and the litigation against the Buyers, anticipating a 100% dividend to unsecured creditors, which the bankruptcy court granted.

Kwok then replaced himself as the plaintiff in the litigation and filed an amended complaint, alleging that the Buyers had proposed the Secret Note at a time when he was recovering from a severe heart attack and unaware that Shorb’s bankruptcy case had been converted to chapter 7. The amended complaint also alleged financial elder abuse and sought return of the property under various theories, including that there was collusion among the Buyers.

The Buyers filed a motion to dismiss Kwok’s amended complaint under Rule 12(b)(6), arguing various legal issues, and also sent a safe-harbor sanctions letter to Kwok under Rule 9011 of the Federal Rules of Bankruptcy Procedure. Kwok only filed a brief response to the Rule 12(b)(6) motion and did not meaningfully counter any of the Buyers’ arguments. The Buyers eventually filed a motion for sanctions under Rule 9011.

The bankruptcy court granted the motion and dismissed the complaint. The court also awarded sanctions against Kwok in the amount of about $21,000. Kwok took an appeal.

The bankruptcy court’s ruling was based on the fact that Kwok participated with the defendants in the illicit conduct which formed the basis for the adversary proceeding. The principle of in pari delicto, which prevents a court from aiding one participant in a wrongful action to recover from another participant, was the basis for the decision.

The opinion also discusses Kwok’s appeal of the sanctions award. He argued that the bankruptcy court erred in granting sanctions. The court determined that there were insufficient findings to support the amount of the award and remanded for further proceedings.

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