March 18, 2024 – A creditor who waited until after a debtor’s discharge to argue that the debtor’s interest in a company was not worthless waited too long under the bankruptcy rules, the U.S. Court of Appeals for the Seventh Circuit has held in In the Matter of Gregory Kleynerman, No. 22-2947 (Feb. 27, 2024).

Gregory Kleynerman and Scott Smith founded Alpha Cargo Technology, LLC (ACT) in 2002. Each man owned one-half the company.

In 2009, ACT sold all its assets, including patents, to Red Flag Cargo Security Systems, LLC (Red Flag). In February 2011, Kleynerman purchased a 75% interest in Red Flag.

Lawsuit Over Sale

In December 2011, Smith sued Kleynerman and Red Flag in Milwaukee County Circuit Court, claiming breach of fiduciary duty and misrepresentation.

The jury found for Smith on the breach of fiduciary claim and awarded him $499,000 in compensatory damages.

Kleynerman appealed the jury’s verdict to the Wisconsin Court of Appeals.

In March 2017, the Court of Appeals ruled that the $499,000 judgment against Kleynerman was to be secured by a lien on his membership interest in Red Flag.

Bankruptcy Filing

In July 2018, Kleynerman filed for Chapter 7 bankruptcy in the U.S. Bankruptcy Court for the Eastern District of Wisconsin.

In the bankruptcy filing, Kleynerman: 1) listed Smith as a creditor because of the $499,000 judgment; and 2) valued his interest in Red Flag at $0.

Because Kleynerman valued his interest in Red Flag at $0, he scheduled it as exempt under Wis. Stat. section 815.18(3)(b). Under that statute, property worth $15,000 or less is exempt from bankruptcy.

As part of the bankruptcy filing, Kleynerman listed Smith as a creditor because of the $499,000 judgment resulting from the jury’s decision in the state court lawsuit.

In the bankruptcy proceedings, Smith argued that the $499,000 was a result of Kleynerman’s fraud and thus could not be discharged. But the bankruptcy court rejected that argument.

After losing the argument, Smith did not object to Kleynerman’s valuation of his interest in Red Flag at $0. Smith did also not object to Kleynerman’s discharge in bankruptcy.

Bankruptcy Re-opened

Kleynerman then asked the state court to deem the $499,000 debt discharged. But Smith argued that section 806.19(4) allows debtors to avoid only debts that are secured by real property.

The state court agreed with Kleynerman. Kleynerman then asked the federal bankruptcy court to re-open his case and rule that the $499,000 debt and the lien on his interest in Red Flag were extinguished.

The bankruptcy court re-opened the case and ruled in Kleynerman’s favor on both the $499,000 debt and the lien. The U.S. District Court for the Eastern District of Wisconsin affirmed.

Smith appealed.

Judge Had Authority to Re-open

On appeal, Smith argued that the bankruptcy judge erred by re-opening Kleynerman’s bankruptcy.

Writing for a three-judge panel, Judge Frank Easterbrook concluded that the bankruptcy judge had the authority under 11 U.S.C. section 350(b) to re-open Kleynerman’s bankruptcy case.

“All the court needed was ‘cause,’ which the state judiciary’s decision supplied,” Easterbrook wrote.

“A debtor who has cause for re-opening cannot dilly-dally, but Kleynerman sought re-opening 70 days after the discharge’s entry and 36 days after the state judge’s post-discharge decision,” Judge Easterbrook wrote. “Smith has not cited any case deeming 70 days too long.”

Wrong Time for Subpoenas

Smith also argued that the bankruptcy judge erred by declining to consider his argument that Kleynerman’s interest in Red Flag was worth more than $15,000, and thus not subject to exemption under Wis. Stat. section 815.18(3)(b).

Easterbrook pointed out that the bankruptcy judge and the district court judge concluded that the proper time to consider that argument was before the discharge.

The appellate panel agreed with that conclusion, Judge Easterbrook wrote, because U.S.C.S. Bankr. R. 4003(b)(1) requires a party in interest to object to a claimed exemption within 30 days of the meeting of the creditors that’s required by 11 U.S.C. section 341.

Easterbrook noted that that meeting occurred on Oct. 4, 2018, which gave Smith until Nov. 3, 2018, to object to KIeynerman’s claimed exemption for his interest in Red Flag.

“But Smith did not object then or at any time before the bankruptcy court entered the discharge order on December 2, 2019,” Judge Easterbrook wrote. “Nor did he seek additional information to facilitate an objection.”

‘It Was Too Much, Too Late’

Easterbrook noted that U.S.C.S. Bankr. R. 4003(d), which applies to proceedings under 11 U.S.C. section 522(f) to avoid liens, did not have a time limit. That timing, therefore, was at the discretion of the bankruptcy judge.

Judge Easterbrook explained that after Smith failed the persuade the bankruptcy judge that the $499,000 judgment was not dischargeable, he did nothing until after the discharge.

After the discharge, Easterbrook noted, Smith asked the bankruptcy judge for permission to issue a raft of subpoenas aimed to uncover information about the value of Kleynerman’s interest in Red Flag.

The bankruptcy judge denied Smith’s request.

“The district court concluded that this was not an abuse of discretion, and again we agree,” Judge Easterbrook wrote. “It was too much, too late.”

“Carefully targeted requests might have been appropriate, given the difference between Rule 4003(b) and Rule 4003(d), but Smith’s blunderbuss requests were anything but targeted,” Easterbrook wrote.

Smith Knew About Red Flag Income

Smith knew that Kleynerman had received $600,000 in income from Red Flag in 2016 and 2017 and another $51,000 in 2018, before he declared bankruptcy, Judge Easterbrook noted.

“Smith could have used this information to contest Kleynerman’s assertion that his interest in Red Flag was worth less than $15,000,” Easterbrook wrote.

Instead, Judge Easterbrook wrote, Smith “put all his eggs in one basket (the fraud objection to discharge) and let the valuation of Red Flag pass without objection,” Judge Easterbrook wrote.