For Whom the Bell Tolls: Obligations and Risks of Third-party Witnesses under Rule 2004 Examinations.
November 27, 2016
Authored by: James Maloney
Two recent Bankruptcy Court cases both remind and illustrate the power and risks presented by discovery of facts and documents under Bankruptcy Rule 2004, showing that it can compel third parties to provide information to support later litigation against them or cause them to lose their 5th Amendment right against self-incrimination.
- In re Great Lakes Comnet, Inc./ (a copy of the case is here: great-lakes-comnet-inc), the Bankruptcy Court for the Western District of Michigan held that the Committee of Unsecured Creditors was entitled to conduct a Rule 2004 examination of a third-party company while explicitly recognizing that the intent of the examination was to prepare for and inform the committee regarding later litigation against the third-party.
- In re Mavashev/ (a copy of the case is here: in-re-mavashev), the Bankruptcy Court for the Eastern District of New York held that a third-party witness would not be prejudiced by any self-incrimination in the act of producing a document central to what was very likely a criminal transaction in association with the debtor, and further that such witness had waived his privilege against self-incrimination by prior, limited testimony in the Rule 2004 examination.
Discovery of facts and documents in bankruptcy litigation takes place under three broad categories of Bankruptcy Rule practice: (1) a Meeting of Creditors under Section 341 and Rule 2003, (2) examination and production of documents under Rule 2004, and (3) mirror-image federal civil rules discovery under Rules 7026-7037 for adversary proceedings or contested matters. For all such discovery, the compulsory participation and scope of inquiry is relatively contained and governed under statutes, rules, and case law, and it is the tendency of jurisprudence over the years to make the rights and obligations thereunder more and more clear. However, the broad scope of subject matter and proper parties to discovery under Rule 2004 seems to yield a staying power against attempts to limit it on the basis of anything other than a facts-and-circumstance, case-by-case approach.
The amorphous, yet clearly large and powerful, scope of subject matter and parties for compulsion under Rule 2004 seems particularly consternating in the recurrent problem of third-party witnesses. These are persons or entities that are not debtors or creditors, yet find themselves under substantial obligations to appear, testify and produce documents under Rule 2004. Most lawyers in this area of practice will be familiar with the scenario of a client who is understandably incredulous that she has to comply with a burdensome obligation of appearance and production pursuant to a subpoena served under Rule 2004.
Practice under Rule 2004 involves many substantive and procedural issues. For purposes of this limited treatment of the subject, the general background of Rule 2004 practice includes:
- The Rule 2004 inquiry may be made by any person with a legitimate interest in the case (i.e., not limited to the Trustee, Debtor, etc.) and upon any person or entity that has the required information (i.e., not limited to a party to the bankruptcy proceeding).
- The scope of Rule 2004 inquiry is very broad and relates to any “acts, conduct, or property or to the liabilities and financial condition of the debtor, or to any matter which may affect the administration of the debtor’s estate, or to the debtor’s right to discharge.”
- In Chapter 11 and Chapter 13 cases, the permissible scope includes the above, plus: inquiry related to “the operation of any business and the desirability of its continuance, the source of any money or property acquired or to be acquired by the debtor for purposes of consummating a plan and the consideration given or offered therefore, and any other matter relevant to the case or to the formulation of a plan.”
- Generally, the breadth of permissible subject matter and potential witnesses has been likened to a “fishing expedition.” However, limits on Rule 2004 include that it cannot be used: to harass parties or witnesses, as a substitute for civil rule or adversary proceeding rule discovery where an action is pending (with limited exceptions), in a post-confirmation or closed case scenario where there is no property of the estate, or where the inquiry is upon a dispute that is barred by res judicata.
- Protections of privileged or confidential subject matter apply in the same way they do to deposition or trial testimony.
One of the most common objections seen in response to Rule 2004 notices and subpoenas to third-party witnesses is that the inquiry appears to be preparation for later litigation and therefore inappropriately attempts to avoid the witness and party protections of discovery under rules of civil cases and adversary proceedings. This was the nature of the objection raised by the witness in the Great Lakes Comnet case. The case was before the Court as a Chapter 11 case, and so involved the broadest scope of Rule 2004 inquiry as set out above. The Debtors in the case had become the subject of a regulatory complaint by the Federal Communications Commission and AT&T that implicated the Debtors and Local Exchange Carriers of Michigan, Inc., a/k/a 123.net (“LEC-MI”) as to improper payments under a revenue sharing agreement.
The Committee of Unsecured Creditors (“Committee”) undertook investigation of potential claims against various parties, including LEC-MI. For its part, LEC-MI voluntarily cooperated with the investigation up to a point, and then declined further participation. The Committee then filed a motion requesting authority to conduct a Rule 2004 examination of LEC-MI, and LEC-MI’s responsive objections included that the Committee motion was a “clandestine attempt” to “circumvent the discovery rules.” The Court found that “good cause” for a Rule 2004 examination includes seeking additional information to determine whether the Debtor estate has causes of action against third parties, noting that the permissible scope of the inquiry can be a “fishing expedition”, “exploratory”, and even “groping”. In granting the Committee motion, the Court discussed with approval that making an extensive preliminary inquiry under Rule 2004 in advance of intended litigation supports goals of civil and adversary proceedings litigation practice by narrowing the eventual causes of action, exploring the potential of defenses and affirmative defenses, and supports the ability of a plaintiff to meet federal pleading standards for “plausible” causes of action or the heightened pleading standard for fraud./
In re Mavashev was a converted Chapter 7 case and therefore dealt with the comparatively lesser scope set out above. However, this case dealt with “property of the debtor” and so was squarely within the scope of permissible subject matter even though the inquiry was of a third-party business entity and individual who had done business with the debtor. The Trustee was pursuing investigation stemming from several transactions wherein the Debtor had delivered a total of $300,000 worth of diamonds to a business called LA Diamonds, but never received payment for them. The course of the investigation yielded the testimony of an informed witness that the Debtor had some manner of arrangement with a convicted felon wherein they would acquire diamonds for no consideration and sell them to pawn shops. The investigation led the Trustee to a pawn shop called Elegant Jewelry and its principal Elie Hanono (“Hanono”).
Basically, Hanono was reasonably cooperative up to a point, and then tried to stop providing information. His Rule 2004 testimony included raising 5th Amendment objections on a question-by-question basis, testifying in some detail regarding transactions with the debtor, but in the end refusing on 5th Amendment grounds to produce a pawn ticket document that was of particular interest to the Trustee. Points of interest covered by the Court in its decision included:
- The 5th Amendment privilege applies in Rule 2004 examinations.
- Corporations and artificial entities do not have 5th Amendment privilege.
- Neither the entity nor an individual custodian of entity records in such capacity has a 5th Amendment privilege against producing entity records, no matter how small the entity may be.
- 5th Amendment protection under the “act of production” doctrine requires that the act be both testimonial and incriminating, and whoever raises the objection must prove that it is both.
- A witness waives the 5th Amendment privilege regarding a transaction by testifying about that transaction.Under these principals, the Court compelled Hanono to produce the pawn ticket over his 5th Amendment objection because the corporate record had not privilege, Hanano had no privilege as its custodian, Hanano had not met his burden of proof that the act of production would be testimonial and incriminating, and had in any event waived any 5th Amendment privilege regarding the production of the pawn ticket by testifying about the transaction the ticket regarded.
Together, these recent cases illustrate the continuing vitality of disputes arising under Rule 2004. In re Great Lakes Comnet, Inc. reminds us of the broad scope of the rule, its use to explore claims and defenses, and perhaps even a bankruptcy court’s preference that eventual adversary cases be well-informed and well-pleaded. From the witness’ perspective, In re Mavashev illustrates the perils of self-incrimination that can evolve along the way in inquiry to a third-party regarding a questionable transaction with a debtor.
/ In re Great Lakes Comnet, Inc., No. GL 16-00290-JTG, 2016 WL 6081100 (Bankr. W.D. Mich. Oct. 17, 2016).
/ In re Mavashev, No. 14-46442-CEC, 2016 WL 5854204 (Bankr. E.D.N.Y. Oct. 5, 2016)
 For a broader treatment of Rule 2004, see T. Horan and M. Busenkell, “Gone Fishing: The Fundamentals of Rule 2004”, ABI Journal, Vol. XXIX, No. 1, February 2010.
/ This approving view of the exploration of claims and defenses is stated in the context of claims directly related to the interests of the unsecured creditors of the estate. A Rule 2004 examination may not be used to explore claims that are unrelated to the bankruptcy estate. In re Rosenberg, 303 B.R. 172, 176-77 (B.A.P. 8th Cir. 2004).