A recent Second Circuit opinion sets a bright-line rule: if the Debtor is named as a defendant in a pre-bankruptcy lawsuit, the automatic stay applies to halt further proceedings.  Bayview Loan Servicing LLC v. Fogarty (In re Fogarty), 20-2187 (2d Cir. July 6, 2022).

The Debtor, Ms. Fogarty, resided in a home on Long Island with a beautiful view of Mastic Bay.  For motives unclear from the opinion, title to the property was held in a limited liability company (essentially wholly-owned by the Debtor), and the Creditor, Bayview, held the mortgage.  Although, the mortgage was in default as of January 2010, it took the Creditor over eight years, until early 2018 to obtain a foreclosure judgment in state court.  While the Creditor had originally omitted the Debtor as a defendant, the Creditor had added the Debtor as a defendant during the course of state court litigation.

After entry of the foreclosure judgment, and a mere four days before the scheduled foreclosure sale, the Debtor filed her bankruptcy petition.  Predictably, the Debtor’s counsel advised the Creditor’s counsel that moving forward with the sale would constitute an automatic stay violation and threatened to seek sanctions.  The Creditor’s counsel disagreed, suggesting that because the property was held by the LLC, the sale was merely an in rem action, not subject to the automatic stay in the bankruptcy case of the individual Debtor.  Equally confident in his position, Creditor’s counsel threatened to seek cross-sanctions if an adversary proceeding were brought alleging a stay violation.

Initially, the Creditor was vindicated when the bankruptcy court agreed that the property owned by the LLC was not property of the estate subject to the automatic stay, and that the sale was merely an in rem action against non-estate property, thus finding no stay violation.  However, on appeal, the district court reversed and remanded, finding a willful stay violation, and the Second Circuit affirmed the district court’s opinion.

The Second Circuit found that the Creditor had violated the automatic stay under the plain text of Section 362(a)(1)[1] because even though the property was owned by a non-debtor LLC, the Debtor was a named defendant in the foreclosure action and under Section 362(a)(2)[2] because the foreclosure judgment was obtained before the bankruptcy filing. The Second Circuit rejected the Creditor’s arguments that the two subsections of the statute may not overlap, and that the Debtor was merely named as an “interested party.”  Finally, the Second Circuit disagreed with the Creditor that the foreclosure sale was a mere ministerial act, and found that the Creditor should have sought relief from the automatic stay before proceeding.  While acknowledging that the Creditor had faced a significant delay in getting to a foreclosure sale, the Second Circuit was ultimately unsympathetic to the Creditor’s appeals to equity.[3]

The Second Circuit’s opinion does leave some unresolved questions:

• What if the Creditor had dismissed the Debtor from the foreclosure action?  The Debtor had no legal title interest in the property, and the Creditor claimed the Debtor was merely named as an interested party. Therefore, relying on In re Ebadi, 448 B.R. 308, 314 (Bankr. E.D.N.Y. 2011), the Creditor argued that since the Debtor was not personally liable, there was no stay violation.  The Second Circuit distinguished Ebadi because, unlike in Fogarty, the Debtor in Ebadi had guaranteed the debt.  More importantly, the Second Circuit held that the reason the Debtor is a named defendant does not matter.  The Second Circuit queried whether it would have changed the analysis had the Creditor dismissed the Debtor, but it stopped short of sanctioning this path, stating that such a sale “might not have violated the automatic stay” (emphasis added).
• Even if the Creditor had attempted to dismiss the Debtor post-petition, could it do so since the judgment was entered pre-petition and moving forward could be a violation of Section 362(a)(2) of a judgment against the Debtor?  Could the Creditor have moved the state court to vacate the order only as to the Debtor (and at that point, would it just have been easier to move for relief from stay in bankruptcy court)?
• What if the Debtor had not resided on the property and had no possessory interest, but the Creditor had named the Debtor as a defendant anyway as a sort of boot-strapping measure?  Could that have changed the Second Circuit’s analysis?  Under the “bright-line” rule laid out, apparently not.
• Does it not matter that there was apparently not a lease between the Debtor and the LLC?  The Court seemed uninterested as to whether the Debtor was paying rent to the LLC or had any legal right to possession of the property.
• How does the Second Circuit’s bright-line rule square with the general rule that the automatic stay applies only to the debtor in multidefendant actions (See e.g., Queenie, Ltd. v. Nygard Int’l,  321 F3d 282 (2d Cir. 2003); In re Miller  262 BR 499) (B.A.P. 9th Cir. 2001)?  The Second Circuit attempts to distinguish Queenie because in Fogarty the defendant remained a party to the foreclosure action “in contrast” to the appeal in Queenie.  Yet, a review of the caption in Queenie suggests that the bankruptcy entities were still named in the appeal.

Perhaps some of these issues will be resolved in further proceedings.  Until then, practitioners, and plaintiff’s/creditor’s counsel, in particular, should take careful note of the Second Circuit’s bright-line rule regarding the automatic stay.

[1] Section 362(a)(1) stays the commencement or continuation of a pre-petition judicial proceeding.

[2] Section 362(a)(2) stays the enforcement of a pre-petition judgment.

[3] For discussion of a 9^th Circuit opinion delving into a more fact-intensive analysis of the automatic stay, see previous blog post here: https://insolvency.foxrothschild.com/2022/05/is-a-postpetition-non-bankruptcy-court-order-a-violation-of-the-automatic-stay-the-ninth-circuit-bankruptcy-appellate-panel-provides-clarity-in-recent-holding/

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