Creditors Beware! Give the Trustee Time To Breathe Or Risk Violating The Automatic Stay

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It’s a common pattern…

  • Company X owes Company Y money
  • Company X files for Bankruptcy
  • Company Y still wants to get paid the money it is owed
  • Company Y decides to file a lawsuit to get its money and they don’t care how they get paid or from whom

Not so fast.

The Bankruptcy Code’s (the “Code”) automatic stay applies to all companies and individuals; it protects the debtor’s property, and the bankruptcy court’s jurisdiction, by barring any act to gain possession of property in the bankruptcy estate or to exercise control over the property of the estate.

The automatic stay is designed to give a trustee or chapter 11 debtor-in-possession some relief from collection actions and to prevent the debtor from being disembodied for the benefit of a few creditors at the expense of the remaining creditors.

Section 362(a) stops creditors from taking steps to get in front of others in an effort to get paid including:

  1. Beginning any action against the debtor
  2. Collecting a debtor’s rents or accounts receivable
  3. Foreclosure or eviction proceedings
  4. Property seizures
  5. Any action to create, perfect, or enforce a lien against the debtor’s property (except mechanic’s liens)

The Code provides exceptions to the automatic stay and some types of actions are not automatically stayed by the filing a bankruptcy petition.  Some examples include:

  1. Criminal actions
  2. Collection of alimony, maintenance, or support
  3. Certain police powers
  4. Issuance of tax deficiency notices
  5. Some SEC or regulatory enforcement actions

Despite being aware of the automatic stay, some crafty creditors might try to sidestep the debtor or trustee and bring an action against a related third party in an effort to get paid.

This is not a good plan since the Trustee or Debtor may have rights against that third party that trump individual creditors’ claims.  A Bankruptcy Court has the power to stop litigation by creditors against third parties (such as former directors and officers of the bankrupt company or against persons who may be in possession of the Debtor’s property) where that litigation may be property of the estate; that power extends to situations where creditors are asserting general or indirect claims so they can receive a greater distribution on a first come, first serve basis. This sort of litigation may be directed at claims or assets which the trustee has an interest in pursuing or recovering, and which, if recovered, will be used to satisfy the claims of all creditors, not just a single one.

Section 541 of the Code broadly defines property of the estate as all “legal or equitable interests of the debtor in property as of the commencement of the case.”  Those interests include the right to file a lawsuit against third parties who may have been in control of the debtor prior to the bankruptcy, or against a person who has in their hand some of the Debtor’s property at the time of a bankruptcy filing.

Many courts apply a two-part test to determine if a cause of action is “property of the estate”:

  1. The claim must be one that the trustee has a right to assert under the applicable state law
  2. The claim is general to the corporation rather than personal to the creditors

A claim is considered “personal” when a third party has injured, not the bankrupt corporation itself, but a creditor of that corporation.  A claim is “general” when no particularized injury would arise if the claim was brought by any creditor. The only proper person to assert such a general claim is the Trustee, and creditors are bound by the Trustee’s action.

If a creditor wants to assert a claim independently of the Trustee’s administration of the bankruptcy case, that creditor must have suffered an injury “significantly different” from the injuries to other creditors. The trustee’s exclusive ability to bring causes of action that affect all creditors supports the goal of the automatic stay by promoting orderly resolution of claims and preventing single creditors from receiving preferred recoveries.

A “particularized injury” is personal to an individual creditor and significantly different from the injuries suffered by other creditors in the bankruptcy case.   Personal causes of action are those in which only the claimant has been harmed and no other claimant or creditor has any interest in the cause.

To allege a personal cause of action, the creditor must show the harm it suffered was more than just the consequence of harm to the debtor.  An example of a particularized injury is where the directors and officers of the bankrupt corporation defrauded an individual creditor for their personal benefit but did not defraud the bankrupt company; or where a third party caused physical, mental or financial harm to a creditor but the bankrupt company itself did not suffer any physical, mental or financial harm; or where the cause of action concerns the creditor’s personal relationship with a debtor but debtor has not suffered any injury.

If a creditor’s injury at the hand of these third parties is the mere fact it was damaged due to nonpayment by the Debtor, the injury is a general claim which all creditors of the Debtor could raise.  For a creditor to have a particularized injury it must show that it has a suffered an injury at the hand of the third party that is significantly different from the injuries suffered by all of the Debtor’s other creditors who failed to receive payment.  If a Trustee has begun litigation seeking to recover funds or assets from third parties for the benefit of all creditors, no creditor may also bring claims that are general claims since those belong to the bankruptcy estate.

Prudent creditors should consult their counsel before beginning any collection activity against the third parties related to the Debtor.  A willful violation of the automatic stay can result in significant punitive damages being assessed against the violator.