Many creditors have been warned of the need to halt collection efforts once they are put on notice that a debtor has filed for bankruptcy. However, the “why” behind this warning, mainly the automatic stay, is often misunderstood or disregarded. Since violations of the automatic stay can have serious ramifications, it is crucial that creditors know what the automatic stay is, what it protects, and how to get relief from the stay so that the creditor can proceed with collection efforts.
What Is the Automatic Stay? What Does It Protect?
A debtor commences a bankruptcy by filing a bankruptcy petition. This is the case regardless of whether the debtor files under Chapter 7, 11, 13, or any other chapter of the United States Bankruptcy Code. Pursuant to 11 U.S.C. § 362 et seq., the filing of the bankruptcy petition also triggers an automatic stay of all collection activities against the debtor and the debtor’s bankruptcy estate. Immediately upon the filing of the bankruptcy petition, the debtor’s bankruptcy “estate” is formed.
The bankruptcy “estate” is comprised of virtually all interests of the debtor, including, but not limited to, equipment, inventory, tangible property, cash, outstanding accounts receivable, unpaid contract balances, etc. When in doubt, a creditor of a bankrupt debtor should assume that the collateral in which the creditor claims an interest is part of the debtor’s bankruptcy estate.
What Should the Creditor Do Once a Bankruptcy Is Filed?
Upon receiving notice of the bankruptcy petition being filed, the creditor is prohibited from taking action to collect any debts from the debtor that arose prior to the case being filed. Said differently, until you can get advice from bankruptcy counsel:
- Stop contact: Automatic “robo” calls, standard collection calls, emails, letters, etc.
- Stop collections efforts: Litigation, foreclosure proceedings, enforcement actions, etc.
- Stop new contracting: Renegotiating contracts, refinancing, mortgage modifications, wage garnishment arrangements, payoff plans, etc. A creditor should not, however, terminate a contract with a debtor because a debtor files for bankruptcy.
What Can a Creditor Do in Order to Collect?
While the protections of the automatic stay are instantaneous, they are not indefinite. Through the filing of a motion for relief from stay, a creditor can ask the court for permission to pursue collection efforts against a debtor and specifically against an asset of the bankruptcy estate. For example, a mortgage creditor can ask for relief to foreclose on a piece of property that is “under water.” Likewise, a lender can request relief to repossess an under-secured asset like a vehicle. In each instance, the creditor must show the court that “cause” exists to lift the automatic stay.
Please click here to access a visual outlining the stay relief process and considerations that creditors should examine when determining whether to file a motion for stay relief.
In making the decision of whether or not “cause” exists to lift the stay, courts will look to a number of factors, including:
- Whether the collateral is properly insured;
- Whether the debtor is taking proper care to maintain the collateral;
- Whether the debtor has failed to pay taxes on the collateral;
- Whether the debtor is making interim payments on the collateral (i.e., adequate protection payments);
- Whether there is any equity in the collateral;
- Whether the collateral is needed for the debtor to reorganize (i.e., a mechanic who needs his mortgaged garage to repair cars and run his business);
- Whether the collateral is diminishing in value; and
- Whether the debtor is causing “undue delay” in the bankruptcy case.
If a debtor fails in any one of these categories, a court may find “cause” to lift the automatic stay. If the creditor’s motion for relief from stay is granted, the creditor can then proceed with all collection efforts vis-à-vis the collateral that is no longer subject to the automatic stay. It is critical that the creditor only proceed against that collateral that is specifically listed in the motion for relief and order granting same. If the creditor takes collection action against other property of the estate or the debtor personally, the creditor may still be sanctioned for violating the automatic stay.
Conversely, a court may deny a creditor’s motion for relief from the automatic stay. If so, the collateral remains part of the bankruptcy estate and subject to the protections of the stay. This means no foreclosures, no litigation, no repossessions, etc. Importantly, creditors can have more than one bite at the apple. A creditor whose motion is originally denied may file another motion for relief if, a few months into the bankruptcy, the debtor is, for example, still not making payments, destroying the property, or failing to maintain the required insurance.
In summary, creditors should heed the warnings given to them when it comes to dealing with debtors in bankruptcy. Indeed, it is better to ask a bankruptcy court for relief from the stay rather than forgiveness for violations of the stay. Why?