September 2013: Bankruptcy & Restructuring Litigation Update - Second Circuit Addresses the Scope of the Bankruptcy Automatic Stay.

by Quinn Emanuel Urquhart & Sullivan, LLP

The automatic stay triggered upon the filing of a voluntary bankruptcy petition is one of the fundamental protections available to a debtor. The automatic stay generally prohibits “the commencement or continuation ... of a judicial, administrative, or other action or proceeding against the debtor” and bars “any act to obtain possession of property of the estate.” 11 U.S.C. § 362(a). This benefit is intended to give the debtor a breathing spell and brings all of the assets of the debtor and claims against it into a single forum, the bankruptcy court, for resolution.

The automatic stay is a “debtor” protection. The literal language of § 362(a) does not extend the automatic stay to non-debtor entities that have not commenced bankruptcy cases but that may be affiliated with the debtors. Some courts have nevertheless interpreted § 362(a) to protect a non debtor where continuing a lawsuit against it would impede the debtor’s orderly reorganization or liquidation; other courts have invoked their equitable power under 11 U.S.C. § 105(a) to achieve the same result. But the scope of a bankruptcy court’s authority to enjoin actions against a non debtor is far from settled. A recent decision by the Second Circuit, In re Residential Capital, LLC, --- Fed. Appx. ---, 2013 WL 3491311(2nd Cir. July 15, 2013), declined to impose a per se rule against the imposition of the automatic stay in favor of a non-debtor and instead determined that a case-by-case assessment is necessary to determine the applicability of the automatic stay to a non-debtor.

Residential Capital, LLC and its affiliate debtors (the “Debtors” or “ResCap”) were one of the largest originators and servicers of residential mortgage loans in the country. Residential mortgage-backed securities issued by ResCap depreciated in value as a result of the 2007-2008 financial crisis. These market losses prompted the filing of a number of lawsuits against ResCap, their corporate parents and/or their officers and directors. On May 14, 2012, the Debtors filed their petitions for relief under Chapter 11 of the Bankruptcy Code with the United States Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”), citing exposure to these lawsuits as a reason for the bankruptcy filing.

One of the lawsuits against ResCap was commenced by the Federal Housing Finance Agency (“FHFA”). In addition to naming the Debtors as defendants, FHFA also sued certain direct and indirect corporate parents and an affiliate of the Debtors (the “Non-Debtor Defendants”). FHFA removed the Debtors as defendants and sought to continue the lawsuit against the Non-Debtor Defendants. The Debtors in turn moved the Bankruptcy Court to enter a declaratory judgment extending the automatic stay to the Non-Debtor Defendants under both §§ 362(a) and 105(a), even though the Debtor Defendants were no longer part of the lawsuit.

The United States District Court for the Southern District of New York (the “District Court”) withdrew the Debtors’ motion from the Bankruptcy Court and assumed jurisdiction. In a bench decision, the District Court denied the Debtors’ motion. The District Court reasoned that because FHFA did not continue the lawsuit against the Debtors, the property of the bankruptcy estates was not at risk; as a result the automatic stay under § 362(a) could not as a matter of law be extended to the Non-Debtor Defendants.

The Debtors appealed to the Second Circuit, arguing that continuation of the proceeding against the Non-Debtor Defendants would nonetheless impede the Debtors’ prospects for successful reorganization. The Debtors argued they would bear the burden of discovery because the documents sought by FHFA were in their possession, and the extensive depositions to which the Debtors’ key personnel would be subject could distract them from focusing on the Chapter 11 process. The Debtors further cited their contractual liability to indemnify the Non-Debtor Defendants for legal costs and any judgment and potential depletion of insurance coverage available to the Debtors as the Debtors and the Non-Debtor Defendants were co-insureds under a number of policies that had a first billed, first paid provision.

The Second Circuit agreed, concluding the District Court erred by failing to make factual findings and holding as a categorical matter that the automatic stay set forth in § 362(a) cannot be applied. 2013 WL 3491311 at *1 (“[There] are no explicit findings with regard to ResCap’s request under Section 362(a).”). The Second Circuit relied upon preexisting Circuit case-law which applied the automatic stay to a debtor’s wholly owned subsidiary on the basis that “a claim against the non-debtor will have an immediate adverse economic consequence for the debtor’s estate.” Id. (quoting Queenie, Ltd. v. Nygard Int’l, 321 F.3d 282, 287 (2d Cir. 2003)). The Second Circuit remanded the case to the District Court and requested that the appropriate fact-findings be entered within 60 days. Id. It expressed no view on whether the Non-Debtor Defendants are entitled to have the lawsuit against them enjoined. Id. (“[W]e do not have to reach that question until” until the requisite findings are made).

The decision confirmed that the automatic stay may be extended to a non-debtor if permitting the litigation to continue against it would impose an “immediate adverse consequence” on the estate. A party to a lawsuit with both debtor and non-debtor defendants cannot avoid application of the automatic stay by simply dropping the debtor defendants and proceeding with the action against the non-debtor entities in lieu of the debtor entities. This decision further clarifies that the Second Circuit’s application of the automatic stay to a non-debtor on the basis of “immediate adverse consequence” to the estate is not necessarily limited to the context of where the non-debtor is a wholly owned subsidiary of the debtor.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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