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Section Review

The Automatic Stay in Multi-party Transactions

Most litigators know that the filing of a bankruptcy petition ("petition for relief") imposes an automatic stay under section 362 of the Bankruptcy Code.1 That stay is Congressionally imposed, protects the debtor (or, in the case of chapter 13, guarantors also), and is triggered by the filing of a voluntary or involuntary petition. The stay restrains various activities, including "the commencement or continuation, including the issuance or employment of process, of a judicial, administrative, or other action or proceeding against the debtor….; the enforcement, against the debtor or against property of the estate, of a judgment….; any act to collect, assess, or recover a claim against the debtor which arose before the commencement of the case under this title…." And so on. The automatic stay on its face only applies to the debtor and the debtor's property and would not ordinarily apply to entities jointly liable with the debtor, such as co-defendants, guarantors or sureties (with the Chapter 13 exception indicated above).
In the typical litigation case - one plaintiff, one defendant - the effect of the bankruptcy petition seems self-evident: if the defendant is the subject of a bankruptcy petition, the case grinds to an immediate halt. Usually one of the parties files a "suggestion of bankruptcy" to alert the trial court, but the stay becomes effective immediately, even without such a filing. If the plaintiff is the subject of the bankruptcy petition, the case continues, perhaps with a trustee or debtor-in-possession substituted for the plaintiff.
That's the quick survey, but complications arise easily enough.2 What if there are multiple defendants, and only one of them is in bankruptcy? What exactly does it mean to stay a multi-party case against fewer than all the parties? What if the defendant had filed a counter-claim, or needs to file one now? Does only half the case continue? What if the non-bankrupt parties include subsidiaries, parents, officers, directors (or even, heaven forfend, counsel) to a debtor? Must the case continue against them, even though the debtor is immune, at least for a while, from being subject to litigation?
This article presents an overview of some of these issues, and was originally prepared in connection with seminars taught by the author. It has been updated for the MBA.
A. Overview
With respect to the stay of actions involving multiple parties, the law is inconsistent. The Courts have generally articulated the concept that a stay of actions against non-debtor co-defendants should be limited to cases of unusual hardship, but the determination of what constitutes such uniqueness does not lead to a consistent line of decisions. Courts weigh imponderables like "fairness", direct or indirect impact on the debtor (such as if the result of a trial against non-debtor defendants will create or enhance claims against the debtor), and hardship. The inconvenience or disruption to a debtor if a suit proceeds against other defendants, especially if the non-debtor defendants are themselves corporate officers of the debtor whose time and attention is needed to manage the reorganization of the Chapter 11 debtor, is a frequent concern.
Following are the highlights of cases in this area. Note that in all cases, the Courts treat Sections 105 and 362 as virtually interchangeable, and do not spend much time analyzing whether a particular action sounds under an extension of the automatic stay, or under Section 105. Ultimately the question almost always comes down to the impact on the debtor; once a Court decides that particular litigation has a significant negative impact, its decision will proceed from there, whether under Section 105 or 362.
The strictest reading of the automatic stay probably is reflected in Maritime Electric Co., 959 F.2d 1194 (3rd Cir. 1991), where the Court invalidated the results of an entire trial that had occurred in the United States District Court in the face of a pending Chapter 13 of one of the defendants. The Court's invalidation, however, extended only to the particular defendant who had been the subject of a bankruptcy proceeding, and all other components of the proceedings, including judgments based on counterclaims, were enforced against the hapless plaintiffs. To the same effect, see McCartney v. Integra Nat'l Bank North, 106 F.3d 506 (3rd Cir. 1997); see also Maritime Electric Co., Inc., 959 F.2d 1194, 1205 (3d Cir. 1991). In Lynch v. Johns-Manville Sales Corp., 710 F.2d 1194 (6th Cir. 1983), the Court declined to stay a tort action against non-debtor co-defendants. Although the Court pointed out incidentally that under federal law, joint tort-feasors were not indispensable parties under F.R. Civ. P. 19 (addressing itself to the impact of the absence of the debtor from the suit), it seems that even if the debtor were an indispensable party the decision would not have been different. The Lynch Court also gave the back of its figurative hand to the argument that multiple litigation, i.e., one suit against the non-debtor defendants and another against the debtors later (perhaps in the Bankruptcy Court), would be duplicative; rather it pronounced that duplication is a by-product of having a Bankruptcy system at all, and that it was therefore just a fact of life in the bankruptcy world. Interestingly, the Court seemed to accept the premise that the automatic stay would preclude non-debtor defendants from taking discovery from the debtors, but suggested that at the right time a Court could be asked for permission to take discovery. 710 F.2d at 1199-1200. In an extensively reasoned decision, a District Court refused to enjoin a proceeding against the non-debtor defendant, even though the debtor might have been an indispensable party under F.R.Civ.P. 19. The Court pointed out that Rule 19(a) describes persons who should be "joined if feasible," and that if a person described in Rule 19(a) cannot be made a party, a suit can continue nevertheless. Royal Truck & Trailer v. Armadora Maritima Salvadorena, 10 B.R. 488 (Dist.Ct.N.D.Ill. 1981); accord, Mass. State Carpenters Pension Fund v. Atlantic Diving Co., 635 F.Supp. 9,15 (D.Mass. 1984).
The Bankruptcy Court will generally not enjoin suits against non-bankrupt co-debtors even if a result of that suit - such as one against the principal of a debtor - could have the indirect effect of "pressuring" the debtor. In re A.J. Mackay Co., 50 B.R. 756 (Dist. Ct. Utah 1985). Also showing virtually no sympathy to enforcing the automatic stay against non-debtor defendants was the Court in In re Related Asbestos Cases, 23 B.R. 523 (Dist.Ct.N.D.Cal.1982), which relied in part on the fact that Congress had provided for stays against non-debtors in Chapters 12 and 13, but not elsewhere. 23 B.R. at 528. See also Maritime Electric Co., supra.
The Court in In the matter of Provincetown Boston Airline, 52 B.R. 620 (M.D.Fl. 1985) reiterated that there were ordinarily only two instances when enjoining of a suit against non-debtors was justified: where the defendant is a principal of a debtor and a key person who must be allowed to devote his or her full time and energy to the debtor, and when the non-debtor was going to use his or her own assets to fund a plan in Chapter 11. See In re 1600 Pasadena Offices, ltd., 64 B.R. 192 (M.D. Fl. 1986); In re MacDonald Associates., Inc., 54 B.R. 865 (D.R.I. 1985). In In re Lion Capital Group, 44 B.R. 690 (S.D. N.Y. 1984), a Court, pursuant to section 105, stayed actions against a debtor's principals for the reason that the plaintiffs had admitted that they intended to use the results of the litigation to preclude the debtor from relitigating the same issues, but that same Court stated that it would not have stayed the action merely because of an indirect (although significant) impact on the debtor . A number of courts have also enjoined suit against a non-debtor under the general premise that suit should not be permitted when it threatens the possibility of successful reorganization, see In re Lazarus Burman Asscs., 161 B.R. 891, 898 (E.D. N.Y. 1993); In re Otero Mills, 25 B.R. 1018 (D. N.M. 1982), or where the results of the litigation against non-debtors will have a direct impact on the economic or legal rights of the debtor. In re Macdonald/Associates, supra.. The Court on the other hand refused to enjoin an action against principals or officers of the debtor on their guarantees where there was no showing that the officers were themselves to be the source of funding of a Plan. In re Keyco, 49 B.R. 507 (E.D N.Y. 1985).
A District Court reversed a Bankruptcy Court which had stayed an action against a non-debtor guarantor and pointed out that a stay of an action was the exception, not the rule. The District Court concluded that if the plaintiff were successful, the only result would be to substitute the claims of a guarantor for the claim of the creditor against the debtor, and that that difference did not mandate a suspension of the litigation.3 In re Brentano's, 36 B.R. 90 (Dist. 36 B.R.90 (Dist. Ct. S.D.N.Y. 1984). For a particularly fervent declaration against granting stays of actions against principals of debtor corporations. See In re Apollo Molded Products, Inc., 83 B.R. 189 (D.Mass. 1988) (Queenan, B.J.). Accord, In re Venture Properties, 37 B.R. 175 (D.N.H. 1984); In re Brookfield Tennis, 29 B.R. 1 (E.D.Wis. 1982). Compare with A.H. Robins Co. v. Piccinin, 788 F.2d 994 (4th Cir. 1986), below at p.11. The Courts have been willing to acknowledge there are cases where a suit against a co-debtor or guarantor will significantly harm the debtor, e.g., In re Codfish Corp., 97 B.R. 132 (D.P.R. 1988) where the Court stayed an action against the principal of the debtor after finding that the expertise of the principal was the debtor's only asset, and was irreplaceable.
In short, the courts have found that a non-debtor or debtor must prove significant harm to the debtor or its assets in seeking to enjoin suits against individuals, and that the standard is to the same extent of severity as any request for injunctive relief under F.R.Civ.P. 65. E.g., In the matter of Electronic Theatre Restaurants Corp., 53 B.R. 458 (Dist.Ct.N.D.Ohio 1985); In re Tarricone, 77 B.R. 430 (S.D.N.Y. 1987). In a case that probably tests the limits, the Second Circuit held that a landlord violated the automatic stay by trying to terminate its lease with a non-debtor lessee, because the impact of that termination would be to destroy the tenancy of that lessee's subtenant, which subtenant was in bankruptcy proceedings. In re 48th Street Steakhouse, Inc., 835 F.2d 427(1987). See also, In re Atlantic Business and Comm. Corp., 901 F.2d 325 (3d Cir. 1990).
The First Circuit has joined the group of Courts expressing disinclination to stay suits just because one defendant has filed a bankruptcy. Austin v. Unarco Industries Inc. 705 F.2d 1 (1983), followed in Lynch v. Johns-Manville Sales Corp., 710 F.2d 1194, supra. In Austin™ one of two codefendants who had won their case in the trial court filed a bankruptcy petition while the plaintiff's appeal was pending before the First Circuit. The non-debtor defendant then asked the Court to stay the proceedings under ß362 or ß105. The First Circuit found that joint tort-feasors were not indispensable parties under federal law, and further found that judicial economy and fairness did not mandate staying the proceedings, since for a stay of the proceedings there would have to be a finding of "a clear case of hardship." Rather, the Court found that a stay of litigation would, if anything, be a hardship on the plaintiff, whose witnesses were dying.
The massive tort cases, however, seem to have developed a slightly more flexible body of law in that the courts have more readily agreed to stay actions against non-debtor parties than in other situations. In one of the A.H. Robins cases, for instance, the plaintiffs had simultaneously sued Aetna Casualty & Surety Company in tort. In seeking to pursue the litigation against Aetna, the plaintiffs cleverly agreed not to pursue the insurance proceeds of the debtor, not to take discovery of the debtor's officers, directors, or employees, and not to pursue the debtor generally. Furthermore, in the particular jurisdictions involved, the Court assumed that there was no doctrine of comparative negligence, contribution or indemnity among joint tort-feasors, so the impact of the suit on the debtor, the plaintiffs maintained, would be nonexistent. Nevertheless, the Court pointed out that the suit "would exhaust the energies" of the corporate officers, and also that Aetna could later file a claim against the debtor. The Court therefore, at the behest of Aetna, enjoined the action against Aetna under Section 105. In re A.H. Robins Co., 828 F.2d 1023 (4th Cir. 1987). A particularly interesting sidelight to that case was the fear expressed by the plaintiff that the statute of limitations against Aetna might expire because of the court-imposed stay, but the Court responded, citing no authority, that the statute of limitations against Aetna would doubtless be tolled by the debtor's bankruptcy since it was Aetna itself which sought to take advantage of the stay. 828 F.2d at 1026. The Courts themselves sometimes distinguish large tort cases based on their very immensity. E.g., Morgan v. Kobrin Securities, 649 F.Supp 1023, 1032 (N.D.111. 1986).
One of the most frequently cited cases in this area is A.H. Robins Co. v. Piccinin 788 F.2d 994 (4th Cir. 1986), in which the Court agreed that the protection of non-debtor parties should occur only in "unusual situations." The Court then found such an unusual situation existed because there was such an identity between the debtor and the non-debtor defendants that the debtor in essence was the real party defendant. For example, the Court was particularly concerned about the res judicata effects of the suits against the third parties, because of the debtor's obligation to indemnify them. But see In re Brentano's, 36 B.R. 90 and other cases cited above. See also, McCartney v. Integra Nat'l Bank, 106 F.3d 506, 511, supra.; In re American Family Centers, 256 B.R. 377 (D. N.J. 2000).
The Court in Robins v. Piccinin also found that insurance contracts were property, although there is some language - not as clear as it might have been - that if there had been enough insurance to cover all possible claims the issue of insurance contracts as property of the estate might not have loomed as large an issue. The Court accordingly enjoined actions against the following: (1) Co-defendant producers and dealers; (2) employees, agents and officers; (3) direct action lawsuits against insurance companies. Accord, Seybolt v. Bio-Energy of Lincoln, 38 B.R. 123 (D. Mass. 1984). Fully agreeing that liability policies were assets of the debtor and hence subject to the stay are the Second Circuit and our own Circuit. McArthur Co. v. Johns-Manville Corp., 837 F.2d 89 (2d Cir. 1988); Tringali v. Hathaway Machinery Co., 796 F.2d 553, 560-61(1st Cir. 1986).
Also in the context of mass claims, although not necessarily tort, is a case in which the Court stayed collection suits by health care providers against patients of a bankrupt HMO, where ordinarily the HMO had reimbursed those providers directly. In re Family Health Services, 21 C.B.C.2d 1377 (C.D. Cal. 1989). A District Judge agonized considerably before enjoining the continuation of a suit against principals of Baldwin-United, but did so only after concluding that the Bankruptcy proceedings of Baldwin-United were so far along that the results of, and investigation undertaken in, the Bankruptcy proceedings would be of use to all parties - a sort of informal discovery process. He also found that the allegations described acts in which the debtors and non-debtors were inextricably involved with each other, and that the duplication between debtor and non-debtor interests would be particularly exacerbated by the discovery process. Even so, he severely limited the duration of his own injunction. Stoller v. Baldwin-United, 41 B.R. 884 (Dist.Ct.5.C.Ohio 1984).
One tip: As a practical matter, in less complicated cases it is customary for the parties to stipulate that where a debtor is not the true target, a suit can continue against the debtor provided that no effort will in fact be made to collect any judgment other than through the processes of the Bankruptcy Court. For language in support of the principle behind such stipulations, see In re Catania, 94 B.R. 250 (D.Mass. 1989); In re Mann, 58 B.R. 953 (W.D.Va. 1986). A caution, though: the automatic stay was created by Congress, and only a Court can alter it: relief from stay cannot be granted by stipulation; it can only be requested by stipulation. Commerzanstalt v. Telewide Systems, Inc., 790 F.2d 206 (2d Cir. 1986).
B. Appeals and counterclaims
In determining whether to enjoin the continuation of an appeal, a Court reviews the underlying configuration of the case, and not the determination as to which side is the appellee, and which the appellant. Thus, an appeal by a debtor of an action commenced against the debtor is itself covered by the automatic stay. See Farley v. Henson, 2 F.3d 273, 275 (8th Cir. 1993); TIAA v. Butler, 803 F.2d 61 (2nd Circuit 1986); Cathey v. Johns-Mansville Sales Corp., 711 F.2d 60, supra; Ingersoll-Rand Financial Corp. v. Miller Mining Co., 817 F.2d 1424 (9th Cir. 1987). Where a counterclaim is filed by a debtor-defendant against a non-debtor plaintiff, does this mean that the debtor's counterclaim would be allowed to continue against the original plaintiff, but that the original suit could not proceed against the original defendant (now the debtor)? Strictly speaking, that is what ß362 says, but if the methodology determining the progress of appeals is followed as described above, i.e., that the characteristic of a case is measured by its underlying configuration, then the entire action should be stayed.

C. Counsel fees
It is not a violation of the automatic stay for counsel who is representing a debtor but who is being paid by the debtor's insurance company to demand payment of his fees in connection with representation of the debtor in litigation, at least where the commitment was one which was originally enforceable as between the insurance company and counsel. In re A.H. Robins Co., 846 F.2d 267 (4th Cir. 1988).
D. Violations of stay
Actions taken in violation of the stay are, generally, void even if there was no notice received of the bankruptcy. E.g., In re Eisenberg, 3 C.B.C. 2d 440 (E.D.N.Y. 1980) (and cases cited); see Burns v. Burns, 112 B.R. 763 (E.D. Va. 1990); In re Shamblin, 890 F.2d 123 (9th Cir. 1989); In re Miller, 4 C.B.C.2d 530 (D.Md. 1981). But see, Sikes v. Global Marine, Inc., 881 F.2d 176 (5th Cir. 1989). In one case the action taken was not avoided where the debtor affirmatively hid the fact of being in bankruptcy. In re Smith Corset Shops, 696 F.2d 971 (1st Cir. 1982); see also Easley v. Pettibone Michigan Corp., 990 F.2d 905, 911-12 (6th Cir. 1993).
A stay generally does not apply to strictly post-petition events. Holland America Ins. Co. v. Succession of Roy, 777 F.2d 992 (5th Cir. 1985); Grady v. A.H. Robins Co., 839 F.2d 198 (4th Cir. 1988) (dictum).Note that the automatic stay does not protect non-debtor parents, be they human or corporate, of a debtor. It also doesn't directly apply to non-debtor subsidiaries of a debtor parent, but since the stock of a subsidiary is itself an asset of the debtor, it isn't too difficult to hypothesize some courts determining that certain actions against subsidiaries (a receivership, for example) are so drastic that they ought to be stayed, at least under ß105, because of the impact on that asset which is under the court's control, i.e., the stock itself. For an example of this reasoning, see In re Stadium Management Corp., 95 B.R. 264 (Dist.Ct.D.Mass. 1988).
E. Channeling
A post-petition type of stay has been developed in some large bankruptcy cases involving hundreds, or thousands, of creditors. Using the authority of Section 105, Bankruptcy Courts have approved the creation of trust for, e.g.,, asbestos victims, both present and future. The major key to the appropriateness of such a trust was that all claims, even future ones, be channeled to the trust and not against the debtor, its affiliates, or insurance companies.
In such cases Courts enjoin acts by holders of claims, directing that all such holders channel their claims into the trust. The Courts have used as their analogy other areas of law which sound like channeling, such as the right of a Bankruptcy Court to authorize the sale of assets subject to a lien, and then direct that the lien follow the proceeds. In the Matter of Johns-Manville Corp., 68 B.R. 618 (1986), aff'd, 78 B.R. 407 (Dist. Ct. S.D.N.Y. 1987), aff'd sub. nom., Kane v. Johns-Mansville Corp., 843 F.2d 636 (2d Cir. 1988). The Second Circuit's discussion of channeling is more exhaustive in McArthur Co. v. Johns-Manville Corp., supra, 837 F.2d 89. To the same effect is In re A.H. Robins Co., 880 F.2d 694 (4th Cir. 1989). For a thoughtful and thorough analysis of "channeling" in a case where the Court found facts insufficient to justify channeling (and where the Court withheld opining as to whether channeling is legal to begin with), read In re Salem Suede, 219 B.R. 922 (Mass. 1998).
End notes

1. All references in this article to "Sections" are to 11 U.S.C., the Bankruptcy Code, unless otherwise indicated.[back]

2. Practitioners should also pay attention to section 105, which provides the authority for a Court to grant injunctions against acts or individuals, even under circumstances not explicitly encompassed by section 362.[back]

3. Under 11 U.S.C., ß502(e)(1)(B), one who is liable to a third party with a debtor, such as a guarantor or indemnitor, cannot have its claim allowed against the debtor until it actually pays the third party.[back]

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