“Stay” Alert: Tips for Dealing with Bankruptcy Issues in Civil Litigation
By James E. Britton and Zachary J. Gregoricus
While the Bankruptcy Code, 11 U.S.C. §§ 101, et seq., affords honest debtors important relief from their financial burdens, it can be a cause of serious stress for attorneys unfamiliar with its twists and turns. With 500,000 new bankruptcy cases filed in 2023 alone, your civil litigation practice will very likely intersect with a bankruptcy matter eventually. Below are some general pointers to help civil litigators orient themselves in the bankruptcy environment.
Don’t Violate the Automatic Stay
Section 362 of the Bankruptcy Code, appropriately known as the “automatic stay,” acts as a stay of, among other things, the “commencement or continuation” of any “action or proceeding against the debtor that was or could have been commenced” before the bankruptcy filing date; the enforcement of any judgment issued prior to the filing date; any act to obtain possession of or exercise control over any property of the debtor’s bankruptcy estate; and any action to create, perfect, or enforce a lien against property of the estate. The stay goes into effect automatically upon the debtor’s bankruptcy filing (absent some extreme cases where the debtor may be a serial bankruptcy filer).
Any civil litigation in which the bankruptcy debtor was a defendant is stayed upon the bankruptcy filing; the debtor will likely file a “notice” (sometimes called a “suggestion”) of bankruptcy in the civil litigation, but the stay applies automatically. Similarly, a party generally cannot initiate suit after the debtor has filed if the action involves a preexisting claim. The stay is very broad and applies to any act that could be considered an attempt to collect a debt from the debtor—even sending demand letters can violate the automatic stay. Violations can carry serious consequences, including sanctions. Furthermore, any acts in violation of the stay will possibly become void, or voidable. Note, however, that only actions initiated against the debtor are stayed, while actions initiated by the debtor may continue as normal.
Once the action has been stayed, the debtor may attempt to remove it to the bankruptcy court, which can have jurisdiction over matters impacting the “property of the estate,” i.e., the debtor’s assets that might be distributable to its creditors. Alternatively, the debtor may let the action lie dormant while it focuses on its bankruptcy proceedings. In the former circumstance, civil litigation plaintiffs should be ready to contest the bankruptcy court’s jurisdiction to avoid litigating in a debtor-friendly forum or argue that the state or district court is best situated to resolve the dispute. In the latter scenario, plaintiffs will have to move for “relief” from the automatic stay in the bankruptcy court and satisfy the high bar of showing why their litigation should be allowed to recommence while the bankruptcy case is still pending.
Make Sure Your Client’s Contractual Rights Are Protected
If your client is a counterparty to a debtor in either a contract where material performance remains to be completed by both parties (“executory” contracts) or an unexpired lease, it is important to be aware of how the Bankruptcy Code may affect your client’s interests. Often a debtor will already be in breach of a contract or unexpired lease by the time it files for bankruptcy. The temptation may be strong to terminate the contract and make a clean break; however, the Bankruptcy Code provides that any contractual provision allowing for automatic or at-will termination in the event of bankruptcy is unenforceable, and the contract cannot be terminated without the consent of the debtor. Knowing what rights your non-debtor client does have with respect to their contract or lease is crucial.
The Bankruptcy Code allows a debtor to either assume (and in some cases assign) or reject executory contracts and unexpired leases. If assumed, the debtor must cure all outstanding monetary and nonmonetary defaults at the time of assumption. Non-debtor parties should therefore make sure that they are served with a notice of potential assumption and the debtor’s proposed cure amount. If you disagree with the proposed cure amount or believe that the debtor is also in non-monetary breach, you must file an objection in the bankruptcy court raising these issues.
The debtor also has the power to assign most unexpired leases and executory contracts to a third party. This can leave your client in the position of being forced to deal with a new counterparty to a carefully negotiated contract. You should be proactive in learning whether the debtor intends to assign your agreement, review the agreement for any argument that it would not be assignable under applicable non-bankruptcy law, and seek the identity of the potential assignee as soon as possible so your client can weigh its business options.
If the debtor rejects your executory contract or unexpired lease, the rejection is treated as a breach of contract occurring prior to the bankruptcy filing date. You therefore are entitled to file a “proof of claim” relating to the rejection.
Determine If and When You Need to File A Proof of Claim
Perhaps you have litigated a claim to judgment and the defendant subsequently files for bankruptcy, or your contract counterparty has breached your agreement and caused you damages in an undetermined amount before filing. Maybe you have a claim that hasn’t been reduced to judgment before the debtor files for bankruptcy, or the debtor rejects your contract in bankruptcy as outlined above. In these and other cases, you may need to file a proof of claim in the debtor’s bankruptcy case.
A proof of claim is a statement of the amount, priority, and nature of the debt that you or your client is allegedly owed by the debtor. If the debtor does not object to your proof of claim (or if the court overrules any objection to it), then your claim is deemed “allowed.” An allowed claim is essentially a ticket entitling you to share pro rata in the distribution of the debtor’s assets.
Depending on the circumstances of the claim and the type of bankruptcy case, failing to file a proof of claim could result in your debt being discharged, meaning any possibility of collecting on it is lost forever. In most Chapter 7 or Chapter 13 cases, a proof of claim needs to be filed within 70 days after the “order for relief” is entered by the bankruptcy court, of which creditors should receive notice. Fed. R. Bankr. P. 3002. In Chapter 11 cases, the debtor will propose a date for claims to be filed by and the court will enter an order approving it, of which creditors should also receive notice. While creditors who are accurately listed in the debtor’s schedules of assets and liabilities do not technically need to file a proof of claim to be paid, given the importance, creditors should be careful to make sure that their claim is accurate and that they are receiving notice of the claims deadline in the event that it is not.
Determine Whether Your Client’s Claim Is Excepted From Discharge or Whether the Debtor Should Be Denied a Discharge
If you represent a creditor, it is essential to determine whether your client’s claim is excepted from discharge or whether the debtor’s discharge should be denied. A key feature of bankruptcy is that, generally, the debts of a debtor are discharged and the debtor obtains a “fresh start.” Certain debts, however, will not be discharged in a bankruptcy case filed by an individual. Specifically, Section 523(a) of the Bankruptcy Code sets forth 20 categories of debts that are excepted from a debtor’s discharge, including debts: (i) for money, property, or services obtained by false pretenses, a false representation, or actual fraud; (ii) for domestic support obligations, i.e., for child support and alimony; and (iii) caused by the debtor’s willful and malicious injury to your client or your client’s property. If your client’s claim falls under Section 523(a), you must commence an adversary proceeding asserting that your client’s claim be excepted from the debtor’s discharge within the deadline set by the Bankruptcy Court.
A debtor’s discharge may be denied pursuant to Section 727(a) of the Bankruptcy Code if the debtor has been determined to have engaged in certain conduct unbecoming of an honest but unfortunate debtor. For a debtor’s discharge to be denied, a party in interest, including the United States Trustee, a Chapter 7 Trustee, and a creditor, must commence an adversary proceeding against the debtor objecting to the debtor’s discharge under one of the several subsections set forth in Section 727(a). For example, a debtor’s discharge will be denied if the debtor transferred or concealed property within one year of the petition date with the intent to hinder, delay, or defraud their creditors. A debtor’s discharge will also be denied if they have destroyed, falsified, or failed to keep or preserve their financial books and records. It will also be denied if they knowingly and fraudulently made a false oath in connection with their bankruptcy case, which includes false statements made at their Section 341 Meeting of Creditors and in their Schedules or Statement of Financial Affairs.
A useful tool for creditors is Rule 2004, oft called a “fishing expedition,” which can, upon motion, allow a creditor to examine the debtor under oath about their assets, liabilities, and financial affairs or to issue a document subpoena to the debtor. As such, a Rule 2004 Examination of the debtor will set the stage in determining whether your client’s claim can be excepted for discharge pursuant to Section 523 or whether the debtor’s discharge should be denied pursuant to Section 727.
Conclusion
Navigating the bankruptcy arena requires vigilance and a comprehensive understanding of its complex provisions. By adhering to key practices such as respecting the automatic stay, protecting contractual rights, timely filing proofs of claim, and determining whether a debtor is entitled to a discharge, civil litigators can mitigate the risks and challenges posed by bankruptcy proceedings, while safeguarding their clients’ interests and maintaining compliance with the Bankruptcy Code. As bankruptcy filings continue to intersect with civil litigation, staying informed and prepared is more crucial than ever.
Zachary J. Gregoricus is an associate in Murtha Cullina LLP’s Litigation and Bankruptcy & Creditors’ Rights Practice Groups, where he routinely serves as counsel to Chapter 7 trustees and creditors in complex bankruptcy cases, adversary proceedings, and contested matters.
James E. Britton is an associate in the bankruptcy and restructuring group of ArentFox Schiff LLP. James also serves as the communications chair for the Bankruptcy Law Section of the Boston Bar Association.
