Bankruptcy Basics: What Every Litigator Should Know

The Bencher—September/October

By Magalie A. Creech, Esquire

Having an understanding of general bankruptcy law is an essential tool in litigation for the general practitioner. It can provide a basis for important strategy decisions, bring about meaningful settlement discussions and, where appropriate, offer a viable exit plan. The Bankruptcy Code is complex, and the case law is nuanced. This article is intended to provide litigators with an overview of bankruptcy law, but discussing specific alternatives with a local bankruptcy practitioner is crucial. Knowing when to take that step and understanding available options are some of the questions this article seeks to answer.

The Automatic Stay

When many lawyers learn that a defendant has filed for protection under the Bankruptcy Code, they share a common reaction: Does this mean my client’s case is effectively over? While the filing does mean the action is stayed to the extent it seeks damages from the debtor or property belonging to the debtor, it is not necessarily a death-knell for the case. This is what is known as the automatic stay and is probably the most recognized aspect of bankruptcy. (See 11 U.S.C. § 362.)

Upon the filing of a voluntary petition for relief that commences a bankruptcy case, with limited exceptions, the automatic stay arises automatically to stop all actions against the debtor and against property of the bankruptcy estate. (See 11 U.S.C.S. § 362(a)(1) and (3).)

The automatic stay has three basic purposes: to provide the debtor a breathing spell from his or her creditors by stopping all collection efforts, to protect creditors from each other by stopping the race for the debtor’s assets and preserving the assets for the benefit of all creditors, and to provide for an orderly liquidation or administration of the estate. See Prewitt v. N. Coast Vill., Ltd. (In re N. Coast Vill., Ltd.), 135 B.R. 641, 643 (9th B.A.P. Cir. 1992). The filing of a bankruptcy petition creates a bankruptcy estate, which includes all legal and equitable interests of the debtor in property as of the commencement of the case.

The most common types of bankruptcy cases are Chapter 7 liquidations, Chapter 11 reorganizations, and Chapter 13 reorganizations. What type of action a debtor files will depend on the debtor’s debt, income and assets, and whether the debtor is an individual or a corporate entity.

It is important to note that the stay suspends covered actions regardless of notice to the affected parties. Normally, a creditor will not be penalized for inadvertent violations of the automatic stay, even though actions taken in violation of the stay are void (or voidable) as a matter of law. (There is a split among the circuits as to whether an action taken in violation of the automatic stay is void or voidable.)

A bankruptcy court may assess damages, attorneys’ fees, and punitive damages against a party who willfully violates the automatic stay. For that reason, it is important to check whether your defendant is in an active bankruptcy case if you are about to file a lawsuit on behalf of a client. The Public Access to Court Electronic Records System (PACER) allows you to search all bankruptcy cases filed throughout the country by debtor last name, social security number, or case number.

One distinction is that the automatic stay does not stay proceedings commenced by the debtor. If you represent the debtor in such a case, it is important to keep the debtor’s bankruptcy counsel apprised of the case’s progress because the debtor may have to make or modify certain disclosures to the bankruptcy court.

Co-Debtor Stay

The filing of a Chapter 13 case also triggers a stay of actions against persons who are jointly and severally liable for consumer debt with the debtor. The co-debtor stay comes into effect automatically when a Chapter 13 petition is filed, regardless of whether the co-debtor is a party to a bankruptcy case. The purpose of the co-debtor stay is “to simultaneously preserve the substantive rights of creditors and to preserve the fresh start of the debtors by preventing indirect collection practices.” In re Cooper, 116 B.R. 469, 472 (Bankr. E.D. Va. 1990) (citing H.R. Rep. No. 595, 95th Cong., 1st Sess. 122, reprinted in 1977 U.S. Code Cong. & Admin. News 6082).

While the co-debtor stay serves to prevent indirect pressure or coercion against co-signors who are usually friends or relatives of the debtor, it is not intended to protect the co-debtor and offers him or her no relief under bankruptcy laws. There is no co-debtor stay in any other chapter of the Code.

Repeat Filers

Has your defendant filed for bankruptcy more than once? Section 362(c)(4)(A)(i) of the Bankruptcy Code provides if a debtor had two or more bankruptcy cases pending within the previous year that were dismissed, then the automatic stay shall not go into effect upon filing of the next case. Make note of this when checking PACER, as it could mean that there is no stay in place and you can proceed with litigation. A party in interest can move to request an order from the bankruptcy court confirming that no stay is in effect. It may be helpful in such a situation to obtain a “comfort order” to show that the stay is not in effect, as state courts are understandably cautious when the defendant has an active bankruptcy case.

Stay Relief, Continued Litigation, and Removal

What is a plaintiff to do when the automatic stay goes into effect? The plaintiff may seek relief from the automatic stay, elect to proceed exclusively against the remaining co-defendants, or remove the suit to the bankruptcy court under 28 U.S.C. § 1452 and Federal Rule of Bankruptcy Procedure 9027.

Relief from the stay may be granted for cause. The Code does not define the term “cause,” which gives the court significant discretion in granting relief from the stay. The court must balance the interests of the moving party and the bankruptcy estate in determining whether stay relief is appropriate. Whether you should seek stay relief may depend on the timing of the motion, in addition to the basis for the request; consulting with a bankruptcy attorney in this situation is recommended.

If you are able to demonstrate grounds for relief from the automatic stay and the motion is granted, then the stay terminates as to that claim and you can proceed with applicable state court remedies. However, any judgment obtained must be returned to the bankruptcy court for enforcement. This is another reason why discussing stay relief measures with a bankruptcy attorney is critical.

The stay will not protect the other defendants in the case who are not in bankruptcy. If the plaintiff elects to proceed against the other defendants only, the stay will not prevent discovery against the debtor as a witness. Determining whether it makes sense to essentially “give up” on the debtor-defendant and proceed against the remaining co-defendants will depend on a number of factors. How strong is the case against the debtor? If successful, is the claim against the debtor dischargeable? What type of case is the bankruptcy, and is the debtor financially viable notwithstanding the bankruptcy? In most instances, if the claim was worth prosecuting to begin with, choosing not to proceed against the debtor-defendant is a nonstarter. If you are not able to get stay relief, then the next option to consider is removal.

Under 28 U.S.C. § 1452, any party to the state court lawsuit has the right to remove it to bankruptcy court. If the case is removed, it can be tried either in the district court in which the bankruptcy court is located or in the bankruptcy court as an adversary proceeding. Litigators who are unfamiliar with the bankruptcy court and its procedures may be reluctant to remove a case, which debtor-defendants can use to their advantage in settlement negotiations. Nevertheless, removal is important to consider because it may be your best option—especially if a defendant files for bankruptcy on the eve of trial.

Dischargeability and Payment of Claims

Is the claim dischargeable? Is the claim secured or unsecured, and how will it be paid? These questions weigh heavily when considering litigation strategy. The discharge will eliminate a debtor’s personal liability for the debt but, in the absence of a court order, a lien securing such debt will survive the discharge. The lien supporting a discharged debt will not attach to assets acquired by the debtor after the discharge. Section 523(a) of the Bankruptcy Code sets forth certain obligations that Congress deems excepted from a debtor’s discharge. These typically involve claims with willful or fraudulent elements such as conversion, breach of fiduciary duty, and intentional torts.  

It is generally up to the holder of the claim to object to its dischargeability in the debtor’s bankruptcy case. This is typically done by filing an adversary proceeding. (See Fed. R. Bankr. P. 7001(6)). Rule 4005 of the Federal Rules of Bankruptcy Procedure provides that the plaintiff has the burden of proof in objections to discharge. Proof must be made by a preponderance of the evidence. There are important deadlines for dischargeability objections, so it is imperative that a creditor closely monitor the bankruptcy case. This proceeding simply determines whether or not the claim is dischargeable; the merits of the claim have either been previously adjudicated or will be adjudicated during the bankruptcy. If the merits of the claim have not been adjudicated, the time and expense of what amounts to two lawsuits is considerable motivation for both parties to discuss resolution options.

Another concern is how a claim will be paid. Claims usually fall into one of three categories in individual bankruptcy cases: priority unsecured debt, secured debt, and general unsecured debt. Priority unsecured claims include domestic support obligations, recent wage claims, and recent taxes, and they are not dischargeable. Secured claims are for debts secured by an interest in property. Secured claims must be paid in full if the debtor wants to keep the collateral, but there are exceptions depending on the type of case, nature of the collateral, and exemptions available to the debtor. The same is true regarding the dischargeability of secured debts. This is another reason why conferring with local bankruptcy counsel early on is recommended. General unsecured claims without priority generally share available distribution pro rata.

The Discharge Injunction

The automatic stay will terminate when property is no longer property of the estate. The debtor and his or her assets are then protected by the discharge injunction. 11 U.S.C. § 524(a) operates as an injunction against any action to collect or recover a discharged debt as a personal liability of the debtor. A discharge under 11 U.S.C. § 1328(a) extinguishes a debtor’s personal obligation to pay the discharged debt. The underlying debt remains notwithstanding the discharge. See Johnson v. Home State Bank, 111 S.Ct. 2150 (1991).

In this sense, the “bankruptcy discharge extinguishes only one mode of enforcing a claim—namely, an action against the debtor in personam—while leaving intact another—namely, an action against the debtor in rem.” Thus, if a creditor does not have an in rem interest in a debtor’s property or if that interest was voided in bankruptcy, the creditor simply has a debt with no right to collect from the debtor or his or her property. This is confirmed by the Bankruptcy Code, which recognizes that a debt, although discharged, may still be repaid by a debtor.

To hold a creditor in contempt for violating the discharge injunction, a debtor must show that the creditor “willfully” violated the discharge injunction. In 2019, the Supreme Court held that the correct test of what constitutes a “willful” violation of the discharge injunction is whether “there is no fair ground of doubt as to whether the [discharge] order barred the creditor’s conduct.” See Taggart v. Lorenzen, 139 S.Ct. 1795 (2019).

Although this holding makes it harder for debtors to obtain contempt sanctions for violations of the discharge injunction, ignorance of bankruptcy law does not serve as an excuse. That is one more reason why developing a relationship with a bankruptcy practitioner can expand a litigator’s prospects for success.

Magalie A. Creech, Esquire, is managing shareholder of the Finkel Law Firm LLC in Charleston, South Carolina. She represents national banking associations and loan servicers in commercial and real property-related litigation, with an emphasis in contested foreclosures, bankruptcies, debt collections, real estate matters, and appeals. She is a member of the J. Bratton Davis Bankruptcy American Inn of Court in Columbia, South Carolina,