The Automatic Stay: Court Says "Not So Fast" When a Defendant Files for Bankruptcy

More and more these days, creditors are learning about the "automatic stay" as their customers, tenants or borrowers file bankruptcy to avoid litigation. Under the Bankruptcy Code, the automatic stay prevents a creditor from taking action, including continuing litigation, against a debtor who owes the creditor money or is liable under non-bankruptcy law. This bankruptcy stay is a powerful shield and can be an attractive incentive for a financially troubled company facing litigation.

But there has been some recent good news for creditors: a federal court of appeals has made it easier to challenge a bankruptcy case for being filed to avoid litigation. In the case of In re 15375 Memorial Corp. v. Bepco, L.P., 589 F.3d 605 (3d Cir. Dec. 2009), a parent company and its subsidiary filed for Chapter 11 in Delaware. The debtors had previously been named as defendants in multiple environmental lawsuits, one of which alleged liability for $178 million in cleanup costs. The debtors, however, had few remaining assets or operations. A codefendant that was not part of the Chapter 11 filing became concerned that the bankruptcy cases would shield the debtors but leave the codefendant exposed in the litigation. The codefendant ultimately reached a settlement with the plaintiff, which included purchasing the right to pursue the plaintiff's claim against the debtors and a related non-bankrupt entity. The codefendant then moved to dismiss the bankruptcy cases, arguing they had been filed in bad faith. The court denied the motion and allowed the companies to remain in bankruptcy, insulated by the automatic stay.

On appeal, however, the Third Circuit disagreed with the bankruptcy court and ruled that the bankruptcy cases were indeed filed in bad faith and should have been dismissed. Why? The debtors were not able to satisfactorily answer two key questions: (1) did their bankruptcy petitions serve a "valid bankruptcy purpose" and (2) were they filed merely to obtain a litigation advantage.

So what qualifies as a valid bankruptcy purpose? According to the appellate court, a bankruptcy must be intended to preserve a company as a going concern or to maximize the value of a company's assets in bankruptcy. In this instance, the debtors had no real going concern to preserve. Additionally, the court found that their bankruptcy cases would not maximize value for their creditors because, among other things, (1) the bankruptcies were filed merely to invoke the automatic stay; (2) the environmental claims could be dealt with in state court; and (3) a plan of liquidation for state court creditors is not enough to justify a bankruptcy. The appellate court felt that the bankruptcies were obviously related to the filing of the environmental lawsuits and, therefore, viewed them as a tactic to avoid litigation.

What might this federal decision mean for you? With the assistance of experienced counsel, creditors now have a better chance of dismissing a bankruptcy case if it was filed for no reason other than to avoid litigation. As a result, they may no longer be held hostage by a bankruptcy case and the automatic stay that can come with it.