WLN Columns

The Impact of the Automatic Stay on Multi-Party Litigation

For creditors seeking to collect debts, it is Bankruptcy 101 that a debtor’s filing of a bankruptcy petition automatically stays the commencement or continuation of actions against the debtor to recover a claim that arose prior to the bankruptcy. While it is easy to understand and apply the requirements of the automatic stay to situations involving one creditor and one debtor, less clear is the impact of a bankruptcy filing by one of the parties in multi-party litigation.

Consider the following real-life example: creditor bank filed suit in state court against a customer for breach of a contract for a loan secured by a yacht. Defendant customer filed an answer to the complaint containing a counterclaim against the Plaintiff bank. In addition, Defendant filed a complaint to add as additional defendants the manufacturer of the boat, the manufacturer of the engine and drive shaft, the manufacturer of a generator, and the marina that serviced and repaired the boat. Defendant’s counterclaim against the plaintiff and his claims against the additional defendants were based upon allegations that there were defects related to the boat that were not repaired or replaced. Plaintiff and the additional defendants filed motions with the court seeking dismissal of the defendant’s claims, which motions were pending before the court when one of the additional defendants, the manufacturer of the boat, filed a Chapter 11 bankruptcy petition.

Shortly thereafter, the defendant requested that the state court action be stayed as to all of the remaining parties pending the outcome of the Chapter 11 case. The remaining additional defendants joined in the request to stay the action. Over the objection of the plaintiff, the court ordered the civil action stayed, citing §362 of the Bankruptcy Code.

Is it possible that a bankruptcy filing can result in the automatic stay being extended to preclude the continuation of litigation against one or all of the non-bankruptcy parties? The short answer is: sometimes. Not surprisingly, this is a question that must be determined on a case-by-case basis.

While the scope of §362 is broad, its clear language stays actions only against the bankrupt debtor. Generally, the automatic stay does not extend to non-debtor codefendants. The automatic stay may not be invoked by entities such as sureties, guarantors, co-obligors, or others with similar legal or factual nexus to the bankrupt debtor. A party is not precluded from recovering a claim against the debtor from the debtors’ insurer, where the proceeds are not an asset of the bankruptcy estate and there is no monetary consequence to the debtor. A bankruptcy filed by a corporation or partnership does not stay actions against individual officers, directors, shareholders, principals or partners.

However, courts have carved out limited exceptions to the general rule expressed above, extending the reach of the automatic stay to non-debtor litigants in “unusual circumstances”. In extending the reach of the automatic stay to non-debtor third parties, bankruptcy courts have relied not on §362, but upon §105 of the Bankruptcy Code. The two situations where courts have found “unusual circumstances” justifying the extension of the stay to third parties are, first, where there is such identity between the debtor and the third party that the debtor may be said to be the real party in interest, and that a judgment against the third party will in effect be a judgment or finding against the debtor, and second, where the protection is essential to the debtor’s efforts of reorganization. Courts that have extended the automatic stay because of potential indemnification implications on the debtor generally do so in cases where the non-debtors’ liability is derivative to their status within the debtor organization. Conversely, where claims against third parties are premised on a breach of fiduciary duty to the plaintiff, and are not derivative of the third party’s relationship to the debtor, extension of the stay is not warranted. Third parties have been found to be essential to reorganization based upon their expertise, intimate relationship to the debtor and/or their anticipated contribution of personal capital. Third parties’ need to obtain discovery from the debtor has not been recognized as an unusual circumstance.

The criteria enumerated by the courts in considering the limited extension of the automatic stay to non-debtors provides creditors in multi-party litigation with ammunition to combat efforts by non-debtor parties to stay the litigation. In certain instances, it may be possible to “disaggregate” the claims and parties, permitting the litigation to proceed against some parties on some claims, while staying others. In situations, such as in the above example, where the court has stayed the action as to all parties and all claims, it may be possible to seek rescission of the stay if the non-debtor parties have failed to file timely proofs of claim in the bankruptcy proceeding to assert disputed, contingent or unliquidated claims or cross claims related to the stayed action. The failure to file such claims and the availability of bankruptcy remedies have been cited by courts as factors in their deliberations on requests to extend the stay. In conclusion, creditors faced with these issues should emphasize to the court that the automatic stay should be extended only where it is necessary to protect the interests of the bankrupt debtor, as opposed to the interests of the non-debtor litigants.

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11 U.S.C. § 362(a).
Stanford v. Foamex L.P., 2009 U.S. Dist. LEXIS 32405 (E.D. Pa., April 15, 2009)
See, e.g., Pitts v. Unarco Industries, Inc., 698 F.2d 313, 314 (1983, CA7 Ind) cert den, 464 U.S. 1003 (1983)
See, e.g., Lynch v. Johns-Manville Sales Corp., 710 F.2d 1194, 1196 (1983, CA6 Ohio)
See, e.g., In re Fernstrom Storage & Van Co., 938 F.2d 731, 735-736 (1991, CA7 Ill)
See, e.g., In re MacDonald/Associates, Inc., 54 BR 865, 867 (1985, BC DC RI); Patton v. Bearden, 8 F.3d 343, 349 (1993, CA6 Tenn)
See, e.g., Stanford, supra; Parry v. Mohawk Motors of Mich., Inc., 236 F.3d 299, 314 (2000, CA6 Ohio), reh den, 2001 US App LEXIS 2087 (2001, CA6 Ohio), cert den, 533 US 951 (2001)
11 U.S.C. § 105(a) (“The court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title…”)
See, e.g., McCartney v. Integra Nat’l Bank N., 106 F.3d 506, 510 (3d Cir. 1997)
Stanford, supra
McCartney, supra, at 510
Stanford, supra
See, e.g., Parker v. Bain (In re Parker), 68 F.3d 1131, 1137 (1995, CA9 Cal)
See, 11 U.S.C. §§ 502, 1111(a); Bankruptcy Rule 3003(c)(2); In re Nutri*Bevco, Inc., 117 BR 771, 778 (BC SD NY 1990).
See, e.g., Willet v. Vitek, Inc., 139 BR 723,725 (1992, DC Nev); GATX Aircraft Corp. v. M/V Courtney Leigh, 768 F.2d 711, 716-717 (1985, CA5 La)

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