Contributed by Brian Wells
While the automatic stay clearly applies to outright attempts to collect property of the estate, such as a lawsuit seeking damages from the debtor, the extent of its protections are less obvious in the context of actions between two non-debtors. For example, suppose a trustee has sued a third party to reclaim fraudulently conveyed property belonging to the estate. Would a creditor be stayed from suing that same party over the same transaction? What if the creditor sued on different legal grounds than the trustee, or sought different damages? Even if the automatic stay did not apply, could a bankruptcy court stay the suit under section 105(a) of the Bankruptcy Code? In the recent decision, Fox v. Picard, the United States District Court for the Southern District of New York considered these questions and held that an action by a creditor against a third party, who had also been sued by the trustee, was properly barred by the automatic stay and an injunction ordered under § 105(a).
When Bernard L. Madoff’s Ponzi scheme was exposed, the vehicle for that scheme – Bernard L. Madoff Investment Securities LLC (“BLMIS”) – was placed in a SIPA liquidation in the United States Bankruptcy Court for the Southern District of New York. Like a bankruptcy, this proceeding was protected by the automatic stay. In addition, a trustee, Picard, was appointed to recover assets, process claims, and make a distribution to BLMIS’s customers. Returns to customers would be based upon their “net equity,” or the amount of money deposited in BLMIS accounts, less the amount of cash withdrawn. Notably this definition did not include compensation for taxes paid on account of non-existent gains or damages for the lost time-value of invested money.
Picard brought an adversary proceeding seeking the return of over $7 billion, asserting fraudulent conveyance claims based on allegations that Madoff investor Jeffrey Picower knew or should have known that rates of return on money invested with Madoff were implausibly high. The action moved towards settlement, but as negotiations were afoot two customers of BLMIS brought their own class actions against the Picower defendants in the United States District Court for the Southern District of Florida. Although their cases were based on the same alleged facts as the trustee’s case (they even cited to the trustee’s filings throughout their pleadings,) the Florida plaintiffs sued under tort instead of bankruptcy law and sought damages different than what the trustee would pay out as “net equity” (i.e., taxes paid on account of non-existent gains and the lost time-value for money invested.)
The trustee, fearing that the risk of multiple lawsuits could scare the Picower defendants out of a settlement, quickly moved for the bankruptcy court to stay the Florida actions. Finding that the claims were property of the estate, the bankruptcy court imposed the automatic stay and held them void ab initio. The bankruptcy court noted that the suits could disrupt the negotiations with or even frustrate the trustee’s ability to collect from the Picower defendants, because the Florida plaintiffs targeted the same limited pool of funds originating from BLMIS. Furthermore, to the extent the stay did not apply, the bankruptcy court issued a preliminary injunction under § 105(a), finding that the Florida actions threatened the BLMIS estate and the bankruptcy court’s jurisdiction over its administration.
The Florida plaintiffs appealed, arguing that their claims were not property of the estate because they were brought under a different legal theory than the trustee’s claims and were seeking damages different from the distributions to be made for their “net equity.” They further argued that the bankruptcy court lacked jurisdiction to enjoin their “independent” proceedings under § 105(a).
Violation of Automatic Stay
On appeal, the district court began its analysis of the stay by noting the Second Circuit rule for third-party claims: “[i]f a claim is a general one, with no particularized injury arising from it, and if that claim could be brought by any creditor of the debtor, the trustee is the proper person to assert the claim, and the creditors are bound by the outcome of the trustee’s action.”
Reviewing the Florida actions, the district court first noted that their factual allegations were “virtually identical” to the facts alleged by the trustee, and that they had pleaded the same wrongs as the trustee’s action. The district court also found the claims general because they were not based on a specific act directed towards or specific duty owed to the Florida plaintiffs, but instead sought to recover for an act harming BLMIS and all BLMIS customers. In addition, the district court noted that the claims could have been “brought by any creditor of the debtor,” as the damages were based upon the Picower defendants’ alleged taking of funds that otherwise could be distributed to all BLMIS customers. The district court rejected the Florida plaintiffs’ argument that they were exempt from the stay because they were seeking different damages, emphasizing that the claims were property of the estate because they could have been brought by any customer, and did not allege damages arising from unique duties to or actions against the litigating customers. Furthermore, the district court rejected the Florida plaintiffs’ argument that their claims were not property of the estate because they arose under a different legal theory, noting that “the bankruptcy laws’ core purpose would be severely undermined” if creditors could bypass the automatic stay and collect in full, simply by styling substantively duplicative claims as sounding in different legal theories. Finding that the Florida actions involved claims that were general, common to all investors, and substantively duplicative of the trustee’s fraudulent transfer action, the district court upheld the bankruptcy court’s application of the automatic stay and concluded that the Florida actions were void ab initio.
§ 105(a) Extension of Automatic Stay
The Florida plaintiffs also contested the bankruptcy court’s order enjoining the Florida actions pursuant to § 105(a), claiming that the bankruptcy court lacked jurisdiction over their “independent” proceeding. The district court began its analysis by noting the breadth of § 105(a), which grants the bankruptcy court authority to “extend the automatic stay to enjoin suits by third parties against third parties if they threaten to thwart or frustrate the debtor’s reorganization efforts.” The district court found that the injunction was substantively warranted because, as the bankruptcy court concluded, the Florida actions could interfere with the estate’s ability to recover fraudulently transferred assets from the Picower defendants, either by disrupting the settlement negotiations or diminishing the pool of assets from which the trustee aimed to recover.
The district court also rejected the Florida plaintiffs’ claim that the bankruptcy court lacked jurisdiction. It noted that a bankruptcy court can enjoin litigation by creditors against third parties in situations where, as here, creditors assert “general, indirect claims in order to achieve a greater distribution on a first come, first serve basis from assets which the trustee has standing to recover, and which, if recovered, will be available to satisfy the claims of all creditors.” The district court emphasized the similarity of the claims to the trustee’s, and the fact that pursuing them and similar types of claims would create a “race to the courthouse [that] would derail the bankruptcy proceedings.”
As the Fox v. Picard decision shows, wordplay and deft pleading alone are not enough to circumvent the broad reach of the automatic stay and injunctions entered pursuant to § 105(a): Courts will look past the form of a cause of action to consider the substance. Where the substance of an action is based on a generalized harm, so that it could be brought by the trustee on behalf of the estate, it will be property of the estate and properly stayed. Even where it is not property of the estate, if an action would threaten the estate or otherwise overlap with a claim properly brought by the trustee, the court can enjoin it through the broad powers of § 105(a).