U.S.: A Bankruptcy Primer - The Automatic Stay Under Chapter 11 And Is There A Way Around It?

June 2003

Sea Venture Volume 21

The Enron bankruptcy proceeding has drawn world-wide attention to the bankruptcy system in the United States. Hardly one day passes in which some aspect of the Enron case is not reported in the Nation's daily newspapers. The purpose of this Article is to provide a basic understanding of the effect that the automatic stay issued by a bankruptcy court has on a creditor's claims against a debtor that has filed for Chapter 11 protection and the potential bases to lift the stay.

The Automatic Stay and Bankruptcy Court's Jurisdiction

When a Chapter 11 reorganization proceeding is filed in the United States, the bankruptcy court is vested with considerable power when it comes to determining how the debtor's assets (also known as the debtor's estate) will be divided among the creditors. Through the use of various judicial means, a bankruptcy court will immediately seek to protect the debtor's estate so that all of the creditors may share, according to their priorities, in whatever assets are available for the satisfaction of debts. Basically, the bankruptcy court will attempt to "freeze" the debtor's assets so that they will not decrease and so that no one creditor can reach assets before the entire bankruptcy estate is divided.

The primary means by which a bankruptcy court can control distribution of the debtor's property is a judicial device called an "automatic stay." The stay is issued automatically upon the filing of the petition with the bankruptcy court and prevents the commencement or continuation of any legal proceeding against the bankruptcy debtor or against any of its property.

The geographic reach of an automatic stay is considerable. In addition to conferring jurisdiction on matters effecting the debtor inside the United States, the automatic stay also has effect outside of the United States to the extent that a foreign creditor is subject to the personal jurisdiction of the bankruptcy court.¹

The extent of personal jurisdiction over a foreign creditor can be far-reaching. In one bankruptcy case, the court found that it had personal jurisdiction over a foreign creditor which had vessels arrested overseas since the foreign creditor knew or reasonably should have known that the seizure of the vessels would have an effect in the United States.

A foreign creditor is not necessarily insulated from an order issued by a United States bankruptcy court. Just as a foreign court's bankruptcy order will generally be given effect by a United States court, a foreign court may recognize and enforce an order issued by a United States bankruptcy court. A foreign creditor that violates the automatic stay may therefore face the consequences of a United States bankruptcy court order being enforced by a court in its own country.

Lifting of the Automatic Stay

While the automatic stay is a powerful tool of the bankruptcy court, it does not mean that the stay will remain in effect under all circumstances until the debtor emerges from the Chapter 11 reorganization. In limited circumstances, the Bankruptcy Code allows a creditor to seek to have the automatic stay lifted "for cause."²

"For cause" is not defined in the Bankruptcy Code. In New York, courts will apply a twelve factor test in reaching a decision on whether to lift the automatic stay - see In Re Sonnax Industries, Inc³ . Court decisions that have lifted the automatic stay under the Sonnax criteria typically involved circumstances where the non-bankruptcy proceeding was at an advanced stage of discovery or trial was about to begin or had already taken place.

The existence of an arbitration clause in a contract between the bankruptcy debtor and a creditor may alone be sufficient for the stay to be lifted. In this circumstance, the court will look to the nature of the claim against the debtor. If the claim were found to be "non-core" as opposed to "core," the bankruptcy court would be required to lift the automatic stay. If the matter were found to be "core" to the bankruptcy proceeding, however, the bankruptcy court would exercise its discretion as to whether the automatic stay should be lifted.⁴

This same reasoning should also apply to enforcement of a foreign litigation clause, although, as yet, there appears to be no case in which this analysis has been applied.⁵

A word of caution in the event that the automatic stay is lifted: The bankruptcy court would probably allow only the claims to be litigated on the merits in the non-bankruptcy forum but no more. Any arbitration award or court judgment obtained outside of the bankruptcy proceeding could be enforced only in the bankruptcy proceeding and not elsewhere .⁶

For creditors with pre-existing security, however, the result would be different. Bankruptcy courts have generally lifted the automatic stay to allow litigation or arbitration against the debtor outside of the bankruptcy proceeding in circumstances where the creditor has sought nothing more than a declaration of liability against the debtor that could serve as a predicate for a recovery on an arbitration award or court judgment directly against insurers, sureties, or guarantors .⁷

Conclusion

As can be seen, the automatic stay issued by the bankruptcy court can have preclusive effect even on a foreign creditor's claim that is pending overseas. Even so, the automatic stay can be lifted in appropriate circumstances, particularly where the creditor has extensively litigated its claim against the bankruptcy debtor elsewhere or it has pre-existing security from the debtor's insurer.

With thanks to Kirk Lyons of Lyons, Skoufalos, Proios & Flood for preparing this article.

 

1.In Re McLean Industries, Inc., 68 B.R. 690 (S.D.N.Y. 1986).

2.11 USC § 362 (d)(1).

3.907 F.2d 1280 (2nd Cir. 1990)

4.In Re United States Lines, Inc., 197 F.3d 631 (2nd Cir. 1999).

5.In Re Sonatrach, 80 B.R. 606, 612 (D. Ma. 1987).

6.In Re Holtkamp, 669 F.2d 505 (7th Cir. 1982).

7.In Re Fernstrom Storage and Van Company, 938 F.2d 731 (7th Cir. 1990).