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When the Bankruptcy Stay isn’t Quite so Automatic

03.08.16

If you practice law for enough years, it’s bound to happen to you: on the eve of a big hearing or trial, the Plaintiff files bankruptcy in order to prevent an adverse ruling or even dismissal of their case. Many attorneys and judges simply assume that the automatic stay forbids any adverse action against the debtor, thus subjecting them to potential sanctions by the bankruptcy court if they attempt to proceed with the litigation. But this assumption is far from accurate.

In fact, the Bankruptcy Code provides that the automatic stay only applies to cases filed prior to the bankruptcy petition “against the debtor.” 11 U.S.C. § 362(a). The automatic stay therefore does not apply to a party that is in a purely defensive stance.

Every state and federal court in Texas that has considered this question has concurred with this simple statement of law, including the US Court of Appeals for the Fifth Circuit, the Texas Supreme Court, and every Texas Court of Appeals. The Texas Supreme Court did so when it concluded that the automatic stay does not toll limitations on claims held by the debtor. See MacGregor v. Rich, 941 S.W.2d 74, 76 n. 1 (Tex. 1997). Similarly, the Fort Worth Court of Appeals, concluded that the automatic stay did not prohibit dismissal for want of prosecution of a case filed by the debtor prior to the commencement of its bankruptcy case. Montgomery Ward & Co., Inc. v. Denton County Appraisal Dist., 13 S.W.3d 828, 829-830 (Tex.App.—Fort Worth 2000, pet.denied). Likewise, the Dallas Court of Appeals affirmed an order granting summary judgment that resulted in dismissal of the debtor’s pre-petition claims—despite the presence of the automatic stay. Amrhein v. La Madeleine, Inc., 2001 WL 818286 *1 (Tex.App.—Dallas 2001, pet. denied). Finally, the US Court of Appeals for the Fifth Circuit held that removal of a case to federal court did not violate the automatic stay because the suit had been filed by the debtor prior to his bankruptcy petition. McMillan v. MBank Fort Worth, N.A., 4 F.3d 362, 366 (5th Cir.1993).

The application of this provision of the bankruptcy code is likely to arise in the context of creditor’s rights litigation—particularly when the litigation involves borrowers whose primary objective is delay. Many of these plaintiffs filed suit to obtain an injunction on foreclosure. And they are willing to incur the negative credit impact of a bankruptcy in order to further delay their secured creditors’ enforcement of their security interest. In such a situation, the plaintiff’s attorney may attempt to prevent the court from dismissing their case by filing for bankruptcy relief on the eve of a hearing.

But in Texas and the Fifth Circuit, the courts have reached the unanimous conclusion that the plaintiff’s bankruptcy filing should have no impact on the pending litigation. Plaintiffs’ counsel should be aware that this type of maneuver is unlikely to succeed. And defense counsel should be prepared to advise state courts—who may be unfamiliar with the bankruptcy code—of their clients’ right to proceed with the defense of the lawsuit.

It must be emphasized that these cases involve defendants that are all in purely defensive stances. Section 362(a)(1) indicates that the automatic stay does apply to actions or proceedings against the debtor. This means that a defendant who has filed counterclaims against a debtor is likely precluded from taking any action in the litigation case—even defensive actions.  Indeed, the Fifth Circuit’s opinion in McMillan makes clear that the existence of counterclaims against the debtor would have complicated its assessment of this issue. Id.

For more in depth discussion of the various contexts in which these issues may arise, please feel free to contact me at jlynch@settlepou.com.