Bankruptcy Litigation: Some Practical Pointers
by J. Robert Nelson
Introduction
The premise of this article, that litigation frequently spawns bankruptcy, is not a novel insight. The recent spate of mass tort suits involving asbestos and dangerous drugs have pushed numerous companies to respond with Chapter 11 filings. Mass tort situations aside, the substantial costs of litigating even one complex case have driven some defendants to seek bankruptcy protection. The mere possibility of a large adverse judgment leads others to bankruptcy. Even the inability to post an undertaking in connection with appeal of an adverse judgment has resulted in bankruptcy filings. Although the circumstances vary, bankruptcy has become a frequently used response to litigation.
Trial lawyers encounter bankruptcy in a wide variety of settings. Some of the more common include:
¥ pursuing a motion for relief from automatic stay to permit prosecution of a pre-bankruptcy suit against a debtor;
¥ submitting a proof of claim against a debtor and handling an objection to the claim;
¥ opposing a debtor's motion to assume or reject a lease or contract;
¥ objecting to the dischargeability of a debt of an individual debtor;
¥ defending a preference or fraudulent conveyance action; and
¥ defending a tort or contract action by a debtor.
While this list is not exhaustive, it will serve in this article to illustrate a number of features of bankruptcy litigation and provide a backdrop for some practical suggestions for litigators.
Bankruptcy Litigation: The Setting
Those who have encountered it can attest that, from the litigators' stand point, things change after a bankruptcy filing. Probably the most dramatic change relates to state and federal court suits pending against a debtor at the time of bankruptcy. Those suits are frozen by the automatic stay under 11 U.S.C. (the "Bankruptcy Code") ¤362. That section stays and enjoins, among other things, "the commencement or continuation . . . of a judicial, administrative, or other action or proceeding against the debtor that was or could have been commenced before the commencement of a case under title 11." Although the bankruptcy court has the discretion to lift the stay for cause (Bankruptcy Code ¤ 362(d)(1)), it is rare that pre-bankruptcy suits are permitted to proceed to trial in a non-bankruptcy court. One reason is that there is no need for pre-bankruptcy suits against a debtor to go forward because the Bankruptcy Code includes its own system for submission and resolution of claims against a debtor. That system is based on an adjudication by the bankruptcy court rather than by a state or other federal court, even if a suit was pending against a debtor at the time of bankruptcy.
Another change initiated by a bankruptcy filing relates to the trial forum. Bankruptcy has its own court system. After a filing, most disputes are adjudicated by bankruptcy judges. When the position of bankruptcy judge was created under the Bankruptcy Reform Act of 1978, bankruptcy judges, who replaced bankruptcy referees under the old system, were given broad power to adjudicate all disputes arising in or related to bankruptcy cases. Unlike federal district judges, however, bankruptcy judges were not appointed under Article III of the Constitution and were not tenured judges. In light of this, the broad grant of jurisdiction to bankruptcy judges was questioned, particularly as it pertained to actions which, while related to a debtor (for example, a contract or tort action by a debtor against a third party) were not historically part of what bankruptcy judges handled. In Northern Pipeline Construction Co. v. Marathon Pipeline Co., 458 U.S. 50, 102 S.Ct. 2858 (1982), the Supreme Court held that the broad grant of jurisdiction was unconstitutional. In reaction, Congress, in 1984, amended the Bankruptcy Code to, among other things, grant primary bankruptcy jurisdiction to Article III district courts. Bankruptcy judges were maintained, but their power to act became derivative of the district court in each district. In this and other jurisdictions, bankruptcy cases are not handled by district judges but rather referred automatically to bankruptcy judges. District courts do, however, retain the power to withdraw the reference either as to an entire bankruptcy case or to particular proceedings within a case.
Turning to the six examples mentioned above, five involve matters that were the traditional domain of bankruptcy referees - stay relief, assumption/rejection of contracts and leases, claims adjudication, dischargeability suits and avoidance actions (preferences and fraudulent conveyances). The amended Bankruptcy Code defines those and similar matters as "core proceedings" under 28 U.S.C. ¤ 157. Trial of "core proceedings" is presided over by bankruptcy judges without intervention by the district court (other than in its role to consider appeals from bankruptcy court decisions).
Although all handled by bankruptcy judges, there are definite procedural differences in the five illustrated "core proceedings." Two of them (dischargeability and avoidance actions) are known as "adversary proceedings" pursuant to Rule 7001 of the Rules of Bankruptcy Procedure ("Bankruptcy Rules"). They are initiated by complaint, and the applicable procedures are governed by adversary Bankruptcy Rules that are similar, in many respects, to the Federal Rules of Civil Procedure.
The other three examples of "core proceedings" include claims litigation, relief from stay actions, and assumption/rejection of leases and contracts. They are known in bankruptcy rubric as "contested matters." They are not initiated by complaint. Claims litigation is triggered by an objection to a duly filed proof of claim. Generally, a proof of claim must be timely filed for a creditor to participate in bankruptcy distributions. In contrast, stay relief and assumption/rejection of contracts or leases are sought by motion. "Contested matters" are presided over by the bankruptcy judge and are governed by some, but not all, of the Bankruptcy Rules that govern "adversary proceedings." However, bankruptcy courts may, if they choose, apply all of the adversary rules to a particular contested matter.
The grant of bankruptcy jurisdiction under 28 U.S.C. ¤ 1334 includes not only "core proceedings" but also actions which "relate to" a debtor. Of the six examples, only tort or contract actions by a debtor fall within the court's "related to" jurisdiction. Traditionally, "related to" actions were not handled by bankruptcy referees. Indeed, it was a "related to" action which resulted in the Supreme Court's decision in Northern Pipeline. The 1984 amendments could have addressed the constitutional issue by requiring that a district court adjudicate all "related to" actions. Instead, with respect to "related to" actions, the amendments provides for initial consideration by a bankruptcy judge who, after evidentiary review, issues proposed findings of fact and conclusions of law. Those proposed findings and conclusions then are subject to objection (Bankruptcy Rule 9033(b)) by the parties. Objections then trigger de novo consideration by the Article III district court.
A Few Practical Suggestions
Bankruptcy litigation is of course a broad topic. Of necessity, the foregoing paragraphs have touched only on a few of the structural and procedural highlights. Any list of practical suggestions also risks serious under-inclusion. With that caveat, the following are a few considerations for lawyers confronting litigation in a bankruptcy setting.
a. Stay Relief
The automatic stay is not an absolute bar to continued prosecution of pre-bankruptcy suits against a debtor. Some actions are excepted from the stay. For example, suits that involve support and custody issues are stay exceptions. In addition, under Bankruptcy Code ¤ 362(d), the bankruptcy court has the discretion to lift the stay to permit a pre-bankruptcy suit to proceed. Relief in such a situation is far from automatic. The petitioning party bears the burden of establishing cause to lift the stay. Bankruptcy courts are more inclined to allow continued prosecution of pre-bankruptcy actions when (1) the bankruptcy was filed on the eve of a trial, (2) there are multiple defendants with a risk of multiple proceedings and conflicting results, and/or (3) the movant agrees to pursue any judgment exclusively against a debtor's insurer so that the bankruptcy estate is not burdened. There may, however, be a practical reason in such circumstances not to pursue stay relief in the early stages of a reorganization case. At that point, it is difficult to assess whether a debtor's financial position will support a small or a large dividend to creditors, and a claimant may not wish to incur the costs of litigating if it is not evident that the debtor can pay.
b. The Trial Forum
Several Bankruptcy Code provisions make clear that the initial choice of trial forum is not necessarily the final choice. The obvious example of this is a pre-bankruptcy suit against a debtor. Because of the automatic stay, it is rare that such a suit proceeds in the original trial court. Rather, it is handled by a bankruptcy judge in the context of claims litigation. Another example involves a debtor's pre-bankruptcy tort or contract suit. Pursuant to provisions in 28 U.S.C. ¤ 1452(a), non-debtor defendants can, if they wish, remove such actions to the district court in which the bankruptcy case is pending as long as such court has "related to" jurisdiction under section 1334. There are, however, specific time limits for removal pursuant to Bankruptcy Rule 9027, and the district court may on motion remand a removed case. A final example of this principle relates to, 28 U.S.C. ¤ 1334(c)(2). That section provides for judicial abstention, (1) but only as to "related to" actions, (2) which are based upon a state law claim or cause of action, (3) as to which an action is already pending which can be timely adjudicated in the original state forum (assuming a lifting of the stay).
c. Jury Trials
The pendency of bankruptcy does not necessarily foreclose a jury trial, and this despite the rulings of the Supreme Court (1) in Katchen v. Landy, 382 U.S.323, 865.Ct. 467, 15 L.Ed.2d 391 (1966), that most proceedings in bankruptcy "are proceedings in equity" to which no right to trial by jury inheres and (2) in Langenkamp v. Culp, 498 U.S. 42,111 S.Ct. 330, 112 L.Ed.2d 343 (1990) that a creditor filing a claim waives the right to a jury trial on a counterclaim asserting bankruptcy avoiding powers. Decisions of the Supreme Court and other courts suggest that the jury trial right is preserved, among other situations, (1) as to a fraudulent conveyance suit by the debtor if the creditor has not filed a claim, (2) as to counterclaims that are not based on avoiding powers and (3) as to "related to" suits by a debtor. Moreover, in those situations in which a jury trial is appropriate (excluding personal injury/wrongful death claims which are handled by the district court) a bankruptcy judge may preside pursuant to 28 U.S.C. ¤ 157(e), but only if specially designated by the district court and with the express consent of all parties to the action.
d. "Related To" Jurisdiction
The grant of "related to" jurisdiction permits debtors to prosecute tort, breach of contract and collection actions in the potentially friendly environment of the bankruptcy court. Defendants not satisfied with that prospect are not, however, without recourse. By demanding and refusing to consent to the bankruptcy court's presiding over a jury, the non-debtor defendant assures that the ultimate decision will rest with the district court rather than the bankruptcy judge. This can occur either (1) if the defendant immediately moves to withdraw the reference so that the case can be tried, in the first instance, before a district judge or (2) if the defendant permits the matter to proceed in the bankruptcy court and then objects to the proposed findings and conclusions, thus triggering de novo consideration by the district court.
e. Objections to Dischargeability
Bankruptcies are filed to deal with and discharge debts. Not all debts are susceptible to discharge, however. Bankruptcy Code ¤ 727 lays out bases for denial of a discharge as to all creditors of a debtor. Section 523, on the other hand, delineates those circumstances in which a discharge can be denied as to specific debts. These sections are relevant to individuals who are debtors and not to corporate debtors.
There are several practical considerations in deciding whether to challenge a discharge. Such challenge makes sense only if there is an expectation that the debtor will accumulate meaningful assets after the bankruptcy so that a debt can be paid. The decision to proceed by complaint under ¤ 523 (nondischargeability of specific debts) or ¤ 727 (denial of discharge of all debt) turns, obviously, on the facts of the case. However, an individual creditor should think twice before pursuing a ¤ 727 action because, if successfully pursued, it will leave a debtor exposed to all of its pre-bankruptcy debts, not just the claims of the complaining creditor.
f. Pre-bankruptcy Judgments and Settlements
Pre-bankruptcy judgments carry weight in bankruptcy. As to the issue of claims allowance and quantification, bankruptcy does not give a debtor the right to re-litigate a matter that has proceeded to an adverse judgment before a bankruptcy filing. Unless overturned on appeal, the pre-bankruptcy judgment fixes the claim against a debtor. Similarly, pre-bankruptcy findings have collateral estoppel effect with respect to issues such as fraud which are raised in a post-filing objection to dischargeability of a debt.
The foregoing notwithstanding, bankruptcy can impact matters that have proceeded either to judgment or settlement before the bankruptcy petition. If post-judgment levies have occurred, payments been made or liens arisen within 90 days of a bankruptcy filing, they all may be recoverable as preferences under Bankruptcy Code ¤ 547. Even settlement payments voluntarily made during the 90 day period may be challenged on the same basis.
g. Appeal of Pre-bankruptcy Judgments
In addition to preference considerations, a bankruptcy filing has a bearing on appeals by a chapter 11 debtor. For one thing, bankruptcy avoids a potentially costly undertaking for issuance of a stay. Because bankruptcy invokes an automatic stay, ordinary bonding requirements do not apply to a debtor challenging a pre-bankruptcy judgment. An exception may relate to post-bankruptcy costs of appeal for which an undertaking may be appropriate.
The automatic stay bears on appeals in another way. The stay obviously is not implicated in an appeal by the debtor. However, it may be in connection with any cross-appeal. Caution dictates that stay relief be sought by a non-debtor seeking to pursue a cross-appeal.
Conclusion
It should be evident from the foregoing that, the automatic stay notwithstanding, bankruptcy and litigation are not mutually exclusive. Indeed, a bankruptcy filing opens up numerous conflicts that require judicial resolution. Some of the rules that govern these conflicts are familiar to litigators, and others are quite different. Because of these differences, there is an advantage to involving lawyers familiar with the intricacies of bankruptcy litigation when dealing with disputes after a bankruptcy filing.
J. Robert Nelson is of counsel to VanCott, Bagley, Cornwall & McCarthy, P.C. Before his move to Utah his practice focused on corporate reorganization and bankruptcy from bases in Los Angeles and New York.
Utah Bar Journal - Volume 18 No. 4 - July/August 2005
Posted by BarJournal at August 6, 2005 11:35 AM
