(as published in the United Trustees Association Quarterly, Summer 2009)
A bankruptcy filing can be an effective tool for a debtor-defendant in a state court action to avoid a trial. The automatic stay of 11 USC 362 immediately stops the state court litigation upon the filing. However, the filing of the bankruptcy by a defendant is not “the end of the line” for the plaintiff in the state court action. There are a variety of considerations that a plaintiff must review and resolve when determining if and how to proceed against the debtor and the remaining defendants in the state court action. The failure to do so can lead to a waiver of rights and complications at a later date. The case of Griffin v. Wardrobe (In re Wardrobe), 559 F.3d 932 (9th Cir. 2009) illustrates this fact.
A bankruptcy filing by a defendant in a state court action should trigger an immediate analysis of what action should be taken against the debtor-defendant in the bankruptcy court. Experienced bankruptcy counsel will act quickly to file a proof of claim in the bankruptcy court and determine whether the plaintiff has a valid claim against the filing defendant for non-discharge of the debt that is the subject of the state court action. If a valid claim exists, an action for non-discharge of the debt is usually filed in the bankruptcy court.
Alternatively, a plaintiff in the midst of complex state court litigation may want to continue with the state court action, either against the debtor-defendant or against third parties or both. The plaintiff may want to finalize the judgment in the state court action in order to assert a claim against the debtor-defendant in the bankruptcy proceeding. While most state court judgments against a debtor will be discharged in bankruptcy, issues litigated in state court relating to certain non-dischargeable acts taken by the debtor (i.e., fraud)  can sometimes have preclusive effect in the bankruptcy court. This can result in the debt being excepted from discharge without the need for full re-litigation of a particular issue. This provides some incentive for plaintiffs to litigate their “non-dischargeable” claims in state court, instead of being forced to litigate their claim in an unfamiliar setting such as a federal bankruptcy court. This also allows a plaintiff to pursue all of the defendants in the same forum without removing the entire state court action to the bankruptcy court.
However, this course of action can present significant risks to plaintiffs. In addition to the inherent risk that the bankruptcy court will not give collateral estoppel effect to a judgment or order entered in the state court matter, proceeding in state court (even after relief from stay is granted for that purpose) can result in liability to the plaintiff if he takes actions beyond that allowed by the bankruptcy court.
In order to continue with any action where the debtor is a defendant, a plaintiff must first seek relief from the automatic stay of 11 U.S.C. 362. However, in most instances, a plaintiff obtaining relief from stay to return to state court against the debtor-defendant, will only have limited rights in the state court action. A recent example of this is the Wardrobe case which revealed what can happen when a creditor-plaintiff seeks to continue with state court litigation, asks the bankruptcy court for relief from stay to do so, but goes well beyond what is allowed in the relief order.
The 9th Circuit Court of Appeals held in Wardrobe, that an order for relief is effective only as to those claims actually pending in state court at the time the order is issued or those claims that were expressly brought to the attention of the bankruptcy court during the relief from stay proceeding. Effectively the court ruled that a relief from stay order does not give the creditor broad discretion in pursuing new causes of action in state court without specific bankruptcy court authorization.
In Wardrobe, the Plaintiff sued the Defendant in state court for breach of contract relating to a home repair job. Just three days before trial, the Defendant filed bankruptcy in order to avoid going to trial. The Plaintiff then filed a motion for relief in the bankruptcy court that specifically requested relief from stay to proceed against the insurance/bonding company and to compel the Debtor to testify at trial. Relief was granted as requested in the motion. However, the court specifically noted in its order that the creditor “may not proceed to enforce that judgment against the Debtor, or property of the estate without further order of [the] court”.
Subsequently, with the discharge date nearing, the Plaintiff filed a motion to extend the last day to file a non-discharge action, claiming that she believed that the debt that was the subject of the state court action was non-dischargeable. She requested that the last day to object to discharge be extended until 30 days after there had been a notice of entry of judgment in the state court action pending between the parties. The court granted the motion as it was unopposed by the Debtor. The Plaintiff then entered into a settlement with the Defendant bonding company.
The Plaintiff, presumably relying on authority provided to her in the previously entered relief order, amended her complaint in state court to include a fraud cause of action against the Debtor-Defendant. The Debtor-Defendant failed to answer the amended complaint and a default judgment was obtained against the Debtor-Defendant for fraud. Immediately after entry of the judgment, the Plaintiff filed a non-discharge action in bankruptcy court objecting to the discharge of the fraud judgment in accordance with 11 U.S.C. 523(a)(2)(A). The Bankruptcy Court gave the judgment preclusive effect, and deemed the judgment non-dischargeable without a trial.
On appeal to the Bankruptcy Appellate Panel (“BAP”), the court reversed the decision and ruled that the Plaintiff’s actions in obtaining a state court judgment against the Debtor-Defendant were in violation of the automatic stay and therefore “void and without preclusive effect”. The BAP’s decision was upheld by the 9th Circuit Court of Appeals. The court held that relief from stay orders are “strictly construed” and that standards of due process apply to limit a creditor’s ability to pursue actions not specifically prayed for in her relief from stay motion. While the creditor claimed that the motion to extend the bar date placed the debtor on notice of her intention to amend her complaint in state court, she had not specifically asked for relief from stay to amend her complaint, and therefore the court could not “grant relief greater than requested”.
The appeals court noted that while a court “has equitable judicial power, its power is confined by ordinary standards of notice and opportunity to be heard”. In Wardrobe, the court had not authorized the creditor to pursue a fraud cause of action against the debtor; it only authorized specific acts which were requested in the motion. The court could not condone activities taken by the creditor which were not specifically disclosed to the court and the debtor in the relief from stay motion.
Essentially the Wardrobe court is promoting “full disclosure” on relief from stay motions to ensure due process and to uphold the sanctity of the stay. The decision “discourages creditors from misrepresenting the actual or potential scope of the cause of action pending before a state court and thereby tends to ensure that the bankruptcy court is fully informed as to the potential effect of any order granting relief from the automatic stay.” This allows the court an opportunity to decide whether there is “cause” under 11 U.S.C. 362(d)(1) to grant relief from stay as to specific actions to be taken by the creditor in state court.
A plaintiff who wishes to litigate an issue against a debtor-defendant in state court should do so with the utmost disclosure. While a creditor is not required to disclose his entire litigation strategy, he cannot merely “pull a fast one” on the debtor-defendant by pursuing new claims in state court without relief from stay specifying the claim he is pursuing. The creditor in Wardrobe relied on a relief order that allowed limited action, yet took new actions which were not specifically disclosed to the court at the time of the motion.
The court in Wardrobe reasoned that “[a] bankruptcy stay protects both a debtor and his or her creditors by protecting the debtor’s assets from collection efforts so that a repayment or reorganization plan can be developed. Allowing one creditor to amend a pending complaint after a relief from stay order has been issued undermines this protection and could threaten the debtor’s reorganization or repayment plan.” This reasoning stresses the importance of the stay to not only protect the debtor, but also to protect third party creditors who have an interest in knowing the extent of the debtor’s assets and liabilities.
The automatic stay is a powerful tool for debtors and should not be taken lightly. Although not specifically discussed in Wardrobe, there can be drastic implications for a creditor who willfully violates the stay. The “misinterpretation” of a relief order can have severe repercussions beyond merely voiding a state court judgment or discharging a particular debt. Intentional actions taken by the creditor in violation of the stay could subject the creditor to an attack by the debtor for damages under 11 U.S.C. 362(k)(1), including actual damages, sanctions and even punitive damages.
The decision, while slightly arduous to creditors by forcing them to “look ahead” and to map out their course of action when filing relief from stay motions, offers clear guidance to creditors when faced with a similar situation. A creditor can either petition the court for a broad relief order that would encompass the actions it wishes to take or it can return to court to seek an order clarifying the scope of the previous entered relief order. The process is clear. A creditor cannot get what he does not ask for. Relief orders are strictly construed and should not be taken as a “free pass” to take all actions against a debtor or third parties in state court which the creditor believes are appropriate. A relief order obtained to pursue a state court action only applies to those causes of action already pending or those disclosed to the court in the creditor’s motion. If it is not in the relief order, it is probably not an option.
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