The Automatic Stay
February 21, 2023
In 1982, British punk rock band The Clash, in their album Combat Rock had a song titled “Should I Stay Or Should I Go” with the chorus “Should I stay or should I go now? Should I stay or should I go now? If I go, there will be trouble, and if I stay it will be double. So come on and let me know . . .” In this Surety Today Blog post we will explore the automatic stay in bankruptcy and the question whether the surety should stay or go and if there will be trouble or even double trouble? We will start with a brief overview of the automatic stay – the who, what, where, why and when, if you will. We will then look at whether surety bonds are subject to the stay and how to get the stay lifted. As we will discuss, the stay is exceedingly broad on purpose and running afoul of it can be bad and costly – indeed even double trouble.
The automatic stay is set forth in the Bankruptcy Code at 11 U.S.C. §362. Once a petition for bankruptcy is filed, in any chapter of bankruptcy – 7, 11, 13, etc., the automatic stay comes into effect. As its name suggests, the stay arises automatically and immediately by operation of law, no order of the court or issuance of a notice is required to bring it into existence.
Who does the automatic stay apply to? The automatic stay is applicable to all entities and persons. The words “entity” and “person” are defined in the Code very broadly as any person, estate, trust, government, corporation or unincorporated company or association. Thus, courts, governmental agencies, like the IRS, banks, and surety companies are subject to the stay.
There are several well-recognized purposes of the automatic stay. The first is to provide relief to the debtor from the pressure and harassment of creditors and to give the debtor a “breathing spell” to focus on rehabilitation or reorganization. The stay also protects property that may be necessary for reorganizing and providing a “fresh start.” The stay is intended to promote one of the primary goals of the bankruptcy process, which is equality of distribution. It preserves the status quo and prevents the “disorganized dismemberment” of the debtor by creditors chaotically running all over the country to various courthouses to obtain independent relief to the detriment of other creditors and the debtor.
What does the automatic stay apply to? To accomplish the purposes of the bankruptcy process, the scope of the stay has intentionally been made very broad in the Code. It applies to the commencement or continuation of any judicial proceeding or other action or proceeding against the debtor that was or could have been commenced prior to the filing of bankruptcy. The enforcement of a judgment or lien against the debtor or against the property of the debtor’s bankruptcy estate that arose prior to the filing of the debtor’s bankruptcy case, including any act to obtain possession of or control over the debtor’s property. A surety’s collateral demand is covered by the stay. The stay applies to any attempt to create, perfect or enforce any lien against the debtor’s property; which includes the filing of a UCC financing statement. The stay also applies to any act to enforce a setoff right against any debt owed to the debtor that arose before the bankruptcy case was filed. Regarding the scope of the automatic stay, it has been observed that the stay is extremely broad and applies to almost any type of formal or informal action taken against the debtor or the property of the estate.
The automatic stay remains in force until property subject to the stay is no longer property of the estate or the earliest of: (i) the time the case is closed; (ii) the time the case is dismissed; or (iii) the time a discharge is granted or denied. As discussed, below, the stay may also be lifted by the Bankruptcy Court upon motion and hearing.
There are exceptions to the automatic stay. The Code provides that the stay does not apply to criminal actions, paternity cases, domestic support, custody or divorce matters, domestic violence, certain police powers and other limited matters. The stay also may not apply if the debtor has recently filed a bankruptcy case under certain circumstances. The automatic stay does not generally apply to separate related entities of the debtor who are not in bankruptcy, such as directors, officers, affiliates, partners, etc. However, such entities could seek protection under 11 USC §105 – injunctive relief. Actions on claims that arose after the commencement of a case are not stayed, however enforcement of any resulting judgment would typically be stayed.
If the automatic stay is violated, such action is either void or voidable depending on the nature of the violation. Further, under the Code in the event of a willful violation of the stay an individual may recover actual damages, costs, attorneys’ fees and in appropriate circumstances punitive damages. Moreover, a violation of the stay can be punished under the Bankruptcy Court’s contempt powers. The Fifth Circuit has held that standing to assert a claim for willful violation of the automatic stay is not limited to the debtor or trustee, and could be asserted by any creditors who have suffered damages because of a violation. St. Paul Fire & Marine Ins. Co. v. Labuzan, 579 F.3d 533 (5th Cir. 2009).
There is one form of collateral that the surety can hold that is not considered to be property of the bankruptcy estate – namely Letters of Credit. Because letters of credit are not property of the bankruptcy estate, it is generally held that the automatic stay does not apply. Why is a letter of credit not subject to the automatic stay? The reason is because of the “independence principle” and the fact that the letter of credit is an agreement between the surety and the bank involving the bank’s assets, not the debtor. Thus, the bank, that issues the letter of credit, is pledging its own credit and its own assets to the surety, regardless of what transpires in the underlying transaction between the principal and the surety or between the bank and the principal. Because of the independence principle the assets of the bankruptcy estate are deemed not to be involved. Thus, the automatic stay does not apply and the surety is free to draw down on the letter of credit and use the proceeds to reimburse itself or pay claims without violating the automatic stay or seeking permission of the bankruptcy court. For more details on this issue see our blog posts: Letters of Credit in Bankruptcy, May 3, 2022 and Letters of Credit in General, April 26, 2022.
What about Surety Bonds, are they covered by the automatic stay? The answer is – it depends. There are many cases holding that a bond posted by a surety to secure the obligations of a debtor is not property of the debtor’s bankruptcy estate. As a result, because the bond is generally considered not to be property of the estate, the automatic stay does not typically apply to the surety or the bond in general. Thus, even when the Principal on a bond is in bankruptcy, the obligee or a claimant may assert a claim against a bond or maintain a cause of action against the surety under the bond and the surety is free to make payments under the bonds.
But, surety bonds provide a good example of the complexity of the application of the automatic stay. While a bond is not property of the estate and claims can be made against and paid from the bond, cancellation of a bond or renewal of a bond can be covered by the automatic stay, particularly with commercial bonds. Many times commercial bonds, such as license bonds, are required for the commercial principal to remain in business. In these circumstances, many courts will find that the automatic stay applies to such actions. The courts reach this conclusion for a variety of reasons. In some cases, the courts observe that cancellation of bonds is not one of the recognized exceptions to the automatic stay in the Code and that prohibiting cancellation furthers the broad purpose of the stay. One Court noted that while the surety may have the right to cancel its bond, “bringing these kinds of contracts within the ambit of the automatic stay ensures that the legal question of whether a particular contract may be terminated will be decided in the proper forum, after a full briefing by the parties rather than by a nondebtor party acting unilaterally and perhaps erroneously.”
Other courts have held that the automatic stay applies because the act of cancelling a bond constitutes a “proceeding” against the debtor and such action is barred by the stay under the Code. For example, in In re Wegner Farms Co., 49 B.R. 440 (Bankr. N.D. Iowa 1985) the Court addressing a grain dealer license bond, stated:
“Pursuant to Iowa Code, the surety could not legally cancel the bond without giving 60 days’ notice by certified mail to the Iowa State Commerce Commission and the Debtor. Although this procedure was informal and not judicial in nature, it nonetheless was a proceeding by the surety to forfeit the Debtor out of a valid extant contract. As such, the procedures initiated by the surety to terminate the Debtor’s interest in the contract was a proceeding against the Debtor in contravention of section 362(a)(1).”
The Wegner Farms Court also held that the debtor, as the principal under the bond had a protected property interest in the bond. The court observed that the bonding agreement was a valid legal contract entered into by the surety and the principal, now the debtor. Even though the payment obligation ran to the third parties doing business with the debtor as a grain dealer, the debtor’s coverage under the bond was a contractual obligation bargained for by the debtor and for which it paid valuable consideration. The Court stated:
“It defies logic to say that the Debtor as the named principal under bond and the payer of the premium for the coverage provided by the bond had no legal or equitable interest in the bonding agreement. Quite the contrary, the Debtor had valid contractual rights in the bonding agreement on the date of filing. Contractual rights constitute intangible property which is included within the definition of property of the estate. Consequently, the surety’s unilateral termination of the agreement post petition was an attempt to obtain possession of property of the estate in contravention of section 362(a)(3).”
As the treatment of letters of credit and bonds demonstrate, if the action will have an impact on the debtor or the property of the estate, the automatic stay will likely apply.
If the automatic stay does apply, or if you are not sure if the stay applies or not, but you are concerned about violating the stay, what can you do? The Code at §362(d) provides the means and ability to obtain relief from the automatic stay. The Code provides that “[o]n request of a party in interest and after notice and a hearing, the court shall grant relief from the stay, … such as by terminating, annulling, modifying or conditioning such stay.” Under section 362(d)(1) the stay may be lifted or modified for cause, including the lack of adequate protection of an interest in property of such party in interest. Under section 362(d)(2) the stay may be lifted or modified with respect to an act against property of the debtor’s bankruptcy estate, if: (a) The debtor does not have an equity in such property; and (b) Such property is not necessary to an effective reorganization.
The surety may move for relief from the stay to take control of bonded projects pursuant to the surety’s assignment rights under the general indemnity agreement, statutory rights as surety or subrogation rights. Under Section (d)(1) the surety’s primary argument is often the principal’s financial inability to complete the bonded projects. Most bankruptcies occur because the debtor has run out of cash and without sufficient cash, the debtor will not be able to pay for labor, supplies and materials. Many times projects have been front loaded so that the cost to complete the project is greater than the remaining contract funds. Further, delay costs and/or liquidated damages incurred as a result of the bankruptcy will only make the cost to complete greater. The principal cannot provide adequate protection because it is not able to competently and timely complete the bonded projects.
Under Section (d)(2) the surety can get relief from the stay if it can establish that its losses will exceed the remaining contract funds such that the debtor has no equity in the contract funds. For purposes of establishing lack of equity all obligations of the debtor can be combined to determine the debtor’s equity position. It is important to note that the burden will be on the surety to establish entitlement to relief from the stay. In several of my recent bankruptcy cases we were able to convince the Trustee that the debtor had no equity in the open projects and we filed a stipulation allowing the debtor to be terminated from the project and the surety to use the contract funds to complete the projects.
The automatic stay can be tricky business, so the surety must proceed cautiously in deciding whether to “stay or go.” Sorry if the song stays in your head for the rest of the day.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (410-659-1321 or firstname.lastname@example.org) or any member of the Surety and Fidelity Practice Group.
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