Options When One of Multiple Defendants Files Bankruptcy
by Eric M. Van Horn
Interesting issues arise in multi-defendant state court lawsuits when one of the defendants files for bankruptcy.
Upon filing for bankruptcy, a debtor is broadly protected by the Bankruptcy Code’s “automatic stay”—a self-executing injunction that prohibits a wide range of actions by creditors (and other parties) against debtors. As a general rule, when the debtor is one of several defendants in a lawsuit, the automatic stay prohibits the action from continuing against the debtor only, not against the other non-debtor defendants. Bowman v. Computer Learning Ctrs., Inc., 73 Fed.Appx. 735 (5th Cir. 2003).
An exception to this general rule may exist when “there is such identity between the debtor and the third-party defendant that a judgment against the third party defendant will in effect be a judgment or finding against the debtor.” A.H. Robins Co., Inc. v. Piccinin (In re A.H. Robins Co.), 788 F.2d 994 (4th Cir. 1986). For the exception to apply, courts generally require a showing of direct and immediate harm to the debtor’s estate. Arnold v. Garlock, Inc., 278 F.3d 426, 436 (5th Cir. 2001) (declining to extend the automatic stay to a non-debtor co-defendant because there was “no formal tie or contractual indemnification” between the co-defendant and the debtor to create an “identity of interests” between them). Plaintiffs have several options to evaluate how to proceed.
A. Seeking Clarification Regarding Application of the Stay.Depending on the nature of the underlying claims and the debtor’s relationship to the other defendants, the extent of the application of the stay may be unclear. Certain state courts may automatically stay the entire action as a precautionary matter. In such instances, litigants may file a motion and request clarification from the bankruptcy court regarding the applicability of the stay. Immediate clarification may be necessary if important deadlines are approaching. If a plaintiff continues an action without clarification, the bankruptcy court may determine the plaintiff’s continuation of such action violated the automatic stay, thereby subjecting the plaintiff to potential damages even absent interference from the state court or objection of the non-debtor defendants. See 11 U.S.C. § 362(k).
B. Severance or Non-Suit. If the claims against the non-debtor defendants are not stayed by the debtor’s bankruptcy filing, the plaintiff may seek to either non-suit the debtor or sever its claims against the debtor and remove them to the bankruptcy court. The plaintiff generally retains discretion to non-suit the debtor, assuming the debtor has not pleaded for affirmative relief. If the plaintiff wishes to continue prosecuting its claims against the debtor, it may seek to sever such claims from the remainder of the lawsuit and remove them to the bankruptcy court.
C. Removal and Remand. The debtor, or any other party, may seek to remove the entire proceeding to the bankruptcy court. See Industrial Clearinghouse Inc. v. Mims (In re Coastal Plains Inc.), 338 B.R. 703 (N.D. Tex. 2006). The bankruptcy court has jurisdiction over a claim assuming the claim could have a conceivable impact on the debtor’s estate. Fire Eagle, L.L.C. v. Bischoff, et. al. (Matter of Spillman Dev. Group, Limited), 710 F.3d 299, 304 (5th Cir. 2013). Upon removal, the plaintiff has several options. First, if the plaintiff wants to continue the suit against all defendants (including the debtor) in the state court, it may seek relief from the stay pursuant to 11 U.S.C. § 362(d) and move to remand the case to state court. Second, if the plaintiff wants to continue the suit in state court against only the non-debtor co-defendants, then the plaintiff may seek a declaration that the stay does not apply to the non-debtors, sever the debtor from the case, and remand to state court. Third, if the plaintiff wants to continue the case in federal court, but has a jury trial right or does not believe that the bankruptcy court has constitutional authority to enter a final order adjudicating the case in the wake of Stern v. Marshall,131 S.Ct. 2594 (2011), the plaintiff may request that the reference to the bankruptcy court be withdrawn to the district court (which has the authority to enter final orders on all claims that have some impact on the bankruptcy estate).
Eric Van Horn is an associate at Wick Phillips and can be reached at email@example.com.