Comparing Liquidation Strategies for Troubled Businesses: Stays or Lack of Stay of Enforcement of Creditors Claims

by René Lastreto II1 and Michael J. Gomez2

A troubled business that must be liquidated has some options depending on several circumstances. Obviously, many factors must be considered in choosing the best option for the business, the equity holders in the business and the creditors. This article explores one consideration-stays of creditor enforcement measures. The Assignment for Benefit of Creditors, Receiverships and Bankruptcy each provide different mechanisms for relief from creditor actions.

1. Assignments for Benefit of Creditors

There is no automatic stay that arises upon a debtor’s assignment for the benefit of creditors. The same is true whether it is a general assignment or a limited assignment. This is historically based on the early equity cases which held no inconsistency with or anything forbidding a creditor from suing on its claim even if that creditor filed a claim with an assignee. See, e.g. Lacy v. Gunn 141 Cal. 511, 518 (1904).

Under the former statutory scheme or even current common law, an assignee for benefit of creditors has no greater rights with respect to things-in-action transferred by the assignment than the assignor had. First National Bank of Stockton v. Pomona Tile Manufacturing Company, 82 Cal. App. 2d 592, 608 (1947); In re: Gibson Lithograph, 64-2 U.S. Tax Cases (CCH) P 9749 (D.C.S.D California, 1964). Since there is no basis for a debtor to require a creditor with an mature claim to refrain from enforcing the claim, an assignee has no additional statutory or common law authority to require the same from creditors. Accordingly, one draw back of an assignment for benefit of creditors is the lack of a “standstill” that arises by operation of law.

Under common law assignments, the assignee may in her discretion and according to what she considers to be in the best interest of the creditors, perform or refuse to perform the assignor’s part of an executory contract. The assignee must exercise ordinary prudence and good faith in dealing with the assignor’s contract obligations and where she induces the other party to perform or reaps the benefits of a contract, the assignee must assume the obligations. Sweet v. Markwat, 158 Cal. App. 2d 700, 707 (1958).

While a stay does not arise automatically, one statutory exception to the general rule relates to the occupancy by an assignee of business premises. Under California Civil Code § 1954.1 a general assignee for the benefit of creditors has the right to occupy. for a period up to 90 days after the date of the assignment, a business premises held under a lease by the assignor. The assignee must pay rent when due for the period of the occupancy. Id. this provision applies whether or not a lease by its terms can be terminated based upon the tenant’s insolvency or the tenant’s execution of an assignment for the benefit of creditors. Id. While not an “automatic stay” similar to what arises under bankruptcy law, this provision does allow assignees to at least temporarily occupy business premises even if the assignor has breached the lease.

There are no reported cases construing Civ. Code § 1954.1 however, in 250 LLC v. Photopoint Corp.(USA) et al., 131 Cal. App. 4th 703, 718 (2005) the Court of Appeal, in dicta, noted that since the assignee for benefit of creditors in that case did not continue to pay rent, the date of termination of a lease could be determined by a trial court with appropriate facts.

2. Receivers

Similar to assignees for the benefit of creditors, there is not an automatic stay of any proceeding because a Receiver is appointed. California Code of Civil Procedure § 568 provides in part that the receiver has under the control of the Court the power to “do such acts respecting the property as the Court may authorize.” Thus under the general provisions governing Receivers, it is contemplated that the Court may authorize the receiver to take actions to protect the property under the Receiver’s control. That should be contrasted with an automatic stay or injunction simply upon the appointment of the Receiver which is not provided under the general Receiver statutes.

Quite often however, in connection with the pending action in which the Receiver is appointed, various injunctions are issued by the appointing court. Commonly, injunctions are issued consistent with the Receiver’s authority prohibiting interference with collection or control of property. Injunctions are issued precluding the conveyance of property or income from the property. Further, injunctions are issued to prevent interference with a Receiver’s specified duties. These injunctions issued by the trial court in connection with the appointment of a Receiver are only effective against the parties subject to the Court’s jurisdiction. That will often not include creditors that may not be parties to the litigation.

California Code of Civil Procedure § 568 permits a receiver under the control of the court to bring and defend actions in his own name as Receiver. Accordingly, the only authority a Receiver may have to seek an injunction against creditor action would have to arise from the order appointing the Receiver or a subsequent order of the court issued in the receivership action. See, Turner v. Superior Court, 72 Cal. App. 3d 804, 813 (1977); Ostrowksi v. Miller, 226 Cal. App. 2d 79, 84 (1964). Since there is no automatic injunction against creditor actions, a Receiver needs to seek an injunction to halt collection efforts.

Under certain circumstances, an injunction may be invoked to stay judicial proceedings arising before or after the action in which the injunction is demanded. Glade v. Glade, 38 Cal. 4th 1441, 1455 (1995); Code Civ. Proc. § 526(b)(1); Civ. Code § 3423(a); Advanced Bionics Corp. v. Medtronic Inc., 29 Cal. 4th 697, 704-708 (2002). Many years ago the California Supreme Court noted “the Courts of this State have the same power to restrain persons within the State from prosecuting actions in either domestic or foreign jurisdictions which Courts of equity have elsewhere.” Spreckels v. Hawaiian Com. Etc Co., 117 Cal. App. 377, 378 (1897).

In a variety of contexts, including contractual disputes involving multiple parties and separate but related actions, injunctions have been properly issued to stay litigation in all but one action, pending resolution of the key matters. Fidelity & Deposit Co. v. Santa Monica Finance Co., 182 Cap. App. 2d 211, 212-217 (1960); Aldrich v. Transcontinental Land etc. Co., 131 Cal. App. 2d 788, 796-97 (1955). There is also the rule that a court of equity may retain continuing jurisdiction to meet future problems and changing conditions. See, Rynsburger v. Dairyman Fertilizer Cooperative Inc., 266 Cal. App. 2d 269, 279 (1968). The strong policy supporting these decisions is often the avoidance of “unseemly conflict” that might arise between California courts if free to make contradictory decisions. Advanced Bionics Corp, Supra 29 Cal. 4th at 706.

In California, an injunction may be issued by a Superior Court to prevent a multiplicity of proceedings. Code Civ. Proc. § 526(a)(6); Civ. Code § 3422 (3). An injunction may not be granted to stay judicial proceedings pending at the commencement of the action in which the injunction is demanded, unless the restraint is necessary to prevent a multiplicity of proceedings. Code C iv. Proc. § 526(b); Civ. Code § 3423(a). Any provisional injunction will require the posting of an undertaking. Code Civ. Proc. § 529(a). Generally, the balancing test most commonly applied by Courts is the likelihood that the plaintiff will succeed on the merits and the interim harm that the plaintiff will suffer if the injunction is not issued compared to the interim harms that the defendant will suffer if it is. IT Corps. v. Imperial, 35 Cal. 3d 63, 69, 70 (1983). The more likely it is that the plaintiff will prevail in the merits, the less severe the interim harms that the plaintiff must allege, particularly when the injunction maintains, rather than alters the status quo. King v. Meese, 43 Cal. 3d 1217, 1227-28 (1987).

Realistic issues facing the Receiver will include whether the Receiver will “prevail on the merits.” Obviously, a claim by the Receiver that the assertion of the creditor’s right lacks merit would be very helpful. However, since the claims likely have merit (at least in part) it may not be a successful strategy to “take on” the claim. Instead, the necessity for proving harm from a multiplicity of actions may be the most effective strategy. An alternative would be to ask the Court to consolidate many pending proceedings or permit the creditors to intervene the action in which the Receiver was appointed. That procedural step will permit some control over the litigation and focus the creditors and their counsel on what exactly the Receiver is trying to accomplish. See Rynsburger supra 266 Cal. App. 2d at 279.

Depending on the type of receivership (general equity, federal, or other speciality receivership), a stay may be available to the receiver to protect against interference with assets of the receivership estate. SEC v. United Financial Group, Inc., 576 F.2d 217 (9th Cir. 1978); SEC v. Wencke, 622 F.2d 1363 (9th Cir. 1980); SEC v. Amer. Capital Invs., Inc., 98 F.3d 1133 (9th Cir. 1996); see Escher v. Harrison Sec. Co., 79 F.2d 777 (9th Cir. 1935) (landlord intervened in action to seek modification of injunction to recover possession of premises) . The stay is typically obtained by proponents that seek the appointment of the receiver, but receivers may be able to obtain an injunction prohibiting the dissipation of potential receivership estate assets. Janvey v. Alguire, 647 F.3d 585 (5th Cir. 2011).

3. Bankruptcy Stay

As a general proposition, no stay is available to assignees that act for the benefit of creditors. Bankruptcy trustees, on the other hand, enjoy well-recognized protections from the ravages of creditors against property held in custodia legis. The stay in bankruptcy prohibits creditors from continuing litigation, initiating new litigation, executing on assets, creating or enforcing liens, and affecting the control of assets. 11 U.S.C. §§ 362(a)(1) – (4); In re LPM Corp., 300 F.3d 1134 (9th Cir. 2002) (“. . . the Code jealously protects the process by which a creditor proceeds against property of the estate as fundamental and absolute.”). The stay also applies to indirect actions that detrimentally affect the value of assets. In re Prudential Lines, Inc., 928 F.2d 565 (2d Cir. 1995) (stay prohibited parent corporation from taking a worthless stock deduction of the bankrupt subsidiary); In re Bialac, 712 F.2d 426 (9th Cir. 1983) (“Neither of these interests are within protections afforded by a literal interpretation of section 362, yet they should be protected by the stay . . .”).

A. Breadth of Automatic Stay

The filing of a bankruptcy petition creates a Bankruptcy Estate, which is protected by an automatic stay of actions by all entities to collect or recover on claims. 11 U.S.C. §§ 541(a) and 362(a). The automatic stay arising in the Bankruptcy Court where a debtor files a petition for relief (The home Bankruptcy Court) applies to all other Bankruptcy Courts. Snavely v. Miller (In re Miller), 397 3d 726, 731 (9th Cir. 2005). The policy behind section 362 is to protect the estate from being depleted by creditors’ lawsuits and seizures of property in order to provide the debtor breathing room to re-organize. White v. City of Santee (In re White), 186 BR 700, 704 (9th Cir. BAP 1995). The automatic stay extends to prevent piece meal dismemberment of the Bankruptcy Estate. Id. Thus, the automatic stay prohibits “any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate” 11 U.S.C. § 362(a)(3). The automatic stay preserves assets for both the estate and creditors. Prewitt v. N. Coast Vill., Ltd. (In re N. Coast Vill., Ltd.), 135 BR 641, 643 (9th Cir. BAP 1992).

The scope of protections embodied in the automatic stay is quite broad and serves as one of the most important protections in bankruptcy law. Eskanos & Adler, P.C. v. Leetine, 309 F.3d 1210, 1214 (9th Cir, 2002). Although the scope of the automatic stay is broad, it does not stay all proceedings. Courts have recognized that the automatic stay does not apply to actions against the debtor in the debtor’s home Bankruptcy Court. In re Miller, supra 397 F.3d, 730; In re N. Coast Vill. Ltd., supra 135 BR at 643. Additionally, the automatic stay has been found inapplicable to lawsuits initiated by the debtor. Eisinger v. Way, (In re Way), 229 BR 11, 13 (9th Cir. BAP, 1998) (Primary policy consideration does not exist where debtor has initiated a lawsuit against a creditor); Martin-Trigona v. Champion Federal Savings & Loan Association, 892 F.2d 575, 577 (7th Cir. 1989) (Statutory language refers to actions “against the debtor”). Alternatively, a defendant in an action brought by a Plaintiff/Debtor may defend itself in that action without violating the automatic stay. Gordon v. Whitmore (In re Merrick), 175 BR 333, 336 (9th Cir. BAP 1994); In re Way, supra 229 BR at 133. The automatic stay may protect non-debtors only under “unusual circumstances” where the interests of the debtor are inextricably interwoven. See, A.H. Robins v. Pyocyanin, 788 F.2d 994, 999 (4th Cir., 1986) Cert. Denied, 479 US 876, 107 S.CT. 251 (1986). However the 9th Circuit has held that “although referred to as extensions of the automatic stay” it is in fact an injunction issued by the Bankruptcy Court after a hearing where it is established that unusual circumstances are needed to protect the administration of the Bankruptcy Estate. Boucher v. Shaw, 572 F.3d 1087, 1093 n.3 (9th Cir.,2009) (Citing In re Chugach Forest Products, Inc., 23 F.3d 241, 247 (9th Cir.,1994); In re Spaulding Composites Co., Inc., 207 BR 899 (9th Cir., BAP 1997). Thus any extension of the automatic stay to non-debtors does not occur automatically but requires the filing of an adversary proceeding requesting the Bankruptcy Court to act under section 105(a).

B. Relief from Stay

1. “For Cause”

11 U.S.C. § 362(d)(1) allows for the granting of relief from the automatic stay “for cause.” What constitutes cause for purposes of section 362(d) “has no clear definition and is determined on a case-by-case basis” In re Tucson Estates, 912 F.2d1162, 1166 (9th Cir., 1990). See also, Little Creek Development Company v. Commonwealth Mortgage Corporation (In the Matter of Little Creek Development Company), 779 F.2d 1068, 1072 (5th Cir., 1986) (Relief from the automatic stay may be “granted for cause, a term not defined in the statute so as to afford flexibility to the Bankruptcy Courts a party seeking relief must first establish a cause of exist for relief under section 362(d)(1)”). United States of America v. Gould (In re Gould), 401 BR 415, 426 (9th Cir., BAP 2009), citing Duvar Apartment, Inc. v. FDIC (In re Duvar Apartment, Inc.), 205 BR 196, 200 (9th Cir., BAP 1996). Once a prima facie case has been established, the burden shifts to the debtor to show that relief from the stay is not warranted. Id.

2. “Lack of Equity and Unnecessary to Effective Reorganization”

A second separate grounds for relief from the automatic stay is that the property at issue has no equity and is not necessary for an effective reorganization. 11 U.S.C. § 362(d)(2). The burden of proof on the issue of the debtor’s equity in property rests with the moving party, while the party opposing such relief has the burden of proof on all other issues. 11 U.S.C. § 362(g). Equity for purposes of section 362(d)(2), is the difference between the value of the property and all encumbrances on it. Sun Valley Newspapers Inc. v. SunWorld Corp (In re Sun Valley Newspapers, Inc.), 171 BR 71, 75 (9th Cir., BAP 1994) (Citing Stewart v. Gurley, 745 F.2d 1195, 1196 (9th Cir., 1984). “The concept of equity in property is based on the premise that the property itself has some economic value to its owner.” Scripps GSB I, LLC, v. A Partners, LLC (In re A Partners, LLC), 344 BR 114, 121 (B. CT. E.D. California, 2006).

Once the issue of equity is determined it is then up to the debtor to prove that the property is necessary for an effective reorganization. The United States Supreme Court in United Savings Association of Texas v. Timbers of Inwood Forest Associates, Limited,484 US 365; 108 S. Ct. 626 (1988) held that a debtor must establish the property is essential for an effective reorganization that is in prospect…. this means a reasonable possibility of a successful reorganization within a reasonable time. Id. at 376, 108 S.CT. 633; In re Dev., Inc., 36 BR 998, 2005 (B.Ct.D. Hawaii, 1984) (cited with approval by Timbers). A debtor must do more than merely assert that it can reorganize if only given the opportunity to do so. American State Bank v. Grand Sports Inc. (In re Grand Sports Inc.), 86 BR 971, 975 (B.Ct.N.D. Illinois 1988).

It is worth noting here that relief from stay proceedings are very limited in scope. In In re Luz International Ltd., 219 BR 837, 843 (9th Cir., BAP 1998), the Bankruptcy Appellate Panel reversed a Bankruptcy Court’s granting of a setoff in the course of granting a motion to modify stay. The Panel explained that the hearing on a motion to modify stay is a summary proceeding in which a Court should seek only to determine whether the party seeking relief has a colorable claim to property of the estate, and the expedited nature of the hearing “limits the Court’s ability to make a full adjudication of the merits of the parties claims.” Id at 842. The Panel recently cited Luz in holding “that a party seeking stay relief it need only established it has a colorable claim to enforce a right against property of the estate.” In re Gould, supra 401 BR at 425 note 14 (9th Cir., BAP 2009); In re Grella, 42 F.3d 26, 32 (1st Cir.,1994).

3. Single Asset Real Estate Cases.

A single asset real estate case is a defined term under the Bankruptcy Code. See 11 U.S.C. § 101(51 B). The Bankruptcy Code defines “single asset real estate” as:

Real property constituting a single property or project, other than residential real property with fewer than four residential units, which generates substantially all of the gross income of the debtor who is not a family farmer and on which no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental thereto. Id.

As one can imagine, most stay relief litigation involving single asset real estate cases often involve the definition of a “single asset real estate” case and whether that definition is applicable to the case at issue.

11 U.S.C. § 362(d)(3) provides the Court shall grant relief from the automatic stay with respect to a stay of an action against single asset real estate unless, within 90 days of the filing of the petition in Bankruptcy unless, the debtor files a plan that has a reasonable possibility of being confirmed within a reasonable time, or commences monthly payments under the contract rate on the value of the creditor’s interest in the real estate.

4. Scheme to Hinder, Delay or Defraud Creditors.

When a Court grants relief from the automatic stay pursuant to 11 U.S.C. §362(d)(4), it gives creditors in rem relief from the automatic stay such that the order is binding in any bankruptcy case filed in the next two years purporting to affect the same real property 11 U.S.C. § 362(d)(4), (b)(20).

To obtain relief under section 362(d)(4), the Court must find the following three elements are present: (1) the Debtor’s bankruptcy filing was part of a scheme; (2) the object of the scheme was to delay, hinder or defraud creditors; and (3) the scheme must involve either (a) the transfer of some interest in the real property without the secured creditor’s consent or Court approval, (b) multiple bankruptcy filing affecting the property. First Yorkshire Holdings, Inc. v. Pacifica L 22, LLC, (In re First Yorkshire Holdings, Inc.), 470 BR 864, 870-71 (9th Cir., BAP 2012).

This provision (and (d) (3) discussed above) was added in 2005. This particular subdivision was included to prevent the “property dumping” schemes which had plagued bankruptcy practice for many years. Under the schemes, numerous transfers were made of commercial real property among various related entities and individuals who would then file successive bankruptcy petitions in order to obtain the benefits of the automatic stay.

1. Mr. Lastreto is an owner/shareholder at Lang Richert & Patch, in Fresno, California. With over 30 years of experience in all aspects of creditor’s rights litigation and insolvency law, Mr. Lastreto focuses his practice on assisting creditors with various issues that arise in both State and Federal Courts, including Bankruptcy Court.

2. Mr. Gomez is an associate in the Financial Services Litigation group at Lang, Richert & Patch, in Fresno, California. Mr. Gomez has been involved in insolvency and restructuring law with an emphasis on creditor’s rights in his six years of practice. Prior to private practice, Mr. Gomez was a law clerk for the Hon. Meredith Jury, U.S. Bankruptcy Judge for the Central District of California.

3. It is unclear that asserting a claim for recoupment violates the stay. See, Bull v. US, 295 US, 247, 262, 55 S.Ct. 695 (1935) (“Recoupment is in the nature of a defense arising out of some feature of the transaction upon which the Plaintiff’s action is grounded”); OZARK LLC v. Americas Mining Corp. 396 BR 278, 432 (S.D. Texas, 2008) (“Recoupment is a common law equitable doctrine that permits a defendant to assert a defensive claim aimed at reducing amount of damages recoverable by a Plaintiff”).