Can a Surety Enforce the Automatic Stay in the Principal’s Bankruptcy?¹

February 2003

Where a contract has not been terminated prior to the bankruptcy, a surety has standing to enforce the automatic stay against the owner. Marilyn Klinger discusses the factors that can affect recovery.

by Marilyn Klinger
Sedgwick, Detert, Moran & Arnold LLP

On occasion, a project owner will arrange for completion of a bonded project, without notifying the surety, and without obtaining relief from the bankruptcy automatic stay that came into effect after the contractor, the bond principal, filed bankruptcy. In those situations where the contract had not been terminated prior to the bankruptcy filing, a surety has standing to enforce the automatic stay against the owner. However, what value there is to the surety in enforcing the automatic stay varies depending upon the bankruptcy court in which the bankruptcy is pending.

The Automatic Stay

Section 362 of the Bankruptcy Code 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)). Section 362’s legislative history describes the purpose of the stay as follows.

The automatic stay is one of the fundamental debtor protections provided by the bankruptcy laws. It gives the debtor a breathing spell from his creditors. It stops all collection efforts, all harassment, and all foreclosure actions. It permits the debtor to attempt a repayment or reorganization plan, or simply to be relieved of the financial pressures that drove him into bankruptcy. [See H.R. Rep. No. 595, 95th Congress, 1st Sess. 340-341 (1977); S. Rep. No. 989, 95th Congress, 2d Sess. 54-55 (1978); U.S. Code Cong. & Ad. News 1978, 5787 at 5840-41.]

Contract Rights Subject to the Automatic Stay

The Bankruptcy Code provides that the “property of the estate” to which the automatic stay applies includes “all legal or equitable interests of the debtor in property as of the commencement of the case” (11 U.S.C. § 541(a)(1)). Courts have held that the Bankruptcy Code’s broad definition of “property of the estate” includes contracts and contract rights,² such that the stay prohibits creditors from unilaterally terminating a contract with the debtor. Thus, an owner cannot simply terminate the contract or hire a replacement contractor while the contract is still in effect.

Violations of the Stay: Void or Voidable?

Section 362 imposes a stay automatically and often without express notice to interested parties (3 Collier On Bankruptcy § 362.11 (15th ed., 1988)). Whether the violation is innocent or willful, the majority rule holds that acts done in violation of the stay are void and without effect such that the creditor may be required to undo the action.³

A limited number of courts have held that acts violating the automatic stay are merely voidable and will take effect in the absence of objection.⁴ The court in In re Soares explained the difference between the majority and minority views as follows.

Treating an action taken in contravention of the automatic stay as void places the burden of validating the action after the fact squarely on the shoulders of the offending creditor. In contrast, treating an action taken in contravention of the automatic stay as voidable places the burden of challenging the action on the offended debtor. [In re Soares, supra, 107 F3d 969, 976 (1st Cir 1997).]

One commentator criticizing the minority “voidable” view, stated:

Some courts view the availability of a remedy from the bankruptcy court as a sufficient safeguard. If only one or two creditors took action despite the filing, the debtor might possibly handle the situation. But if five or six decide to run the risk, a debtor and his or her counsel might well be too distracted. If the view that it may be a good business risk to proceed were to become prevalent, debtors might find the situation impossible. [3 Daniel R. Cowans, Bankruptcy Law and Practice, §11.3(n) (1998).]

Post-Violation Motion for Relief from Stay

Luckily, in the majority of jurisdictions, a creditor who violates the stay in hopes of later validating its action via a motion for relief from stay will not face a favorable reception in the courts.⁵ One court noted simply that “[j]udicial toleration of an alternative procedure of self-help and post hoc justification would defeat the purpose of the automatic stay.” [See Computer Communications, Inc. v Codex Corp. (In re Computer Communications, Inc.), supra, 824 F2d 725 at 731 (9th Cir 1987).]

Does a Creditor Have Standing To Enforce the Automatic Stay?

Courts have uniformly recognized the right of a creditor to enforce the automatic stay against other creditors, citing a variety of sources including legislative history, case law, and legal commentaries.⁶ The legislative history behind Section 362(a)(1) states in relevant part that:

The automatic stay also provides creditor protection. Without it, certain creditors would be able to pursue their own remedies against the debtor’s property. Those who acted first would obtain payment of claims in preference to and to the detriment of other creditors. Bankruptcy is designed to provide an orderly liquidation procedure under which all creditors are treated equally. A race of diligence by creditors for the debtor’s assets prevents that. [H.R. Rep No. 595, 95th Congress, 1st Sess. 340 (1977); S. Rep. No. 989, 95th Congress, 2d Sess. 49 (1978); U.S. Code Cong. & Ad. News 1978, 5787 at 5835. Beyond debtor-enforcement, courts limit enforcement of the automatic stay to other creditors. Courts ruling on the issue have expressly refused to extend the right to enforce the automatic stay to third parties such as a purchaser of the debtor’s assets, In re Prairie Trunk, supra, at 930-31, or a debtor’s daughter, In re Bragg, 56 B.R. 46, 50 (M.D. Ala 1985).]

Sanctions for Violating the Automatic Stay

Unfortunately, a surety raising the issue of an owner’s violation of the automatic has no guarantee regarding a court’s reaction to the news. Most courts treat knowing and willful violations of the automatic stay as contempt of court.⁷ One court articulating the reason for contempt sanctions stated that:

Section 362 acts as an injunction against interference with the bankruptcy court’s jurisdiction over petitioning debtors. Therefore, when a party violates §362’s automatic stay provision, he is harming not only the debtor, but the effectiveness of the bankruptcy court itself in fulfilling the role Congress designed for it. That is why the natural consequence of a §362 violation is a contempt citation. [In Stonegate Sec. Services, Ltd., 56 B.R. 1014, 1019 (N.D. Ill 1986).]

However, not all courts are in agreement with respect to contempt sanctions. Whereas most courts view the automatic stay as “essentially a court-ordered injunction” [In re Lord, 270 B.R. 787 (M.D. Ga 1998)], a minority of circuits refuses to recognize the remedy because the automatic stay arises out of statute and not from a court order.⁸

Circuits, recognizing contempt as the appropriate sanction, include the Second, Third, Fourth, Fifth, Sixth, Seventh, Eighth, and Eleventh Circuits. The Ninth Circuit recognizes civil contempt as the appropriate remedy for stay violations,⁹ and recently recognized the bankruptcy court’s power to issue contempt orders.¹⁰

The Good News: Recovery for Damages

The Bankruptcy Code addresses damages resulting from a violation of the automatic stay in Section 362(h) as follows.

An individual injured by any willful violation of a stay provided by this section shall recover actual damages, including costs and attorneys’ fees, and, in appropriate circumstances, may recover punitive damages [11 U.S.C. §362(h)].

The Bad News: The Majority Holds that Corporate Creditors Are Not Entitled to Damages

While creditors may enforce the automatic stay provision of Section 362, not all creditors are equally entitled to collect damages for violations. The Third and Fourth Circuits hold that corporations are included in the definition of “individuals” entitled to collect damages under Section 362(h).¹¹ However, courts in all other jurisdictions have held, almost uniformly, that corporate debtors (and, by necessary extension, corporate creditors) are not individuals entitled to recover damages.¹²

Thus, the remedy available to the surety will once again depend on where the principal filed bankruptcy.

The Bad News Tempered, Somewhat

Even those courts that refuse corporate entities’ recovery of damages for violations of the automatic stay nonetheless recognize civil contempt as a viable alternative basis for recovery.¹³ However, there are certain inherent limitations on recovery for civil contempt.

First, the standard for imposing civil contempt is typically higher than that imposed by section 362(h). Second, a bankruptcy court has discretion in deciding whether or not to order contempt under Section 11 U.S.C. section 105, whereas Section 362(h) states that an individual injured by a violation “shall” recover damages.¹⁴ Finally, civil contempt allows for compensatory damages, but not punitive damages, whereas Section 362(h) makes punitive damages available in response to willful violations of the stay.¹⁵

Conclusion

A bankruptcy creditor, such as a surety, who encounters another creditor violating the automatic stay has standing, in the vast majority of courts, to bring the violation to the court’s attention. However, whether or not a surety can recover damages caused by the violation depends on a number of factors.

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¹Credit must be given to Peter Cofield of Sedgwick, Detert, Moran & Arnold’s Los Angeles Surety Practice for the thorough research and creative analysis in this article.

²See, e.g., Westmoreland Human Opportunities, Inc. v Walsh, 246 F3d 233 (Pa 2001) (expansive nature of the Bankruptcy Code’s definition of property of the estate encompasses rights and interests arising from ordinary contractual relationships); In re Resource Technology Corp., 254 B.R. 215 (scope of property rights included in bankruptcy estate is broad and includes any contract rights that debtor possessed at time of bankruptcy petition); In re Sherlock Homes of W NY, 246 B.R. 19 (WD NY 2000) (contract rights that debtor possesses on petition date are included in “property of the estate,” even though those contract rights would have had only limited or even no value to debtor itself); Computer Communications, Inc. v Codes Corp (In re Computer Communications, Inc.), supra, 824 F2d 725 (contract falls within definition of property of the estate); Computer Communications, Inc. v Codex Corp. (In re Computer Communications, Inc.), 824 F2d 725 (1987) (citing the debtor’s property rights in the contract).

³See, e.g., Kalb. v Feuerstein, 308 U.S. 433 (1940); In re Soares, 107 F3d 969 (1st Cir 1997); In re 48th Street Steakhouse, Inc., 835 F2d 427 (2nd Cir 1987), cert denied, 485 U.S. 1035 (1989); In re Siciliano, 13 F3d 748 (3rd Cir 1994); Smith v First America Bank, N.A. (In re Smith), 876 F2d 524 (6th Cir 1989); In re Schwartz, 954 F2d 569 (9th Cir 1992); Job v Clader (In re Clader), 907 F2d 953 (10th Cir 1990) (per curiam); Albany Partners Ltd. v Westbrook (In re Albany Partners, Ltd.), 749 F2d 670 (11th Cir 1987), as well as district courts in a number of states. See also, e.g., In re Wright, 75 B.R. 414 (MD Fla 1987) (creditor who learns of pending bankruptcy proceeding may have duty to undo actions taken in violation of stay); In re Johnson, 18 B.R. 755 (SD Ohio 1982) (creditor violating automatic stay must restore debtor’s status quo as it existed at the time of bankruptcy filing); In re Dungey, 99 B.R. 814 (SD Ohio 1989) (creditor initiating post-petition collection without knowledge of bankruptcy petition has affirmative duty to restore the status quo). But see, also, In re Hutchins, 211 B.R. 325 (ED Ark 1997) (employer not necessarily required to reinstate employee even though termination of employment contract violated Chapter 13 stay).

⁴See, e.g., Jones v Garcia (In re Jones), 63 F3d 411 (5th Cir 1995); Easley v Pettibone Michigan Corp., 990 F2d 905 (6th Cir 1993); In re Brooks, 79 B.R. 479 (B.A.P. 9th Cir 1987), aff’d, 871 F2d 89 (1989); Job v Clader (In re Clader), supra, 907 F2d 953, 956 (10th Cir 1990) (per curiam) (recognizing that equitable principles may required holding a violating act as voidable); Brownstone v United States, 46 F3d 1573 (Fed Cir 1995).

⁵See Ramirez v Fuselier (In re Ramirez), 183 B.R. 583, (9th Cir BAP 1995), quoting In re AM Int’l Inc., 46 B.R. 566, 567 (MD Tenn 1985).

⁶See, respectively, In re Prairie Trunk Railway, 112 B.R. 924 (ND Ill 1990); James v Washington Mutual Savings Bank (In re Brooks), 871 F2d 89, 90 (9th Cir 1989); Homer National Bank v Namie, 96 B.R. 652 (WD La 1989), citing, inter alia, 2 Collier On Bankruptcy § 362.04 at 362-32 (15th ed. 1988).

⁷See Mountain Am. Credit Union v Skinner (In re Skinner), 917 F2d 444 (10th Cir 1991) (court may punish stay violations under 11 U.S.C. § 362(h) or as contempt under 11 U.S.C. § 105).

⁸Matter of Rimsat, Ltd., 208 B.R. 910 (ND Ind 1997); In re Calstar, Inc., 159 B.R. 247 (D Minn 1993).

⁹Johnson Environmental Corp. v Knight (In re Goodman), 991 F2d 613, 620 (9th Cir 1993)

¹⁰Caldwell v Unified Capital Corp. (In re Rainbow Mag., Inc.), 77 F3d 278 (9th Cir 1996). Although Caldwell did not expressly overrule General Associated, it recognized that Congress’s subsequent reformation of Rule 9020 and the Supreme Court decision in Chambers v NASCO, Inc., 501 U.S. 32 (1997) superseded the Ninth Circuit decision in Plastiras v Idell (In re Sequoia Auto Brokers, Ltd.), 827 F2d 1281 (9th Cir 1987) upon which the court in General Associated based its holding that the bankruptcy court lacks inherent power to issue civil contempt orders.

¹¹See, e.g., Cuffee v Atlantic Business and Community Development Corp. (In re Atlantic Business and Community Development Corp.), 901 F2d 325 (3rd Cir 1990); Budget Service Co. v Better Homes of Virginia, Inc., 804 F2d 289 (4th Cir 1986); Koffman v Osteoimplant Technology, Inc., 182 B.R. 115 (D Md 1995).

¹²What is perhaps more surprising, however, is that not all courts allow a trustee to recover damages under 362(h). See, e.g., In re Pace, 67 F3d 187, 193 (9th Cir 1995) (any harm suffered in the form of costs and attorneys’ fees is actually incurred by a thing, the bankruptcy estate, and not by the trustee, as an individual); Martino v First National Bank of Harvey (In re Garofalo’s Finer Foods, Inc.), 186 B.R. 414, 439 (ND Ill 1995) (finding that a chapter 7 trustee is an “individual” for the purposes of section 362(h)).

¹³In re General Associated Investors, Ltd. Partnership, supra, 159 B.R. 551 (D Ariz 1993).

¹⁴David Swarthout, Note, When Is An Individual A Corporation?—When The Court Misinterprets A Statute, That’s When!, 8 Am Bankr Inst L Rev 151, 165 (Spring, 2000).

¹⁵See 3 Collier on Bankruptcy 362.11[3] (15th ed. 1988). See also David Swarthout, Note, When Is An Individual A Corporation, supra.

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