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.
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, 1 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. 2
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. 3 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. 4 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. 5 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. 6 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. 7
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, 8 and recently recognized the bankruptcy court's power to issue contempt orders. 9
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). 10 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. 11
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. 12 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. 13 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. 14
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.