Section 362 of the Bankruptcy Code provides that any actions which will negatively affect the bankruptcy estate are stayed during the course of the bankruptcy. That statement is, of course, a simplification, as the Code section itself is multiple pages long and addresses a wide variety of situations. This legal guide will address the question of how the automatic stay affects the parties to litigation when one of the defendants files for bankruptcy.
ONE PLAINTIFF, ONE DEFENDANT
In a case involving just two parties, a plaintiff and defendant, the effect of the automatic stay is pretty straight forward. If it is the plaintiff who files the lawsuit, that lawsuit will generally continue, especially if it is seeking monetary damages. If damages are eventually awarded to the plaintiff, the bankruptcy estate will benefit, so it is usually in the interest of the bankrutpcy estate to proceed with the litigation. This is no different in a scenario where there are multiple plaintiffs, so the "mulitple plaintiffs" situation will not be discussed any more detail.
If it is the defendant who files bankruptcy, then the automatic stay will almost always work to halt the lawsuit, and the plaintiff will be prevented from seeking a judgment against the defendant. The exception to this is where the defendant has a counterclaim against the plaintiff, and it would be in the interest of the bankruptcy estate to pursue the counterclaim and risk an adverse judgment.
Where the lawsuit has been brought against more than one defendant, the question often arises: what happens if just one of the defendants files for bankruptcy? The general rule is that the automatic stay in bankruptcy only applies to the debtor and not to third parties, even if the third parties are codefendants with the debtor in a lawsuit. See Sav-A-Trip v. Belfort, 164 F.3d 1137 (8th Cir. 1999); Bowman v. Computer Learning Ctrs., Inc., 73 Fed.Appx. 735 (5th Cir. 2003); Queenie Ltd. v. Nygard Int’l, 321 F.3d 282 (2d Cir. 2003) (citing 3 Collier on Bankruptcy § 362.03(3)(d) (15th ed. 2002)).
The main issue is whether proceeding against the non-bankrupt defendants would affect the bankruptcy estate. In the Queenie case, cited above, the court held that the case was indeed stayed against one of the non-bankrupt defendants because that particular defendant was a wholly owned subsidiary of the debtor defendant. Obviously, in that case a judgment against the subsidiary would affect the bankruptcy estate of the debtor defendant.
"Although 11 U.S.C.S. § 362(a)(1) is generally available only to a debtor, proceedings against nonbankrupt codefendants may be stayed by a bankruptcy court where there are "unusual circumstances." Such a situation arises when there is such identity between the debtor and the third-party defendant that the debtor may be said to be the real party defendant and that a judgment against the third-party defendant will in effect be a judgment or finding against the debtor. An illustration of such a situation would be a suit against a third-party who is entitled to absolute indemnity by the debtor on account of any judgment that might result against them in the case. In addition, such a relationship may exist where codefendant liability is directly attributable to the debtor."
In re Dow Corning Corp., 86 F.3d 482 (6th Cir. 1996).
So the ultimate question is whether there are "unusual circumstances" that require application of the automatic stay against non-bankrupt defendants. This is going to be a case by case analysis which requires careful consideration of how a judgment against the defendant could affect the bankruptcy estate.
If you are a non-bankrupt defendant, you can usually file a motion either in the trial court where the underlying lawsuit is located, or in the bankruptcy court, to try to get the automatic stay to apply to you. If you are a plaintiff, and the non-bankrupt defendant fails to make such a motion, you are still at risk if the bankruptcy trustee decides that your action violates the stay, so make sure that you have thoroughly examined the effect of a judgment against the third party defendant on the bankruptcy estate.