Common Issues When a Party to Litigation Faces Financial Distress

Bankruptcy Filing Impact on a Settlement
Several issues arise when a settlement party files for bankruptcy.  For instance, settlement proceeds may be considered property of the estate and therefore payments made pursuant to a settlement may be recovered by a bankruptcy trustee including through preference litigation.
Pursuant to 11 U.S.C. § 547, certain payments made by a debtor in advance of the commencement of a bankruptcy filing may be avoided and recovered by a bankruptcy trustee. To avoid such payments, the trustee must demonstrate that the payments were made (1) of the debtor’s property; (2) to or for the benefit of a creditor; (3) for or on account of an antecedent debt; (4) while the debtor was insolvent; and (5) within 90 days before the bankruptcy was filed (or one year in the case of an “insider”). The creditor also must have received more than the creditor would have in the bankruptcy had it not received the payments. 11 U.S.C. § 547.
In order to protect a payment made pursuant to a settlement agreement from later being avoided as preferential, any plaintiff’s counsel with a concern about the financial condition of the prospective debtor should consult bankruptcy counsel about how to structure the agreement in such a way to preclude or substantially hinder the trustee from making a prima facie case pursuant to Bankruptcy Code section 547.

Substantive Bankruptcy Laws and Bankruptcy Filing Procedural Rules
First of all, it is important to note that, while the Federal Rules of Evidence apply to proceedings in bankruptcy court, any litigator who appears in bankruptcy court will need to get acquainted with the Federal Rules of Bankruptcy Procedure (the Bankruptcy Rules).  The Bankruptcy Rules are similar to and in many respects mirror precisely many (but not all) of the Federal Rules of Civil Procedure (FRCP); however, if you have a case in bankruptcy, do not just assume that the procedural rules will be exactly the same.

Disputes are generally decided in bankruptcy court in two contexts: (1) adversary proceedings and (2) contested matters. Contested involuntary proceedings are a third category, and these are governed by Bankruptcy Rule 1018. But most disputes are either adversary proceedings or contested matters, and different rules apply depending on the characterization of the dispute.

Bankruptcy Rule 7001 provides a list of proceedings that must be commenced as an adversary proceeding, and that list includes most actions to recover money or property and those seeking injunctive or equitable relief. If you are seeking relief contemplated by Bankruptcy Rule 7001, you will need to comply with all of the “7000 series” of the Bankruptcy Rules. While many of these rules simply adopt their counterpart within the FRCP, other rules differ in key respects from their FRCP counterparts. Bankruptcy Rule 7004(b) on service of process (which is a requirement for an adversary proceeding but not a contested matter), for instance, provides for service of process by first class mail (other than service on an insured depository institution), in contrast to FRCP 4.

An adversary proceeding, once initiated, is assigned a case number in addition to the main bankruptcy case number. In contrast, contested matters—which are basically all disputes not covered by Bankruptcy Rules 7001 or 1018—do not receive an additional case number. Relief needs to be requested by motion, and they are simply treated as motions within the main bankruptcy case. In a contested matter, you do not need to comply with all the 7000 series of rules, but you do need to comply with some of them. For example, while a motion initiating a contested matter does not, like an adversary proceeding, require service of process, many of the procedural rules do apply, including the rules on discovery, summary judgment, and enforcement. Bankruptcy Rule 9014(c) contains the list of rules from the 7000 series that apply to contested matters. Some examples of contested matters include motions to lift or modify the automatic stay, motions for adequate protection, and motions to sell assets of the estate. Evidentiary hearings on these motions often are complex and take longer to try than certain adversary proceedings.

Statutes of Limitations
One threshold bankruptcy issue a litigator needs to consider is the statute of limitations. Under certain circumstances, Bankruptcy Code section 108 allows for the extension of time of any statute of limitations to commence an action that the debtor could have taken before filing its bankruptcy petition for two years after the petition date, unless the applicable statute of limitations would expire later under applicable non-bankruptcy law.

The Automatic Stay
Most litigators know that when a bankruptcy petition is filed, the automatic stay is imposed, but the impact of the automatic stay is not always simple to navigate. The automatic stay is an integral part of the Bankruptcy Code because it helps preserve the status quo and is intended to prevent a chaotic and uncontrolled scramble for a debtor’s assets by creditors. The stay prohibits the commencement, continuation, and/or enforcement of most acts against the bankruptcy estate or property of the estate. The effect of the automatic stay on pending litigation is sometimes confusing for non-bankruptcy practitioners. If the action was commenced against the debtor, as a general rule, it is stayed regardless of its current posture. If the debtor is the plaintiff and there are no counterclaims seeking affirmative relief, the pre-petition action is not stayed. 

Section 362(b) of the Bankruptcy Code contains many exceptions to the automatic stay. For example, the automatic stay does not prohibit the commencement or continuation of many forms of family law litigation (such as custody disputes) or the commencement or continuation of an action or proceeding by a governmental unit. However, if there is ever any doubt about whether the automatic stay applies, do not guess! This is not a situation where it is better to ask for forgiveness than to ask for permission, because sanctions (including attorney fees) commonly are imposed on those who violate the stay. Suffice it to say, when in doubt you should seek relief from the automatic stay before taking any other action; such a request is done by motion, so it is a contested matter, not an adversary proceeding.

The automatic stay does not bar a party from commencing an adversary or contested proceeding against the debtor in the bankruptcy court. Section 362(d) of the Bankruptcy Code and Bankruptcy Rule 4001 create a procedure for creditors to seek relief from the stay. Upon the request of a party-in-interest and after notice and hearing, the court shall grant relief from the stay for cause, including lack of adequate protection of an interest in property of such party-in-interest.

The party requesting relief from the stay has the burden of proof on the issue of the debtor’s equity in property, while the party opposing relief from stay has the burden on all other issues.  However, the moving party must first establish a prima facie case in support of its request for relief from the automatic stay.

Removal
One alternative to seeking relief from the stay, however, is to remove the pending lawsuit pursuant to 28 U.S.C. § 1452. Pursuant to that section, any party may remove “any claim or cause of action in a civil action . . . , to the district court for the district where such civil action is pending, if such district court has jurisdiction of such claim or cause of action under section 1334 of this title.” 28 U.S.C. § 1452(a). The court to which such a claim is removed may remand “on any equitable ground,” and such determination is not appealable. 28 U.S.C. § 1452(b).

Bankruptcy Rule 9027 governs the procedure for bankruptcy removals and remands. Among other important provisions, Bankruptcy Rule 9027 sets the deadlines for filing a bankruptcy removal. If the action was initiated pre-petition, Bankruptcy Rule 9027(a)(2) provides that a removal may be filed within the longest of (a) 90 days after the order for relief, (b) 30 days after entry of an order terminating the automatic stay if the action is subject to the automatic stay (i.e., if the action seeks relief from the debtor), or (c) 30 days after a chapter 11 trustee is appointed (but not later than 180 days after the order for relief). If the action is initiated post-petition, Bankruptcy Rule 9027(a)(3) provides that a removal may be filed within the shorter of (a) 30 days after receipt, through service or otherwise, of a copy of the initial pleading setting forth the claim or cause of action to be removed; or (b) 30 days after receipt of the summons if the initial pleading has been filed with the court but not served with the summons.

Although section 1452 and Bankruptcy Rule 9027 appear to clearly state that such a removal must be filed in the district court in the district where the action is pending, bankruptcy removals often get filed in the district where the bankruptcy is pending, and often the removals are filed in bankruptcy court. The propriety of such filings is often judged on the basis of local rules and local practice, so be sure to review the local rules with respect to bankruptcy removals in addition to Bankruptcy Rule 9027.

Stern v. Marshall: Constitutional Authority of the Bankruptcy Court under Attack
Notwithstanding the painstaking specificity with which certain statutes and rules appear to provide bankruptcy courts with authority to hear certain matters, the constitutional authority of the bankruptcy court is currently under attack. In bankruptcy proceedings, 28 U.S.C. § 157 allocates decision-making power over adversary proceedings and contested matters to both the district court and the bankruptcy judges within the district. Upon referral by the district court, the statute authorizes bankruptcy judges to hear and determine core proceedings, subject to ordinary appellate review. Id. For noncore proceedings, bankruptcy judges may only hear the proceeding and submit proposed findings of fact and conclusions of law to the district court for de novo review. 28 U.S.C. § 157(c)(1). If the parties to the proceeding consent, the bankruptcy judge may hear and determine a noncore proceeding, including entering a final order or judgment, subject to ordinary appellate review. 28 U.S.C. § 157(c)(2).

Stern v. Marshall (564 U.S. 2 (2011)), involved an adversary proceeding by a creditor to declare his defamation claim nondischargeable and a counterclaim by the debtor’s estate for tortious interference. The Supreme Court held that although there was statutory authority for the bankruptcy judge to decide the counterclaim—because it was listed as a core proceeding under 28 U.S.C. § 157(b)(2)(C)—there was no constitutional authority for the bankruptcy judge to do so because an Article III court was required. Id. at 6. The Court stated that there would be constitutional authority for the bankruptcy court to determine the counterclaim only if the counterclaim stemmed from the bankruptcy case itself or “would necessarily be resolved in the claims allowance process.” Id. 

Although Stern focused on a relatively narrow aspect of bankruptcy judges’ authority, courts around the country have struggled with interpreting the decision and its implications. Litigants are using the decision to call into question bankruptcy judges’ authority to hear and determine a myriad of matters that they have historically presided over. Indeed, Stern will affect litigation strategies of both companies attempting to reorganize their affairs and trustees pursuing claims on behalf of the estate. This is especially true of fraudulent transfer and fiduciary duty litigation—two of the most common types of litigation commenced in bankruptcy courts. Any litigator who handles an adversary proceeding in bankruptcy will need to consider the implications of Stern and its progeny.

D&O and Other Insurance Issues
Directors and officers of financially distressed companies face a heightened risk of personal liability. Difficult decisions made by a struggling company’s management may be vulnerable to second-guessing in bankruptcy, including by a trustee seeking a recovery from management for the company’s failure. Executives of struggling companies also face the significant practical concern that the bankrupt company may not have the financial wherewithal to meet its indemnification obligations.

Absent careful front-end planning by the company during the process of obtaining insurance, a bankruptcy filing can present challenges for individual directors and officers seeking access to D&O policy funds. A common question that arises: To what extent are the proceeds of the D&O policy property of the estate?

Many courts consider the D&O policy and its proceeds separately in determining whether they are the property of the bankruptcy estate of the insured debtor. In this regard, a majority of courts consider D&O policies property of the debtor’s estate. See, e.g., La. World Exposition, Inc. v. Fed. Ins. Co. (In re La. World Exposition, Inc.), 832 F.2d 1391, 1399 (5th Cir. 1987)(“There are a great many bankruptcy cases holding that liability insurance policies that provide coverage for the bankrupt’s liability belong to the bankrupt’s estate.”) (emphasis in original) (collecting cases); Ochs v. Lipson (In re First Cent. Fin. Corp.), 238 B.R. 9, 16 (Bankr. E.D.N.Y. 1999)(“[W]hen a corporation becomes the subject of a bankruptcy case, its insurance policies become property of the bankruptcy estate.”).

The larger issue is whether D&O policy proceeds also are the property of the estate. Courts have developed divergent approaches to answer this question that may depend on one or more of the following considerations: (1) whether the operative policy provides entity coverage to the bankrupt corporation; (2) whether the bankrupt corporation has a legitimate interest in the policy proceeds; and (3) whether the policy proceeds are the largest available asset in the bankruptcy proceeding. Numerous courts have held that, where the debtor company does not have a “direct interest” in the proceeds of a D&O policy, the proceeds are not property of the bankruptcy estate.  See, e.g., La. World Exposition, Inc., 832 F.2d 1391; In re MCSi, Inc., Secs. Litig., 371 B.R. 270 (S.D. Ohio 2004); Youngstown Osteopathic Hosp. Ass’n v. Ventresco (In re Youngstown Osteopathic Hosp. Ass’n), 271 B.R. 544 (Bankr. N.D. Ohio 2002); Imperial Corp. of Am. v. Milberg, Weiss, Bershad, Spechtrie & Lerach (In re Imperial Corp. of Am.), 144 B.R. 115 (Bankr. S.D. Cal. 1992); In re Daisy Sys. Secs. Litig., 132 B.R. 752 (N.D. Cal. 1991); Zenith Lab., Inc. v. Sinay (In re Zenith Lab. Inc.), 104 B.R. 659 (Bankr. D.N.J. 1989). Other courts have found, however, that where there are claims for indemnification coverage under the applicable insurance agreement, the D&O policy proceeds may be property of the bankruptcy estate. See In re Leslie Fay Cos., Inc., 207 B.R. 764 (Bankr. S.D.N.Y. 1997);Circle K Corp. v. Marks (In re Circle K Corp.), 121 B.R. 257 (Bankr. D. Ariz. 1990). These courts reason that payments to the directors and officers for defense expenses would deplete the policy limits, thereby increasing the debtor’s exposure to indemnification claims in other litigation. See, e.g.,Circle K Corp., 121 B.R. at 261–62. Thus, according to these courts, the debtor’s interest in being reimbursed by the insurer for the amounts it must indemnify its directors and officers is sufficient to hold that the policy’s proceeds are an asset of the bankruptcy estate.

If policy proceeds are deemed property of the estate, directors and officers may be precluded from accessing those proceeds without court approval. The property of the estate analysis may depend in part on the type of D&O policy and on the applicable jurisdiction. Because individual executives may not be subject to the automatic stay, the practical consequences can be very significant for individuals who are relying on insurance funds to cover their litigation costs.

Keywords: bankruptcy and insolvency litigation, Bankruptcy Code, bankruptcy rules, settlements, directors and officers, Stern v. Marshall