The most beneficial protection provided to individuals and corporate entities filing during bankruptcy proceedings is the “automatic stay”. The automatic stay is immediately invoked upon the filing of a bankruptcy petition and prevents any creditor from taking actions to collect a pre-petition debt. This article will explore whether any other individual or corporate entity also obligated to the same debt (also know as a “co-debtor”) is protected by the automatic stay, even if they did not seek bankruptcy relief.
Chapter 13 Co-Debtor Bankruptcy Stay
“[I]t is universally acknowledged that an automatic stay of proceedings accorded by § 362 may not be invoked by entities such as sureties, guarantors, co-obligors, or others with a similar legal or factual nexus to the ... debtor.” McCartney v. Integra Nat. Bank N., 106 F.3d 506, 509–10 (3d Cir. 1997)(citing Maritime Elec. Co. Inc. v. United Jersey Bank, 959 F.2d 1194, 1205 (3r Cir. 1991)(quoting Lynch v. John-Manville Sales Corp., 710 F2d. 1194, 1196-97 (6th Cir. 1983)). However, collection actions may be stayed against Chapter 13 co-debtors pursuant to 11 U.S.C. § 1301. Section 1301(a) “[was] designed to protect a debtor operating under a Chapter 13 individual repayment plan case by insulating him from indirect pressures from his creditors exerted through friends or relatives that may have cosigned an obligation of the debtor.” H.R.Rep. No. 95–595, 95th Cong., 2nd Sess. 426, reprinted in 1978 U.S.C.C.A.N. 5787, 5963, 6381.
To understand the co-debtor stay in Chapter 13 proceedings, it is best to explain it by using an example. Imagine a husband that files for Chapter 13 protection and his wife does not also file for bankruptcy. The husband lists a credit card debt that both the debtor and his wife are obligated to pay. The automatic stay will protect both the debtor and the co-debtor (ie. husband and wife), even though she did not file for bankruptcy.
It should also be noted that the co-debtor stay only applies to “consumer debts”. Pursuant to 11 U.S.C. § 101, a consumer debt is defined as a “debt incurred by an individual primarily for a personal, family, or household purpose.” This generally includes credit cards, mortgages, medical bills, personal loans, and car loans. Notably, the definition of consumer debt does not include tax debts.
Even though this article uses a husband and wife as the example, the protection of the co-debtor stay will extend to any individual who is responsible for a consumer debt. This includes debtor/friend and parent/child relationships.
If an individual files for Chapter 7 or Chapter 11 bankruptcy protection, the co-debtor stay will not apply. Generally, the co-debtor stays only exists in Chapter 13 individual cases and extends to consumer debts. However, in limited situations, the co-debtor stay may be extend in other bankruptcy proceedings and non-consumer debts.
Extending the Co-Debtor Stay to Chapter 7 and Chapter 11 Bankruptcy Proceedings
The prohibition of extending the automatic stay to nonbankruptcy co-debts in Chapter 7 and Chapter 11 bankruptcy proceedings has been liberalized in recent years. It is most common in corporate bankruptcy cases. These courts have extended the automatic stay to nonbankrupt co-defendants in “unusual circumstances.” “Unusual circumstances” can be found 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.” McCartney v. Integra Nat. Bank N., 106 F.3d 506, 509–10 (3d Cir. 1997) (quoting A.H. Robin., Inc. v. Piccinin, 788 F2d 994, 999)(relying on both the automatic stay provision and the bankruptcy court's equitable powers under 11 U.S.C. § 105 to enjoin actions against nondebtor codefendants in the Dalkon Shield products liability litigation because of the potential impact on the estate and the availability of insurance proceeds to satisfy the claims); (citing In re American Film Technologies, Inc., 175 B.R. 847, 855 (Bankr.D.Del.1994) (staying prosecution of wrongful discharge claims against former and present directors of debtor corporation because of debtor's indemnification obligations and its possible exposure to collateral estoppel prejudice); In re Family Health Services, Inc., 105 B.R. 937, 942–43 (Bankr.C.D.Cal.1989)(staying collection actions against nondebtor members of debtor HMO because judgments against nondebtors would trigger claims for indemnification from the debtor HMO).
Furthermore, “courts have also extended the stay to nondebtor third parties where stay protection is essential to the debtor's efforts of reorganization.” McCartney at 510. (3d Cir. 1997). “This exception has generally been limited to circumstances where principals or officers of a corporate entity have guaranteed the corporate debts.” In re Mid-Atl. Handling Sys., LLC, 304 B.R. 111, 128–29 (Bankr. D.N.J. 2003 (citing In re Lazarus Burman Associates, 161 B.R. 891, 899–900 (Bankr.E.D.N.Y.1993)(enjoining guaranty actions against nondebtor principals of debtor partnerships because principals were the only persons who could effectively formulate, fund, and carry out debtors' plans of reorganization); In re Steven P. Nelson, 140 B.R. 814, 816–17 (Bankr.M.D.Fla.1992) (enjoining actions against nondebtor guarantor of debtor corporation's obligations where guarantor was president of debtor and president's services, expertise and attention were essential to the reorganization of the debtor).
“Yet the purpose served by extending the stay to directors and officers indemnified by the debtor must be consistent with the purpose of the stay itself, to “suspend actions that pose a serious threat to a corporate debtor's reorganization efforts.” In re Uni-Marts, LLC, 399 B.R. 400, 416 (Bankr. D. Del. 2009)(quoting In re First Cent. Financial Corp., 238 B.R. 9, 19 (Bankr. EDNY 1999); In re United Health Care Org., 210 B.R. 228, 234 (S.D.N.Y.1997) (staying creditor suits against non-debtors where those actions would harm the reorganization effort); In re Continental Airlines, 177 B.R. at 479 (staying litigation that would adversely affect the debtor's “ability to pursue a successful plan of reorganization under Chapter 11”).
The broader rule here is that a debtor's stay may extend to a non-debtor only when necessary to protect the debtor's reorganization. The threatened harm may be to needed debtor funds (e.g., when non-debtors are entitled to indemnification) or personnel (e.g., when debtor needs the services of non-debtors facing crushing litigation). The question is whether the action against the non-debtor is sufficiently likely to have a “material effect upon ... reorganization effort[s],” that debtor protection requires an exception to the usual limited scope of the stay.
In re Uni-Marts, LLC, 399 B.R. 400, 416 (Bankr. D. Del. 2009)(citations omitted).
Accordingly, case law has demonstrated that the co-debtor stay can be extended in very limited situations. If you are and individual or corporate entity looking to file for bankruptcy and are concerned how the bankruptcy may affect a co-debtor, please call our firm for a free consultation to speak with one of our experienced bankruptcy attorneys.