Trial Magazine

At some point, a plaintiff attorney will encounter a corporate defendant or related party that files for bankruptcy. Bankruptcy litigation resembles federal commercial litigation but is a separate and unique world. Success in bankruptcy court requires a keen understanding of the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure (Federal Bankruptcy Rules), as well as over 40 years of modern case law.

“Success” may vary from case to case, but it could be obtaining a satisfactory recovery from the debtor, the continuation of an action against a non-debtor defendant, or even just taking discovery from a debtor to help your claims against non-debtor defendants in your drug or device litigation.

The Bankruptcy Code has two main goals: Give debtors a “fresh start” by relieving them from financial burdens, and balance the debtor’s interests with those of its creditors.¹ The bankruptcy process is an adversarial, multiparty proceeding in which the debtor or trustee takes the lead and creditors may contest certain aspects of the debtor’s reorganization or liquidation.

Some of these matters result in negotiated, consensual resolutions. Other times, lawsuits are filed in bankruptcy court, and those disputes are classified as “adversary proceedings”—they are initiated through filing a complaint, just like under the Federal Rules of Civil Procedure.²

Then there are “contested matters,” which arise when the parties-in-interest disagree over the relief requested—those are frequently initiated by a motion or, to a lesser extent, an application to the court and require a hearing and decision from the bankruptcy judge.³ Examples of contested matters include when there is an objection to a reorganization plan, when there is an objection to a creditor’s proof of claim, and when there’s a motion to lift the automatic stay.

Individual people, partnerships, corporations, or municipalities can file for bankruptcy, and debtors frequently file under Chapter 7 or Chapter 11. In Chapter 7 cases, a court initially appoints a trustee, and creditors have an option to elect a permanent trustee to collect and monetize the debtor’s pre-bankruptcy property.⁴ In Chapter 11 cases—the most common scenario for businesses and the most likely to affect plaintiffs—the debtor typically remains in possession of its pre-bankruptcy property and is called a “debtor-in-possession,” with the right to manage and operate its business.⁵

Creditors play an important role in the bankruptcy proceeding: Acting individually or through an official or ad hoc committee, they counterbalance the debtor or trustee. An official committee of unsecured creditors may be appointed by the Office of the U.S. Trustee,⁶ a component of the U.S. Department of Justice.

Creditors sometimes form ad hoc committees to advance a common interest, and other committees, including tort and equity security committees, are occasionally appointed. Plaintiffs and their counsel should strongly consider seeking appointment to an official committee, and absent that, may want to participate in an ad hoc group of aligned interest holders. Committees frequently play a role in courtroom advocacy and behind-the-scenes agreements.

The bankruptcy rules require creditor groups or attorneys representing multiple creditors to make specific disclosures to participate in a bankruptcy case. For example, Federal Bankruptcy Rule 2019 requires every group or committee to file a verified statement that spells out the facts and circumstances concerning the group or committee’s formation, including the name of each entity at whose insistence the group was formed, the name and address of each creditor, the nature and amount of each disclosable economic interest held in relation to the debtor, and the date of acquisition of the economic interest.⁷

A number of other statutes are relevant to bankruptcy cases, and the Federal Bankruptcy Rules apply in all jurisdictions.⁸ Review local procedural rules and orders to determine whether you have to seek admission pro hac vice to appear in the debtor’s bankruptcy case or whether you should retain and associate with local counsel for the purposes of making an appearance.

Beware the Automatic Stay

A bankruptcy filing causes the imposition of an automatic stay against the commencement or continuation of a judicial action or proceeding against the debtor.⁹ The automatic stay is triggered regardless of whether the non-debtor litigant is aware of it, and it does not require judicial intervention. The Bankruptcy Code contains harsh penalties for violating the automatic stay, including actual and punitive damages.¹⁰

Notify a non-bankruptcy court of an automatic stay as soon as you become aware of it. If you are litigating against both a debtor and non-debtors, you may advise the court that you intend to continue your action against the non-debtor defendants, since the plain language of §362(a) of the Bankruptcy Code only stays actions against the debtor.¹¹

A debtor, however, may seek an injunction from the bankruptcy court to shield non-debtor defendants, including a debtor’s officers, directors, and corporate owners.¹² The success of this maneuver depends on the factual record and the law of the bankruptcy court where the debtor’s case is filed. Your client—the non-debtor plaintiff— will have the opportunity to oppose the injunction and to conduct discovery on whether the injunction is appropriate and necessary. The test for whether a bankruptcy court will apply this stay depends on the circuit and district court where the debtor’s bankruptcy case is filed.

Discovery. While it has no bearing on discovery of non-debtor litigants, the automatic stay may curtail discovery from the debtor. Some courts have held that it prohibits service of discovery on a debtor in a non-bankruptcy proceeding.¹³ Other courts have found that discovery served on a debtor does not violate the automatic stay when that discovery is propounded via a third-party subpoena and is related to claims against other defendants.¹⁴

The Claims Process

A key element of the bankruptcy process involves the filing of claims. The Bankruptcy Code defines a “claim” as a “right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured.”¹⁵

Whether and when a creditor¹⁶ is required to file a proof of claim varies by the debtor’s bankruptcy chapter. Check to see whether a deadline for filing proofs of claim or a “bar date” has been set. This information should be on the debtor’s bankruptcy docket, available via ECF/Pacer or a third-party claims agent if the debtor retained one.

The consequences of the failure to file a timely proof of claim are draconian. A proof of claim form (Form 410) requires disclosure of the creditor’s name, the amount of the claim, the basis for the claim, the nature of security and perfection (if applicable), priority, and other information.¹⁷

In many Chapter 7 cases, the deadline is absolute.¹⁸ In consumer cases when no distributions to unsecured creditors are expected, no deadline may be established. In Chapter 11 cases, the bankruptcy court, at the request of the debtor, can extend the deadline for all creditors, and individual creditors can request an extension for cause, including in the case of “excusable neglect,” a nearly impossible standard to meet.¹⁹

Doing Discovery

In bankruptcy cases, you can still do some discovery depending on the circumstances. Federal Bankruptcy Rule 9014 provides that, in contested matters, the discovery tools found in Federal Rules of Civil Procedure 26 and 28 through 37 apply.²⁰ Federal Bankruptcy Rule 2004 also permits the investigation of any entity concerning “the acts, conduct, or property or to the liabilities and financial condition of the debtor, or to any matter which may affect the administration of the debtor’s estate, or to the debtor’s right to a discharge.”²¹

Lastly, under §341, creditors may have an opportunity to ask the debtor questions at the first meeting of creditors convened by the Office of the U.S. Trustee.²² The goals of this discovery can be understanding the debtor’s pre-bankruptcy conduct and transactions, as well as discovery to assist creditors to understand any settlement with the debtor or non-debtor third parties.

Chapter 11 Plan

The ultimate goal of a Chapter 11 case is to confirm a plan that will reorganize or liquidate the debtor in an orderly fashion. At the outset, Chapter 11 grants the debtor the exclusive right to file a plan and restricts interested parties from filing a plan absent relief from the bankruptcy court.²³ The Bankruptcy Code addresses claim classification, the required and discretionary contents of a plan, how disclosure and solicitation must occur, and acceptance of a plan.²⁴

A plan must create classes of creditors; identify which classes will have their claims “impaired” under the plan; specify how “impaired” claims will be altered; treat every entity in a class the same as the other class members; and provide adequate means for the plan’s implementation, including settling claims belonging to the debtor or to the estate.²⁵ A class of claims is “impaired” unless with respect to each claim in the class, the plan “leaves unaltered the legal, equitable, and contractual rights to which such claim . . . entitles the holder of such claim.”²⁶

Impaired status defines your legal rights under the plan. In the context of drug and device cases, a claim against a debtor would be impaired if it compromises your recovery from the debtor, releases or compromises a claim or cause of action against a non-debtor third party, or both.

Disclosure statement. After a plan is proposed, the bankruptcy court must approve a disclosure statement that provides creditors enough information to make an informed judgment about whether to vote to accept or reject the plan. A “plan proponent” often will ask the court to approve solicitation, voting, and confirmation hearing procedures, as well as plan-related discovery procedures.

Review these procedures, and look carefully at the disclosure statement to see if it includes the requisite information. Also closely examine the deadlines for: voting and ballot elections (such as releases), objections, and plan confirmation-related discovery. And help your client timely complete and submit all forms and ballots.

Plan confirmation hearing. After the voting deadline, the bankruptcy court will hold a hearing to decide whether to approve (“confirm”) or deny plan confirmation under §1129. The bankruptcy court may not make changes to the plan, and its determination evaluates whether the plan proponent can satisfy §1129’s elements.

One key element is the “best interests of creditors’ test,” which requires that each holder of an impaired claim or interest either accept the plan or receive no less than it would in a Chapter 7 liquidation.²⁷ Another key requirement is that the plan be “feasible,” meaning it is not likely to be followed by liquidation or the need for further financial reorganization of the debtor.²⁸

A plan does not require the acceptance by all classes of impaired creditors. Rather, the plan must be accepted by at least one impaired class of creditors for the plan proponent to satisfy §1129(b)’s “cramdown” requirements on all classes of rejecting impaired creditors.²⁹ The plan discharges the debtor’s pre-confirmation debts; binds the debtors’ creditors, including those who did not vote on the plan; and precludes recourse against the debtor or its estate, except as expressly provided in the plan.

Third-party releases. When litigating against non-debtors, closely examine the plan’s release, injunction, and exculpation provisions for third-party releases. If a plan contains such a release, carefully consider whether there is a factual and legal basis for it, and interpose an objection to such releases when appropriate.

Some courts permit non-consensual third-party releases in certain circumstances. The Fifth Circuit “broadly . . . foreclose[s] non-consensual non-debtor releases and permanent injunctions.”³⁰ The Second Circuit has stated: “No case has tolerated nondebtor releases absent the finding of circumstances that may be characterized as unique.”³¹

Similarly, the Sixth Circuit described non-debtor releases as a “dramatic measure” and set forth a seven-factor test for determining when such releases are appropriate.³² It’s a common tactic to seek to use a debtor’s bankruptcy plan to secure releases for the debtor’s officers, directors, owners, subsidiaries, and affiliates.

A debtor may seek to use a §524(g) “channeling injunction” in tandem with a plan’s third-party releases so that all creditors look solely to a trust for recovery. A §524(g) channeling injunction—a permanent injunction issued by a bankruptcy court—is specifically for asbestos claims, but debtors have attempted to use §105(a) to implement channeling injunctions for non-asbestos claims.³³

Class Action Issues

A defendant debtor’s filing of a bankruptcy petition frequently presents very important issues for class action litigants. A class representative (or even a proposed class representative) can appear in a bankruptcy case to object and be heard with respect to a debtor’s bankruptcy case,³⁴ and the class representative can seek appointment to an official committee.³⁵

A class representative can seek class certification by the bankruptcy court and seek leave to file a class proof of claim.³⁶ While Federal Bankruptcy Rule 7023 permits class certification in adversary proceedings, it does not automatically apply in contested matters.³⁷ Rather, the bankruptcy judge enjoys broad discretion in applying the rule.³⁸

Bankruptcy courts consider whether the class was certified pre-petition, whether the members of the putative class received notice of the bar date, and whether class certification will adversely affect the administration of the bankruptcy case.³⁹ Then, if Federal Bankruptcy Rule 7023 applies, the bankruptcy court must determine whether the class movant satisfies Federal Rule of Civil Procedure 23. As a practical matter, class certification requires evidence, and the typical time line of a bankruptcy case may not permit the collection of necessary evidence before the bar date.

Jurisdiction and estoppel issues. Appearing in court or filing a proof of claim is generally sufficient to establish personal jurisdiction in bankruptcy courts.⁴⁰ Bankruptcy courts derive subject matter jurisdiction from 28 U.S.C. §§157 and 1334, and they hear cases by what is called “referral” from the district courts sitting above them.

After referral, a bankruptcy court has jurisdiction over “core” matters that include cases under title 11, proceedings arising under title 11, and proceedings arising in a case under title 11,⁴¹ as well as “non-core” proceedings that are related to a case under title 11 but could be brought in the absence of a bankruptcy case. Hypothetically, a district court could refer a class action to a bankruptcy court because it is “related to” a bankruptcy case.

Filing a proof of claim is the first step in the claims’ allowance process. This is followed by the debtor’s (and other parties-in-interest’s) opportunity to object to the allowance of the claim. That triggers a contested matter, involving a “core” proceeding under 28 U.S.C. §157(b)(2)(B) and causing the bankruptcy court to determine the allowability and amount of the claim.

A key consideration when deciding to seek class certification in the bankruptcy court is collateral estoppel. Depending on applicable state collateral estoppel principles, the disposition of a class certification motion in bankruptcy court could affect your client’s substantive rights outside bankruptcy court. For example, an unsuccessful class certification attempt could constitute proof that you litigated the issue and that it was adjudicated by a final judgment.

Depending on the forum state’s collateral estoppel test,⁴² it is likely that an unsuccessful attempt to certify a class in the bankruptcy case would have involved litigation that resulted in a valid and final judgment over whether the proposed class plaintiffs could satisfy the requirements of Federal Rule of Civil Procedure 23. It is also likely that the plaintiff would have had a full and fair opportunity to litigate the issue. Lastly, a court could ask whether any mutuality of estoppel could exist between the plaintiff and the debtor.

Non-bankruptcy attorneys shouldn’t cut and run when a defendant files for bankruptcy. These scenarios can present unique opportunities to find some measure of justice for your clients.

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Gordon Z. Novod is a director at Grant & Eisenhofer in New York City and can be reached at gnovod@gelaw.com.

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Notes

1. See 11 U.S.C. §§101–1532.
2. Fed. R. Bankr. P. 7001. The rule enumerates which scenarios are considered adversary proceedings and are therefore governed by certain rules.
3. Fed. R. Bankr. P. 9014.
4. 11 U.S.C. §§701–704.
5. 11 U.S.C. §1107.
6. 11 U.S.C. §1102(a)(1).
7. Fed. R. Bankr. P. 2019.
8. Fed. R. Bankr. P. 1001–9037; 28 U.S.C. §§157 (procedures), 158 (appeals), 1334 (jurisdiction), 1408–1410 (venue), 1411 (jury trials), 1412 (venue), 1441 (removal).
9. 11 U.S.C. §362(a)(1). Section 362(a)(3) also stays “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.”
10. 11 U.S.C. §362(k)(1).
11. 11 U.S.C. §362(a).
12. 11 U.S.C. §§105(a), 362(a). This request is usually initiated by filing a complaint in an adversary proceeding or a motion for a permanent injunction in the bankruptcy court.
13. In re Residential Capital, LLC, 480 B.R. 529, 535–537 (Bankr. S.D.N.Y. 2012) (concluding that while “section 362(a) does not, standing alone, protect the Debtors from discovery in third-party actions,” id. at 537, §105(a) could be applied to limit or restrict third-party discovery from the debtors absent further order of the court).
14. See Peter Rosenbaum Photography Corp. v. Otto Doosan Mail Order Ltd., 2004 WL 2973822, at *2 (N.D. Ill. Nov. 30, 2004); see also In re Mahurkar Double Lumen Hemodialysis Catheter Patent Litig., 140 B.R. 969, 977 (N.D. Ill. 1992) (holding that the debtor and its employees were not protected by the automatic stay with respect to discovery relating to claims against other defendants).
15. 11 U.S.C. §101(5)(A).
16. A “creditor” is defined in the Bankruptcy Code as an: “(A) entity that has a claim against the debtor that arose at the time of or before the order for relief concerning the debtor; [or an] (B) entity that has a claim against the estate of a kind specified in section 348(d), 502(f), 502(g), 502(h) or 502(i) of this title.” 11 U.S.C. §101(10).
17. Fed. R. Bankr. P. 3001.
18. Fed. R. Bankr. P. 3002(c).
19. Fed. R. Bankr. P. 3003(c)(3).
20. Fed. R. Bankr. P. 9014(c), 7026, 7028–7037.
21. Fed. R. Bankr. P. 2004(b).
22. 11 U.S.C. §341.
23. 11 U.S.C. §1121.
24. 11 U.S.C. §§1121–23, 1125–26.
25. 11 U.S.C. §§1123, 1129.
26. 11 U.S.C. §1124(1).
27. 11 U.S.C. §1129(a)(7).
28. 11 U.S.C. §1129(a)(11).
29. 11 U.S.C. §§1129(a)(8); 1129(b). Section 1129(b)(1) permits the confirmation of a plan in spite of its rejection by a class or classes of voting creditors, so long as the plan satisfies all of the other applicable provisions of §1129(a), and the plan must not unfairly discriminate and must be fair and equitable.
30. In re Vitro S.A.B. de C.V., 701 F.3d 1031, 1061 (5th Cir. 2012) (citation omitted).
31. In re Metromedia Fiber Network, Inc., 416 F.3d 136, 142 (2d Cir. 2005).
32. In re Dow Corning Corp., 280 F.3d 648, 658–61 (6th Cir. 2002).
33. See, e.g., In re TK Holdings Inc., No. 17-11375-BLS, Dkt. No. 2120 (Bankr. D. Del. Feb. 21, 2018) (discussing that the Takata plan channeled personal injury and wrongful death claims, but not economic loss claims, to a trust).
34. 11 U.S.C. §1109(b).
35. 11 U.S.C. §§1102(a)(1), (2), (4), (b)(1).
36. Fed. R. Bankr. P. 9014(c), 7023; In re Associated Cmty. Servs., Inc., 520 B.R. 650, 653–54 (Bankr. E.D. Mich. 2014) (observing that a creditor seeking to apply Federal Bankruptcy Rule 7023 to a proof of claim purportedly filed on behalf of a class of creditors should file a motion under Federal Bankruptcy Rule 9014(c) at the earliest possible time in the bankruptcy case).
37. Fed. R. Bankr. P. 7023.
38. In re Craft, 321 B.R. 189, 198 (Bankr. N.D. Tex. 2005).
39. In re Musicland Holding Corp., 362 B.R. 644, 654 (Bankr. S.D.N.Y. 2007); In re MF Global Inc., 512 B.R. 757, 763 (Bankr. S.D.N.Y. 2014); In re Chaparral Energy, Inc., 571 B.R. 642, 646 (Bankr. D. Del. 2017).
40. The filing of a proof of claim by a foreigner is sufficient to establish the personal jurisdiction of the bankruptcy court because the proof of claim is analogous to a complaint whereby a plaintiff submits to the court’s jurisdiction for all counterclaims. Kline v. Ed. Zueblin (In re Am. Exp. Grp. Int’l Servs.), 167 B.R. 311 (Bankr. D.D.C. 1994). This is noteworthy for foreign creditors since Federal Bankruptcy Rule 7004(d) permits nationwide service of process, without regard to the minimum contacts with the bankruptcy court’s state.
41. See generally Binder v. Price Waterhouse & Co., LLP (In re Resorts Int’l, Inc.), 372 F.3d 154 (3d Cir. 2004).
42. See, e.g., Monat v. State Farm Ins. Co., 677 N.W.2d 843 (2004) (discussing Michigan’s collateral estoppel test).