Upon the filing of a bankruptcy petition, an automatic stay goes into effect which provides a debtor with immediate protection from collection efforts by creditors. But the automatic stay is not without limitations.

In a recent opinion, the U.S. Court of Appeals for the Sixth Circuit recently considered whether the automatic stay should apply to prevent a foreclosure sale in a case in which the debtor’s good faith, actions and credibility in filing for Chapter 13 were called into question.[1] The Sixth Circuit ruled against the debtor, affirming the bankruptcy court’s earlier findings that the debtor’s actions were “outrageous.”

BACKGROUND

The case involved a business dispute between Deborah Sarmadi and Dean Balding Baxter. In an attempt to recover a debt Baxter owed to her, Sarmadi purchased a loan related to a property owned by Baxter and had the note and deed of trust assigned to her. Sarmadi was unable to obtain payment on the loan, and had her attorney foreclose on the property on May 23, 2013. She then purchased the property at the foreclosure sale and the deed was recorded on May 29, 2013.

After recording the deed, Sarmadi and her attorney became aware that Baxter had filed for Chapter 13 bankruptcy one day before the foreclosure sale - on May 22, 2013. On July 8 Sarmadi moved for relief from the automatic stay, to annul the stay, and to confirm the foreclosure sale. The hearing on the motion was scheduled for August 22, but Baxter’s bankruptcy case was dismissed on August 2 pursuant to a motion filed by the Chapter 13 Trustee due to Baxter’s failure to provide necessary documentation to the Bankruptcy Court. The dismissal was set aside on September 6.

The automatic stay motion was eventually heard on December 12 and was granted based on “overwhelming” evidence. The Bankruptcy Court refused a request to alter or amend the order, the Bankruptcy Appellate Panel of the Sixth Circuit affirmed the Bankruptcy Court’s decision, and Baxter then appealed to the Sixth Circuit. In the interim, Baxter’s case was again dismissed due to his failure to appear at the meeting of creditors.

On appeal, the Sixth Circuit affirmed the lower court order, holding that the decision to annul the automatic stay based on a finding that Baxter filed his bankruptcy petition without good faith was appropriate.

THE AUTOMATIC STAY AND THE APPEAL

The filing of a bankruptcy petition creates an automatic stay on most proceedings against a debtor pursuant to Section 362 of the Bankruptcy Code. However, a party can request relief from the automatic stay “for cause, including the lack of adequate protection of an interest in property of such party in interest.” The Sixth Circuit explained that “cause” for lifting the stay includes a debtor’s lack of good faith in filing a bankruptcy petition. The test for good faith involves the evaluation of a number of factors and is fact specific.

In this case, Sarmadi requested that the bankruptcy court annul the stay and ratify action – the foreclosure sale – which was taken in violation of the stay, as opposed to requesting that the stay be lifted in advance of foreclosing. The Sixth Circuit explained that courts are typically reluctant to approve of such actions “absent limited equitable circumstances.”

In its order granting Sarmadi’s motion, the Bankruptcy Court listed the following factors as being the exceptional circumstances justifying relief: “(1) that Baxter’s plan did not provide for the payment of Sarmadi’s claim; (2) the lack of insurance on the property, which was leased to a third party; and (3) Baxter’s lack of good faith in filing for bankruptcy.”

On appeal, Baxter argued that the Bankruptcy Court abused its discretion because, among other things, his actions were not fraudulent and that Sarmadi and her attorney received (via email) notice of his bankruptcy before the foreclosure sale. He apparently conceded that grounds existed to lift the stay, but not to ratify actions taken in violation of it.

The Sixth Circuit rejected Baxter’s arguments and affirmed the Bankruptcy Court. It noted that the Bankruptcy Court was in the best position to evaluate the parties’ credibility, and that it found Baxter’s lacking. This conclusion was based on conflicting statements made by Baxter as well as failures to perform obligations required of him during the bankruptcy proceedings.

CONCLUSION

The key takeaway from this case? The stay may be automatic, but it’s not impenetrable. Under appropriate circumstances, creditors or other parties in interest may be able to convince the bankruptcy court to lift the stay, or even ratify actions taken in violation of it. And debtors who hope to rely on the protections provided by the automatic stay must act in good faith – both in filing a case and performing their obligations once a case is filed – to maintain those protections.