A company attempting to reorganize its affairs in bankruptcy may seek to enjoin its creditors or other third parties from suing members of the company's senior management team during the course of the reorganization proceedings, so that the senior management members can devote their time and resources to the reorganization effort without distraction. Courts throughout the country have applied differing standards in determining when the granting of an injunction of proceedings against a non-debtor is appropriate. A recent decision of the Ninth Circuit Court of Appeals has established the standard that will govern proceedings in that circuit from now on.

In Solidus Networks, Inc. v. Excel Innovations, Inc., (In re Excel Innovations, Inc.),1 the Ninth Circuit, confronted with an issue of first impression in the Circuit, held that, in determining whether to issue a preliminary injunction enjoining proceedings against a non-debtor pursuant to section 105(a) of the Bankruptcy Code, a bankruptcy court must apply the traditional preliminary injunction standard. Under this standard, the bankruptcy court must balance the debtor's likelihood of success in its reorganization efforts against the relative hardship of the parties, in addition to considering the public interest, if warranted. Further, the party seeking the injunction must provide evidence supporting each of the required elements for the issuance of injunctive relief. In Excel Innovations, finding that the bankruptcy court applied the incorrect legal standard, or, alternatively, misapplied the correct legal standard, the Ninth Circuit vacated an injunction issued by a bankruptcy court staying arbitration proceedings against a debtor's founder and major shareholder and remanded the case for further proceedings.

Third Party Prosecutes Claims Against Debtor's Founder

Ned Hoffman, the founder and major shareholder of both Excel Innovations, Inc. and Indivos Corporation, entered into a number of agreements with Indivos in 2000. Excel was a party to certain of those agreements. The agreements contained an arbitration clause, requiring any dispute arising from them to be dealt with through binding arbitration.

In 2003, Indivos commenced arbitration proceedings against Hoffman and Excel, alleging, among other things, breach of contract and tortious conduct, in connection with Indivos's possible merger with Solidus Networks, Inc. About a month after the arbitrator granted partial summary judgment in favor of Indivos, Hoffman and Excel filed voluntary petitions for relief under Chapter 13 and Chapter 11, respectively, thereby invoking the automatic stay as to all proceedings. Hoffman's bankruptcy case was dismissed in September 2004, and he resigned as a director and officer of Excel in December 2004.

In February 2005, Indivos recommenced the arbitration proceedings against Hoffman on the basis that the automatic stay was no longer in effect as to Hoffman, because Hoffman's bankruptcy case had been dismissed. The arbitrator permitted the continuation of the arbitration, but limited it to claims involving only Hoffman. In July 2005, prior to the close of the arbitration, Excel commenced an adversary proceeding in bankruptcy court against Indivos, Solidus, Hoffman, the arbitration company and the arbitrator, seeking declaratory and injunctive relief with respect to the arbitration. In its complaint, Excel argued that the arbitration violated the automatic stay arising in its bankruptcy case.

Bankruptcy Court Grants Injunctive Relief; BAP Affirms

In September 2005, Excel filed a motion for a preliminary injunction enjoining the continuation of the arbitration and attached an affidavit from Hoffman in support thereof. In the affidavit, Hoffman asserted that, if the arbitration continued, he would: (1) demand indemnification from Excel for any damages awarded against him on the basis that he was acting as an officer and agent of Excel (2) focus on his own personal interests and not those of Excel (3) be compelled to disclose certain privileged communications between himself and Excel's lawyers.

In granting an injunction staying the arbitration until Excel confirmed its plan of reorganization, the bankruptcy court reasoned that a section 105(a) injunction is appropriate where the proceedings "could conceivably have an effect on the administration of the bankruptcy estate."2 The bankruptcy court found that "Excel established a 'reasonable probability' of possible negative impacts on the estate," and, furthermore, that Excel had met the traditional test for the granting of a preliminary injunction.3 The bankruptcy court's holding was based on the findings that Excel could suffer harm because: (1) Hoffman might assert a defense of indemnification; (2) denying the stay might lead to inconsistent results between the bankruptcy court and the arbitration; and (3) Hoffman might disclose privileged lawyer-client communications, where Excel was the holder of the privilege.

Indivos and Solidus appealed to the Bankruptcy Appellate Panel for the Ninth Circuit, arguing that the bankruptcy court applied the incorrect legal standard. The BAP affirmed, holding that "a § 105(a) injunction is appropriate when the debtor and non-debtor's interests are so intertwined that an action against the non-debtor is in effect a claim against the debtor."4 The BAP's reasoning in affirming the bankruptcy court's decision was grounded in, among other things, its finding that a denial of injunctive relief would risk inconsistent judgments and that such a circumstance presented such "unusual circumstances" to warrant an "exception to the general rule that the automatic stay did not apply to actions against non-debtors."5 Moreover, the BAP found that Excel independently met the traditional test for the granting of a preliminary injunction and that permitting the arbitration proceedings to continue would "cause irreparable harm to Excel."6

Indivos and Solidus appealed to the Ninth Circuit, arguing that the traditional preliminary injunction standard applied to the bankruptcy court's injunctive powers under section 105(a).

Ninth Circuit Follows Majority of Circuits in Applying Traditional Standard for Preliminary Injunctions to § 105(a) Injunctions

The Ninth Circuit, in noting that the issue was one of first impression in the Circuit, reversed the holding of the bankruptcy court and the BAP's affirmation. The Ninth Circuit rejected the primary legal standard applied by the bankruptcy court, under which a preliminary injunction is appropriate whenever a proceeding "could conceivably have any effect on the administration of the bankruptcy estate."7 The Ninth Circuit noted that this is the standard for determining whether a "bankruptcy court has subject matter jurisdiction over a motion for a preliminary injunction" and could not conceivably be the standard for determining whether the issuance of the preliminary injunction is appropriate.8 The Ninth Circuit also rejected the BAP's "unusual circumstances" test, finding that this test is not separate and apart from the traditional test for granting preliminary injunctions.

The Ninth Circuit held that a bankruptcy court may issue an injunction pursuant to section 105(a) provided that the bankruptcy court considers the following: "[1] whether the debtor has a reasonable likelihood of a successful reorganization, [2] the relative hardship of the parties and [3] any public interest concerns, if relevant."9 The test is meant "to ensure that stays would not be granted lightly."10

In so holding, the Ninth Circuit applied the traditional non-bankruptcy standard for granting a preliminary injunction, which requires the moving party to show the following: "(1) a strong likelihood of success on the merits, (2) the possibility of irreparable injury…if preliminary relief is not granted, (3) a balance of hardships favoring the plaintiff and (4) advancement of public interest," where applicable.11 Under this traditional standard, a court may also grant the injunction by demonstrating one of the following: "probability of success on the merits and the possibility of irreparable injury, or that serious questions are raised and the balance of hardships tips sharply" in the plaintiff's favor.12

While both the bankruptcy court and the BAP held that Excel had met its burden under the traditional standard for preliminary injunctions, the Ninth Circuit disagreed, stating that "the injunction cannot be affirmed under their application of the usual standard."13 The Ninth Circuit analyzed the bankruptcy court's findings of fact and concluded that they did not warrant the issuance of the injunction. First, said the Ninth Circuit, the bankruptcy court failed to consider whether Excel had made a sufficient showing of its reasonable likelihood of success on the merits. "That failure to consider a critical element of the injunction standard is reversible error."14 Next, in weighing the hardships of the parties, the Ninth Circuit found that the bankruptcy court disregarded the potential harm to Indivos, which was also reversible error and that Excel had failed to make a sufficient showing of irreparable harm to Excel. The Ninth Circuit stated that "[a]lthough the bankruptcy court recited the usual preliminary injunction standard, the court failed to apply it. The court ignored both Excel's likelihood of success and the alleged harm to Indivos."15

The Ninth Circuit vacated the preliminary injunction granted by the bankruptcy court and affirmed by the BAP and remanded the case for further proceedings.

Debtors Should Consider the Injunction Standards in Selecting Venue

The Ninth Circuit's adoption of the traditional standard for the issuance of a preliminary injunction in Excel Innovations follows the holdings of a majority of the other circuits that have been confronted with either a request for a section 105(a) injunction staying proceedings against a non-debtor, including the Fourth, Fifth and Sixth Circuits, or a request for some other form of injunction outside the scope of section 362(a)'s automatic stay, including the Second, Third and Eighth Circuits. "The Seventh Circuit, in contrast, has expressly held that the moving party need not show irreparable harm."16 The First Circuit has granted a stay in a non-debtor action "without applying or discussing the usual preliminary injunction standard."17

As the circuit courts continue to differ in the standard applicable to the issuance of an injunction under section 105(a) staying proceedings against a non-debtor, companies considering filing for protection under the Bankruptcy Code must take the differing standards into account when considering their venue options. If the ability of a company to reorganize may turn upon the extent of the protection from legal proceedings that the company may give to the members of its senior management team during the course of the reorganization effort, the company may wish to select a venue for its bankruptcy case in which a preliminary injunction against proceedings against a non-debtor may be more easily obtained.