While Bankruptcy Code section 105 grants broad powers to issue injunctions, most bankruptcy courts are reluctant to enjoin litigation in other venues. A recent ruling by the U.S. Court of Appeals for the Ninth Circuit follows this trend, reversing a preliminary injunction issued by a bankruptcy court staying arbitration proceedings between two nondebtor parties.

However, the Ninth Circuit also articulated specific standards for when such a section 105 injunction may be obtained. In re Excel Innovations, Inc., 502 F.3d 1086, 2007 WL 2555941 (9th Cir. Sept. 7, 2007).

Injunctions typically have been issued in big-ticket cases in which piecemeal litigation involving debtor-related entities would make administration of the bankruptcy case difficult. The best examples are mass tort cases such as the Dalkon Shield and asbestos litigation. Oberg v. Aetna Casualty & Surety Co., 828 F.2d 1023 (4th Cir. 1987) (multiple suits against debtor’s insurance carrier enjoined); A.H. Robins Co. v. Piccinin, 788 F.2d 994 (4th Cir.), cert. den., 479 U.S. 876 (1986) (multiple suits against debtor’s officers and directors enjoined).

But apart from the large cases involving multiple nonbankruptcy suits, it has been unclear as to other instances in which it would be appropriate to issue an injunction under section 105 to stop litigation. The Ninth Circuit’s ruling in Excel now provides substantial guidance on section 105 injunction applications.

Settlement Agreement

The dispute in Excel arose following settlement agreements signed by Ned Hoffman, Excel’s former CEO and major shareholder, and Indivos Corporation, for which Hoffman also was a major shareholder.

Excel was a party to one of the agreements. The agreements forbade Hoffman from controlling, disrupting or influencing the management or policies of Indivos. Any disputes over the agreements were referred to arbitration before the AAA.

Indivos initiated arbitration against Hoffman and Excel, alleging they attempted to disrupt a merger between Indivos and a third-party. Hoffman and the debtor had filed a patent infringement action against Indivos. Hoffman filed a chapter 13 bankruptcy case and the debtor a chapter 11. Hoffman’s bankruptcy case was dismissed after a few months and Indivos recommenced the arbitration against him.

Excel started an adversary proceeding in its bankruptcy case seeking an injunction against the arbitration. Excel argued that Hoffman might claim to be Excel’s agent leading to new liabilities against it.

Indivos agreed to certain conditions on the arbitration, including that there would be no further evidence taken, and the bankruptcy court denied the injunction based on those protections. Hoffman immediately asked the arbitrator to take new evidence, and when he agreed to do so, Hoffman asked the bankruptcy court to revisit the injunction question.

Injunction Issued

This time, the bankruptcy court issued the injunction, focusing on the possible violation of the attorney client privilege by Hoffman in his testimony. Later Hoffman supplemented the record by adding that he planned to seek indemnification from Excel against any award that was made in the arbitration in addition to possible revelation of privileged legal advice.

The Bankruptcy Appellate Panel for the Ninth Circuit (BAP) affirmed over Indivos’ argument that the bankruptcy court applied the wrong legal standard.

The BAP relied on language in rulings by the U.S. Court of Appeals for the Fourth Circuit, concluding that an injunction should issue in cases in which the debtor’s and non-debtors’ interests are so intertwined that, in effect, an action against the nondebtors was a claim against the debtor. The BAP also found that Excel fulfilled the traditional standards for an injunction because Excel had shown a “fair chance” of success, and that it would be irreparably injured without the injunction.

Ninth Circuit Reversal

The Ninth Circuit reversed, holding that the bankruptcy court and the BAP applied an incorrect legal standard.

Indivos had argued that the bankruptcy court must apply the usual preliminary injunction standards and that Excel had failed to meet that standard. Excel claimed that it need only show that the injunction would promote the objectives of the Bankruptcy Code.

The Ninth Circuit held, in accord with the majority of other circuits, that section 105 injunctions must meet the usual preliminary injunction standards.

In the context of enjoining other litigation that might interfere with a bankruptcy case, these standards are whether the enjoined action will interfere with a reasonable likelihood of a successful reorganization, the relative hardships on the parties of the injunction or denial thereof, and any public interests if relevant. Other factors are not considered in this context; for example, irreparable harm is not required, just the balancing of hardships.

Because the bankruptcy court did not apply the correct standard, it had to be reversed, the Ninth Circuit concluded. The bankruptcy court found only that the litigation in the other forum “could conceivably have an effect on the administration of the bankruptcy estate.”

Similarly, the BAP erroneously had relied on the Fourth Circuit’s “unusual circumstances” doctrine, which holds that the automatic stay may be extended by way of an injunction if unusual circumstances result in the interests of the debtor and the non-debtor becoming inextricably interwoven. The BAP mistakenly treated the “unusual circumstances” standard and the usual preliminary injunction standards as separate bases for injunctive relief.

The Ninth Circuit found that the bankruptcy court did not consider the issue of whether Excel demonstrated a reasonable likelihood of reorganization. That alone merited reversal. The BAP did find a likelihood of success, but the finding was not supported by the record before the bankruptcy court. Moreover, the Ninth Circuit found that both the bankruptcy court and the BAP ignored potential harm to Indivos from granting the injunction. The Ninth Circuit remanded the case to the bankruptcy court for further proceedings.

Under the first prong of the Excel test, bankruptcy courts need only find that the outside litigation interferes with the reasonable likelihood of a successful reorganization. The Ninth Circuit does not limit the forms that such interference may take. Loss of management time, interference with confidential communications, and even significant cost-drains on the bankruptcy estate may be the kind of interference that can be stopped.

Under the second prong, burden is balanced between debtor and outsider. There is no requirement of irreparable harm. Thus a significant cost burden alone such as might result from an indemnity obligation may be enough to support the injunctive relief. Whether bankruptcy courts will overcome traditional reluctance to interfere with outside litigation remains to be seen, but the Ninth Circuit has given them the tools to do so if they wish.