The oil and gas crisis produced yet another curious set of circumstances and a decision addressing the applicability of the automatic stay to an action against a principal of the debtor. In Luppino v. York, Case No. 16-00409-XR (W.D. Tex. Dec. 8, 2016) (D.I. 13), the United Stated District Court for the Western District of Texas rejected a defendant’s argument that because the LLC in which the defendant was a member was in bankruptcy, a suit against the defendant could not continue because of the automatic stay imposed by section 362(a)(6) of the Bankruptcy Code. This case is another example of the relatively high bar for extending the automatic stay to protect non-debtors.

The plaintiff in the civil action, John N. Luppino (“Luppino”) invested in Republic Resources, LLC (“Republic”), a Texas oil and gas venture that leased land for drilling. Republic and Luppino entered into several subscription agreements entitling Luppino to distributions based on his fractional share of oil and gas sales from various well projects that would be operated by Republic. Several months after Republic filed for chapter 11 (and its case was converted to chapter 7), Luppino sued Republic’s principals and a bank for fraud and breach of contract. Specifically, Luppino alleged that instead of using the funds in the prescribed manner, Republic’s principals, John V. York (“York”) and Steven Price (“Price”), diverted the funds to their other business interests.

On the day on which the answer to the Luppino complaint was due, York (but not the other two defendants) filed a notice of Republic’s pending bankruptcy case in the civil action. York argued that Luppino’s claims necessarily implicated Republic because they were derivative of the subscription agreements (to which York was not a party) and were, therefore, barred by the automatic stay. York further argued that Luppino’s claims were premised on piercing Republic’s corporate veil. In support of his argument, York relied on In re Fiddler’s Creek, LLC, Ch. 11 Case No. 10-03846-ALP, 2010 WL 6618876 (Bankr. M.D. Fla. Sept. 15, 2010). In Fiddler’s Creek, the United States Bankruptcy Court for the Middle District of Florida established that a suit for a breach of a golf club membership agreement brought by a member against an officer of the club, which was a chapter 11 debtor, was void ab initio because it was premised on piercing the corporate veil of the debtor and therefore violated the automatic stay.

The Luppino court disagreed with York’s argument. The court began its analysis by citing Fifth Circuit precedent that the automatic stay may apply to non-debtor third-party defendant in “unusual circumstances” showing “such identity between the debtor and the third-party defendant that the debtor may be said to be the real party defendant and a judgment against the third-party defendant will in effect be a judgment or finding against the debtor.” The court found none of the unusual circumstances present in the case at hand and distinguished Fiddler Creek.

First, the court observed that the allegations that York and Price manipulated Republic to their own benefit were not premised on piercing the debtor’s corporate veil. Next, the court noted that Republic, unlike the debtor in Fiddler Creek, would not be collaterally estopped from litigating against Luppino or any other similarly situated creditor, and there was no indication that Republic had any counterclaims against Luppino. Finally, the court observed that unlike in Fiddler Creek, Republic was not required to indemnify York. The court concluded that Republic would not be harmed by a judgment against York (although the court was sympathetic to York’s argument that he could not have breached a contract to which he was not a party – an argument that the court reserved for another day).

York also presented two alternative arguments. First, he argued that Republic was a necessary and indispensable party under Federal Rule of Civil Procedure 19. The court disagreed because the rule only requires a joinder of it is feasible. Relying on authority, the court rejected the argument because Republic was in bankruptcy. Ironically, the automatic stay worked against York’s alternative argument. The court also rejected York’s argument that Republic’s chapter 7 trustee was the only party that had standing to litigate against York for mismanaging Republic and harming its value. The court observed that Luppino’s complaint did not allege any harm to Republic, but rather that the funds that he (Luppino) was defrauded by the diversion of funds away from Republic’s drilling projects.

Counsel to principals and sponsors of bankrupt entities should take note of the decision in Luppino while formulating their litigation strategy. It shows that a claim related to the affairs of the debtor may not necessarily be stayed by operation of section 362 of the Bankruptcy Code.