If you ask the average person (a non-bankruptcy lawyer, that is) what they know about bankruptcy, chances are they will reference the Bankruptcy Code’s “automatic stay” provisions in their answer. That is because, the automatic stay, which is found in section 362(a) of the Bankruptcy Code, is considered one of the most fundamental tenets of bankruptcy law. The filing of a bankruptcy petition triggers the protections of the automatic stay—staying, among other things, “the commencement or continuation . . . of a judicial, administrative, or other action or proceeding against the debtor that was or could have been commenced before the commencement of the case under this title.” 

The requirement that an action must be against the debtor is generally strictly construed. Nonetheless, bankruptcy courts have relied upon section 105(a) of the Bankruptcy Code, which permits bankruptcy courts to “issue any order, process, or judgment that is necessary or appropriate” to carry out the provisions of the Bankruptcy Code, to extend the protections of the automatic stay to non-debtors. This extension creates a whole new set of questions pertaining to when the protections of the automatic stay are available to non-debtors.

The Fourth Circuit provided some guidance on the issue in A.H. Robins Co. v. Piccininwhere it articulated the “unusual circumstances” test for extending the automatic stay to non-debtors—often cited to provide the protections of the automatic stay to the debtor’s officers and directors. According to A.H. Robins Co. v. Piccinin, “unusual circumstances” exist when “there is such identity between the debtor and the third-party defendant that the debtor may be said to be the real party defendant and that a judgment against the third-party defendant will effect be a judgment or finding against the debtor.”

In addition to the “unusual circumstances” test, some courts have followed the test articulated in Queenie Ltd. v. Nygard Int’l, where the Second Circuit found that the automatic stay can apply to non-debtors if a claim against the non-debtor will have “an immediate adverse economic consequence for the debtor’s estate.” As we previously wrote, in In re Residential Capital, LLC, the Second Circuit reaffirmed the decision in Queenie Ltd. v. Nygard Int’l and clarified that the decision “should not be interpreted as being limited to wholly-owned subsidiaries of a chapter 11 debtor.”

Although various courts that have used the tests set out in A.H. Robins and Queenie Ltd. v. Nygard Int’l, the reach of those tests remains unclear. The subjective nature of the tests in those cases leave much to the discretion of a bankruptcy court—making it difficult for parties to predict when the automatic stay will be applied to protect non-debtors.

SDNY 19 Mad Park, LLC

For now, it appears that the question of whether the automatic stay will be extended to non-debtors continues to be a subjective one. In Judge Gropper’s recent decision in In re SDNY 19 Mad Park, LLC, the debtor, SDNY 19 Mad Park, LLC, filed a motion seeking entry of an order extending the automatic stay to Antonio Magliulo, a member and manager of the debtor, with respect to two lawsuits filed against the debtor and Magliulo. The first lawsuit was brought by employees who alleged that the debtor failed to comply with New York Labor Laws (NYLL) and the Fair Labor Standards Act (FSLA) by, among other things, failing to pay tips and alleged overtime to the employees/plaintiffs. The second action was brought by a former employee alleging malicious prosecution.

Magliulo’s management of the debtor’s business was governed by an operating agreement that contained exculpation and indemnification provisions. The debtor argued the lawsuits should be stayed as against Magliulo because (i) allowing the lawsuits to proceed would have binding res judicata effect on the claims against the debtor’s estate, (ii) there was an absolute identity of interest between the debtor and Magliulo, such that allowing the actions to proceed would cause irreparable harm to the debtor’s estate, and (iii) Magliulo’s exculpation and indemnification rights would also result in binding claims against the debtor’s estate. The employees countered that any indemnification provisions pertaining to the NYLL and FLSA claims were unenforceable (per state law) and that there was a strong likelihood that indemnification would be denied because of the intentional/willful nature of Magliulo’s claim (per the carve out in the indemnification provision).

After noting that some courts have extended the automatic stay to non-debtors pursuant to section 105 of the Bankruptcy Code, Judge Gropper noted that a motion staying an action against a debtor’s principal is “extraordinary relief.” He explained that the mere possibility that Magliulo has indemnification rights against the debtor “does not tip the balance in favor of a stay.” In support of his decision, Judge Gropper noted that there is conflicting law on a defendant’s right to indemnification against a judgment in a case under the NYLL and the FLSA. Moreover, Judge Gropper stated that the purpose of extending the stay to non-debtors is to “suspend actions that pose a serious threat to a corporate debtor’s reorganization efforts.” In this case, the debtor failed to show that any indemnification rights Magliulo had against the debtor should result in a stay of actions against him. The possibility of the offensive use of estoppel was not enough as there was “nothing in the record to indicate that Magliulo’s defense of [the litigation] would not be as vigorous as if the Debtor remained a defendant.” Accordingly, Judge Gropper found that the debtor had not shown that extending the stay to the debtor’s management was warranted.

Conclusion

Although automatic stay protections can be extended to non-debtor entities under certain circumstances, In re SDNY 19 Mad Park, LLC reminds us that such extension continues to be an extraordinary exercise of a bankruptcy court’s equitable discretion. The particular circumstances of a case have to be sufficiently “unusual” to merit such an expansion. Debtors seeking to extend the automatic stay to non-debtors will have to show that such “extraordinary” relief is warranted.