Stay Still Attaches to Undisclosed Property 30 Years after Bankruptcy

Posted by NCBRC - May 26, 2022

Plaintiff’s attorneys were liable for monetary contempt sanctions for violating the automatic stay due to their failure to investigate the plaintiff’s bankruptcy petition which was filed decades earlier to determine whether he had disclosed his interest in mineral rights in land that was the subject of a current state lawsuit. In re McConathy, No. 90-13449 (Bankr. W.D. La. May 20, 2022).

In 1990, the debtor and his wife filed a chapter 7 bankruptcy petition for which they received a discharge. On two occasions they reopened their bankruptcy to disclose previously undisclosed assets and in both cases the assets were addressed and the case closed. However, unbeknownst to the bankruptcy court and chapter 7 trustee, at the time he filed his petition, the debtor owned mineral rights on land in Kansas.

Long after his bankruptcy was closed, American Warrior Inc. (AWI) filed a partition action in state court to acquire the mineral leases of various mineral rights interest-holders in the area, including the debtor. After obtaining a default judgment, AWI obtained 100% ownership of the leases and extracted oil to the tune of $7 million. Some of the other prior leaseholders then hired lawyers, Carmichael and Schlatter, to determine whether the partition judgment was subject to challenge. Carmichael discovered the debtor’s ownership interest and contacted him about the potential lawsuit against AWI. The debtor was unsure of whether he had an interest in mineral rights and disclosed to Carmichael his prior bankruptcy, suggesting that any gain he received in the partition challenge would benefit his bankruptcy creditors. The attorneys then filed suit on behalf of the debtor and a number of non-debtor co-plaintiffs who were impacted by AWI’s partition action.

Over a year after filing suit, Carmichael investigated the debtor’s bankruptcy filings and learned that the debtor had not disclosed his interest in the mineral rights. Nonetheless, the attorneys refused to answer interrogatories about whether the debtor had ever filed for bankruptcy and they failed to reopen the bankruptcy to disclose the asset.

Upon learning of the bankruptcy, AWI moved to reopen and sought a declaration that the state lawsuit was invalid because it violated the automatic stay. It also sought civil contempt sanctions against the debtor and his attorneys in the amount of $315,000. Some of the non-debtor parties in the state litigation filed a separate motion to annul the stay.

The bankruptcy court began with a review of AWI’s Article III and prudential standing. For Article III standing a party must show “(1) an injury in fact (2) that is fairly traceable to the actions of the defendant and (3) that likely will be redressed by a favorable decision.” AWI met these requirements. Its injury consisted of the costs of litigation and reopening the bankruptcy case, was caused by the defendants’ violation of the stay, and could be redressed by an order of the court voiding the lawsuit and/or awarding damages. Likewise, AWI had prudential standing which requires that the “plaintiff is asserting his own legal rights and interests rather than the rights and interests of third parties.”

The court turned to whether the debtor violated the automatic stay. It found that because the debtor never disclosed the mineral rights and the trustee therefore never administered them, they remained part of the bankruptcy estate and the automatic stay continued to attach to them. The court held that “[w]hen someone other than the estate’s sole representative files a suit to adjudicate the rights of parties with respect to an asset of the estate, such action violates the automatic stay provisions of 11 U.S.C. § 362(a)(3).” Therefore, the state lawsuit challenging ownership of the mineral rights violated the stay.

The debtor argued that even if there were a stay violation, the stay is enforceable only by debtors, creditors, and trustees and that AWI was not within the statute’s “zone of interest.” The court noted that the “zone of interest” test is relevant to the determination of whether certain legislation encompasses a plaintiff’s claim. Here, the court found two statutes were implicated: section 105(a) and section 362(a)(3), neither of which specify the parties authorized to seek relief.

The Fifth Circuit has interpreted the zone of interest test broadly, foreclosing suit “only when a plaintiff’s interests are so marginally related to or inconsistent with the purposes implicit in the statute that it cannot reasonably be assumed that Congress authorized that plaintiff to sue.” Collins v. Mnuchin, 938 F.3d 553, 574 (5th Cir. 2019), aff’d in part, vacated in part, rev’d in part sub nom. Collins v. Yellen, ––– U.S. ––––, 141 S.Ct. 1761, 210 L.Ed.2d 432 (2021).”

The court found: “The automatic stay is designed to protect the preservation of estate property. Debtor and his counsel violated the stay when they sued AWI over claims that belong exclusively to the estate. When the stay was violated, it resulted in a particularized harm to AWI by forcing it to defend an invalid lawsuit. Accordingly, AWI satisfied the zone of interest test by establishing that it suffered financial injury resulting from statutory violations which are, at the least, ‘arguably within the zone of interests’ protected by the statute violated.”

The court went on to say that even if AWI’s claim was not within the “zone of interest” of the automatic stay statute, the bankruptcy court could remedy the violation of the automatic stay both through its civil contempt power under section 105(a), and through its broader inherent authority to sanction abusive litigation practices.

A court may issue contempt sanctions where it finds “1) that a court order was in effect, 2) that the order required certain conduct by the respondent, and 3) that the respondent failed to comply with the court’s order.” The respondent may offer as a defense that there was “fair ground of doubt” as to whether its conduct violated an order. Relying on that defense, the debtor and his counsel argued that there was no reasonable basis for them to have concluded that the automatic stay was still in effect thirty years after his bankruptcy case.

The court found the facts contradicted the defense. Specifically, the debtor’s counsel knew of the bankruptcy and sought a higher fee for the extra work it would cause. Counsel also knew that the debtor owned the mineral rights prior to the bankruptcy case but did not examine the bankruptcy records to determine whether the debtor listed the asset in his schedules until after they had filed suit against AWI. Further, debtor’s counsel misled the state court as to the status of the bankruptcy case.

Both the debtor and his counsel offered the additional defense of good faith. The debtor claimed to have made the necessary disclosures to his counsel and then relied on counsel to take the appropriate action. His counsel argued that they filed the lawsuit to preserve the claim against a possible lapse of the limitations period. They also stated that they believed the bankruptcy trustee could substitute in if necessary after the suit was filed.

The court was unpersuaded. In the first place, it found neither good faith nor reliance on advice of counsel was a defense to civil contempt. As to the debtor’s counsel, the court found that they had enough information to have an affirmative duty to investigate whether the lawsuit would violate the stay. Furthermore, debtor’s counsel represented other clients in the suit against AWI whose interests would have conflicted with the bankruptcy trustee’s had the trustee been substituted for the debtor in the lawsuit, so their claim of later substitution was suspect.

Having found the elements of civil contempt, the court turned to its inherent authority to impose sanctions in the face of “bad faith or willful abuse of the judicial process.” It noted that “[c]ivil contempt may only be employed in two situations: to coerce the defendant into compliance with a court order and/or to compensate the complainant for losses sustained.” Because it was too late to coerce compliance, the court looked to compensation for AWI.

Here, the court considered the debtor’s good faith and found that AWI failed to establish that the debtor acted in bad faith. In fact, the court found that while reliance on counsel is no defense to civil contempt it may be considered when doling out sanctions. Because of the debtor’s disclosures to his attorneys and his reliance on them to act appropriately, the court declined to impose monetary sanctions on the debtor.

On the other hand, the court found debtor’s counsel acted in bad faith in their failure to investigate the debtor’s bankruptcy despite the fact that the debtor alerted them to it and authorized them to contact the trustee. The court further found that counsel impeded AWI’s efforts to get information about the bankruptcy. In the face of this “outrageous” conduct, the court found AWI was entitled to recovery of the fees and costs incurred by reason of the state lawsuit and bankruptcy reopening. It ordered AWI to submit a fee statement reflecting the fees incurred as a result of the misconduct.

The court denied AWI’s motion for declaratory relief against non-debtor co-plaintiffs in the state lawsuit finding that AWI failed to point to any misconduct on their part which would justify invalidating their state action.

Finally, the court turned to the non-debtor co-plaintiffs’ motion to annul the automatic stay. Section 362(d)(1) permits a court to annul the stay “for cause” at the request of a party in interest. Though the co-plaintiffs’ request was prompted by AWI’s attempt to void the entire state lawsuit, including their claims, and the court had decided against AWI on that motion, it went on to address and deny the co-plaintiffs’ claim. It found they failed to establish “cause,” and that this was their third attempt to annul the stay, the court having denied the first two attempts.

The court concluded: “1) the claims asserted by Debtor in the Kansas lawsuit are voidable and are therefore invalid and without effect, 2) the motion for contempt should be granted in part, and 3) the motion to annul the stay should be denied. Monetary sanctions against Debtor’s counsel will be awarded after the court determines the reasonableness of attorneys’ fees.”

McConathy Bankr WD La May 2022

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