It is common in litigation to have numerous parties on each side. If one defendant files bankruptcy, exclusive jurisdiction of all ongoing matters is transferred to the federal bankruptcy court and the action outside of the bankruptcy court is automatically halted (“stayed.”) But assuming there is more than one defendant but only one files bankruptcy, what happens to the rest of the legal action against the other defendants? That question is answered in this article.
The Automatic Stay:
When a debtor initiates bankruptcy proceedings, an automatic stay immediately goes into effect preventing any actions against the debtor and the debtor’s property. 11 USC §§ 103(a), 362(a). The automatic stay applies in all Chapters of bankruptcy. Further, even if the bankruptcy filing is a sham, the automatic stay still goes into effect. Wekell v. United States (9th Cir. 1994) 14 F3d 32, 33.
1. Application of the automatic stay
Pursuant to 11 U.S.C. § 362(a)(1), the automatic stay prohibits creditors and other parties from commencing or continuing an action against the debtor that was or could have been commenced pre-petition. Additionally, the automatic stay prevents creditors from enforcing a pre-bankruptcy judgment against the debtor or its property, i.e., “any act to obtain possession of property of the estate.” 11 U.S.C. § 362(a)(3).
Although the automatic stay does not prevent the debtor from appealing claims made by the debtor, the debtor may not appeal claims against him while the automatic stay is in place. Parker v. Bain, 68 F.3d 1131, 1137–1138.
2. Application to third parties
However, the automatic stay does not protect nonbankrupt third parties even when the codefendants are closely related to the debtor. U.S. v. Dos Cabezas Corp. (9th Cir. 1993) 995 F.2d 1486, 1491 (“the automatic stay does not extend to actions against parties other than the debtor, such as codebtors and sureties.”) California courts have held that bankruptcy of one defendant in a multidefendant case does not stay the proceeding as to the other defendants. Queenie, Ltd. v. Nygard Int'l (2nd Cir. 2003) 321 F3d 282, 287; In re Miller (9th Cir. BAP 2001) 262 BR 499, 503-504 & fn. 6; Fortier v. Dona Anna Plaza Partners (10th Cir. 1984) 747 F2d 1324, 1329-1330.
However, courts have made exceptions where the debtor is an indispensable party to the pending action. In these instances, the court may issue an injunction to stay the entire action. United States v. Dos Cabezas Corp. (9th Cir. 1993) 995 F2d 1486, 1491, fn. 3. Generally, an indispensable party is a party that must be included in the instant action in order for relief to be granted.
3. Penalty for violating automatic stay
Should an individual willfully violate the stay, the debtor, if injured, shall recover actual damages and possibly punitive damages. 11 U.S.C. § 362(k)(1).
Keep in mind that it is possible to continue the claim against the bankrupt who denies liability in an adversarial proceeding in the bankruptcy forum. See our article on Bankruptcy. Further, if the debt was predicated on nondischargeable claims (intentional wrong doing, for example) bankruptcy protection may be denied for that debt and that argument should be advanced in that forum.
A typical and appropriate reaction of a plaintiff receiving notice of bankruptcy of a single defendant in a multi defendant action is to dismiss that party from the action and proceed independently in the bankruptcy forum for that particular claim. The remainder of the case against the other defendants continues in the original forum. Careful analysis of the role of the bankrupt defendant in terms of establishing liability against the other defendants must be made. One may be sure that the remaining defendants will seek to claim that the now “missing” defendant was at fault and they are innocent of any liability.