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A whirlwind review: bankruptcy proceedings in state courts
By J. Scott Bovitz and Elihu M. Berle

Although bankruptcy is based on federal laws, it can have a profound impact on state proceedings. It is important for all bench officers and lawyers handling civil cases to know the basic rules of bankruptcy.

The objective of this article and self-study test is to provide an introduction to bankruptcy laws and procedures, with a special emphasis on the impact on state court proceedings.

Bankruptcy is the process by which an insolvent individual's or organization's debts are liquidated. The goal of bankruptcy proceedings is to maximize the equitable return to creditors and to provide a fresh start to the debtor through the discharge of debts.

Bankruptcy proceedings are initiated and litigated in federal courts, and they trump nearly all state court proceedings. By virtue of the Supremacy Clause of Article VI of the U.S. Constitution, individual states may not enact laws that supersede, modify, or interfere with the national bankruptcy system. (Sherwood Partners Inc. v. Lycos Inc., 394 F.3d 1198 (9th Cir. 2005).)

The different types of bankruptcies are all chapters of Title 11 of the United States Code, which is known as the Bankruptcy Code. A bankruptcy started under one chapter may be converted as a proceeding under a different chapter.

Chapter 7 is the "liquidation chapter." The goal here is to liquidate a debtor's assets and distribute the net proceeds to creditors. A debtor may voluntarily file a bankruptcy petition, or three or more creditors may file an involuntary bankruptcy petition. (See Bankruptcy Code, 11 U.S.C. Sections 109, 303.) The federal court appoints a trustee, and all the debtor's assets are transferred to a "bankruptcy estate." (11 U.S.C. Section 541.) The chapter 7 trustee liquidates the assets and pays the creditors under court supervision.

Chapter 11 is the "reorganization chapter" and is commonly used by business debtors (such as the Los Angeles Dodgers). The debtor here usually retains possession of assets and tries to repay creditors over time. A chapter 11 petition may be filed voluntarily or involuntarily. (11 U.S.C. Sections 301, 303.) The debtor creates a plan of reorganization that provides for discharge of some obligations, the immediate payments of some debts, and the future payment of other creditors over time. The federal court might also appoint a trustee to create and manage the reorganization plan, or alternately appoint an examiner to prepare a report on the debtor's assets, liabilities, and current management team. (11 U.S.C. Section1104(a), (c).)

Chapter 13 is the wage earner's chapter. Only individuals use it. (11 U.S.C. Section 109(e).) In contrast, individuals, partnerships, and corporations may use both chapters 7 and 11. (11 U.S.C. Sections 101, 109.) No involuntary petitions may be filed under chapter 13, and the debtor must have regular income to pay off creditors. (11 U.S.C. Sections 109(e), 303(a).) The debtor presents to the federal court a "chapter 13 plan," agreeing to pay most secured creditors in full over time, with unsecured creditors often being repaid only between 5 to 50 percent of their debts in installments.

Under 11 U.S.C. Section 362, an "automatic stay" arises when a bankruptcy petition is filed under any chapter of the Bankruptcy Code. No hearing, notice, or order is required before the automatic stay goes into effect: "The automatic stay is self executing, effective upon the filing of the bankruptcy petition." (In re Gruntz, 202 F.3d 1074 (9th Cir. 2000).) Moreover, the stay is applicable even if the bankruptcy petition was unauthorized: "the Bankruptcy Code's automatic stay goes into effect [even] when the filing of the petition is ultra vires." (Wekell v. U.S., 14 F.3d 32 (9th Cir. 1994).)

The automatic stay is a cornerstone of the Bankruptcy Code. (See In re White, 186 B.R. 700 (9th Cir. BAP 1995).) "Essentially, the policy behind [Section] 362 is to protect the estate from being depleted by creditors' lawsuits and seizures of property before the trustee has had a chance to marshal and distribute the assets." (Martin-Trigona v. Champion Fed. Sav. & Loan Assn., 892 F.2d 575 (7th Cir. 1989).)

The automatic stay is also intended to give debtors breathing room by stopping all collection efforts, all harassment, and all foreclosure actions. (In re Bloom, 875 F.2d 224 (9th Cir. 1989).) Additionally, the automatic stay prevents piecemeal dismemberment of the estate and allows the debtor time to reorganize. (In re Computer Communications Inc., 824 F.2d 725 (9th Cir. 1987).)

The scope of the automatic stay is very broad. Title 11, Section 362(a) of the United States Code generally lists all the proceedings that are stayed, including all cases against the debtor to recover debts that arose before the filing of the petition. There are statutory exceptions to the automatic stay listed in 11 U.S.C. Section 362(b), including criminal actions, paternity suits, and several family law-related actions.

The automatic stay will eventually terminate without court order: The stay expires at a time determined by whether the action in question is directed against property of the estate or against some other target, such as the debtor or the debtor's property. For actions that are directed against the debtor or property of the debtor, the stay expires at the earliest of the time the case is closed, the time the case is dismissed, or the time a discharge is granted or denied. (11 U.S.C. Section 362(c)(2).) The stay of an act against property of the estate continues until the property is no longer property of the estate. (11 U.S.C. Section 362(c)(1).)

What happens to all the civil litigation between the debtor and other entities once a stay goes into effect? Only some of the most important issues are discussed below.

Litigation against the debtor is stopped, unless that litigation is proceeding in the home bankruptcy court. (In re Roxford Foods Inc., 12 F.3d 875 (9th Cir. 1993).) The automatic stay will prevent litigation in state court or even a distant bankruptcy court. (In re Miller, 397 F. 3d 726 (9th Cir. 2005).)

Prosecution of an appeal from an action that was originally brought against the debtor is stayed. (Parker v. Bain, 68 F.3d 1131 (9th Cir. 1995).) Prosecution of an appeal, however, is not stayed if the debtor was the original plaintiff. (Delpit v. C.I.R., 18 F.3d 768 (9th Cir. 1994).)

When faced with the bankruptcy filing by one defendant, most plaintiffs will simply dismiss the debtor/defendant without prejudice. Under rare circumstances, dismissing a defendant could violate the automatic stay. (Dean v. Trans World Airlines Inc., 72 F.3d 754 (9th Cir. 1995).)

Perfecting voluntary or involuntary liens and recording deeds will usually violate the automatic stay. (In re Edwards, 214 B.R. 613 (9th Cir. BAP 1997).) But, mechanic's liens are subject to special treatment. Perfection of a mechanic's lien is permitted by providing notice, rather than filing a postpetition complaint in state court. (Village Nurseries v. Gould (In re Baldwin Builders), 232 B.R. 406 (9th Cir. BAP 1999).)

Litigation of a debtor's cause of action against a nondebtor defendant is not stayed by the filing of debtor's bankruptcy petition, although the real party in interest in such litigation is usually the bankruptcy trustee or, in a chapter 11 case, the debtor in possession. (Haley v. Dow Lewis Motors Inc., 72 Cal.App.4th 497 (1999).)

If a commercial lease has expired by its terms or by acceleration under state law, whether before or after the bankruptcy case started, then the landlord is not stayed from evicting the debtor. (11 U.S.C. Section 362(b)(10).) The filing by a tenant of a bankruptcy case will usually cause an automatic stay, stopping foreclosure proceedings and most eviction proceedings. However, a landlord can file "a certification under penalty of perjury that...the debtor, during the 30 day period preceding the date of the filing of the certification, has endangered property or illegally used or allowed to be used a controlled substance on the property." (11 U.S.C. Section 362(b)(23).) Unless the debtor files an objection, the landlord will obtain relief from the automatic stay in 15 days. (See 11 U.S.C. Section 362(m).)

One of the principal advantages of a bankruptcy proceeding to the debtor is relief from suits by creditors. When a debtor receives a "bankruptcy discharge" under any chapter of the Bankruptcy Code, most creditors are enjoined from pursuing their pre-bankruptcy civil claims against that debtor. (11 U.S.C. Section 524(a).)

An individual may receive a discharge under chapters 7, 11, or 13. But, a corporation that liquidates under chapter 7 or 11 does not receive a discharge of its obligations. A corporate shell survives the chapter 7 liquidation, but its valuable assets will be seized and sold by the trustee. Unsold assets are returned to the corporation. But the corporation will still owe the nondischarged debt. Corporations and partnerships may discharge obligations in a chapter 11, but only if they have nonliquidating reorganization plans confirmed by the bankruptcy court.

On occasion, a defendant in litigation in state or federal court raises the affirmative defense of "discharge in bankruptcy." In response, some plaintiffs/creditors assert that they were never given notice of the prior debtor's bankruptcy, or were not listed in the debtor's schedule of debts. If the debtor's case was a "no asset" bankruptcy, dischargeability of claims is generally unaffected by the debtor's failure to schedule a creditor. (In re Beezley, 994 F.2d 1433 (9th Cir. 1993).)

But, when a creditor holds a potentially nondischargeable claim, that creditor may seek a determination that it was "neither listed nor scheduled" and the creditor held an otherwise nondischargeable claim under certain specified provisions of 11 U.S.C. Section 523(a)(2). (See 11 U.S.C. Section 523(a)(3).) "[S]tate courts have the power to construe the discharge and determine whether a particular debt is or is not within the discharge because discharge in bankruptcy is a recognized defense under state law." (In re Pavelich, 229 B.R. 777 (9th Cir. BAP 1999).)

Even if a claim is nondischargeable, that claim may expire under applicable state law. For example, California "Code of Civil Procedure Section 683.020, which defines the period for enforceability of judgments, provides after the expiration of 10 years after the date of entry of a money judgment or a judgment for possession or sale of property the judgment may not be enforced. However, a party may preserve a California judgment by filing an application for renewal under the terms of Code of Civil Procedure Sections 683.120 and 683.130 before the expiration of the 10 year enforceability period. Such application automatically renews the judgment for a period of 10 years. ([Code of Civil Procedure Section 683.120 (b)].)" (Kertesz v. Ostrovsky, 115 Cal.App.4th 369 (2004).)

Absent an order from the bankruptcy court setting aside a lien, a secured creditor's lien will survive bankruptcy discharge. (11 U.S.C. Section 506.) Secured creditors are affected by 11 U.S.C. Section 552, which provides, in part, that property acquired by the debtor after the filing of a petition in bankruptcy will not be subject to a secured creditor's lien. It negates the typical after-acquired collateral clauses in security agreements or deeds of trust. (11 U.S.C. Section 552(a).) However, an exception is provided for proceeds, rents, or profits arising directly from the collateral package existing as of the date of bankruptcy. (11 U.S.C. Section 552(b).)

Finally, a debtor's discharge does not impact the liability of third parties. (11 U.S.C. Section 524(e).) Therefore, litigants frequently prosecute actions in state court on discharged claims, even naming the debtor as a nominal defendant in the complaint, for the purpose of liquidating claims and permitting collection from insurance companies or third parties. (Forsyth v. Jones 57 Cal.App.4th 776 (1997).)

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