The Bankruptcy Process: The Automatic Stay Part 1

The Bankruptcy Process: The Automatic Stay Part 1

The automatic stay is an important benefit of filing for bankruptcy. It is a rule which allows the debtor to call a “timeout” from creditor collection efforts. As soon as the bankruptcy process gets underway, the automatic stay kicks in. In this presentation, we’ll look at the automatic stay, what it does and how it operates.  

An automatic stay under Section 362 of the United States Bankruptcy Code is a bankruptcy court order that goes into effect as soon as a party files for relief under any chapter of bankruptcy. It protects the debtor and his assets from creditors to facilitate an “equitable treatment of creditors in the collective bankruptcy process.” The stay prevents creditors from going after the party that’s filed for bankruptcy even if that creditor received no notice of the filing.

When Congress enacted Section 362 of the bankruptcy code in 1978, its legislative intent behind the automatic stay was presented as follows:

“(The automatic stay) gives the debtor a breathing spell from his creditors. It stops all collection efforts, all harassment, and all foreclosure actions. It permits the debtor to attempt a repayment or reorganization plan, or simply to be relieved of the financial pressures that drove him into bankruptcy…”

The bankruptcy court must have an opportunity to sort matters out and begin an orderly administration of the estate. Creditors can’t harass, contact, sue, or generally pester a debtor. If a creditor does so in violation of the stay, its actions are void and may be reversed by a court.

The automatic stay provisions are broad and can be applied to all types of creditors, including governmental units. The stay applies, among other things, to:

·       Almost all administrative proceedings against the debtor;

·       The enforcement of any judgment obtained before the commencement of the case;

·       Any act to obtain possession of property of the estate;

·       Any act to create, perfect or enforce a lien against property of the estate;

·       Any act to collect, assess or recover a claim against that debtor; and

·       The setoff of any debt owing to the debtor

Let’s break down some of these circumstances in which the automatic stay applies.

First, once a person files a bankruptcy petition, the automatic stay immediately stops the bank from foreclosing on, or repossessing, the debtor’s real or personal property. Examples include the debtor’s home or her car. 

The automatic stay doesn’t allow the debtor to avoid mortgage or car payments. It temporarily stops foreclosure or collection proceedings, but payments and interest will continue to accrue, and foreclosure proceedings can be brought as soon as the automatic stay is lifted. So, if one wants to keep one’s house or car in the long run, one should continue to make mortgage or car payments.

Secured creditors, such as mortgage and auto financing companies, can often get relief from the automatic stay and secure the right to proceed with collection and foreclosure efforts by filing a motion for relief from the automatic stay. Section 362(d) of the bankruptcy code discusses the grounds for obtaining relief, though these determinations are necessarily made on a case-by-case basis. The two most common methods for relief from the stay are found in §362(d)(1) and §362(d)(2).

The first, §362(d)(1), states that relief from the stay may be granted for a creditor “for cause, including the lack of adequate protection of an interest in property...”

The “adequate protection” caveat exists because bankruptcies don’t happen in a vacuum. The needs of creditors must also be considered. For example, if a bank has a lien on the debtor’s home, the bank wants the debtor’s home to preserve its value. Should the home lose value due to neglect by the debtor, the bank’s security interest would be harmed.

Examples of debtor actions that can lead to automatic stay relief for a creditor due to adequate protection include wasting the resource (perhaps taking long unnecessary road trips in the case of a car or failing to make repairs to the roof of a house), mismanagement and damage to the property. Showing that any of these are occurring could allow the court to lift the automatic stay and allow foreclosure proceedings to commence or continue.

§362(d)(2) of the bankruptcy code also allows a court to grant a creditor relief from the automatic stay if the creditor can satisfy the following two prongs:

1)    The debtor doesn’t have equity in the property the creditor seeks AND

2)    The property isn’t necessary to an effective reorganization.

If reorganization is unlikely or the collateral is unnecessary, the collateral will eventually be foreclosed on or sold and its proceeds will become part of the bankruptcy estate. 

The automatic stay also applies to residential lease evictions and protects renters who file for bankruptcy from being evicted from their rental property. However, there are exceptions. First, if the bankruptcy court finds that the tenant never had the right to occupy the leased premises, then the leased premises never become part of the bankruptcy estate, and the automatic stay will not apply. The tenant is a mere “squatter,” who cannot secure a right to possess property merely by filing for bankruptcy.

Second, a tenant can be evicted if the landlord started the eviction process before the bankruptcy filing.

Finally, the automatic stay will not prevent an eviction if the landlord is evicting the tenant “based on endangerment to the property or the illegal use of controlled substances within the property.”

The automatic stay will also stop utility shut-offs. If a debtor is behind on an electricity, water, gas, phone, or other utility bill and is under threat of having service cut off, the automatic stay prohibits utility companies from doing so while the stay is in place. Furthermore, a utility can’t refuse service or discriminate against the debtor solely on the basis that he has filed for bankruptcy. The stay isn’t a blanket protection: the debtor may have to “provide adequate assurance of payment” within 20 days to prevent the utility company from shutting off service. An adequate assurance of payment can be a deposit, letter of credit, prepayment, or evidence of a promise that the debtor will make regular payments to the utility providers.

The automatic stay even prevents a government agency from recovering an overpayment of public benefits such as unemployment or welfare payments. Normally, the agency is entitled to collect the overpayment of benefits out of a debtor’s future checks, but once the debtor files for bankruptcy, the automatic stay can stop an agency from recouping the overpayment. The agency may recoup overpayment in future eligibility payments once the stay is lifted.

The automatic stay stops almost all entities from instituting wage garnishments until the stay is lifted.  A wage garnishment is a court order requiring an employer to withhold a certain amount of an employee’s pay and distribute that amount to a creditor named in the court order.  The stay does not, however, stop garnishments to pay spousal support and child support orders. 

Also, after the debtor files for bankruptcy, a creditor can’t continue to litigate a lawsuit against the debtor to recover on claims that arose before the filing. If a creditor files a lawsuit against the debtor prior to the petition date, the suit halts pending the bankruptcy proceeding.

Typically, a debtor who is a defendant in pre-petition litigation will provide written notice to the court and other parties that the action must be stayed shortly after it files its bankruptcy petition. In a real-life example, Mammoet-Starneth, an engineering company that specializes in the design and construction of giant observation wheels and structures, filed for Chapter 11 bankruptcy in December 2017. Prior to filing the petition, New York Wheel had sued Starneth in May of 2017 for project delays and recovery of costs associated with the $580 million, 630-foot tall giant New York Wheel attraction that Starneth was to build on Staten Island.

In its bankruptcy filing, Starneth stated that an automatic stay applies and protects it from creditors and shields it from the New York Wheel lawsuit.  Applying the law to these facts, it appears that the automatic stay does apply and will halt, at least temporarily, New York Wheel’s lawsuit against Starneth because the lawsuit was filed prior to the bankruptcy petition’s filing. 

The automatic stay is a powerful tool to help debtors get a breather while a bankruptcy proceeding goes forward. In another presentation, we’ll discuss the automatic stay’s limitations.