Possession Is Not 9/10ths of Bankruptcy Law – Second Circuit Enforces Sanctions Against a Secured Creditor for Refusing to Return Collateral Properly Seized Prior to Bankruptcy Filing

Contributed by Conray C. Tseng
In In re Weber, the Second Circuit Court of Appeals upheld sanctions against a secured creditor under section 362(k) of the Bankruptcy Code after the creditor refused to return collateral it had seized properly under applicable non-bankruptcy law prior to the debtor’s bankruptcy filing.  Although a previous district court decision condoned such actions, the Second Circuit not only abrogated the earlier decision and held that the creditor’s actions violated the automatic stay, but also held that reliance on the earlier decision did not shield the secured creditor from liability.  If possession is 9/10ths of the law, the Second Circuit makes the remaining 1/10th really matter.
In 2006, Christopher Weber obtained a loan from the State Employees Federal Credit Union (“SEFCU”), which was secured by Mr. Weber’s pickup truck.  The loan agreement permitted SEFCU to repossess Mr. Weber’s vehicle upon default.  In 2009, Mr. Weber defaulted on the loan.  On January 10, 2010, SEFCU properly repossessed Mr. Weber’s vehicle and advised Mr. Weber that, under New York state law, Mr. Weber had the right to redeem the vehicle upon payment of amounts due and certain costs.  On January 14, 2010, Mr. Weber commenced a chapter 13 bankruptcy case.
After filing his chapter 13 petition, Mr. Weber notified SEFCU of the filing, demanded return of his vehicle, and advised SEFCU that refusal to return the vehicle violated the automatic stay under section 362(a) of the Bankruptcy Code.  After SEFCU refused to return the vehicle, Mr. Weber commenced an adversary proceeding, and the bankruptcy court entered an order requiring SEFCU to show cause why SEFCU should not return the vehicle and why the bankruptcy court should not award damages under section 362(k) of the Bankruptcy Code for violation of the automatic stay. 
Even though SEFCU returned the vehicle, Mr. Weber pressed for damages as a result of his inability to use the vehicle for the approximately three-month period from the petition date until the return of the vehicle.  SEFCU moved for summary judgment arguing that an earlier decision in the district required a debtor to take an affirmative step to recover collateral (e.g., a commencing a turnover action) before the collateral became property of the debtor’s estate.  Accordingly, SEFCU argued that it did not exercise control over property of Mr. Weber’s estate and did not violate the automatic stay.  The bankruptcy court agreed and granted summary judgment in favor of SEFCU.  Mr. Weber appealed.
The district court reversed and, relying upon the U.S. Supreme Court’s decision in U.S. v. Whiting Pool, Inc., 462 U.S. 198 (1983), rejected Alberto.  The district court found SEFCU’s failure to return Mr. Weber’s pickup truck violated the automatic stay.  Because SEFCU knew of Mr. Weber’s bankruptcy filing and retained the vehicle, SEFCU’s violation was willful and subject to damages and attorneys’ fees.
The Second Circuit affirmed the district court’s decision and held that SEFCU violated the automatic stay.  Under section 541 of the Bankruptcy Code, the commencement of a bankruptcy proceeding creates an estate comprised of “all legal or equitable interests of the debtor in property as of the commencement of the [bankruptcy] case.”  Section 541 of the Bankruptcy Code includes within the estate all such property interests, “wherever located and by whomever held.”  To assemble the bankruptcy estate, section 542 of the Bankruptcy Code requires that, during a bankruptcy case, a third party “in possession, custody, or control” of estate property “shall deliver” that property to the debtor.  During the bankruptcy proceeding, the automatic stay of section 362 of the Bankruptcy Code, in conjunction with sections 541 and 542 of the Bankruptcy Code, shelter the debtor’s estate from actions by creditors, providing the debtor an opportunity for relief and a fresh start.  Specifically, section 362 of the Bankruptcy Code imposes an automatic stay on “any act to obtain possession of property of the estate … or to exercise control over property of the estate.”  Under section 362(k) of the Bankruptcy Code, those who willfully violate the automatic stay in an individual’s bankruptcy case may be liable for damages and costs. 
In Weber, the Second Circuit first examined whether SEFCU’s refusal to return Mr. Weber’s vehicle constituted an unlawful exercise of control over property of Mr. Weber’s estate.  The Second Circuit noted that, even though Mr. Weber no longer maintained possessory rights in the vehicle, New York state law provided Mr. Weber an equitable interest in the vehicle (i.e., the right to redeem). 
Relying on the Supreme Court’s decision in Whiting Pool, the Second Circuit held that section 542 of the Bankruptcy Code granted Mr. Weber a possessory interest in the vehicle based upon Mr. Weber’s existing equitable interest in the same.  In Whiting Pool, the Supreme Court affirmed a lower court decision pursuant to section 542 of the Bankruptcy Code requiring the IRS to return property it had seized prepetition.  The Supreme Court reasoned that the seizure of property did not determine the IRS’s rights to the property, but only brought the property into the IRS’s custody.  To permit the IRS to retain the property, the Supreme Court declared, “would deprive the bankruptcy estate of the assets and property essential to its rehabilitation efforts and thereby would frustrate the congressional purpose behind the reorganization provisions.”  The Second Circuit agreed such reasoning applied in Weber although Whiting Pool was a chapter 11 case.
Whiting Pool, however, did not address whether SEFCU could condition release of the property on Mr. Weber providing “adequate protection” or whether Mr. Weber needed to commence an adversary proceeding for the vehicle to become property of the estate as suggested by Alberto.
As noted above, Alberto suggests that property in the possession of a third party does not become property of the debtor’s estate until the debtor takes an affirmative step to obtain the property (e.g., a turnover action).  The Alberto court reasoned that because the property was already in the possession of a creditor when the stay went into effect, the creditor did not “act to obtain possession … or to exercise control.”  
The Second Circuit found Alberto’s reasoning unpersuasive.  The Second Circuit reasoned that SEFCU’s prepetition possession of the vehicle did not alter the fact that the vehicle was property of Mr. Weber’s estate.  Section 541 of the Bankruptcy Code specifically includes property “wherever located and by whomever held.”  The Second Circuit also held that Mr. Weber did not need to initiate a turnover proceeding.  The Second Circuit reasoned that section 542 of the Bankruptcy Code is “self-executing.”  To adopt the Alberto rule, the Second Circuit further reasoned would place upon the debtor an unnecessary burden of undertaking a series of adversary proceedings to gather the estate, thereby increasing the cost of administration and decreasing assets available for reorganization.  Accordingly, the Second Circuit held that section 542’s “shall deliver” language should be taken at face value – without any qualifications.  In rejecting the Alberto decision, the Second Circuit joined the majority view held by a number of other circuits.
The Second Circuit applied similar reasoning in rejecting SEFCU’s argument that it could condition surrender upon Mr. Weber providing adequate protection.  The Second Circuit held that section 542 of the Bankruptcy Code requires a creditor to deliver the property to the debtor; only after the creditor surrenders the property or in conjunction with such surrender may a creditor request the bankruptcy court provide adequate protection. 
As a final matter, the Second Circuit addressed whether could SEFCU “willfully” violate the automatic stay if it relied upon the existing Alberto precedent.  The Second Circuit held that specific intent is not necessary for stay violations – general intent to perform the offending act was sufficient.  The Second Circuit concluded that SEFCU intended to deprive Mr. Weber of his vehicle, and, accordingly, SEFCU violated the automatic stay.  Nonetheless, the Second Circuit noted that SEFCU’s good faith reliance on Alberto may shield SEFCU from punitive damages, but not actual damages and costs.
In closing, secured creditors may wish to exercise caution when retaining property seized prepetition.  Weber serves as a cautionary tale that asserting an aggressive position vis-à-vis the automatic stay – even when grounded in case law – may not later shield a creditor from damages.  Further, although Weber is a chapter 13 bankruptcy, many of its principles are apt to apply to in the chapter 11 context.