Restructuring

Contributed by Frank Grese
In a recent ruling by summary order, a three-judge panel of the United States Court of Appeals for the Second Circuit in Residential Capital, LLC v. Fed. Hous. Fin. Agency (In re Residential Capital, LLC), unanimously held that the automatic stay under section 362(a) of the Bankruptcy Code may apply to litigation against a non-debtor corporate parent or non-subsidiary affiliate if such litigation would have an immediate adverse consequence on the debtor’s bankruptcy estate.
Upon the filing of a bankruptcy case, section 362(a) of the Bankruptcy Code automatically stays a number of actions that may adversely affect a debtor’s estate, including the commencement or continuation of any action against the debtor to recover a prepetition claim or to pursue litigation against the debtor to enforce a claim.  Any act to obtain possession of or control over property of the debtor’s bankruptcy estate is also stayed.  While it is clear that pre-bankruptcy litigation against a debtor is precluded by the automatic stay, it has been less clear when litigation against a non-debtor is stayed by the automatic stay.
The Second Circuit provided some guidance in Queenie, Ltd. v. Nygard Int’l, 321 F.3d 282, 287 (2d Cir. 2003), where it held that “the automatic stay can apply to non-debtors, but normally does so only when a claim against the non-debtor will have an immediate adverse economic consequence for the debtor’s estate.”  The Second Circuit then provided several “examples” of such an immediate adverse impact which involved litigation against a non-debtor to establish an obligation guaranteed by the debtor, litigation against a debtor’s insurer, and litigation where there is such identity between the debtor and the non-debtor defendant that the debtor could be said to be the real defendant.  After citing these principles, the Second Circuit then affirmed the trial court’s decision to apply the stay to a non-debtor corporation wholly-owned by the debtor, because adjudication of a claim against the non-debtor corporation would have an immediate adverse economic impact on the debtor.
Background
The ResCap debtors were in the mortgage origination and servicing business and, together, constituted the fifth largest servicer of residential mortgage loans in the United States before selling their business operations and other assets as part of their chapter 11 case.  A key part of ResCap’s business consisted of securitizing or selling mortgage loans that ResCap purchased, brokered, or originated.
After the residential real estate market’s collapse in 2008, many of the mortgage-backed securities issued by ResCap’s various securitization trusts lost value.  As a result, ResCap and its corporate parents and/or its officers and directors were subjected to a number of lawsuits throughout the United States.  These lawsuits were one of the reasons leading ResCap to file for chapter 11 in May, 2012.
One of these lawsuits was brought in 2007 by the Federal Housing Finance Agency (FHFA) in its capacity as conservator for Freddie Mac, which purchased certain of ResCap’s mortgage-backed securities.  FHFA alleged that ResCap violated federal and state law by making false and misleading statements and omissions in registration statements, prospectuses, and other documents concerning its mortgage-backed securities offerings.  In addition to naming the ResCap debtors as defendants, FHFA named certain direct and indirect corporate parents and affiliate:  GMAC Mortgage Group, Inc., Ally Financial, Inc., and Ally Securities, LLC.  FHFA’s main theory of liability against GMAC Mortgage Group and Ally Financial is a controlling-person theory – that these entities controlled ResCap when it made false statements.  FHFA alleged that Ally Securities, in its capacity as an underwriter, made material misstatements and omissions in violation of federal and state law.
Upon the commencement of ResCap’s chapter 11 filing, FHFA amended its complaint and removed ResCap as a defendant; however, FHFA continued prosecuting its case against the non-debtor corporate parents and affiliate.  ResCap commenced an adversary proceeding in the bankruptcy court and moved for a declaratory judgment that the automatic stay prohibits FHFA from continuing its litigation against those non-debtor affiliates.  The district court (Judge Denise Cote) withdrew the case from the bankruptcy court to the district court, and subsequently denied ResCap’s relief in an unwritten bench decision.  ResCap appealed the district court’s ruling to the Second Circuit.
District Court’s Ruling and Arguments on Appeal
In denying ResCap’s motion to stay FHFA’s litigation, the district court held that the automatic stay imposed by section 362 cannot apply to a non-debtor.  The district court noted that FHFA’s action is no longer proceeding against ResCap and that FHFA was not moving against property of the debtors’ estates.  The district court concluded that the automatic stay could only be extended to non-debtors if a court exercised its equitable powers through section 105 of the Bankruptcy Code, but that it was precluded from issuing injunctive relief under section 105 in this instance because of the anti-injunction provision of 12 U.S.C. § 4617(f), which prohibits a judicially-imposed stay (as opposed to a statutorily-imposed stay like that provided for in section 362).
While acknowledging that the automatic stay generally does not preclude litigation against non-debtors, ResCap relied on sections 362(a)(1) and 362(a)(3) and Second Circuit precedent in support of its argument that the stay applies to non-debtors where the debtor and non-debtors are so intertwined that the debtor is effectively the defendant, or where litigation against the non-debtor will adversely affect property of the debtor’s estate (citing Queenie, 321 F.3d at 287; 48th Street Steakhouse, Inc. v. Rockefeller Group, Inc. (In re 48th Street Steakhouse, Inc.), 835 F.2d 427, 431 (2d Cir. 1987)).
ResCap argued that, notwithstanding FHFA’s removal of ResCap as a defendant from its litigation after the bankruptcy filing, FHFA’s continued prosecution of ResCap’s corporate parents and affiliate hindered its ability to restructure under chapter 11.  Among other things, ResCap argued that (i) it would bear most of the extensive discovery burden given that FHFA’s allegations against the non-debtor affiliates focus on ResCap’s conduct and ResCap possesses virtually all of the documents that FHFA is seeking in discovery; (ii) property of the estate would be adversely affected because of ResCap’s obligation to indemnify its corporate parents and affiliate for any judgment plus defense costs; and (iii) because all parties share insurance coverage, the proceeds of which are paid on a first billed, first paid basis, the corporate parents and affiliate would deplete the insurance proceeds defending against FHFA’s litigation, and such proceeds would not be available to ResCap in the future.
FHFA argued, among other things, that its action against the corporate parents and affiliate is not an action or proceeding against ResCap and does not seek to possess or control property of its bankruptcy estate.  Therefore, according to FHFA, the district court was correct in concluding that FHFA’s action against the parents and affiliate cannot be stayed through the mere application of section 362.  FHFA also took issue with ResCap’s contention that current Second Circuit precedent, particularly Queenie, supported its view that the automatic stay should apply to the non-debtor corporate parents and affiliate.  FHFA argued that Queenie is inapplicable because it applied the automatic stay to a non-debtor that was wholly-owned by the debtor and, therefore, involved estate property, unlike here, where ResCap is wholly owned by the solvent non-debtors at issue.
Second Circuit’s Ruling
On appeal, the Second Circuit sided with ResCap and concluded that the district court erred when it held that the automatic stay imposed by section 362 cannot apply to a non-debtor and denied the applicability of the stay as a categorical matter.  To the contrary, the Second Circuit clarified that section 362’s automatic stay may apply to non-debtors in some limited circumstances and quoted Queenie in support thereof.  321 F.3d at 287 (“The automatic stay can apply to non-debtors, but normally does so only when a claim against the non-debtor will have an immediate adverse economic consequence for the debtor’s estate.”).  The Second Circuit continued by noting that “in Queenie, for example, this Court held that the automatic stay applied to proceedings against a debtor’s wholly owned corporation.”  Id.  The Second Circuit remanded the case back to the district court and ordered that factual findings be made, within sixty days, as to whether FHFA’s action against the corporate parents and affiliate would have “immediate adverse economic consequences” on ResCap’s estate.
Conclusion
While rulings by summary order technically do not have precedential effect, the Second Circuit’s ruling in In re Residential Capital, LLC – that at the automatic stay may apply to litigation against a non-debtor corporate parent or non-subsidiary affiliate if such litigation will have an immediate adverse consequence on the debtor’s bankruptcy estate – is significant because it clarifies that the Second Circuit’s Queenie decision should not be interpreted as being limited to wholly-owned subsidiaries of a chapter 11 debtor.  Even though the Second Circuit was clear that applying the stay against a non-debtor is the exception and not the norm, the ruling means that the automatic stay can theoretically be applied to an action against many categories of non-debtors so long as the debtor’s estate would suffer an immediate adverse consequence if the litigation or proceeding were to continue.