Restructuring

The United States Supreme Court has granted certiorari on an issue that has greatly divided Circuit Courts of Appeal – the question of whether an entity that retains possession of a debtor’s property has an affirmative obligation to return that property to the debtor or trustee immediately upon the filing of the bankruptcy petition or risk being in violation of the automatic stay. 

Section 362 of the Bankruptcy Code, the “automatic stay,” is one most important protections and powerful tools the Bankruptcy Code offers.¹ Filing a bankruptcy petition immediately triggers the stay, stopping all acts and proceedings against a debtor and its property.² Additionally, section 362(k)(1) of the Bankruptcy Code allows a debtor to file a motion for a creditor to be held in contempt for willful violation of the automatic stay. As the automatic stay provides powerful protections at high stakes, it is no surprise that exactly which actions (or inactions) are stayed is an often-litigated question.

Courts disagree about whether a failure to act can constitute a violation of the automatic stay. Two examples of scenarios in which this issue has arisen are when a creditor refuses to return property that it properly repossessed before the bankruptcy petition was filed and when the state, acting as a creditor, knowingly retains a debtor’s disputed taxes. The Supreme Court recently granted certiorari in City of Chicago v. Fulton, 19-357 (Sup. Ct.) to resolve a circuit split concerning this question. 

The majority of circuit courts (the “Majority”)³ that have addressed this issue hold that the automatic stay requires creditors to turn over immediately any property in which the bankruptcy estate has an interest.⁴ The Majority includes the Second, Seventh, Eighth, Ninth, and Eleventh Circuits.⁵ These courts hold that the provision’s statutory language, its legislative history, the Bankruptcy Code’s “turnover provision,” and bankruptcy policy support their interpretation.

A minority of circuit courts (the “Minority”) to address this issue hold that retention of a debtor’s property maintains the status quo, is not an affirmative act, and does not violate the automatic stay.⁶ The Minority includes the Third, Tenth, and the District of Columbia Circuits.⁷ These courts have held that the provision’s statutory language supports their position and disagree with the Majority’s interpretation of the automatic stay’s legislative history and the turnover provision. 

Statutory Language

Section 362(a)(3) of the Bankruptcy Code, the relevant portion of the automatic stay, provides, in part, that the filing of a bankruptcy petition “operates as a stay . . . of . . . any act to obtain possession of property of the estate . . . or to exercise control over property of the estate.”

The Majority, holding that creditors violate the automatic stay by not turning over property, argues that the commonsense meaning of “exercis[ing] control” includes holding onto a debtor’s property and refusing to return it.⁸ Under this argument, the automatic stay should prevent a creditor from continuing to prevent a debtor from regaining control over property of the estate.

The Minority, holding that inaction does not violate the automatic stay, argues that the plain language of the relevant automatic stay provision preserves the status quo and only prohibits creditors from taking affirmative action to exercise control over property of the estate.⁹ These courts assert that the statutory language is prospective in nature such that the exercise of control is not stayed, but the act to exercise control is stayed.¹⁰ Following this reasoning and assuming maintaining possession is not an act to exercise control, a creditor maintaining possession of a debtor’s property does not violate the automatic stay.

Legislative History

As originally enacted in 1978, section 362(a)(3) of the Bankruptcy Code only stayed “any act to obtain possession of property of the estate or of property from the estate.” In 1984, Congress amended section 362(a)(3) by inserting the language “or to exercise control over property of the estate.”

The Majority determined that the 1984 amendment from “to obtain possession” to “to obtain possession … or to exercise control” indicates congressional intent to broaden the concept of possession and make clear that the automatic stay applies to property of the estate that is not in the possession of the debtor.¹¹

The Minority counters that Congress did not provide an explanation of the 1984 amendment and that the Majority’s interpretation is a significant textual enlargement.¹² The Minority determined that the addition of “to exercise control” intended to prohibit nonpossessory conduct that would interfere with the estate’s authority over a particular property interest, such as a creditor in possession of property belonging to the debtor’s estate improperly selling it, rather than merely retaining property.¹³ Additionally, the Minority argues that the text is unambiguous, and accordingly, there is no need to resort to legislative history to uncover its meaning.¹⁴

The Turnover Provision

Section 542 of the Bankruptcy Code, the “turnover provision,” compels the return of property to a debtor’s estate, including property in which the debtor does not have a possessory interest at the time the bankruptcy proceedings commenced, unless such property is of inconsequential value or benefit to the estate. Courts debate both whether the turnover provision is self-executing, meaning if it applies automatically upon filing of a bankruptcy petition, and if the turnover provision should be read in conjunction with the provisions of the automatic stay.¹⁵

According to the Majority, the turnover provision is both self-executing and should be read in conjunction with the provisions of the automatic stay.¹⁶ The Majority argues that the turnover provision is self-executing because the statute states that a creditor-in-possession “shall deliver” estate property to the debtor.¹⁷ Moreover, the Majority asserts that reading these two sections together furthers a bankruptcy objective to consolidate the debtor’s property.¹⁸ The Majority argues this achieves consolidation because the turnover provision provides the right to the return of property, while the automatic stay provides the remedy for the failure to return such property.¹⁹

In contrast, the Minority asserts that the turnover provision is not self-executing for three reasons.  First, the Minority interprets Federal Rule of Bankruptcy Procedure 7001(1) to require a debtor to bring an adversary proceeding in bankruptcy court in order to give the Court the opportunity to determine if the property is subject to turnover.²⁰ Second, the Minority argues that mandating that creditors automatically turn over any property that a debtor deems worthy of turnover would allow debtors to strip creditors temporarily of their rights to assert affirmative defenses, or to claim that the property is not property of the estate.²¹ Finally, the Minority asserts that the United States Supreme Court’s reasoning in Citizens Bank of Maryland v. Strumpf, which (as discussed more here) held that a bank’s imposition of a temporary administrative hold on a debtor’s deposit account did not constitute a setoff and did not violate the automatic stay, implies that notwithstanding the word “shall,” the turnover provision is not self-executing.²² 

Significantly, the Minority argues that even assuming the turnover provision is self-executing, there is no textual link between the turnover provision and the automatic stay, so violation of the turnover provision does not warrant sanctions for violation of the automatic stay.²³ Specifically, bankruptcy courts do not need the provisions of automatic stay to enforce the turnover of property to the estate because such courts have broad equitable powers under section 105(a) of the Bankruptcy Code and can provide equitable relief as necessary or appropriate.²⁴

Policy

The Majority argues that if a creditor does not violate the automatic stay by retaining a debtor’s property, the purpose of bankruptcy is ignored—i.e., allowing the debtor to regain a financial foothold and repay creditors.²⁵ According to the Majority, to regain a financial foothold effectively, a debtor must be able to use its assets while it works with a court to establish a rehabilitation plan.²⁶ 

The Minority asserts that the Majority’s policy argument is not supported by the statute’s text or its legislative history.²⁷ The Minority counters that the automatic stay’s primary purpose is to maintain the status quo between the debtor and its creditors.²⁸

Conclusion

The core of the dispute is whether the automatic stay simply preserves the status quo or whether it prevents creditors and other entities from continuing to prevent a debtor from exercising control of property of the estate. Both sides make persuasive textual and policy arguments. City of Chicago v. Fulton will likely be argued and decided before the Supreme Court’s term ends in late June. We will continue to monitor the case and will follow up with a post detailing the potential impact of the Supreme Court’s decision. Interestingly, this will be the second time the Supreme Court considers an automatic stay issue this year (click here to read Denial of Stay Relief is Final Order, Says the U.S. Supreme Court).