The Second Circuit Announces the Standard for Determining Whether the Automatic Stay Applies to Non-Debtor Entities

By: Raff Ferraioli

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

In In Re Residential Capital, LLC,[1] the United States Court of Appeals for the Second Circuit remanded the case, while preserving appellate jurisdiction,[2] in order to resolve whether the automatic stay applied to non-debtors.[3]  Prior to the appeal, the District Court for the Southern District of New York denied the debtors’ motion to stay a lawsuit brought by the Federal Housing and Finance Agency (“FHFA”) against the debtors’ corporate parents and affiliates.[4] In 2011, FHFA brought an action against the debtors and certain of their corporate parents and affiliates, alleging that they made material misstatements concerning mortgage-backed securities purchased by Freddie Mac.[5]  While that suit was ongoing, the debtors filed for bankruptcy.[6]  Despite the bankruptcy filing, FHFA continued to prosecute its claims against the non-debtor defendants.[7]  The district court held that the automatic stay could not extend to non-debtor entities because they were not in bankruptcy, without determining whether the lawsuit against those entities would have immediate adverse economic consequences on the debtors’ estates.[8]On appeal, the Second Circuit remanded the case, instructing the district court to make such a determination.[9]

Acting in accordance with the Second Circuit’s remand instructions, the district court held that the automatic stay did not apply to the non-debtors after finding that the FHFA’s litigation against the non-debtors would not have an immediate adverse economic consequence on the debtors’ estates.[10]  First, the district court found that the shared insurance policies between the estates and non-debtors will not have an immediate and adverse effect on the debtors’ estates because (1) there was a provision that relinquished all rights and proceeds under the plan to the government; (2) the FHFA was unlikely to meet the twenty-five million dollar threshold under the policy; and (3) the time table provided no immediate threat.[11]  Second, and regarding an indemnification obligation, the district court found that there would be no immediate adverse economic consequences on the debtors because the debtors had made no payments to Ally pursuant to any indemnification agreement and, under the debtors’ plan, Ally agreed to release the debtors from all indemnification claims.[12] 

Generally, the automatic stay provision only applies to debtors.[13] However, the automatic stay can also extend to non-debtors in certain circumstances.   For example, in Queenie, Ltd. v. Nygard Int’l,[14] the Second Circuit held that the automatic stay could apply to non-debtor entities, but only when the claim against the non-debtor entity will have an “immediate adverse economic consequence [on] the debtor’s estate.”[15]  In Queenie, the debtor wanted the automatic stay to apply to himself, his wholly owned non-debtor corporation, and to another group of non-debtor appellants.[16]  The Queenie court held that the automatic stay applied to the non-debtor corporation because that “adjudication of a claim against the [non-debtor] corporation [would] have an immediate adverse economic impact on [the debtor].”[17] Accordingly, the Second Circuit’s approach in Queenie expands the automatic stay beyond the plain language of section 362(a).[18] Thus far, the Third and Fourth Circuits have also adopted this expansive application of the automatic stay in circumstances where “the debtor may be said to be the real party defendant and that a judgment against the third-party defendant will in effect be a judgment or finding against the debtor.”[19] 

Based on the District Court’s decision, it is evident that while courts have applied the automatic stay broadly, there are limitations. A court may apply the automatic stay to non-debtors, but the debtor must be able to demonstrate hard facts, and not theoretical assertions, that there will be an immediate adverse economic consequence to its estate. Ultimately, if a non- debtor can demonstrate that allowing the litigation against the non-debtor will have an immediate economic adverse consequence on the debtor, the non-debtor will get the benefits of a bankruptcy without filing.

[19] A.H. Robins Co., Inc. v. Piccinin, 788 F.2d 994, 999 (4th Cir. 1986); see also McCartney, 106 F.3d at 510.