Avoiding Bankruptcy Stay Violations: An Update

Introduction

In 2021, the U.S. Supreme Court ruled that a creditor did not violate the automatic stay in bankruptcy when it refused to surrender vehicles after the owners filed Chapter 13 bankruptcy cases. Specifically, the Court ruled that the creditor had not violated the part of the automatic stay that prohibits “any act … to exercise control” over property of the bankruptcy estate.

However, the Court did not rule on whether the creditors’ actions violated other parts of the automatic stay. Further, the Court’s ruling has generated disputes about its meaning in other contexts, particularly account garnishments. The stakes in these matters can be high, as a violation of the automatic stay can result in liability for attorney fees, emotional distress damages, and punitive damages. Therefore, this month we revisit the Court’s ruling, highlight some recent court cases in which it has been invoked, and draw some lessons from them.

The Supreme Court’s Decision

The Supreme Court case was City of Chicago, Illinois v. Fulton, et al. (“Fulton”). The case arose from the city’s practice of impounding cars based on the owners’ failures to pay fines. Each of the owners filed Chapter 13 and asked the city to return their vehicles, but the city refused. The lower courts all ruled that the city’s refusal violated the automatic stay, which is imposed by Bankruptcy Code section 362. In particular, they ruled that the city’s refusal violated subsection 362(a)(3) as an “act … to exercise control over” the debtors’ property.

The Supreme Court overruled the lower courts. The Court held that the city had not violated subsection (a)(3), because that subsection requires an “act” to “exercise” control, which implies an affirmative act that changes the status quo, as opposed to merely retaining possession of the vehicles, which maintains the status quo. Second, the Court stated that any ambiguity in the language of subsection (a)(3) must be resolved in the city’s favor because the bankruptcy code includes a separate provision, section 542, that concerns when a creditor has to turn over property to the debtor. In other words, holding that subsection (a)(3) always requires a creditor to turn over property would render section 542 redundant.

Taking Fulton Too Far (and Paying the Price)

In April 2023, a bankruptcy court in Florida ruled that a creditor was not protected by Fulton when it refused to release a garnishment it had served on Blue Cross Blue Shield in order to capture payments owed to the debtor.[1] The court wrote that the case “illustrates how matters can escalate when a creditor makes the unilateral decision that its action or inaction does not violate the automatic stay.”

In response to the garnishment, Blue Cross withheld approximately $12,000.00 of funds before the debtor’s bankruptcy filing and stated that it would withhold additional funds until the state court ordered otherwise. The debtor promptly informed the creditor of his bankruptcy filing and demanded that the garnishment be dissolved, noting that Blue Cross was continuing to withhold funds after the bankruptcy filing. The creditor, relying on Fulton, declined to release the garnishment and blamed Blue Cross for withholding post-bankruptcy funds, noting that the garnishment was not continuing in nature and that the creditor had not asked Blue Cross to withhold post-petition funds.

The bankruptcy court ruled, however, that the creditor’s position “is incorrect under the facts and circumstances of this case.” The court pointed out that under Florida law, Blue Cross faced liability to the creditor if it did not comply with the garnishment and was immune from liability to the extent it acted in good faith. In short, Blue Cross had a strong legal incentive to continue withholding funds until the state court told it not to, and there was no evidence that Blue Cross had not acted in good faith.

Further, the court wrote that it was the responsibility of the creditor, not Blue Cross, to stop the “downhill snowballing” of what the creditor had started (i.e., the garnishment). Also, while the creditor alleged that it had a lien on the $12,000.00 that had been captured pre-petition, it never filed a motion with the bankruptcy court to enforce the alleged lien. Finally, the bankruptcy court found that Fulton was not on point because, unlike in Fulton, the creditor’s inaction changed the status quo insofar as the creditor captured more of the debtor’s assets after the bankruptcy filing.

The court found that the creditor had willfully violated the bankruptcy stay and scheduled a hearing to consider damages to be awarded to the debtor. The creditor and debtor subsequently reached a settlement in which the creditor agreed to forego $30,000.00 of payments that it otherwise would receive from the debtor’s bankruptcy plan and to also pay $3,255 of the debtor’s attorney fees.

Finding the Right Balance

In August 2023, the Ninth Circuit Court of Appeals affirmed a lower court’s ruling that Fulton protected a creditor who failed to take action to return garnished funds to the debtor and even opposed the debtor’s motion to quash the garnishment.[2]

The creditor served a garnishment on the bank and captured approximately $9,000.00 in the debtor’s account. The debtor then filed bankruptcy and demanded that the creditor instruct the bank to release the funds. The creditor promptly stayed the garnishment proceedings pending in state court and informed the bank that it was not opposed to the funds being released to the debtor. However, the creditor declined to dismiss the garnishment and opposed the debtor’s motion to quash the garnishment, arguing that the debtor was entitled to only a stay of the garnishment, which the creditor had already provided.

The lower court agreed that under Fulton the creditor had done all that it was required to do and “had no affirmative duty to ensure the return of estate property to” the debtor. The lower court also held that the creditor had also not violated any other part of the bankruptcy stay. However, the lower court noted that the creditor’s “garnishment did not capture any more funds postpetition” and that “[t]he result would likely be different … if this were … a bank account garnishment that encompassed postpetition deposits in the account.” In other words, the creditor was not violating the bankruptcy stay by sitting on its hands so long as post-petition funds were not involved.

Similarly, in 2021, a bankruptcy court in Pennsylvania ruled that creditors were protected by Fulton and did not otherwise violate the bankruptcy stay when they declined to release a garnishment on the debtor’s bank account.[3] The creditors took no action after the bankruptcy filing with respect to the garnishment and merely declined to respond to the debtor’s demand that they withdraw the garnishment so that he could access the funds in his account. The court wrote that the creditors –

“maintained the status quo as of the petition date. They were not required to withdraw the attachment because to do so would put them in a more disadvantageous position [i.e., they would have lost their garnishment lien on the funds] than they had been as of the petition date and they were entitled to maintain the status quo.”

The debtor argued that unless the creditor took some act to stop the garnishment process, the garnishment would have continued until the creditors obtained a judgment for the captured funds, and the funds would have been released to the creditors. In other words, the debtor argued that the garnishment would “downhill snowball” unless the creditor stepped in, and therefore the creditor’s failure to step in violated the bankruptcy stay. The court rejected that argument, noting that under Pennsylvania law there could be no snowballing of the garnishment process without affirmative efforts by the creditor.

Takeaways

In terms of takeaways from the above cases, the clearest is that if a creditor’s garnishment or other collection action will, if left in place, capture additional assets of the debtor after the bankruptcy filing, then the creditor must take affirmative steps to prevent that from happening. Failure to do so will almost certainly be a violation of the automatic stay and expose the creditor to sanctions. Similarly, even if additional assets will not necessarily be captured, if the collection process itself will move forward after the bankruptcy filing unless the creditor takes action to stop it, then the creditor must take such action.

Further, the creditor will likely not be able to pass the blame for any post-petition activity to a third party, such as an account garnishee. A bankruptcy court is likely to hold that the creditor started the collection process and therefore is responsible for staying it, even if that involves taking action to stop a third party.

In sum, it is only if the status quo as of the bankruptcy filing will not change even if the creditor takes no action that the creditor might be protected by Fulton. We emphasize “might be protected” because there can be no guarantee of the outcome in any particular case and because considerations beyond maintaining the status quo might influence a court’s decision. For example, in the Pennsylvania case, the court did not rest its holding only on the fact that the creditor had not compromised the status quo. Rather, the court added that the creditor was not required to withdraw the garnishment “because to do so would put them in a more disadvantageous position” insofar as they would lose the lien of their garnishment. In other words, if the creditor would lose nothing by releasing the funds to the debtor, then the court might not have been as quick to rule in the creditor’s favor. This echoes a ruling from a bankruptcy court in Virginia in 2019, in which the court rejected a creditor’s argument for not releasing a garnishment in part because the creditor had never “asserted that they have a legal interest in the garnished funds superior to the Debtor’s right to exempt the funds.”[4]

Accordingly, while Fulton was a victory for creditors, it is still necessary to look closely at the particular facts and circumstances of each case and to take prompt action in the bankruptcy court if there is a potential stay violation. As demonstrated by the Florida case referenced above, a creditor that “makes the unilateral decision that its action or inaction does not violate the automatic stay” may be inviting trouble.

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[1] The case is In re Namen, 649 B.R. 603 (Bankr. M.D. Fla. 2023).
[2] The case is Stuart v. City of Scottsdale (In re Stuart), 2023 U.S. App. LEXIS 20305 (9^th Cir. Aug. 7, 2023) (affirming
Stuart v. City of Scottsdale (In re Stuart), 632 B.R. 531 (B.A.P. 9^th Cir. 2021).
[3] The case is Margavitch v. Southlake Holdings, LLC (In re Margavitch), 2021 Bankr. LEXIS 2784 (Bankr. M.D. Pa. 2021).
[4] The case is In re Nimitz, 2019 Bankr. LEXIS 3798 (Bankr. E.D. Va. 2019).