October 25, 2014

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Collateral Damages: Secured Creditors, Turn Over Repossessed Collateral, Or Else!

It was just an old jalopy legally repossessed by his credit union . . . until he filed a bankruptcy petition and the red lights of the automatic stay started flashing. Smokey pulled the lender over and started issuing citations so be forewarned, put your hazard lights on and drive carefully through the postpetition fog, because this decision is relevant to all secured creditors under all Bankruptcy Code Chapters, not just car lenders under Chapter 13. In a recent Second Circuit decision, the Court affirmed the judgment of the United States District Court for the Northern District of New York, which concluded that a secured creditor violated the Bankruptcy Code’s automatic stay by refusing to return a 4-banger that it had legally repossessed several days before plaintiff filed for relief under Chapter 13 of the Bankruptcy Code. In re Weber (Weber v. SEFCU)No. 12-1632-bk (2d Cir. May 8, 2013). A copy of the decision can be foundHERE.

Secured creditors own the road of repossession outside of bankruptcy. But cross that line into postpetition country and the traffic laws back home no longer apply. The rule of the automatic stay under section 362 of the Bankruptcy Code is expansive. It extends so far as to require the turnover of property of the estate that was legally seized prepetition—so long as the debtor retains even an equitable interest in such property under state law. Moreover, failure to turn over such property to the estate after knowing the owner filed a bankruptcy petition subjects the lender to liability for damages, costs and fees for willful violation of the automatic stay—regardless of what the road signs indicated.

Property of the estate is defined broadly under section 541(a) of the Bankruptcy Code to include “all legal or equitable interests in property as of the commencement of the case.”  Section 542(a) of the Bankruptcy Code requires any entity in possession, custody or control of certain property of the estate to deliver such property to the trustee. In tandem with those sections, section 362 of the Bankruptcy Code in turn shelters such property of the estate from creditor action by implementing an automatic stay.

Here, the debtor retained an equitable interest in a repossessed beater under New York state law, which entitled the debtor to certain rights in connection with the clunker and rendered such interest property of the estate under section 541. After it knew of the bankruptcy filing, lender SEFCU retained the jalopy in reliance on In re Alberto, a decision from the District Court of the Northern District of New York concluding that a secured lender had no obligation to return a repossessed slab upon a subsequent bankruptcy filing until the debtor took an affirmative action to reclaim it, such as obtaining a turnover order, and that such possession did not meanwhile constitute an exercise of control over property of the estate. The District Court reasoned that the creditor did not act to obtain possession or exercise control of the old barge in violation of the stay because the debtor no longer had a possessory interest in his ride and the creditor had lawfully taken possession.

Rejecting the District Court’s reasoning, the Second Circuit relied on a majority of other circuits which conclude that an estate’s equitable interest in property entitles it to turnover of such property. Such courts reason that the primary goal of reorganization is to assemble all property of the estate, even property seized prepetition, in an attempt to rehabilitate the debtor—and that assets should be used productively to such end in the physical custody of the debtor—even if the property interest held by the debtor would not entitle the debtor to physical possession under state law. The Court held that the plain language of the Bankruptcy Code requires turnover under section 542(a) and that a secured creditor may request adequate protection only upon such turnover—not before. Thus, SEFCU was in flagrant violation of the automatic stay, regardless of the Alberto highway signage.

SEFCU was heading down a one-way street. Not only did it have to turn the car around and take the long road home, but the advertising was there to issue a “safe driving award.” The Court held SEFCU liable for plaintiff’s damages, costs and attorneys’ fees for willful violation of the automatic stay under section 362(k). SEFCU argued in vain that it was protected by its good faith reliance on In re Alberto. However, the Court held that 362(k) does not require specific intent to violate the automatic stay. A creditor willfully violates the automatic stay by merely (i) knowing of the bankruptcy petition and (ii) possessing general intent to perform the act that violates the automatic stay.

So check the tires on your caddy, always use your blinkers, keep a watchful eye out for Tijuana Taxis and Sunoco Specials, and give the debtor back his rust bucket if he files for bankruptcy protection.

© 2014 Bracewell & Giuliani LLP

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About this Author

Partner

Evan Flaschen is the chair of the Financial Restructuring Group at Bracewell & Giuliani LLP.  His practice includes representation of many of the world's largest institutional investors, hedge funds, Wall Street proprietary desks, fund managers, leveraged finance participants and financial services companies in out-of-court restructurings, in-court proceedings and distressed M&A transactions, both domestically and internationally.

Mr. Flaschen has represented noteholder and bondholder...

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Associate

David Lawton is a member of the firm's Financial Restructuring team. Mr. Lawton's practice focuses on the representation of hedge funds, institutional investors, fund managers and other lenders and equity groups in complex workouts, insolvency proceedings, and litigation in U.S. and international corporate restructurings with particular emphasis on Australian workouts. Mr. Lawton has worked in a variety of sectors. His industry highlights include tribal gaming, agribusiness and real estate. Mr. Lawton has also assisted corporate clients with mergers and acquisitions...

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