Navigating the High-Stakes Terrain of Commercial Bankruptcy Litigation: Common Pitfalls and How to Avoid Them

Anatomy of an Adversary Proceeding

There are two (2) main procedural avenues for the resolution of disputes in a bankruptcy case: contested matters[1] and adversary proceedings.[2]  Contested matters are typically resolved through motions practice in the main bankruptcy case, while an adversary proceeding (commonly referred to by bankruptcy practitioners as an “AP”) is a separate lawsuit commenced within the main bankruptcy case.  Adversary proceedings thus have many of the hallmarks of any other lawsuit in state or federal court, including more stringent service requirements (albeit more relaxed than in other litigation contexts), discovery rules, dispositive motions, and ultimately, a trial.

Misunderstanding the Legal Process and Timing

One of the most remarkable departures from the Federal Rules of Civil Procedure in an adversary proceeding is the relaxed rules for service of process.  In an ordinary lawsuit in a North Carolina state court, or in a non-bankruptcy federal lawsuit, service of the summons and complaint must typically be accomplished by personal service on the defendant or, if service is accomplished via U.S. Mail or a designated delivery service (such as UPS or Federal Express), it must be accompanied by some signatory evidence that the defendant in fact received the process.[3]  However, service of the summons and complaint in an adversary proceeding may be accomplished via first-class U.S. Mail.[4]  That’s right—no return receipt or other evidence of delivery is required. Because a defendant in an adversary proceeding can be validly served via first-class U.S. Mail, it is not uncommon for a defendant to mistakenly discard or ignore the summons and complaint, because without the formality of having to sign a return receipt or delivery receipt (or being served by the Sheriff, for example), defendants may be completely unaware that a lawsuit has been commenced against them. Thus, creditors in a bankruptcy case must pay close attention to any mail they receive during the pendency of the case, as failure to respond to a properly served summons and complaint in an adversary proceeding can result in the entry of a default and a default judgment against the defendant.[5] Because of the potentially significant adverse consequences that can arise as a result of failing to timely respond to a filed complaint in an adversary proceeding, defendants in an adversary proceeding should contact experienced bankruptcy counsel as soon as possible after receiving the summons and complaint.

On the flip side, some creditors in bankruptcy may wind up being the plaintiff, or the party initiating an adversary proceeding. One of the most common reasons for a creditor to file an adversary proceeding against a debtor is to seek to have a debt owed to the creditor by the debtor excepted from the debtor’s discharge.[6]  Again, timing is critical because, for certain categories of debts that can be excepted from discharge,[7] there is a strict deadline by which the creditor must file its adversary proceeding, and the deadline cannot be extended unless the extension is sought before it expires.[8]  Thus, it is always a good idea for a creditor to contact experienced bankruptcy counsel as soon as the creditor becomes aware of the debtor’s bankruptcy filing, as the creditor may not only be subject to a filed adversary proceeding as a defendant, but may also have time-sensitive rights as a potential plaintiff that can be irretrievably lost if not timely asserted.

Failing to Properly Assess the Financial Position of the Debtor

For a creditor seeking to have a debt excepted from discharge under 11 U.S.C. § 523(a), it is imperative to properly assess the debtor’s financial condition, because there are many cases where the “juice is not worth the squeeze.” For example, if the debt owed to the creditor is $10,000 or less, it will generally be cost-prohibitive to seek to have that debt excepted from discharge, as legal fees in a contested adversary proceeding can easily exceed this amount, and unlike in state court, there is no fee-shifting mechanism available for a creditor asserting a non-dischargeability claim (meaning that the creditor will bear its own costs and legal fees, even if it wins and the debt is declared non-dischargeable). Another important consideration is the debtor’s likely ability to pay a debt excepted from discharge. Again, creditors should avoid throwing good money after bad and having a debt excepted from discharge if it appears substantially certain that the debtor is unlikely ever to have the means to pay the non-discharged debt.

Overlooking the Impact of Automatic Stay

The automatic stay is a statutory injunction that, as its name implies, goes into effect automatically whenever a debtor files for bankruptcy.[9]  Among other things, the automatic stay prohibits a creditor from continuing to litigate a lawsuit against the debtor to collect or liquidate a prepetition debt.[10]  Thus, if the creditor has a lawsuit pending against the debtor when the debtor files for bankruptcy, the creditor has a couple of options.  It can seek relief from the automatic stay in the bankruptcy court, it can effectively suspend the litigation pending the outcome of the bankruptcy case, or it can, in some circumstances, remove the pending state-court lawsuit to the bankruptcy court as an adversary proceeding. 

Motions for relief from the automatic stay are contested matters that require a motion to be filed in the bankruptcy court and will typically result in a hearing before the bankruptcy judge, who will determine if relief from the stay is appropriate.[11]  In some cases, if the debtor is a consumer and a repeat filer, the automatic stay may be limited or may not go into effect at all.  In some consumer cases, the most cost-effective action may be to simply suspend the state court lawsuit until the debtor’s bankruptcy case is dismissed, as many Chapter 13 debtors fail to consummate their Chapter 13 plan and wind up having their case dismissed without a discharge of their debts. If the suit was solely to liquidate the amount of the creditor’s claim against the debtor, that process can be accomplished through the claims resolution process in the bankruptcy case.[12] Removal of a lawsuit to the bankruptcy court is a complicated process subject to strict deadlines, and is best handled by an experienced bankruptcy litigator.[13]  In any case, the most important consideration for a creditor with a pending lawsuit against a defendant who files for bankruptcy is to avoid violating the automatic stay, as this can shift the negotiating leverage in the debtor’s favor by giving the debtor a potential claim for damages and, in appropriate circumstances, punitive damages against the creditor[14] (and unlike a creditor litigating to have a debt excepted from discharge, a debtor can recover his or her costs and attorneys’ fees from a creditor for a violation of the automatic stay).[15]

Inadequate Due Diligence on Preference Claims and Fraudulent Transfers

For the plaintiff in an adversary proceeding, it is important to remember that pleadings filed in a bankruptcy case (including in an adversary proceeding) are subject to Rule 11.[16]  Thus, for a debtor’s attorney seeking damages for violation of the automatic stay, it is essential that the amount of damages sought be adequately supported by the evidence.[17]  Similarly, a debtor’s attorney or trustee asserting avoidance actions under Chapter 5 of the U.S. Bankruptcy Code (such as preference claims or fraudulent transfer claims) must ensure that the factual allegations in the complaint “have evidentiary support—or if specifically so identified, are likely to have evidentiary support after a reasonable opportunity for further investigation or discovery.”[18] For a trustee or debtor-in-possession asserting a preference claim, there is a separate element that the plaintiff has conducted “reasonable due diligence in the circumstances of the case” and taking into account the defendant’s available affirmative defenses under 11 U.S.C. § 547(c).[19]

Preference claims arise where a creditor is paid by the debtor within a specified period prior to the debtor filing for bankruptcy,[20] and the payment allows the creditor to receive more from the debtor than it would have received if the payment had not been made and the debtor’s bankruptcy estate were liquidated under Chapter 7.[21]  The policy goal behind preference claims is to ensure that all similarly situated creditors of the debtor receive equal treatment.[22]  Thus, for example, if the debtor pays an unsecured loan owed to a family member in full just prior to filing for bankruptcy, while not paying any other unsecured creditors, the family member whose loan was paid should expect to receive a demand from the trustee to return the funds, and failing a voluntary turnover, will likely be sued for avoidance of the preferential transfer.  There are a number of affirmative defenses to a preference claim (and to the cousin of the preference claim, the fraudulent transfer[23] claim), but affirmative defenses can be lost if not pled. Thus, it is important to contact experienced bankruptcy counsel as soon as a creditor realizes that it is the subject of a preference or fraudulent transfer claim.

Ignoring Alternative Dispute Resolution Options

Many commercial counterparties to contracts include mediation or arbitration clauses in their contracts. These clauses typically require that in the event of a dispute between the parties to the contract, the dispute will not be litigated in court, but will instead be resolved by binding arbitration.  When a party to such a contract becomes a debtor in bankruptcy, the issue becomes whether the bankruptcy court will enforce the arbitration clause or not. There are important policy reasons why a bankruptcy court might disregard an arbitration clause in a prepetition contract between a creditor and a debtor, the most obvious of which is that bankruptcy is intended to operate as a centralized forum for the resolution of all claims against a debtor, and there is a risk of inconsistent outcomes if some creditors’ claims are resolved in the bankruptcy court while other creditors’ claims are resolved in arbitration.  However, depending on the nature of the dispute (and how far along it may have progressed in arbitration before a bankruptcy case is filed), it may be more economical and efficient to seek the bankruptcy court’s blessing to resolve the dispute in arbitration, even if the arbitrator’s award will ultimately be administer by the bankruptcy court as part of the claims allowance process. Experienced bankruptcy counsel can assist in determining whether an arbitration clause in a given contract is likely to be enforceable in bankruptcy, and whether it makes practical sense to seek to resolve the creditor’s claims in a private arbitration rather than through an adversary proceeding.

Underestimating the Role of Secured Creditors

A secured creditor has rights in collateral that supplement its right to collect its debt from the debtor personally.[24] By contrast, an unsecured creditor has no collateral to secure its claim, and only has a claim against the debtor personally to collect its debt. Depending on the value of its collateral relative to the amount of its claim, a secured creditor may be materially better off in bankruptcy litigation than an unsecured creditor.  Recall that there is generally no fee-shifting available in bankruptcy litigation.  However, there is an exception to this general rule for a secured creditor whose claim amount is exceeded by the value of its collateral (such a creditor is often referred to in bankruptcy parlance as “oversecured” because its collateral is worth more than its claim). An oversecured creditor is entitled to recover post-petition interest and costs and fees and add those amounts to its secured claim.[25] Thus, depending on the nature of the adversary proceeding, a secured creditor may be able to add its legal fees incurred in the adversary proceeding to the amount of its secured claim. This obviously has a material impact on the settlement calculus for a trustee or debtor-in-possession, since a secured creditor in such a position may be able to effectively defend the adversary proceeding by using the bankruptcy estate’s funds.

Overlooking Post-Bankruptcy Considerations

As discussed above, if a creditor is contemplating suing a debtor to have its debt declared non-dischargeable, an important consideration is whether the post-discharge debtor is likely to have the means to pay the debt.  After all, a discharge of debt does not necessarily mean that the debtor will have assets sufficient to satisfy any future judgment, particularly if the debtor filed for Chapter 7 and its non-exempt property was liquidated in bankruptcy (because a creditor enforcing a money judgment under North Carolina law typically cannot reach exempt assets, just like the Chapter 7 trustee cannot reach exempt assets).[26] In a complex Chapter 11 case, resolution of an adversary proceeding with the debtor may contemplate future business between the creditor and the debtor, which may require additional due diligence to ensure that the creditor’s interests are adequately protected. Another important consideration is that the Bankruptcy Code authorizes a trustee or debtor-in-possession to avoid and recover unauthorized post-petition transactions.[27]  Thus, a creditor settling an adversary proceeding with the debtor should seek bankruptcy court approval of any such settlement pursuant to Rule 9019 of the Federal Rules of Bankruptcy Procedure, so that it is insulated from any later claim that the debtor was not authorized to make the transfer contemplated by the settlement.[28]  Experienced bankruptcy counsel can ensure that any resolution of an adversary proceeding is appropriately memorialized and approved by the bankruptcy court.

[1] See Fed. R. Bankr. P. 9014.

[2] See Fed. R. Bankr. P. 7001.

[3] See N.C. Gen. Stat. § 1A-1, Rule 4(j)(1)c. (permitting service of process upon a natural person by delivering a copy of the summons and complaint via registered or certified U.S. Mail, with a return receipt requested).  See also Fed. R. Civ. P. 4(e)(1) (permitting service of process in a federal lawsuit by complying with applicable state law for service for the state in which the federal judicial district is located).

[4] See Fed. R. Bankr. P. 7004(b).

[5] See Fed. R. Bankr. P. 7055; Fed. R. Civ. P. 55.

[6] See generally 11 U.S.C. § 523(a).

[7] See 11 U.S.C. § 523(c).

[8] In other words, unlike many other deadlines which can be extended after the deadline has run, the deadline to commence an adversary proceeding for exception to discharge cannot be extended after the fact for excusable neglect. Compare Fed. R. Bankr. P. 4007(c) with Fed. R. Bankr. P. 9006(b)(3)(A).

[9] See 11 U.S.C. § 362(a).

[10] 11 U.S.C. § 362(a)(1).

[11]  See generally 11 U.S.C. § 362(d).

[12] See generally 11 U.S.C. § 502.

[13] See generally 28 U.S.C. § 1452; Fed. R. Bankr. P. 9027.

[14] See 11 U.S.C. § 362(k)(1).

[15] Id.

[16] Fed. R. Bankr. P. 9011.

[17] See, e.g., https://www.smithdebnamlaw.com/practice-area/litigation/commercial-construction-litigation-and-disputes/

[18] Fed. R. Bankr. P. 9011(b)(3).

[19] 11 U.S.C. § 547(b).

[20] Within ninety (90) days prior to the Petition Date if the creditor is unrelated to the debtor; within one (1) year prior to the Petition Date if the creditor is an “insider” of the debtor as defined in 11 U.S.C. § 101(31).  See 11 U.S.C. § 547(b)(4).

[21] See generally 11 U.S.C. § 547(b) & (c).  The elements of a prima facie preference claim and the numerous affirmative defenses available to a creditor defending a preference claim are beyond the scope of this article.

[22] See, e.g., 11 U.S.C. § 726(a).

[23]  See generally 11 U.S.C. § 548. Note that 11 U.S.C. § 544 allows a trustee or debtor-in-possession to assert state law avoidance claims as well. In North Carolina, this is typically the Uniform Voidable Transactions Act, N.C. Gen. Stat. § 39-23.1 et seq.

[24] The secured creditor’s rights in the collateral are sometimes referred to as in rem rights, while its right to collect the debt from the debtor through the enforcement of a money judgment is an in personam right. Importantly, a discharge in bankruptcy only eliminates a creditor’s in personam rights against the debtor; it does not eliminate the creditor’s in rem rights (i.e., its lien) in the debtor’s collateral.

[25] See 11 U.S.C. § 506(b).

[26] See N.C. Gen. Stat. § 1C-1601(a); 11 U.S.C. § 522(b)(1).

[27] 11 U.S.C. § 549.

[28] This is typically an issue where the settlement contemplates the debtor transferring money or property (such as a new lien) to the creditor; it is not typically a concern where the creditor is paying the debtor to resolve the claim.