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Surety Faces Liability for Violating Bankruptcy Stay by Insisting that Owners Pay It, Not Contractor
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May 3, 2010
By John Fedun
The Labuzans were owners of Contractor Technology, Ltd. (CTL), a general contractor. St. Paul Fire & Marine Insurance Co. provided payment and performance bonds to CTL for several projects. The Labuzans entered into a personal indemnity agreement with St. Paul to reimburse St. Paul for any claims it had to pay on behalf of CTL.
While several projects were ongoing, CTL filed a voluntary petition for Chapter 11 bankruptcy reorganization. About a week later, St. Paul contacted the owners of the ongoing projects and told the owners that if they made payment to CTL and St. Paul later was required to pay on any bonds for those projects, St. Paul would reduce its liability to the project owner by the amount of any such payment.
CTL alleged that the resulting reduction in revenues prevented it from meeting its financial obligations, causing its Chapter 11 reorganization to be converted into a Chapter 7 liquidation.
St. Paul eventually paid more than $32 million on the CTL bonds and sued the Labuzans in U.S. District Court on their personal indemnity agreement. In defense of St. Paul’s suit, the Labuzans asserted that St. Paul violated the Bankruptcy Code’s automatic stay provision at 11 USC §362(k). The Labuzans claimed that St. Paul’s violation prevented CTL from reorganizing successfully and, therefore, resulted in St. Paul having to pay on the bonds it issued for CTL.
The Labuzans also invoked §362(k) to assert more than $55 million in affirmative claims against St. Paul for CTL’s loss of value, judgments against the Labuzans, possible future judgments against the Labuzans, IRS liens against CTL, attorney fees and Labuzans' loss of earning capacity.
The Labuzans also were permitted by the Bankruptcy Court to assert a $200,000 unsecured claim against the estate of CTL – making the Labuzans creditors of the CTL estate.
The U.S. District Court for the Southern District of Texas found that St. Paul acted unlawfully by violating the automatic stay. But, the court ruled that the Labuzans lacked standing to assert the §362(k) claim because CTL, not the Labuzans, owned that claim against St. Paul. By that point in the litigation, §362(k) was the Labuzans' only remaining defense against St. Paul’s $32 million indemnity claim against them. The District Court entered judgment against the Labuzans for that amount. The Labuzans appealed. The U.S. Court of Appeals for the 5th Circuit reversed and remanded. St. Paul Fire and Marine Insurance Co. v. Labuzan, 579 F.3d 533 (5th Cir. 2009).
The question before the appeals court was whether, pursuant to §362(k), individuals other than the debtor claiming injury from a violation of the automatic stay have constitutional and prudential standing to pursue a claim for resulting damages.
Section 362(k) provides in part: “[A]n individual injured by any willful violation of a stay provided by this section shall recover actual damages, including costs and attorneys’ fees, and, in appropriate circumstances, may recover punitive damages.”
The appeals court held that the Labuzans easily satisfied the constitutional standing requirements to assert their claim: injury in fact, traceable to the defendant and likely to be redressed by a favorable decision.
The appeals court focused its analysis on whether the Labuzans satisfied the prudential standing requirements for their claim. Prudential standing requirements concern “(1) whether a plaintiff’s grievance arguably falls within the zone of interests protected by the statutory provision invoked in the suit, (2) whether the complaint raises abstract questions or a generalized grievance more properly addressed by the legislative branch, and (3) whether the plaintiff is asserting his or her own legal rights and interests rather than the legal rights and interests of third parties.”
The Labuzans argued that §362(k) expressly gave them standing as “an individual” injured by St. Paul’s actions. They also argued they came within the zone of interests protected by §362(k), their injuries were not abstract or generalized, and their injuries were distinct from those of CTL. St. Paul argued that the Labuzans did not own the claims they were asserting, the Labuzans’ claims being only secondary versions of CTL’s claims. St. Paul argued that CTL’s claims had been resolved in St. Paul’s settlement with the bankruptcy trustee.
In considering whether the Labuzans’ grievance fell within the zone of interest protected by §362(k), the appeals court considered the statutory language and legislative history. First, the court noted that the term “individual” as used in §362(k) is not defined by the Bankruptcy Code but is used throughout the Code to refer to both debtors and non-debtors. Next, the court cited the Code’s legislative history, which provides: “The automatic stay also provides creditor protection.” Finally, the court considered 11 USC §1109(b), the standing statute of Chapter 11 of the Bankruptcy Code, in the context of the Labuzans’ claim that they were prevented from proceeding under Chapter 11 by St. Paul’s violation of the automatic stay. Section 1109(b) provides:
| A party in interest, including the debtor, the trustee, a creditor’s committee, an equity security holder’s committee, a creditor, an equity security holder, or any indenture trustee, may raise and may appear and be heard on any issue in a case under this chapter.
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The court held that when §1109(b) is read “in conjunction with §362(k), it becomes clear that Congress did not enact §362(k) solely for the benefit of debtors” and, therefore, “debtors and creditors are entities whose grievances fall ‘within the zone of interests’ protected by §362(k).”
The appeals court noted that one purpose of the automatic stay is to give debtors “a breathing spell” free from collection efforts and creditor harassment so they can attempt to reorganize. Another purpose, the appeals court found, is to provide creditor protection by ensuring an orderly liquidation process in which all creditors are treated equally and in which creditors are not encouraged to “race” each other in pursuing remedies.
The court next found with little discussion that the Labuzans, “as creditors of CTL, also adequately meet the second prudential concern – ‘whether the complaint raises abstract questions or a generalized grievance more properly addressed by the legislative branch.’ ”
Finally, the court considered whether the Labuzans were attempting to assert claims that belonged solely to the estate of CTL. St. Paul argued that CTL directly suffered the loss and that the judgment against the Labuzans arose from CTL’s failure to meet its obligations.
The court first considered 11 USC §541(a)(1), which provides that the property of the bankruptcy estate includes “all legal or equitable interests of the debtor in property as of the commencement of the case.” The court noted that the plain language of §541(a)(1) implies that a §362(k) can never be brought as of commencement of the case because, by definition, an automatic stay violation occurs post-filing. Thus, the court held that §362(k) automatic-stay-violation claims are not solely property of the bankruptcy estate, at least to the extent they are not asserted by the trustee. The court cited precedent that “debtors have a private action for damages under §362(k)” and, therefore, concluded that “assuming the Trustee [of CTL’s bankruptcy estate] had standing to assert a §362(k) claim against St. Paul, that standing was not exclusive.”
The court held that CTL and the Labuzans could own separate claims against St. Paul arising out of the same general series of events and the claims would not be mutually exclusive. The court found there “is nothing illogical” about saying that St. Paul directly injured both the Labuzans and CTL during the same course of dealings.
The court concluded by holding: “pursuant to §362(k), the Labuzans, as pre-petition creditors of CTL, have standing to assert a claim against St. Paul. [But,] to the extent the Labuzans’ claims are based on their status as owners/equity holders of CTL, §362(k) cannot be invoked.” The appeals court rejected St. Paul’s argument that such relief should be extended to secured creditors only, noting there was no statutory basis for such a position.
The appeals court remanded the case to the District Court for further proceedings, including resolution of whether the Labuzans as creditors were injured by St. Paul and whether the Bankruptcy Trustee’s settlement of its §362(k) claims against St. Paul affected the Labuzans’ claims as creditors. In that settlement, St. Paul waived its claims against the bankruptcy estate and received or was allowed to keep $1.6 million.
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