To Return or Not To Return. That Is The Question.

January 28, 2021

By: Lance R. Miller, Christopher A. McNulty

Category: Bankruptcy, Restructuring & Creditor-Debtor Rights

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Most lawyers and bankers understand the basic terms of the automatic stay when a Debtor files bankruptcy. 11 USC section 362 applies to all bankruptcy chapters and provides as follows:

(a)Except as provided in subsection (b) of this section, a petition filed under section 301, 302, or 303 of this title, or an application filed under section 5(a)(3) of the Securities Investor Protection Act of 1970, operates as a stay, applicable to all entities, of—
the commencement or continuation, including the issuance or employment of process, of a judicial, administrative, or other action or proceeding against the debtor that was or could have been commenced before the commencement of the case under this title, or to recover a claim against the debtor that arose before the commencement of the case under this title;
the enforcement, against the debtor or against property of the estate, of a judgment obtained before the commencement of the case under this title;
any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate;
any act to create, perfect, or enforce any lien against property of the estate;
any act to create, perfect, or enforce against property of the debtor any lien to the extent that such lien secures a claim that arose before the commencement of the case under this title;
any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case under this title;
the setoff of any debt owing to the debtor that arose before the commencement of the case under this title against any claim against the debtor; and
the commencement or continuation of a proceeding before the United States Tax Court concerning a tax liability of a debtor that is a corporation for a taxable period the bankruptcy court may determine or concerning the tax liability of a debtor who is an individual for a taxable period ending before the date of the order for relief under this title.

A recent United States Supreme Court case, however, turned on its head what many practitioners believed to be common knowledge about this tried and true provision of the Bankruptcy Code.

City of Chicago, Illinois v. Fulton is a product of four cases that were consolidated by the Court of Appeals for the Seventh Circuit. 141 S. Ct. 585 (2021).

The City of Chicago impounded the vehicle of four different individuals for failure to pay various fines. Upon filing Chapter 13 bankruptcy petitions, each individual requested that the City return his or her vehicle. The City refused.

The Bankruptcy Court held that the City’s refusal to return the vehicle in each case was a violation of the automatic stay. The City appealed the Bankruptcy Court decision to the Seventh Circuit Court of Appeals.

The Seventh Circuit affirmed, holding that the City had acted to exercise control over the vehicles in violation of 11 U.S.C. § 362(a)(3).

The City then appealed to the Supreme Court of the United States, which granted certiorari to resolve a split in the circuits regarding whether mere retention of the property of a bankruptcy estate violated § 362(a)(3). The Court ultimately vacated the judgment of the Court of Appeals, holding that an entity merely retaining property of a bankruptcy estate after the filing of a petition does not violate § 362(a)(3).

Justice Alito, delivering the unanimous opinion of the Court, explained that given the language of the Code “the most natural reading… is that § 362(a)(3) prohibits affirmative acts that would disturb the status quo of estate property as of the time when the bankruptcy petition was filed.” The Court held that retaining possession of property that was acquired prior to the filing of a bankruptcy petition does not constitute an affirmative act within the meaning of § 362(a)(3). The Court reasoned that to read § 362(a)(3) to include the retention of property as a sufficient “act to obtain possession… or… exercise [of] control”, would be to render 11 U.S.C. § 542 superfluous. Section 542 governs when property must be turned over to an estate

The purpose of § 362(a)(3) is to prevent collection efforts outside of the bankruptcy case that would change the status quo, while § 542 is meant to operate within the bankruptcy proceeding to govern the process of turning property back over to the debtor or the trustee.

The Court further explained that the blanket turnover provision that § 362(a)(3) would become if the interpretation of the Court of Appeals (and the Bankruptcy Court) were to be adopted would contradict any exceptions that § 542 sets forth. The result would be for § 362(a)(3), rather than § 542, to become the primary turnover provision in the Bankruptcy Code.

Justice Sotomayor, in her concurring opinion, pointed out that there are other ways for a debtor to get relief of this kind. Namely, § 542(a) could provide the relief sought by the individuals in this case, although the process would likely be more burdensome.

Although it took the Supreme Court over 35 years to figure it out, Arkansas’s own Bankruptcy Judge, the Honorable James G. Mixon, had it figured out in 1985. In In re Hoffman, 51 B.R. 42, (May 30, 1985), Judge Mixon held it was not a violation of the automatic stay for a bank to place an administrative freeze on Debtor’s demand accounts upon notice of a bankruptcy filing. The Bank would not be able to exercise the common law right or contractual right of set off, but it could freeze the funds. To exercise the right of set off, the Bank would be required to obtain relief from the automatic stay.

This article was co-authored by Mitchell Williams Law Clerk Savannah Johnston.

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