Mere Possession of Debtor’s Property is Not a Stay Violation

You are in possession of property belonging to a Chapter 11 debtor. The debtor is threatening to seek sanctions from the Bankruptcy Court if you do not release the property.  Must you surrender the property to the debtor?

When a company commences a bankruptcy case, Bankruptcy Code section 362(a) imposes a wide-ranging injunction against various acts, including acts to obtain possession of the debtor’s property or to exercise control over the debtor’s property.  The automatic stay’s intent is to best preserve the debtor’s estate and prevent individual creditors from seizing a debtor’s assets to the disadvantage of other creditors. If the Bankruptcy Court finds that a creditor willfully and knowingly violated the stay, a Bankruptcy Judge can assess damages and legal fees and can even assess punitive damages if appropriate.

But, does a creditor violate the automatic stay when they passively retain property that it lawfully took or had possession of before bankruptcy?

The Supreme Court answered this question in a case entitled City of Chicago, Illinois v. Futton, 141 S. Ct. 585, 589 (2021) where Chief Justice Alito, writing on behalf of the Court, said that Bankruptcy Code section 362(a) (3) does not require a creditor to turn over property to the debtor upon the debtor’s bankruptcy filing.  Justice Alito said that in order to violate the automatic stay, the creditor must take an affirmative act to change the status quo.

Of course, the debtor has a remedy to get back its property.  The creditor could be compelled to turn over the property if an adversary proceeding (filing of a complaint) is commenced against the creditor pursuant to section 542(a) of the Bankruptcy Code.  But, that section has various defenses and exceptions that could be asserted by a creditor and the creditor may demand adequate protection – which creates substantial bargaining leverage for creditors.  The creditor has further leverage if the property is needed for the debtor’s business since an adversary proceeding under section 542 can take several months to decide.

Where is this situation likely to arise?  One example is where a corrugated box manufacturer owed money by the debtor is in possession of dies owned by the debtor.  Another is where a catalog merchant purchases paper and has it drop shipped to the printer.  A third may be where a distributor or manufacturer is owed money by the debtor and is in possession of goods already paid for by the debtor. 

If the creditor is merely trying to maintain the status quo to hold on to the property, then the creditor should not be deemed to have violated the automatic stay.  The affirmative acts necessary to be deemed to have violated the automatic stay is something more active than the creditor simply retaining what it already was in possession of.

But, it can be a fine line between passive and active.  The best advice: Place the debtor’s property in a safe place and do not touch it until directed by the Bankruptcy Court or until you have reached a settlement with the debtor.  Never make a threat. Simply state that you are maintaining the status quo.  If asked by the debtor, merely say that you are reviewing whatever your rights in the debtor’s property are. The odds are that the debtor will prefer to settle the matter rather than litigate- perhaps by granting you an administrative claim, perhaps by treating you as a critical vendor. 

Reprinted with permission from the Q4 2021, issue of Perspective by CRF. © 2021 Credit Research Foundation. All Rights Reserved.