Bankruptcy Litigation Committee

ABI Committee News

Using §105 Injunctions to Enjoin Collection Actions against a Debtor’s Principals

The use of §105(a) to enjoin actions against a chapter 11 debtor’s principals has a long history under the Bankruptcy Code. 1 The body of case law that has developed on the subject, however, is somewhat of a hodgepodge in that it has not produced a clear set of standards and therefore is lacking in predictive utility.

The Calpine Decision
           
Adding to the tapestry of case law in this area is the recent case of Hawaii Structural Ironworkers Pension Trust Fund v. Calpine Corp., 2006 U.S. Dist. LEXIS 92499 (S.D.N.Y. Dec. 20, 2006). The action sought to be enjoined in Calpine was a securities fraud case against Calpine and certain of its directors for allegedly making false statements in Calpine’s registration statement.

The bankruptcy court in Calpine enjoined the action against the directors under §105(a) for two principal reasons: Continuation of the action “would place the Debtor at risk of collateral estoppel and evidentiary prejudice” and would unduly distract the debtor-in-possession’s directors and other representatives from the DIP’s reorganization efforts. Id. at *5. In cases where the nonbankruptcy action is predicated upon the acts or conduct of the DIP's officers or other principals, the risk of “evidentiary prejudice,” as well as the potential use of collateral estoppel against a DIP, has often been cited as a basis to sustain a §105(a) injunction. See, e.g., Eastern Air lines Inc. v. Rolleston (In re Jonasphere Clubs Inc.), 124 B.R. 635, 642 (S.D.N.Y. 1991) (continuation of action “would likely prejudice Eastern’s future defense of identical claims based upon identical facts”); Lomas Financial Corp. v. Northern Trust Company (In re Lomas Financial Corp.), 117 B.R. 64, 67 (S.D.N.Y. 1990) (bankruptcy court accurately concluded that it was “not possible for the debtor to be a bystander to a suit which may have a $20 million issue preclusion effect against it in favor of a pre-petition creditor.”). But cf. Plessy Precision Metals Inc. v. The Metal Center Inc. (In re The Metal Center Inc.), 31 B.R. 458, 463 (Bankr. D. Conn. 1983) (automatic stay prevents preclusive effect upon the DIP of an adverse judgment against the DIP’s nondebtor co-defendant).

On appeal, the district court in Calpine first set forth an analytical construct in which to resolve the issue before it. Specifically, the request for a §105 injunction was regarded as a request for a preliminary injunction, whereby the court stated that in the bankruptcy context, the following four factors should be considered: (1) instead of imminent irreparable harm generally, which is the traditional requirement for a preliminary injunction, there must be a threat to the reorganization process that is imminent, substantial and irreparable; (2) a reasonable likelihood of reorganization; (3) a balancing of the harm to the debtor and its reorganization against that to the other party if an injunction is issued; and (4) a balancing of the public interest in successful reorganizations with other competing societal interests.” Id. at *13-14.

With respect to the first factor, the district court perceptively noted that the Second Circuit’s decision in Queenie Ltd. v. Nygard Int’l., 321 F.3d 282 (2d Cir. 2003), squarely rejected the proposition that the potential risk to a DIP of offensive collateral estoppel could be used as a basis for staying a suit against a nondebtor co-defendant of the DIP. Calpine 2006 U.S. Dist. LEXIS 92499, at *14-15 (S.D.N.Y. Dec. 20, 2006) (“to a stay a suit against a co-defendant due purely to the potential risk to a debtor of offensive collateral estoppel would create ‘a vast and unwarranted interference with creditors’ enforcement of their rights against nondebtor co-defendants.’”) (quoting Queenie Ltd. v. Nygard Int’l., 321 F.3d 282, 287-88 (2d Cir. 2003)). While, for this reason, the district court expressly declined to conclude that principles of preclusion provided “an adequate independent basis for enjoining the state court action,” it did “recognize that a prudent debtor would devote managerial and financial resources to assisting in the defense against the state court action because of the potential impact upon a claim or suit against the debtor.” Id. at *16. The district court agreed with the bankruptcy court that the time and resources which the DIP’s management and personnel would have to expend defending the suit was supportive of the first factor. Id. at *15-16.
           
The other three factors were considered by the district court somewhat summarily, specifically that it deferred to the bankruptcy court on the likelihood of a successful reorganization, balanced the equities in favor of the DIP because (1) there was a potential dispute with the nondebtor co-defendants over limited insurance coverage for defense costs, and (2) there was a finding of real harm to the debtor without an injunction and no concommitant harm to the opposing parties for the temporary delay in the prosecution of their action; and found a public benefit from the reorganization of the DIP’s power generation business. Id. at *12-18. Thus, the bankruptcy court’s §105(a) injunction was upheld.

Other Grounds for a §105(a) Injunction

Courts considering a request for a §105(a) injunction to stay actions against a nondebtor co-defendant of the DIP have fairly consistently analyzed the request as a preliminary injunction and engaged in a similar multi-factor analysis as did the court in Calpine. The most attention or area of controversy in these cases, however, usually lies with the first factor; the threat of irreparable harm to the reorganization.

Most courts have held or recognized that irreparable harm can be established for this purpose if the nondebtor co-defendant has a right of indemnity against the DIP. See, e.g., In re United Health Care Org., 210 B.R. 228, 232 (S.D.N.Y. 1997); North Start Contracting Corp. v. McSpedon (In re North Star Contracting Corp.), 125 B.R. 368, 371 (S.D.N.Y. 1991) (right of indemnification); Biderman Industries U.S.A. v Zelnick (In re Biderman Industries U.S.A.)¸ 200 B.R. 779, 784 (Bankr. S.D.N.Y. 1996) (recognized stay is appropriate where there is an indisputable right to indemnity). Cf Lomas Financial Corp. v. The Northern Trust (In re Lomas Corp.), 117 B.R. 64, 68 (S.D.N.Y. 1990) (finding right of indemnity supportive of injunction generally, as opposed to specifically satisfying imminent and irreparable harm requirement). 2 Some of these same courts (North Star Contracting, Lomas) have also found imminent and irreparable harm when the time and attention of the DIP’s key management and reorganization personnel would be distracted away from the reorganizations to deal with the lawsuit in question. See, also, Chase Manhattan Bank v. Third Eighty-Ninth Associates (In re Third Eighty-Ninth Associates), 138 B.R. 144, 147-48 (S.D.N.Y. 1992); Lazarus Burman Associates v. National Westminster Bank (In re Lazarus Burman Associates), 161 B.R. 891, 900 (Bankr. E.D.N.Y. 1993). Still another factor that has been held to establish imminent and irreparable harm is when continuation of the action would prevent or jeopardize a promised contribution of funds by the DIP’s principal to support reorganization. See In re United Health Care Org., 210 B.R. 228, 233-34 (S.D.N.Y. 1997) (creditor’s attachments against assets of DIP’s principals were preventing them from obtaining funding for global settlement with DIP’s creditors); Third Eighty-Ninth Associates, 138 B.R. at 147 (recognizing that where “present and substantial,” principal’s proposed financial contribution to DIP could justify stay of guarantee action).

Conclusion

The decision in Calpine clarified the law with respect to §105(a) injunctions by providing an analytical construct in which to determine the propriety of such injunctions, as well as by capsulizing the legal principles that have developed in that area of the law. As affirmed by Calpine and other case law, it remains important to consider applying for injunctive relief for the DIP’s principals if the suit in question would result in a drain in time for the DIP’s key management and personnel and a consequent drain on reorganization resources would inhibit a contribution of funds available to support reorganization or would give rise to an indisputable right of indemnity.


1 One of the earliest and most frequently cited cases to sanction the use of §105(a) in this context is Otero Mills Inc. v. Security Bank & Trust (In re Otero Mills Inc.), 21 B.R. 777 (Bankr. D. N.M. 1982), aff’d 25 B.R. 1018 (D. N.M. 1982). Otero Mills enjoined a bank from proceeding with an action on a personal guarantee given by the debtor’s president for the bank’s loan to Otero Mills, the debtor. The court was apparently influenced by the fact that the guarantor had offered to contribute his assets to the reorganization, id. at 779, and that the bank was secured by assets of the debtor and adequately protected. Otero Mills, 25 B.R. at 1022.

2 The right of indemnity, broadly speaking, would appear to exist in any case where the principal of the DIP guaranteed the DIP’s debt to a creditor. See Plessey Precision Metals Inc. v. The Metal Center Inc. (In re Metal Center Inc.), 31 B.R. 458, 462 (Bankr. D. Conn. 1983) (noting that under “[u]nder nonbankruptcy law, it is well settled that a guarantor who pays the debt of his principal has a cause of action against the principal for reimbursement”).