February 25, 2014

Section 362(n): Powerful Lender Tool in Serial Small Business Bankruptcy

by Kim Schmittel


Assume that you are a lender attempting to foreclose on a relatively small commercial asset (i.e., a hotel or gas station) in a judicial foreclosure state (like Kentucky or Indiana). After fighting for months and months to get to judgment and schedule a sale date, at the eleventh hour your borrower files a Chapter 11, which stays your foreclosure sale and portends even more delay. Assume this case is designated a "small business" case, under which the Debtor has non-insider debt totaling less than $2,490,925 (as of 2013). After litigating inside of the Chapter 11 for several additional months, the Bankruptcy Court ultimately dismisses the case. Happily, you now are ready to head back to state court to complete the foreclosure sale. Nothing could possibly interfere with that sale now, right?

Not so fast! 48 hours before the foreclosure sale, you learn that your borrower has hired new counsel and filed another Chapter 11 case. You call your lawyer and ask how this could possibly be permissible. There has to be something in the Bankruptcy Code that prohibits a debtor from filing a bankruptcy right after the first one was dismissed, right? Unfortunately, there is no easy answer to that question. You might be able to move to dismiss the second case as a bad faith filing, but resolution of that motion itself will interpose significant delay. How can you keep your sale date?

Answer after the Jump!

The answer is Section 362(n)(1) of the Bankruptcy Code. In 2005, Congress added provisions that dramatically curtailed the utility of a second small business case. The section is not particularly well-known and has not generated much case law (by my count, it has been substantively cited in fewer than 3 reported cases), but it can be a powerful tool. The section essentially states that, subject to a couple of exceptions, if a small business case is dismissed, no automatic stay comes into effect for any small business case filed in the subsequent 2 years. It provides:

(n)(1) Except as provided in paragraph (2), [the automatic stay] does not apply in a case in which the debtor --

(A) is a debtor in a small business case pending at the time the petition is filed;

(B) was a debtor in a small business case that was dismissed for any reason by an order that became final in the 2-year period ending on the date of the order for relief entered with respect to the petition;

(C) was a debtor in a small business case in which a plan was confirmed in the 2-year period ending ont eh date of the order for relief entered with respect to the petition; or

(D) is an entity that has acquired substantially all of the assets or business of a small business debtor described in subparagraphs (A), (B), or (C), unless such entity establishes by a preponderance of the evidence that such entity acquired substantially all of the assets or business of such small business debtor in good faith and not for the purpose of evading this paragraph.

There are two exceptions, set forth in Setion 362(n)(2). First, if the second case is an involuntary bankruptcy involving no collusion with the debtor, Section 362(n)(1) does not apply. Second, if the debtor can prove that the filing of the second case "resulted from circumstances beyond the control of the debtor," and that it is more likely than not that the debtor will confirm a feasible plan within a reasonable period of time, Section 362(n)(1) also does not apply.

Assuming those exceptions do not apply, there simply is no automatic stay to prevent your foreclosure sale. However, it may be advisable to request that the Bankruptcy Court issue an order determining that the automatic stay does not apply. As a practical matter, it may be difficult to effectively explain to state court judges and personnel that despite the second case, there is no automatic stay. This kind of "comfort order" may prove useful in keeping your sale on track.