Creditors Beware: Bankruptcy Stay May Shield Property Possessed but Not Owned by Debtor

08.16.2022

The automatic stay triggered by a bankruptcy filing may protect the debtor’s residence even if the debtor does not own the property, according to a recent decision from a New York-based federal appeals court.

In a case of first impression decided in July 2022, the Second Circuit set a bright-line rule that the Bankruptcy Code’s automatic stay provisions “are violated by the foreclosure sale of a property when the debtor is a named party in the foreclosure proceedings, even if the debtor holds only a possessory interest in the property.”  In re Fogarty, 39 F.4th 62, 71 (2d Cir. 2022).  The case addressed a foreclosure on a home occupied by the debtor but owned by the debtor’s limited liability company (LLC), which had not filed for bankruptcy.

The decision may surprise some creditors because a fundamental precept of corporate law is that an LLC is a legal entity separate from its members, so the members have no ownership rights in assets owned by the company.  Thus, when a member of an LLC files a bankruptcy petition, assets owned solely by the LLC do not constitute property of the debtor’s bankruptcy estate and aren’t necessarily shielded from collection efforts by the automatic stay.  However, if the member who entered bankruptcy holds a possessory interest in a residence owned by the non-debtor LLC, the member’s possessory interest itself may constitute property of the bankruptcy estate and be entitled to the protections of the automatic stay.

In the Fogarty case, the individual debtor lived in a house owned by an LLC in which the debtor held a 99 percent membership interest.  The house was subject to a mortgage to secure debt owed by the LLC.  When the LLC defaulted on the mortgage prior to the debtor’s bankruptcy, the loan servicer started a foreclosure action in state court.  The LLC was initially the only named defendant in the foreclosure action, but the servicer later added the debtor as a defendant.  The servicer obtained a judgment allowing a foreclosure sale.

Four days before the scheduled foreclosure sale, the individual debtor filed a Chapter 7 bankruptcy petition.  Debtor’s counsel called the servicer on the eve of the sale to contend the automatic stay barred the foreclosure sale because the property was the debtor’s residence, even though she did not own the property.  The servicer rejected the argument on the grounds that the debtor’s petition for personal bankruptcy did not protect assets owned by the LLC.  Although the servicer could have sought stay relief from the bankruptcy court to allow the foreclosure sale, the servicer chose not to do so. The sale took place and the third-party purchaser evicted the debtor after securing relief from the automatic stay.

The debtor filed a motion in her bankruptcy case seeking sanctions against the servicer for a willful violation of the automatic stay.  The bankruptcy court denied the motion, but on appeal the district court reversed and instructed the bankruptcy court to determine the amount of actual damages and to consider punitive damages.  The Second Circuit Court of Appeals affirmed the district court’s ruling in favor of the debtor.

It remains to be seen whether other courts follow the Second Circuit’s lead.  The Fourth Circuit has held that, at least for nonresidential property, “[a] mere possessory interest under an expired lease is insufficient to trigger an automatic stay . . .”  In re Premier Auto. Servs., Inc., 492 F.3d 274, 281 (4th Cir. 2007).

In the absence of clear authority, wise creditors will seek stay relief to avoid potentially costly consequences.  A creditor found in violation of the automatic stay may be ordered to pay the debtor’s actual damages, including attorney fees—and, depending on the jurisdiction, emotional distress damages.  A creditor may also face punitive damages if the bankruptcy court finds the creditor acted maliciously or with reckless disregard and actual knowledge of the stay.  A creditor with a track record of stay violations may be presumed to have acted in bad faith, weighing in favor of a punitive damages award.

If you need legal advice regarding applicability of the automatic stay, please contact the author or any member of Nexsen Pruet’s Bankruptcy and Creditors’ Rights practice group.

Co-authored by: Andrew Kragie, Law Clerk

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