Recently I have been contacted by many attorneys and parties involved in litigation in state and federal court. Either the defendant wants to know if filing bankruptcy can help stop the litigation and discharge the liability, or plaintiff wants to know if the threat by someone to file bankruptcy before or during litigation is a real prospect. Like most answers in law, it depends.
Bankruptcy is indeed a powerful tool, and I’ve seen it used or personally handled matters involving:
- Personal Injury
- Business Torts
- Landlord/Tenant
- Debt Collection
- Construction Defect
- Divorce Proceedings
- Tax Litigation
That said, the misuse of bankruptcy can invite terrible consequences on the party invoking its benefits without understanding how the bankruptcy process works. There are several steps to evaluate.
- Is the Underlying Bankruptcy Workable?
The first part of the equation is not the litigation, but the underlying bankruptcy. If the person files bankruptcy, there is a very detailed analysis of his or her debts, income, assets and other financial circumstances.
They must first be eligible for the chapter of bankruptcy they want. Perhaps they have too much income for a Chapter 7. Maybe the debt limits exceed what is available in a Chapter 13. Maybe the sheer cost of a Chapter 11 is too great.
Next, even if the party is eligible for bankruptcy, it could be a bad idea because the party may lose assets. For example, while California has a homestead exemption to protect equity in a home, it is limited. In fact, right now the maximum possible exemption is $75,000 - $175,000 (legislation is pending to potentially increase the maximum to $300,000). With skyrocketing prices in the Bay Area, a lot of people have equity they cannot protect, or other assets such as stocks, cash or vehicles with too much equity that may also be exposed to creditors.
- Is the Bankruptcy Filed in Bad Faith to Evade Litigation?
Filing bankruptcy with pending litigation is not a problem in itself. And for those being sued by debt collectors, bankruptcy is often a natural result, and no one will think twice about it. But for those litigating other matters, bankruptcy should be approached with care. Some courts have dismissed bankruptcy cases for bad faith where the bankruptcy was filed solely to defeat litigation. The facts of many of these cases share a pattern of (1) filing on the eve of trial or toward the end of litigation; (2) concealed assets and sloppy preparation of the bankruptcy filing, and (3) no other debts that would be discharged in bankruptcy.
It’s a holistic analysis, because there are times when I advise clients and other counsel that bringing the case into bankruptcy court appears to be a good strategy. Sometimes it is not. Perhaps filing bankruptcy has the appearance of forum shopping and that risk must be calculated into the decision. Or taking into account the whole financial situation and the nature of the litigation, bankruptcy serves little utility (but then again, doing that same analysis will sometimes result in bankruptcy providing a silver bullet).
- Assuming You Can File Bankruptcy, Can the Other Party File an Adversary Proceeding Against You?
Let’s assume you made it past the eligibility and bad faith obstacles. The debt that is being litigated must also be dischargeable. The bankruptcy code provides a list of debts that are not dischargeable. Some are automatically not dischargeable, such as child support and restitution. Other debts require a party to bring a claim in the bankruptcy court in a very short window of time to challenge the discharge of a debt - this includes fraud, embezzlement, larceny and torts. Failure to bring a timely claim results in a discharge of the liability.
Let’s say you hit a bicyclist and she suffers fairly serious injuries. She sues you in state court for negligence and related claims. If you file bankruptcy and attempt to discharge your liability to the bicyclist, she can challenge your right to discharge the liability by filing an adversary proceeding in bankruptcy court.
An adversary proceeding is a federal complaint in bankruptcy court. It’s like any other litigation with a complaint, answer, discovery and trial. It’s a high bar to prove or defend these actions (and costly as to time, money and emotional investment), so bringing such claims is not to be done lightly.
A personal injury claim like our bicyclist (or any vehicle-related claim for that matter) is a very grey area, where a judge could rule for either side. Was the debtor’s conduct so egregious (in bankruptcy court, the term is “willful and malicious” with very specific elements that must be proven, which differs from ordinary negligence), that the debt should not be discharged? You already know there are at least two versions of the story about what happened. This means there is a lot of vetting of the merits of the case to determine if the willful and malicious claim can be successfully prosecuted or defended in bankruptcy court.
An implied lesson is that if you anticipate a lawsuit or are fighting a lawsuit presently, you may be fighting a new lawsuit in bankruptcy court by filing for bankruptcy. That can be either a good thing or bad thing depending on each party’s goals.
- Can Plaintiff Seek Relief from the Automatic Stay and Return to State Court?
One of the great powers of bankruptcy is the automatic stay that stops many creditor actions in their tracks, including pending litigation. Another angle to investigate is whether a party litigating in another court that was stopped by the bankruptcy can seek relief from the automatic stay to return to state court and continue litigation to a judgment. This is another fact sensitive inquiry. Sometimes it is appropriate, sometimes not.
Factors to evaluate include how far along the litigation was in process before the automatic stay placed the proceeding in suspension. Filing on the eve of trial draws inherent suspicion, and bankruptcy judges are more likely to grant relief from stay for judicial economy reasons in such a case. Another issue is how tangential the litigation is to the bankruptcy proceeding; the less related, the more likely relief from stay will be granted. And the list goes on. Just bear in mind that filing bankruptcy does not necessarily prevent state court litigation from continuing in the near future. It may, but this is yet another consideration.
- This is Only the Surface of the Surface
I cannot begin to emphasize the complexity and analysis that goes into determining whether to file bankruptcy with pending litigation or to attack a debtor’s discharge in bankruptcy court. There are numerous other factors such as issue preclusion, jurisdictional complications, taking a 2004 examination before litigating in bankruptcy to name just a few.
Whether you are a party or attorney involved in active or threatened litigation, if someone threatens or plays the bankruptcy card, spend the time and money to figure out what that really means. You could find yourself at either a tremendous advantage or disadvantage depending on how bankruptcy factors into the existing set of circumstances.
