Filing for bankruptcy triggers the "automatic stay," which protects debtors from the reach of creditors during a bankruptcy case. In a Chapter 11 bankruptcy case, the automatic stay grants a failing business the breathing room to reorganize, giving the debtor the chance to negotiate with creditors and otherwise bars the commencement or continuation of proceedings against the debtor's bankruptcy estate.
Although the automatic stay generally only protects debtors, under some circumstances the bankruptcy courts might stay or enjoin the commencement or continuation of proceedings against non-debtor third parties, such as the debtor's insurance company.
Protecting Third Parties in "Unusual Circumstances"
Section 362(a) of the U.S. Bankruptcy Code specifically prohibits all acts and proceedings to collect "against the debtor." As the language of the provision indicates, the automatic stay generally applies only to protect the debtor and the property of its bankruptcy estate. In other words, the automatic stay does not ordinarily extend to protect non-debtor third parties or their property. However, courts have found that the automatic stay extends to stay lawsuits against non-debtors in "unusual circumstances."
The kinds of unusual circumstances that have swayed bankruptcy courts to extend the automatic stay to non-debtors include:
- When there is an "identity of interest" between the debtor and the non-debtor, e.g., when a bankrupt debtor is the sole owner of a non-debtor corporation (so that a judgment against the third party corporation would effectively be a judgment against the debtor)
- When a lawsuit threatens the assets of the debtor, e.g., in cases of mass tort liability where the suit against the debtor and its insurer, if successful, would deplete all available coverage for the debtor
Issuing Supplementary Stays Under Section 105(a)
Bankruptcy courts may also enjoin proceedings against non-debtor third parties by using their equitable powers under Section 105(a) of the Bankruptcy Code. This section specifically authorizes the court to "issue any order, process, or judgment that is necessary or appropriate to carry out the provisions [of the Code]." The very broad language of this provision effectively permits the bankruptcy court to issue injunctions to stay lawsuits brought against non-debtors, if the court thinks that enjoining such proceedings is necessary to the debtor's successful reorganization.
Extension of Bankruptcy Stay Not Automatic
Although the courts have extended the bankruptcy stay to protect non-debtor third parties, either under the automatic stay provision of Section 362 or by issuing an injunction under Section 105, the extension of the stay is not automatic. This means that lawsuits against non-debtor third parties are not automatically stayed by mere virtue of the fact that a co-defendant has filed for bankruptcy. Rather, the non-debtor third party must bring a motion before the court to request that the court stay the lawsuit or other action against them.
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