Chapter II. Improving Creditor Certainty and Lowering Costs

• Jurisdiction: United States

II. Improving Creditor Certainty and Lowering Costs

§ 2.01 Protection of Interests in Collateral Repossessed Prepetition

(a) Section 362(a)(3) should be amended to expressly require the return of estate property to the party entitled to possession of estate property under the Bankruptcy Code.

(b) A new paragraph should be added to section 362(b), providing that

(1) any estate property held by a creditor and subject to a potential loss of value due to accident, casualty, or theft may be retained by a creditor holding the property unless the party entitled to possession under the Bankruptcy Code provides proof of insurance or other security sufficient to protect the creditor against such loss of value;

(2) if the creditor’s interest in estate property is a statutory lien dependent upon possession by the creditor, then, in addition to the requirement of protection of value set out above, upon transfer of the property to the appropriate party (A) the property shall be deemed to be continuously subject to a lien, equivalent in amount and priority to the creditor’s statutory lien, (B) such lien shall be effective during and after the debtor’s case, and (C) if the debtor retains possession of the property after the case is closed, the creditor shall have a right of replevin or other right to recover the property, and upon recovery, the creditor’s statutory lien shall be restored as if there had been no break in possession; and

(3) these provisions are without prejudice to a creditor’s right to retain the collateral while promptly seeking annulment of the automatic stay based on a lack of adequate protection, on bad faith, or on other unusual circumstances.

(c) A new subsection should be added to section 542, providing that a creditor holding property of the debtor or the estate secured by a consumer debt shall, upon demand by the party entitled to the property under this title, deliver the property to that party, except as provided in the new paragraph added to section 362(b), set out above.

(d) The new subsection to section 542 should be added to the exceptions in Federal Rule of Bankruptcy Procedure 7001(1), so that the appropriate party may enforce such right by motion. A party entitled to possession may seek only turnover rather than the imposition of sanctions for violation of the automatic stay; the new subsection would allow turnover to be pursued by motion rather than by adversary proceeding.

Background. By putting a pause on creditor collection activity, bankruptcy’s automatic stay not only provides a breathing spell for debtors but also helps all creditors by preventing piecemeal liquidation of the debtor’s assets. When the stay goes into effect, it is inevitable that creditors will be in different stages of the collection process and that some of these creditors will have repossessed collateral but not yet disposed of the collateral. A substantial split in the case law has developed over what a creditor must do to comply with the automatic stay as it applies to personal property — often a motor vehicle — that has been repossessed prepetition.

After default, state law allows a secured creditor to take possession of personal property.¹⁵⁵ In some of the cases that have reached the bankruptcy courts, the creditor is a municipality with a claim for unpaid traffic or parking fines, for which the municipality gets a lien after taking possession of a motor vehicle — usually by towing. At this point, all the creditor has is the right to possess the property. State law will determine what the creditor may do next, which often includes selling or otherwise disposing of the property. Until the creditor disposes of the property, the debtor remains the owner of the property.¹⁵⁶

In between repossession and sale, the automatic stay can intervene to create the issues addressed by the recommendations in this section. Under section 541, the bankruptcy estate consists of all of the debtor’s “legal and equitable interests” in property, which includes the debtor’s right to redeem the property. In United States v. Whiting Pools, Inc., the Supreme Court ruled that a creditor had to turn over property it had in its possession to the debtor given the duty in section 542 of a person in possession of property of the estate to deliver the property to the trustee.¹⁵⁷ The party in possession, however, often has an argument that section 542 does not apply and resists turnover. Thus, as a practical matter, turnover may require a legal proceeding to obtain the physical delivery of the property. Procedurally, a party demanding turnover may be required to commence an adversary proceeding in the bankruptcy case,¹⁵⁸ which takes both time and money.

To reach a result similar to a turnover action, some debtors have pointed to the automatic stay’s language that prohibits “any act . . . to exercise control over property of the estate.”¹⁵⁹ Their argument is that a creditor’s possession of estate property is an act that exercises control over that property and therefore violates the automatic stay. If that argument is correct, the only way for the creditor to purge itself of the automatic stay violation is to surrender possession of the property. Because a violation of the automatic stay can be prosecuted via motion, the debtor has achieved the practical result of a turnover action — possession — without the delay and expense of an adversary proceeding.¹⁶⁰

Most published decisions have held that a creditor’s postpetition possession of estate property by itself violates the automatic stay as the exercise of control over that property, but the circuits have split.¹⁶¹ The courts have reached differing results for doctrinal reasons, with many of the cases parsing whether possession is an “act” as well as whether it constitutes “control.”¹⁶² The details of the doctrinal dispute under the existing law are not relevant to the Commission’s recommendation for statutory amendments. Like many doctrinal disputes, the one here injects uncertainty into the system. Adding to this uncertainty is the Supreme Court’s decision in Citizens Bank of Maryland v. Strumpf, where the Court ruled that a bank’s administrative hold on a debtor’s bank account was not an act to exercise control over the account.¹⁶³ Strumpf, it can be argued, lends some weight to the notion that passive possession is not an exercise of control, but on the other hand, it deals only with the bank’s contractual obligation to make disbursements at the debtor’s request, rather than with possession of the debtor’s property.

Recommendation. The Commission discussed how these cases are trying to reconcile conflicting policy concerns.¹⁶⁴ Before creditors surrender collateral in their possession, they have a reasonable expectation that the collateral will not decline in value, an expectation that bankruptcy protects through the concept of adequate protection. In addition, some creditors in possession of collateral have a statutory lien that depends on the creditor continuing possession, and bankruptcy law should respect these nonbankruptcy rights. Debtors, on the other hand, frequently have an immediate need for property held by creditors at the time of filing, and the delay and expense needed to obtain a turnover order under section 542(a) may make a bankruptcy filing useless in addressing that need.

The Commission decided that the best solution would be a statutory amendment that resolved the conflicting policy concerns in a pragmatic way. The centerpiece of the Commission’s recommendation is an amendment to section 362(a)(3) that expressly recognizes retention of estate property as a violation of the automatic stay. Because retention would be a stay violation, such an amendment would require the creditor to return the property to the debtor to cease violating the automatic stay.

To protect the creditor’s interest, an exception to the automatic stay would allow the creditor to retain the property if it was subject to accident, casualty, or theft loss and the debtor did not provide proof of insurance (or equivalent security). For example, a creditor could retain a motor vehicle unless the debtor provided proof of insurance.

The holder of a statutory lien dependent upon possession would have to surrender possession upon being provided proof of insurance, but the Bankruptcy Code also would be amended to protect the status quo of the lien. After surrendering possession, the Bankruptcy Code would deem as a matter of federal law that the lien continues in the same amount and priority as if the creditor had retained possession. The lien would remain effective during and after the bankruptcy case. Once the case ended, the creditor would have the right to obtain a writ of replevin, giving the creditor the power to get possession back, and federal law would provide for restoration of the statutory lien to exactly the status that would have existed had the creditor not given up possession during the bankruptcy case.

The Commission’s recommendation to protect statutory lienholders has a precedent in existing provisions. Section 362(b)(3) provides for an exception to the automatic stay for an act necessary to perfect a security interest or to maintain or continue the perfection of a security interest. The security interest must be one that would beat the bankruptcy trustee’s “strong-arm” powers to avoid security interests that would not have priority against judicial lienholders or bona fide purchasers of real estate.¹⁶⁵ This exception does not clearly apply to a creditor in possession of collateral because merely holding possession is not clearly an “act” within the meaning of the statute.¹⁶⁶ Similarly, section 542(b)(2) allows a creditor to give notice to maintain or continue perfection of a security interest where nonbankruptcy law requires seizure of property but the creditor cannot because the property is now part of a bankruptcy estate. Like section 542(b)(2), the Commission’s recommendation...