Going for Broke: a Legal Primer on When a Government Action May Proceed Against a Bankrupt Defendant
| Publication year | 2023 |
| Author | Alexander M. Calero |
AUTHORS*
Alexander M. Calero
Kelly Suk
The filing of a bankruptcy petition automatically stays the commencement or continuation of a legal action against a debtor. In other words, any civil or administrative proceeding filed against a debtor is stayed upon the filing of a petition in bankruptcy court.
However, when the plaintiff is a government entity, such as a municipality or state department, and if the action was brought pursuant to the government's "police and regulatory power," the legal action may be excepted from the reach of the automatic stay and can proceed to entry of a final judgment against the debtor (the Police and Regulatory Powers Exception). In some cases, though, bankruptcy courts have enjoined actions falling within the scope of the Police and Regulatory Powers Exception because the government action frustrates the fundamental purposes behind the bankruptcy process.
To determine whether a government action falls under the Police and Regulatory Powers Exception to the automatic stay, courts analyze the purpose of the action and remedies sought by the government. This article provides an overview of key concepts and legal standards used by courts to determine when a government action may proceed against a bankrupt defendant. The article discusses the scope of the automatic stay, the contours of the Police and Regulatory Powers Exception, and the legal tests used by courts to determine whether a government action threatens the bankruptcy process. With California legal practitioners in mind, this article primarily cites to caselaw from the United States District Courts within the Ninth Circuit.
The filing of a petition in a bankruptcy court automatically triggers a broad injunction that halts myriad actions against the debtor and the property of the estate called the automatic stay.1 The stay ensures that disputes
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concerning the debtor and the debtor's property are now centralized in the bankruptcy court, and remains in effect until the stay is lifted, the case is dismissed, or until the debtor receives or is denied a discharge.2
Courts have held that the general policy behind the automatic stay is to grant complete and immediate, albeit temporary, relief to the debtor from creditors, and to prevent dissipation of the debtor's assets before an orderly distribution to all creditors can be effected.3 Additionally, legislative history explains that the primary purpose of the stay is to give the debtor a "breathing spell" from actual collection efforts and ensure equal treatment of creditors.4 The purposes of the stay would be frustrated if creditors could obtain and enforce monetary judgments against the debtor in piecemeal fashion in other forums while the bankruptcy process takes place.
As noted above, the automatic stay is sweeping, and includes a prohibition against the "commencement or continuation," including the issuance of legal process, of a judicial, administrative, or other action or proceeding "against the debtor that was or could have been commenced before the [filing of the bankruptcy petition] or to recover a claim against the debtor that arose before the [filing of the bankruptcy petition]."5 The stay can provide powerful protection for a debtor either presently embroiled in, or anticipating, litigation for conduct that occurred pre-petition. Strictly applied, the automatic stay generally only affects legal actions against the debtor, and does not apply to actions against nonbankrupt co-defendants.6 Put another way, a legal action against a nonbankrupt co-defendant may proceed notwithstanding the stay.
In addition to the automatic stay, bankruptcy courts may also issue separate injunctions that are necessary or appropriate to carry out the policy objectives of the Bankruptcy Code pursuant to its section 105 injunctive power.7 As discussed below, bankruptcy injunctions may limit the prosecution of a government action against a debtor if the bankruptcy court determines that the action threatens the bankruptcy process.
Included within the automatic stay provisions of the Bankruptcy Code are categorical exceptions to the automatic stay, where Congress determined certain interests outweigh the important objectives of the Bankruptcy Code, for example, criminal proceedings and actions to establish child support.8 Recognizing that the automatic stay is vulnerable to abuse by debtors improperly seeking refuge under the stay in an effort to frustrate necessary government functions, Congress enacted the Police and Regulatory Powers Exception to the stay.9
The Police and Regulatory Powers Exception provides that the filing of a bankruptcy petition does not stay the commencement or continuation of an action or proceeding by a governmental unit to enforce its police and regulatory powers, including the enforcement of a judgment other than a money judgment, obtained in an action or proceeding by the governmental unit to enforce its police or regulatory power.10 Only a "governmental unit" may avail itself of the Police and Regulatory Powers Exception, which the Bankruptcy Code defines to include a state, municipality, or a department or agency of a state or municipality.11
This exception embodies Congress' recognition that a government action to protect the public merits a higher priority than the debtor's rights to a "cease fire" or the creditors' rights to an orderly administration of the estate.12 Legislative history
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sheds some light on the appropriate scope of the Police and Regulatory Power Exception. When Congress amended the Bankruptcy Code in 1978, Congress included the Police and Regulatory Powers Exception as a reaction to court decisions that had stretched and expanded the automatic stay to foreclose states' efforts to enforce their antipollution laws.13 The House Report explained the Police and Regulatory Power Exception by stating:
Thus, where a governmental unit is suing a debtor to prevent or stop violation of fraud, environmental protection, consumer protection, safety, or similar police or regulatory laws, or attempting to fix damages for violation of such law, the action or proceeding is not stayed under the automatic stay.14
The Police and Regulatory Powers Exception has enabled various government actors to pursue legal actions to enforce a variety of ordinances and laws notwithstanding the automatic stay. For example, a county suing a public utility for violation of a state's unfair competition law,15 a county enforcing violations of zoning, building, and health codes,16 a city's refusal to issue a neighborhood parking pass based on unpaid parking tickets,17 a state department revoking a medical license,18 a state department suing a mortgage company for violation of consumer protection laws,19 a federal agency revoking tax exempt status of a church,20 and another federal agency enforcing employment laws.21
Further, as stated above, under the Police and Regulatory Powers Exception, a monetary judgment is treated differently than a non-monetary judgment (i.e., a permanent injunction prohibiting violations of consumer protection laws). The government may move to enforce any non-monetary judgment against a debtor under the Police and Regulatory Power Exception. In contrast, while the exception allows a public entity to proceed to entry of a monetary judgment against a debtor, it may not move to enforce that monetary judgment.22 Courts have reasoned that allowing certain governmental actions to proceed to entry of a judgement does not fundamentally contravene the policy behind the automatic stay-to give the debtor a breathing spell from actual collection efforts.23 However, permitting the government to enforce and collect on what is now the assets or res of the bankruptcy estate, would indeed disrupt the proper and orderly administration of the estate. Instead, the government must file a claim for the amount of the monetary judgement in bankruptcy court if it wishes to collect on the money judgment.24
To avail itself of the Police and Regulatory Powers Exception, the government does not need to move the bankruptcy court for relief from the automatic stay.25 Instead, the onus is on the debtor or the appointed trustee to move the bankruptcy court to enforce the stay or otherwise enjoin the action.26 However, and although the onus is on the debtor, a state trial court or administrative tribunal may, and often does, elect to independently stay the government's action until the government obtains a ruling from the bankruptcy court finding that the action is excluded from the stay. To obtain a ruling that a government action falls within the Police and Regulatory Powers Exception to the stay, the government may file a motion in bankruptcy court for a determination that the stay does not apply to the action, or alternatively, for modification of the stay for cause.
A key issue often litigated under the Police and Regulatory Powers Exception is whether the government is actually exercising its police or regulatory powers, or whether the government is instead acting as a creditor trying to collect a debt. When the government acts to enforce its police and regulatory powers, courts have held that the action is not restricted by the automatic stay. On the other hand, if the government is acting as a private party seeking to collect on a debt, courts have found that such actions are prohibited by the stay, and the government should be treated the same as any other creditor.
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In the Ninth Circuit, courts apply two alternate tests for determining whether the government's action falls within the scope of the Police and Regulatory Powers Exception: the "pecuniary purpose" test and the "public policy" test.27 Satisfaction of either test will suffice to exclude...
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