[co-author: Andrew Kragie, Law Clerk]

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

In a first impression case decided in July 2022, the Second Circuit established a clear rule that the automatic stay provisions of the Bankruptcy Code “are violated by the foreclosure sale of a property where the debtor is a named party in foreclosure proceedings, even if the debtor has only a right of possession in the property”. In re Fogarty, 39 F.4e 62, 71 (2nd Cir. 2022). The case involved the foreclosure of 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 come as a surprise to some creditors because a fundamental tenet of corporate law is that an LLC is a separate legal entity from its members, so members have no ownership rights to assets owned by the corporation. Thus, when a member of an LLC files for bankruptcy, the assets held solely by the LLC do not constitute ownership of the bankruptcy assets of the debtor and are not necessarily immune from the efforts recovery by automatic suspension. However, if the member who has declared bankruptcy has a right of possession in a residence belonging to the non-debtor LLC, the right of possession of the member himself may constitute ownership of the assets of the bankruptcy and be entitled to the protections of automatic suspension.

In the Fogarty case, the individual debtor lived in a home owned by an LLC in which the debtor had a 99% interest. The house was mortgaged to secure the LLC’s debt. When the LLC defaulted on the mortgage before the debtor went bankrupt, the loan officer sued for foreclosure in state court. The LLC was initially the only named defendant in the foreclosure action, but the repairer later added the debtor as a defendant. The server agent obtained a judgment authorizing a foreclosure sale.

Four days before the scheduled foreclosure sale, the individual debtor filed a Chapter 7 bankruptcy petition. The debtor’s attorney called the repairman on the eve of the sale to argue that the automatic stay prevented the foreclosure sale because that the property was the debtor’s residence, even if she did not own it. The servicer dismissed the argument on the grounds that the debtor’s personal bankruptcy petition did not protect the assets belonging to the LLC. Although the repairer could have applied for a stay in bankruptcy court to allow the sale with foreclosure, the repairer chose not to. The sale took place and the third-party purchaser evicted the debtor after having obtained the lifting of the suspension by operation of law.

The Debtor filed a petition in her bankruptcy filing seeking sanctions against the servicing agent for a willful violation of the automatic stay. The bankruptcy court denied the petition, but on appeal the district court overturned and ordered the bankruptcy court to determine the amount of actual damages and to consider punitive damages. The Second Circuit Court of Appeals upheld the district court’s decision in favor of the debtor.

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

In the absence of clear authority, savvy creditors will seek a stay 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 attorneys’ fees and, depending on the jurisdiction, damages for emotional distress. A creditor may also face punitive damages if the bankruptcy court finds that the creditor acted maliciously or with reckless recklessness and actual knowledge of the stay. A creditor with a history of stay violations may be presumed to have acted in bad faith, which weighs in favor of an award of punitive damages.