California Court Discusses Automatic Stay Protections in Bankruptcy

In bankruptcy proceedings, the automatic stay and discharge injunction provides critical protections for debtors by preventing creditors from collecting on debts outside the bankruptcy process. These protections have limitations, however, particularly when a debtor’s assets have been exempted from the bankruptcy estate, as demonstrated in a recent California case. If you have debts you cannot pay, you may be eligible for bankruptcy relief, and you should talk to a California bankruptcy attorney as soon as possible.

History of the Case

It is reported that the debtors, a married couple, filed for Chapter 7 bankruptcy in 2010 in the United States Bankruptcy Court for the Central District of California. At the time of the filing, the debtor held an interest in a Delaware limited liability company. The debtors disclosed this interest in their bankruptcy schedules and claimed an exemption for its value under California law. The bankruptcy trustee did not object to the exemption, effectively removing the asset from the bankruptcy estate. The bankruptcy court later granted the debtors a discharge, and the case was closed.

It is alleged that several years after the bankruptcy case was closed, the debtor became involved in litigation in the Delaware Court of Chancery concerning his interest in the LLC. The litigation involved claims against a co-owner, including allegations of breach of fiduciary duty. The LLC intervened in the case and filed counterclaims against the debtor, alleging conversion and tortious interference with contractual rights. The Delaware court ultimately ruled that, under Delaware law, the debtor’s membership interest in the LLC had been automatically terminated upon the bankruptcy filing, leaving him with only an economic interest in the company. The Delaware Supreme Court later affirmed this ruling.

It is reported that in 2021, the debtors returned to bankruptcy court and filed a motion asserting that the Delaware litigation violated both the automatic stay under 11 U.S.C. § 362 and the discharge injunction under 11 U.S.C. § 524. Specifically, the debtors argued that the statutory provision under Delaware law terminating the debtor’s membership interest upon bankruptcy violated federal bankruptcy protections and that the counterclaims filed by the LLC in Delaware court were an improper attempt to collect on a discharged debt. The bankruptcy court denied the motion, and the district court affirmed. The debtors then appealed to the Ninth Circuit.

Automatic Stay Protections in Bankruptcy

On appeal, the court conducted a de novo review of the bankruptcy court’s decision, considering whether the automatic stay or discharge injunction had been violated.

Regarding the automatic stay, the court emphasized that the stay applies only to property that remains part of the bankruptcy estate. Because the debtor had successfully exempted his interest in the LLC during the bankruptcy proceedings, the asset was no longer considered property of the estate. Consequently, the court found that the automatic stay did not apply to the Delaware litigation or the statutory termination of the debtor’s membership rights.

The court also reviewed the applicability of the discharge injunction under 11 U.S.C. § 524, which prohibits creditors from attempting to collect discharged debts. The court determined that the Delaware litigation did not seek to collect a pre-bankruptcy debt but rather involved the resolution of property rights under Delaware corporate law. Because the litigation concerned the debtor’s post-bankruptcy interest in the LLC rather than an attempt to hold the debtor personally liable for a pre-existing obligation, the court found no violation of the discharge injunction.

Additionally, the court rejected the debtors’ argument that the Delaware law governing LLC membership rights was preempted by federal bankruptcy law. The court cited previous case law indicating that while federal bankruptcy law prevents state law from depriving a debtor of their economic rights in an LLC, it does not override provisions governing membership termination. As a result, the court held that the debtor properly retained only an economic interest in the LLC after filing for bankruptcy.

Finding no error in the lower courts’ decisions, the Ninth Circuit affirmed the dismissal of the debtors’ claims.

Meet with a Trusted California Bankruptcy Attorney

If you have questions about whether you are eligible to file for bankruptcy, it is smart to meet with an attorney as soon as possible. Matthew D. Roy is a trusted California bankruptcy attorney who can evaluate your case and inform you of your options. To arrange a meeting with Mr. Roy, contact us online or call (916) 361-6028.