Introduction
The automatic stay that arises in a bankruptcy case can be a heavy shield, but it generally only protects the debtor. When a California attorney was recently sued in an Illinois district court, he tried to invoke the protection of the automatic stay from the Los Angeles bankruptcy cases of his former firm and its owner—Girardi & Keese and Thomas Girardi. The attorney was not entitled to a stay under section 362(a)(1) of the Bankruptcy Code. The district court was the incorrect forum for the request to extend the automatic stay, and the legal basis was unsound. However, the attorney was entitled to a stay under section 362(a)(3), as to the constructive trust that had been requested because it affected property that was asserted to be property of the bankruptcy estates. See Edelson PC v. Girardi, 2021 WL 3033616 (N.D. Ill. July 19, 2021).
Facts
After an airliner crashed into the Java Sea, killing all 189 persons on board, the families of certain of the victims retained Girardi & Keese to sue Boeing, the plane’s manufacturer, in Chicago. Girardi & Keese, a Los Angeles law firm, engaged the Chicago office of Edelson P.C., as local counsel in the case.
Settlements with each family were struck. By the end of March 2020, Boeing had transferred the settlement moneys to Girardi & Keese’s account. The clients were supposed to be fully paid by the end of the following month. In November 2020, however, Edelson learned that Girardi & Keese failed to fully pay the clients and that it lacked the funds to do so. Edelson therefore filed a motion requesting that Thomas Girardi and Girardi & Keese be held in contempt. Edelson alleged that Girardi had misappropriated client funds. Edelson’s insurance carrier would eventually make the clients financially whole.
Edelson brought a separate action in Chicago against Girardi & Keese, and various attorneys and employees of the firm, including Girardi, David Lira, Keith Griffin, and others. Lira and Griffin were Girardi’s associates. Edelson alleged that Lira and Griffin had worked with Girardi to embezzle the settlement moneys, to commingle those moneys with fees to which Edelson was entitled, and to share in the illicit gains.[1]
Following the revelations in Chicago, creditors of Girardi and Girardi & Keese commenced involuntary bankruptcy cases against them in Los Angeles. An order for relief under chapter 7 of the Bankruptcy Code was entered in each case.
Statement of the Issue
As part of his motion to dismiss Edelson’s action, Lira, who was not himself a debtor in bankruptcy, asserted that the automatic stay in the bankruptcy cases of Girardi and Girardi & Keese prevented Edelson’s action from continuing against Lira.
The Stakes for Lira
If Lira could invoke the automatic stay, then he would avoid the expense of defending against Edelson’s action and the risk of being held liable. It might also have blocked, or at least delayed, the development of a record potentially affecting his interests if an attorney disciplinary proceeding were brought against him in connection with his license to practice law in California.[2]
Section 362(a)(1)
Section 362 of the Bankruptcy Code is entitled “Automatic stay.” Subsection (a)(1) provides as follows:
. . . a petition filed under section . . . 303 of [the Bankruptcy Code] . . . operates as a stay, applicable to all entities, of . . . the . . . continuation . . . of a judicial, administrative, or other action or proceeding against the debtor that was . . . commenced before the commencement of the [bankruptcy] case under this title, or to recover a claim against the debtor that arose before the commencement of the [bankruptcy] case under this title . . . .
11 U.S.C. § 362(a)(1).
The express terms of the statute did not protect Lira as a non-debtor. In that regard, the general rule is that the automatic stay does not protect third parties who are non-debtors. Nevertheless, Lira advocated that section 362(a)(1), automatically required a stay of Edelson’s action against him.
Lira was correct when he asserted that there are exceptions to the general rule that the automatic stay does not protect third parties who are non-debtors. In “unusual situations,” where there is such a similarity or identity of interests that failing to protect the non-debtor will put the assets of the debtor at risk, or a judgment against the non-debtor will, in practice, be a judgment against the debtor, the automatic stay can protect the non-debtor.[3] An example of an unusual situation is where the non-debtor third party is a defendant in a lawsuit and is entitled to absolute indemnity by the debtor in the event of an adverse judgment. Lira asserted that California labor law afforded him absolute indemnity in the Edelson action by Girardi and/or Girardi & Keese.
However, the basic flaw in Lira’s attempt to enlist the automatic stay from the bankruptcy cases of Girardi and Girardi & Keese based upon such an exception is that Lira presented it in the wrong forum. Courts considering how the automatic stay could protect non-debtor third parties have relied upon two sections of the Bankruptcy Code. They are section 362(a)(1), discussed above, and section 105, which authorizes the court to issue an injunction that is “necessary or appropriate to carry out the provisions” of the Bankruptcy Code. Accordingly, those courts have concluded that extending the automatic stay to protect non-debtor third parties required the issuance of injunctions by the bankruptcy court.[4] The court in Edelson was a federal district court supervising a civil action in Chicago, not the bankruptcy court handling the bankruptcy cases of Girardi and Girardi & Keese in Los Angeles. Thus, the district court in Chicago was not the proper forum to consider whether an injunction should be issued to extend the automatic stay in the bankruptcy cases of Girardi and Girardi & Keese to protect non-debtor Lira from the Edelson action.
While the court was able to dispatch Lira’s effort to invoke section 362(a)(1) on procedural grounds, it decided to discuss the substance of the absolute indemnity exception advanced by Lira. In A.H. Robins, the Fourth Circuit recognized “a suit against a third party who is entitled to absolute indemnity by the debtor on account of any judgment that might result against them in the case” as “[a]n illustration” of an “unusual situation” where a bankruptcy court could properly stay proceedings against a non-debtor co-defendant.[5] In doing so, the Fourth Circuit relied on In re Metal Center, where the Connecticut bankruptcy court stated that “[w]here, however, a debtor and a nondebtor are so bound by statute or contract that the liability of the nondebtor is imputed to the debtor by operation of law, then the Congressional intent to provide relief to debtors would be frustrated by permitting indirectly what is expressly prohibited in the Code.”[6]
Lira cited section 2802(a) of the California Labor Code in support of the absolute indemnity exception. Section 2802(a) of the California Labor Code requires the employer to indemnify its employee for following unlawful directions “unless the employee, at the time of obeying the directions, believed them to be unlawful.” Edelson, however, alleged in its complaint that Lira had knowledge of and took part in Girardi’s misappropriation and conversion of client moneys. In view of Edelson’s allegations, Lira could not be treated as having an entitlement to indemnity from the debtor, absolute or otherwise, that would justify granting him the protections of the automatic stay.[7] Because Edelson’s allegations rendered Lira unable to assert a claim for absolute indemnity, Lira could not successfully invoke section 362(a)(1) in support of his request for a stay of proceedings.
Section 362(a)(3)
Section 362(a)(3) of the Bankruptcy Code provides as follows:
a petition filed under section . . . 303 of [the Bankruptcy Code] . . . operates as a stay, applicable to all entities, of . . . any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate . . . .
Section 362(a)(3) offered Lira an alternative basis to extend the automatic stay to Edelson’s action.[8]
The district court thought it seemingly “obvious” that Edelson’s request to impose a constructive trust – which Edelson could seek as to moneys transferred from Boeing to Girardi & Keese for which Edelson asserted an entitlement – was subject to being stayed under section 362(a)(3).[9] A constructive trust is “[a]n equitable remedy by which a court recognizes that a claimant has a better right to certain property than the person who has legal title to it.”[10] Here, Edelson was claiming that it held the beneficial interest in certain funds to which Girardi & Keese, i.e., the debtor, had legal title. However, section 362(a)(3) protects property of the debtor’s bankruptcy estate, and property of the bankruptcy estate is defined as including “ . . . all legal or equitable interests of the debtor in property as of the commencement of the [bankruptcy] case.”[11] Accordingly, the funds on which Edelson sought to impose a constructive trust were property of the Girardi & Keese bankruptcy estate.
Invoking section 362(a)(3) so as to stay Edelson’s constructive trust claim was proper, because if Edelson were to succeed on that claim, then the value of the bankruptcy estate would be reduced. “This is because property in which the debtor holds legal but not equitable title as of the commencement of the case—for example, property impressed with a constructive trust under state law—is property of the estate only to the extent of the debtor’s legal title.”[12] Girardi & Keese and Girardi’s bankruptcy cases were commenced after Edelson had discovered and disclosed to the district court the possibility that they had misappropriated client funds. Accordingly, Edelson would argue that the funds at issue should be deemed as having already been subject to a constructive trust, i.e., that Edelson held the beneficial interest in such funds, as of the point when the bankruptcy cases were commenced.
While the district court applied section 362(a)(3) to block the constructive trust request, it declined to do so as to the conversion and breach of contract claims that had been asserted against Lira.
The automatic stay generally does not protect non-debtor third parties. However, as in the case of the constructive trust claim against Lira, a creditor’s pursuit of property of the bankruptcy estate that is in the possession of a non-debtor third party may be a circumstance where the third party is entitled to the protections of the automatic stay.
The problem with Edelson’s constructive trust argument, as suggested, above, is that it would have relied on section 541(d) of the Bankruptcy Code, which states as follows:
Property in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest . . . becomes property of the estate under subsection (a)(1) or (2) of this section only to the extent of the debtor’s legal title to such property, but not to the extent of any equitable interest in such property that the debtor does not hold.
Courts that have construed section 541(d) have noted its limited effect when entities in the position of Edelson try to invoke a constructive trust. The Sixth Circuit, for one, has stated as follows:
With regard to a constructive trust, we have been clear that this section does not authorize bankruptcy courts to recognize a constructive trust based on a creditor’s claim of entitlement to one; rather, section 541(d) only operates to the extent that state law has impressed property with a constructive trust prior to its entry into bankruptcy.[13]
Edelson had not obtained a constructive trust prior to the commencement of the Girardi and Girardi & Keese bankruptcy cases. Therefore, if Edelson were to succeed in its post-petition attempt to impose a constructive trust, the result would necessarily be to remove property that was asserted to constitute property of the Girardi bankruptcy estates. As the district court stated, “Edelson’s request for a constructive trust must be stayed until the bankruptcy litigation is resolved.”[14]
Conclusion
As is apparent from the district court’s reasoning, a non-debtor third party seeking to invoke the automatic stay from a bankruptcy case would be well advised to carefully consider the basis for doing so and to seek that relief from the correct court.
[1] The litigation is ongoing. Edelson has since amended its complaint. The amended complaint or complaints have been filed under seal.
[2] The court in an attorney disciplinary proceeding may take judicial notice of the records in a civil action. Mushrush v. State Bar, 17 Cal.3d 487, 489 n.1 (1976) (Supreme Court granted motion to take judicial notice while noting that Supreme Court was not bound by findings of fact of Superior Court); California Evidence Code § 452(d) (“Judicial notice may be taken of . . . [r]ecords of . . . (2) any court of record of the United States . . . .”). The State Bar Court may apply the principles of collateral estoppel in attorney disciplinary proceedings to preclude the attorney who is the subject of the proceedings from re-litigating an issue that was decided adversely to the attorney in a civil proceeding according to the clear and convincing standard of proof. In re Kittrell, No 95-O-14321, 2000 WL 1682426 (Review Dep’t State Bar Court Cal. Oct. 26, 2000) (jury’s finding in a civil action against attorney that was made using clear and convincing evidence was a conclusive determination in later disciplinary proceedings that attorney committed acts involving moral turpitude and was binding on the attorney). Also, in disciplinary proceedings, witness testimony from a civil proceeding is admissible whether or not the witness is available. California Business and Professions Code § 6049.2.
[3] Edelson PC v. Girardi, Case No. 20 C 7115, 2021 WL 3033616 at *14 (N.D. Ill. July 19, 2021) (citing Fox Valley Constr. Workers Fringe Benefit Funds v. Pride of the Fox Masonry & Expert Restorations, 140 F.3d 661 (7th Cir. 1998); A.H. Robins Co. v. Piccinin, 788 F.2d 994 (4th Cir. 1986); In re Fernstrom Storage & Van Co., 938 F.2d 731 (7th Cir. 1991).
[4] See, e.g., Chugach Timber Corp. v. Northern Stevedoring & Handling Corp. (In re Chugach Forest Products, Inc.), 23 F.3d 241, 247 n.6 (9th Cir. 1994) (use of “unusual circumstances” standard contemplates bankruptcy court’s issuance of an injunction to extend the automatic stay pursuant to its equity jurisdiction). The Seventh Circuit has not yet considered the appropriate procedure by which exceptions to the general rule of section 362(a)(1) could be raised. Edelson, 2021 WL 3033616 at *15.
[5] A.H. Robins, 788 F.2d at 999.
[6] Plessey Precision Metals, Inc. v. The Metal Center, Inc. (In re The Metal Center, Inc.), 31 B.R. 458, 462 (Bankr. D.Conn. 1983).
[7] Bidermann Industries U.S.A., Inc. v. Zelnik (In re Bidermann Industries U.S.A., Inc.), 200 B.R. 779, 784 (Bankr. S.D.N.Y. 1996) (“. . . unusual circumstances do not exist where . . . the right to indemnity is not absolute . . . .”).
[8] “Though Lira may not invoke section 362(a)(1) to obtain a stay of these proceedings from this Court, he may be able to achieve the same result under section 362(a)(3).” Edelson, 2021 WL 3033616 at *16. “[T]he plain words of the provision go past protecting just the debtor and protect any property of the estate.” Id.
[9] Id.
[10] Trust, Black’s Law Dictionary (11th ed. 2019) (emphasis added).
[11] 11 U.S.C. § 541(a)(1).
[12] Amedisys, Inc. v. Nat. Century Financial Enterprises, Inc. (In re Nat. Century Financial Enterprises, Inc.), 423 F.3d 567, 576 (6th Cir. 2005) (citing, inter alia, 11 U.S.C. § 541(d)). In Amedisys, a provider of nursing home services brought a Louisiana state court action by which it sought to impose a constructive trust over funds that it asserted to be the proceeds of accounts receivable that it owned. The funds were held in a bank account of the debtor, which provided healthcare accounts receivable financing and had commenced a bankruptcy case in the Southern District of Ohio. The provider’s Louisiana state court action was filed post-petition against the debtor’s bank, and it asserted that the debtor’s account at the bank contained both the proceeds of receivables that had been sold to the debtor and the proceeds of receivables that had not been sold to the debtor. The Sixth Circuit agreed with lower court determinations that the provider’s prosecution of the lawsuit was subject to the automatic stay under section 362(a) because a favorable determination would “potentially deplete the property of the bankruptcy estate.” Amedisys, 423 F.3d at 575. In the view of the Sixth Circuit, the state court action against the debtor’s bank was an act to obtain possession of property of the bankruptcy estate under section 362(a)(3).
[13] Poss v. Morris (In re Morris), 260 F.3d 654, 666 (6th Cir. 2001).
[14] Edelson, 2021 WL 3033616 at *16.