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Lender repossesses the equipment of its In Chicago’s case, the Seventh Circuit business borrower after it defaults on its Court of Appeals affirmed the bankruptcy secured loan agreement. Because borrower court’s imposition of sanctions on the City needs the equipment to run its business, it for its failure to return a debtor’s car after then files a Chapter 11 petition and promptly bankruptcy, having impounded it prior to asks lender to return the equipment. Lender bankruptcy for unpaid traffic violations. refuses because the equipment secures the According to the Seventh Circuit, the City’s FEBRUARY 2020 defaulted loan. Depending on where the passive retention of the debtor’s car was “an

THE PUBLICATION FOR CREDIT & FINANCE PROFESSIONALS $9.00 debtor sought bankruptcy relief (e.g., New act to … exercise control” over that property, York or New Jersey), lender may be subject warranting sanctions against the City. The to sanctions for holding on to the equipment. Supreme Court agreed in December 2019 to hear the case. The debtor (or a bankruptcy trustee) will then ordinarily seek the prompt turnover The Supreme Court Precedent of the repossessed equipment in court. The Supreme Court “considered the inter- The debtor will argue the equipment play between the automatic stay and the needs to continue operating because turnover provision in” the Bankruptcy Code the debtor owns it. When the lender is in a similar case 24 years ago. The court secured, though, the court will have to held that a “bank’s temporary withholding provide lender with “adequate protection” of funds in a debtor’s bank account, pend- (e.g., cash payments, additional collateral) ing resolution of the bank’s right” to set off before ordering the turnover of the equip- that account did not violate the automatic ment. That is the usual result. stay. It reasoned the Bankruptcy Code’s turnover provision was not “self-executing.” Thus, the debtor had to ask the bankruptcy court to order the turnover of the funds.

Redeeming In another case, 36 years ago, the Supreme Court ordered the repossessing secured lender (the “IRS”) to turn over its collateral Repossession so long as the debtor provided the lender with some form of “adequate protection,” reasoning the lender’s right to adequate protection replaced “the protection afforded Sanctions for Passive Retention by possession.” Most important, the debtor But what happens when the debtor also had to ask the bankruptcy court for a turn- seeks sanctions for lender’s initial refusal to over order. The lender was entitled to resist turn over the equipment? Did lender violate turnover if the debtor failed to provide ade- the Bankruptcy Code’s automatic stay, i.e., quate protection. And the bankruptcy court did it “exercise control over property of the had to rule on the issue. [debtor’s] estate?” Federal appellate courts covering California, Oregon, Washington, The Supreme Court in Chicago’s case Illinois, Indiana, New York, Connecticut, should resolve the split among the fed- Vermont, Missouri, Florida and Georgia eral courts of appeals. More important, have held that it did, affirming the bank- though, lenders need certainty when ruptcy court’s imposition of sanctions. exercising their bargained for remedies. Michael L. Cook, Esq., is of But three federal appellate courts cover- Most important, debtors and bankruptcy counsel in the New York office of ing New Jersey, Delaware, Pennsylvania, trustees should not be able to threaten Schulte Roth & Zabel LLP. He served as a partner in the New York office the District of Columbia and Colorado lenders with sanctions for exercising their for 16 years, devoting his practice to have held that lender did not violate the pre-bankruptcy remedies properly. business reorganization and creditors’ automatic stay. These courts focused on rights litigation after leading the whether lender had an affirmative duty to Why the Supreme Court reorganization practice at another release the collateral. Should Fix the Problem international law firm for 20 years. Here are the reasons why the Court should His clients include professional The City of Chicago recently asked the U.S. reverse the Seventh Circuit in the Chicago firms, lenders, acquirers, trustees, creditors’ committees, troubled Supreme Court to resolve this so-called case. First, the Bankruptcy Code’s automatic companies and other parties. “split” among the federal courts of appeals. stay is meant to stop collection efforts and

1 BUSINESS CREDIT FEBRUARY 2020 pending foreclosure actions. It also protects Turnover Requires a Court Order right to reclaim its property, they can relieve the creditor body by preventing individual Debtors and trustees argue that the Code’s secured lenders from the threat of sanc- creditors from grabbing assets ahead of turnover provisions, when read literally, tions. The Bankruptcy Code’s automatic other creditors, ensuring an orderly bank- provide for the automatic turnover of the stay should not require lenders, on the pain ruptcy case administration. The automatic debtor’s property by the repossessing of sanctions, to do what the Code’s turnover stay merely bars creditors from taking any lender. The relevant section does provide provision does not—immediately surrender affirmative act to exercise control over the the third party holding the debtor’s prop- repossessed collateral in the absence of a debtor’s property. It is prospective in nature. erty “shall deliver [it] to the trustee,” but court ruling. For a creditor to exercise control over a the Supreme Court and three circuit courts debtor’s property, the language of the auto- of appeals have held that this provision is No Threat to Reorganization matic stay requires some post bankruptcy not “self-executing.” Instead, the debtor or The Supreme Court should also reject a affirmative act. In the words of one Court of trustee must sue the lender in the bank- debtor’s argument that its ability to reorga- Appeals, “Stay means stay, not go.” ruptcy court to give that court a chance to nize would be threatened in the absence of determine whether the property is subject an immediate turnover by the lender. The When a lender repossesses equipment to turnover. The Federal Bankruptcy Rules debtor or trustee can quickly start a turnover prior to bankruptcy, mere passive retention provide for a streamlined court procedure. proceeding to recover any essential property of that property after bankruptcy should not Courts routinely require explicit proof with a court order. As the Supreme Court be subject to sanctions when the lender before property is ordered to be turned said a few months ago, the Bankruptcy never does anything further to “exercise over. For example, the bankruptcy court Code makes “reorganization possible [but] control over” the equipment. For preserving must first decide whether the property does not permit anything and everything the pre-bankruptcy status quo, the lender even belongs to the debtor. And if it does that might advance that goal.” should not be penalized. Congress hardly belong to the debtor, the secured lender is intended the passive retention of a debtor’s entitled to “adequate protection” (e.g., peri- *This is reprinted from Business Credit property prior to bankruptcy to qualify as an odic cash payments; insurance coverage) magazine, a publication of the National act to exercise control over that property. to ensure that the lender’s collateral will not Association of Credit Management. This be harmed by the debtor’s continued use article may not be forwarded electronically The relevant legislative history accompany- of it during the bankruptcy case. or reproduced in any way without written ing the Code’s automatic stay is unhelpful. permission from the Editor of Business Congress never explained its intent, but Courts can provide the right balance Credit magazine. three federal courts of appeals have used between debtors’ and creditors’ rights. By common sense in applying the Code. preserving the status quo and the debtor’s

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