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Why Are the States in This Case?

Why Are the States in This Case?

By Abigail R. Ryan

The phrase “Speak now, or forever hold your peace” is associated with weddings, but it applies equally well to bankruptcy proceedings. Parties must speak up in a bankruptcy by filing a proof of claim, objection, adversary or other pleading to address any outstanding issues with the debtor. If a party fails to timely do so and the plan is confirmed and/or a discharge is granted, that party must forever hold their peace regarding the unraised issues.

The requirement to raise outstanding issues in a bankruptcy applies as much to the states as to other parties. For this reason, states routinely appear in bankruptcy cases to “speak now” on matters that impact payment on their claims and enforcement of their police and regulatory laws.

Monetary Amounts: Collections and Claims

One of the most common reasons that the states appear in bankruptcy cases is to collect monetary amounts owed by the debtor. Generally, debtors owe taxes to the state, but other monetary amounts can include fines and penalties, contract claims, restitution claims and governmental loans. Under their police and regulatory powers, states may liquidate monetary claims in state court as an exception to the stay (unlike most creditors), but they can only collect these money judgments from the bankruptcy estate through the bankruptcy process (like other creditors).1

While most governmental debts are general unsecured claims, there are instances when a state’s claim may be secured,2 priority or nondischargeable.3 In other cases, the state might be entitled to an administrative-expense claim for performing a necessary regulatory duty for the debtor that preserves the debtor’s estate. For example, a debtor might not be able to afford to plug an oil well that state law requires to be plugged. If the state plugs the well on the debtor’s behalf, the state is entitled to an administrative-expense claim under 11 U.S.C. § 503(b)(1) for the response costs incurred.4

Regulatory Issues: Enforcing State Laws

Bankruptcy is not the proverbial “get out of jail free card,”5 as debtors must still obey state laws. Specifically, 28 U.S.C. § 959(b) states that debtors

shall manage and operate the property ... according to the requirements of the valid laws of the State in which the property is situated, in the same manner that the owner or possessor thereof would be bound to do if in possession thereof.6

Recognizing the need for states to enforce their laws during a bankruptcy, the legislature passed 11 U.S.C. § 362(b)(4), which is the police and regulatory powers exception to the automatic stay allowing the states to enforce state laws that are aimed at protecting human health, safety and environment.7 So, while the states enjoy the police and regulatory exception to the automatic stay under § 362(b)(4) and can proceed in a state forum to protect human health, safety or the environment without seeking bankruptcy court approval,8 sometimes it is unclear whether the state’s action falls under this exception.9 A court order confirming the applicability of the police and regulatory power exception is prudent.10

Under 11 U.S.C. § 525(a), “a governmental unit may not deny, revoke, suspend, or refuse to renew a license, permit, charter, franchise, or other similar grant ... solely because” a debtor is or has been in bankruptcy.11 Typically, the debtor’s license is property of the bankruptcy estate.12 However, it is property that is regulated under state law.13 For example, if a debtor holds a liquor license, and, after14 filing for bankruptcy, the debtor — for a reason other than the bankruptcy — is out of compliance with the state’s laws governing the license, before acting to enforce any law that would affect the status of the license, the state should bring the noncompliance issue to the bankruptcy court’s attention through an expedited motion to determine nonapplicability of the automatic stay pursuant to § 362(b)(4) or similar motion.15 This type of motion is different from a motion to lift the automatic stay for cause pursuant to 11 U.S.C. § 362(d) because application of § 362(d) is premised on the fact that the automatic stay is in place, and a request must be made before acting to enforce against a debtor.

Section 362(b) lists exceptions to the automatic stay, so that as to those exceptions, no stay is ever in place.16 Seeking a determination that the stay does not apply is good practice, particularly for any police and regulatory case that the state may want to file post-petition.17 This is true because once a regulatory case has been filed in a state forum, the debtor is likely to file a motion with the bankruptcy court alleging a violation of the automatic stay and might seek an injunction against the state to which the state will have to reply. If a stay violation is found, any acts taken in violation of the stay might be void,18 and if a willful19 stay violation is found, the bankruptcy court can order the state to pay the debtor damages due to the stay violation.20

Another common reason that states participate in a bankruptcy case is because the debtor has outstanding environmental problems. Debtors with environmental contamination21 issues that threaten human health, safety and the environment cannot abandon those issues in contravention of state environmental laws.22 While states might move forward with enforcement proceedings under their police and regulatory powers, it could still be necessary to participate in the bankruptcy case to ensure that the environmental contamination issues are timely and properly addressed.

For example, a debtor might seek to abandon contaminated property, and the states will file an objection to the abandonment.23 At times, states might find it beneficial to negotiate with chapter 7 trustees or chapter 11 debtors to set up environmental-response trusts for the contaminated property. When a debtor seeks to sell a contaminated property, the states will be involved to ensure that the purchaser has the ability to receive the necessary permits for the site, has the financial means to meet financial insurance requirements and has the ability to remediate the contaminated property. Finally, in any chapter 11 case that involves contaminated property, the states will thoroughly review any disclosure statement and plan to ensure that the property is properly addressed.

Finally, a fundamental principle is that the bankruptcy court is not intended to serve as a haven for wrongdoers,24 and bankruptcy courts have recognized that the police and regulatory exception to the automatic stay helps prevent the bankruptcy court from becoming such a haven.25 As such, when it appears that a debtor has filed for bankruptcy to escape the enforcement of state laws, the states might respond by filing a motion to dismiss, convert or appoint a chapter 11 trustee in the bankruptcy case.26

Conclusion

The examples set out in this article are just a few of the many reasons that states get involved in bankruptcy cases. Above all else, the fundamental reason that states become involved is because they understand that in bankruptcy, one must “speak now, or forever hold their peace.”

Abby Ryan is the bankruptcy counsel for the National Association of Attorneys General, where she offers bankruptcy support, training and legal assistance to state and territory Attorneys General, and coordinates an annual national bankruptcy conference for governmental practitioners.

  1. 1 In re Gandy, 327 B.R. 796, 804 (Bankr. S.D. Tex. 2005) (stating that “a state court may liquidate the claim and enter a judgment but the governmental unit is stayed from enforcing the money judgment against a debtor without an order of the bankruptcy court”).

  2. 2 See, e.g., Ohio v. Kovacs, 469 U.S. 274, 285-86 (1985) (recognizing that “a State may protect its interest in the enforcement of its environmental laws by giving clean-up judgments the status of statutory liens or secured claims”).

  3. 3 States may file adversary proceedings seeking to have debts found nondischargeable under 11 U.S.C. § 523(a)(2), (4), (6). See also 11 U.S.C. § 523(a)(7) (as to individual debtors, fines and penalties owed to and for benefit of government are nondischargeable); 11 U.S.C. § 1141(d)(6)(A) (extending nondischargeability to corporations for debts “of a kind specified in paragraph 2(A) or 2(B) of section 523(a) that is owed to a domestic governmental unit”); 11 U.S.C. § 1192(2) (recognizing that debts “of the kind specified in section 523(a) of this title” are nondischargeable).

  4. 4 See In re H.L.S. Energy Co., 151 F.3d 434 (5th Cir. 1998) (approving state’s administrative claim under § 503(b)(1) for plugging debtor’s inactive wells). See also Alan S. Tenenbaum & Jeanne T. Cohn, Environmental Bankruptcy Law: A Practice Guide, pp. 159-68 (2023).

  5. 5 See In re Cont’l Air Lines Inc., 61 B.R. 758, 781 (S.D. Tex. 1986) (“Although the reorganization court unquestionably retains discretion to enjoin suits filed pursuant to 28 U.S.C. § 959, Congressional intent is to be given effect unless compelling equitable considerations support injunctive relief. The automatic stay cannot be relied upon to vitiate the clear and dispositive legislative decision.”).

  6. 6 28 U.S.C. § 959(b); see also Cty. of Allegheny v. Cracked Egg LLC, 624 B.R. 84, 88 (Bankr. W.D. Pa. 2021) (stating that “[t]he mere fact that a debtor has filed for bankruptcy protection does not obviate the requirement that a debtor abide by applicable law. Congress has recognized as much when it passed 28 U.S.C. § 959(b)”).

  7. 7 United States v. Nicolet Inc., 857 F.2d 202, 208 (3d Cir. 1988) (recognizing that Senate and House Committee “reports state that ‘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 a law, the action or proceeding is not stayed under the automatic stay.’ S. Rep. No. 989, at 52 (emphasis added), 1978 U.S. Code Cong. & Admin. News at 5838; H.R. Rep. No. 595 at 343 (emphasis added), 1978 U.S. Code Cong. & Admin. News at 6299”).

  8. 8 Chao v. Hosp. Staffing Servs. Inc., 270 F.3d 374, 385 (6th Cir. 2001) (stating that “[w]hen a governmental unit decides to undertake an enforcement action and believes [that] its action falls within the police-power exception, it need not petition the bankruptcy court for permission to proceed in the ordinary course, but ... the agency runs the risk that a court will later find its action outside the exception’s ambit and declare the action void ab initio”).

  9. 9 See In re First All. Mortg. Co., 263 B.R. 99, 107 (B.A.P. 9th Cir. 2001) (stating tha “[n]ot every police and regulatory action is automatically exempt, however ... regulatory laws that directly conflict with the control of the res or property by the bankruptcy court will be stayed”) (internal citations omitted); see also In re Samost, 2020 Bankr. LEXIS 829 (Bankr. D.N.J. April 2, 2024) (finding that New Jersey Department of Environmental Protection’s (NJDEP) actions did not fall under 11 U.S.C. § 362(b)(4) exception, and, as such, NJDEP violated automatic stay; court to consider imposing actual damages against NJDEP).

  10. 10 See, e.g., In re Joe’s Friendly Serv. & Son Inc., 2019 Bankr. LEXIS 880, *31 (Bankr. E.D.N.Y. 2019) (stating that “[a]lthough the statute does not require the governmental unit to seek a determination under § 362(b)(4) in advance of exercising their authority, any party taking action against a debtor or its property does so at its peril”).

  11. 11 11 U.S.C. § 525(a) (emphasis added).

  12. 12 11 U.S.C. § 541; see also In re Cen. Ark. Broad. Co., 170 B.R. 143, 146 (Bankr. E.D. Ark. 1994).

  13. 13 See, e.g., Milk Indus. Regul. Off. v. Ruiz, 122 F.4th 1, 11-15 (1st Cir. 2024); McMullen v. Sevigny, 386 F.3d 320 (1st Cir. 2004) (finding that debtor’s license was property of estate, but police and regulatory exception applied to allow state to enforce state laws).

  14. 14 See In re Gandy, 327 B.R. at 800 (finding that in police and regulatory cases where, by virtue of 11 U.S.C. § 362(b)(4) no stay has arisen, state courts have concurrent jurisdiction with bankruptcy court to determine whether automatic stay applies).

  15. 15 See In re Express Grain Terminals LLC, 2022 Bankr. LEXIS 945 (Bankr. N.D. Miss. 2022) (Mississippi Department of Agriculture filed motion to revoke debtor’s license and court allowed revocation); see also Trinity Meadows Raceway Inc. v. Tex. Racing Comm’n, 2007 Bankr. LEXIS 3018 (Bankr. N.D. Tex. Sept. 11, 2007) (finding that Texas Racing Commission did not violate stay when it revoked debtor’s racetrack license because state was enforcing its police and regulatory powers); see also In re RGV Smiles by Rocky L. Salinas D.D.S. PA, 626 B.R. 278 626 (Bankr. S.D. Tex. 2021) (applying police and regulatory powers exception to action filed by Texas Attorney General’s Office and denying injunction requested by debtor).

  16. 16 See 3 Collier on Bankruptcy ¶ 362.05.

  17. 17 See In re Gandy, 327 B.R. at 800; see also In re Joe’s Friendly Serv. & Son Inc., 2019 Bankr. LEXIS 880, *31 (finding that state courts share concurrent jurisdiction to determine whether police and regulatory exception applies and stating that “[a]lthough the statute does not require the governmental unit to seek a determination under § 362(b)(4) in advance of exercising their authority, any party taking action against a debtor or its property does so at its peril”).

  18. 18 See Chao, 270 F.3d at 385.

  19. 19 See Black Diamond Energy of Del. Inc. v. Wyo. Oil & Gas Conservation Comm’n, 2024 Bankr. LEXIS 2877 (Bankr. E.D. Pa. 2024) (willful violation does not require specific intent; rather, creditor willfully violates stay if they know about bankruptcy filing, but still commits any act that violates 11 U.S.C. § 362).

  20. 20 Id.

  21. 21 Environmental contamination issues can include oil and gas wells; contaminated areas of land; totes and barrels holding oil, gas or chemicals; above- and below-ground storage tanks; municipal solid waste; tires; and more.

  22. 22 Midlantic Nat’l Bank v. N.J. Dep’t of Env’t Prot., 474 U.S. 494, 507 (1989) (noting that since Midlantic opinion, bankruptcy courts differ as to immediacy of threat to human health, safety or environment that is necessary to stop abandonment); see also Tenenbaum & Cohn, supra at 297-313.

  23. 23 See, e.g., In re Comanche Iron & Metal Inc., Case No. 14-60072 (Bankr. N.D. Tex. 2014) (due to improper notice, trustee’s motion to abandon property that was contaminated was approved; Texas Attorney General’s Office had order approving abandonment vacated and worked in bankruptcy to have site remediated).

  24. 24 Nurses’ Registry & Home Health Corp. v. Burnwell, 533 B.R. 590, 598 (Bankr. E.D. Ky. 2015).

  25. 25 See Berg v. Good Samaritan Hosp., 230 F.3d 1165, 1167 (9th Cir. 2000) (recognizing that police and regulatory exemption to automatic stay “prevents the bankruptcy court from becoming a haven for wrongdoers”).

  26. 26 See In re NRA of Am., 628 B.R. 262 (Bankr. N.D. Tex. 2021) (granting State of New York’s motion to dismiss and dismissing NRA bankruptcy as filed in bad faith in effort to avoid compliance with State of New York’s regulatory scheme); see also In re Forest Hill Funeral Home & Mem. Park-East LLC, 364 B.R. 808 (Bankr. E.D. Okla. 2007) (state agency’s motion to dismiss case for bad faith was granted).

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