The Second Circuit gave a virtual carte blanche allowing businesses to use misleading advertising aimed at poaching customers from a competitor in chapter 11 reorganization, in a decision upholding a district judge who reversed the bankruptcy court.

In her June 24 decision, Circuit Judge Maria Araújo Kahn said it would be an “unimaginable result” if the automatic stay were interpreted to prohibit “any action that affects consumer choice.” Without even citing the First Amendment, she saw no basis for making a distinction between “improper” and “legitimate” advertising when it comes to the automatic stay.

The opinion also definitively holds at the circuit level that Taggart is the standard for automatic stay violations, not just discharge violations.

$19.2 Million for a Stay Violation Reversed

A provider of commercial and residential communications services, the debtor filed a chapter 11 petition to reorganize. A competitor quickly mounted a direct mail campaign targeting the debtor’s customers.

The advertising informed the recipients that the debtor was in chapter 11 and asked whether the debtor would be able to stay in business. The advertising said that the debtor’s future was “unknown” and insinuated that the debtor might cease providing services.

Alleging that the advertising was “knowingly false” and caused “confusion” among its customers, the debtor filed an adversary proceeding in bankruptcy court in Manhattan, contending that the competitor had violated the automatic stay.

Granting summary judgment in favor of the debtor, the bankruptcy court held that the competitor’s advertising violated the automatic stay in Section 362(a)(3) as “an act to control property of the estate, namely, the debtors’ customers or contracts with those customers.” The bankruptcy court reserved decision on damages until it decided whether the competitor’s actions satisfied the standards for civil contempt.

After trial, the bankruptcy court issued an order imposing almost $19.2 million in sanctions for a “literally false and intentionally misleading advertising campaign that wrongfully interfered with the Debtors’ customer contracts and goodwill.” In re Windstream Holdings Inc., 627 B.R. 32, 37–38 (Bankr. S.D.N.Y. 2021).

On appeal, District Judge Cathy Seibel reversed, writing an opinion that focused on when advertising could violate the automatic stay and whether there was a “fair ground of doubt” about a stay violation under Taggart v. Lorenzen, 139 S. Ct. 1795 (2019).

Even if the advertising interfered with customer contracts and harmed the debtor’s goodwill, Judge Seibel found no “control” over estate property. She also found a “fair ground of doubt” about whether the advertisements were stay violations. Windstream Holdings Inc. v. Charter Communications Inc. (In re Windstream Holdings Inc.), 634 F. Supp. 3d 99 (S.D.N.Y. Oct. 6, 2022). To read ABI’s report, click here.

The Second Circuit affirmed Judge Seibel on both grounds.

Is Taggart the Standard?

When it comes to automatic stay violations regarding a corporate debtor, Circuit Judge Kahn began her analysis of the merits by observing how the authority to impose sanctions is contained in Section 105(a), not in Section 362(k), which only applies to individual debtors.

Next, Judge Livingston laid out the contempt standard for discharge violations contained in Taggart v. Lorenzen, 139 S. Ct. 1795,1799 (2019), where the Supreme Court held that a bankruptcy court may hold a creditor in civil contempt when there is objectively “no fair ground of doubt” that the creditor violated the discharge injunction. The “no fair ground of doubt” standard is met “when there is no objectively reasonable basis for concluding that the [party’s] conduct might be lawful under the discharge order.” Id. at 560. To read ABI’s report on Taggart, click here.

Judge Kahn described the “open question” as being “whether the same standard also applies to stay violation contempt proceedings.” With little analysis, she saw “no reason why Taggart’s objective standard should not apply equally to a civil contempt action for violation of the automatic stay provision.”

Fair Ground of Doubt?

To decide whether there was a “fair ground of doubt” about a stay violation, Judge Kahn first analyzed whether customer contracts and goodwill are considered estate property.

Judge Kahn cited the Second Circuit for having held “that contract rights are property of the estate, and that therefore those rights are protected by the automatic stay. See In re AMR Corp., 730 F.3d 88, 102–03 (2d Cir. 2013).” She agreed with the district court that the debtor had “some kind of contracts” with customers that were estate property.

Next, Judge Kahn cited Circuit Judge Learned Hand for having held “that a debtor’s goodwill can be properly categorized as property of the estate, protected by the automatic stay. See Mut. Life Ins. Co. v. Menin, 115 F.2d 975, 977 (2d Cir. 1940) (Hand, J.).” Following the most renowned judge ever to sit on the Second Circuit, Judge Livingston held that the debtor’s goodwill “is properly classified as property of the estate.”

Exercise of Control?

Even though the customer contracts and goodwill were estate property, did the competitor exercise control?

Rather than “tak[ing] possession or exercis[ing] control over [the debtor’s] customer contracts or goodwill,” Judge Kahn said that the competitor “launched an advertising campaign to convince [the debtor’s] customers to switch their subscriptions to [the competitor].” She lauded the district judge for having said that impairing or interfering with estate property involves litigation “or other legal action that would, or did, indirectly destroy or transfer control of the debtor’s property.”

“Conduct that affects consumer behavior is different from the type of conduct proscribed by § 362(a)(3) of the Bankruptcy Code,” Judge Kahn said. Citing the Fifth Circuit 40 years ago, she added, “The Bankruptcy Code does not prevent a third-party competitor from informing the public about a debtor’s insolvency or even criticizing the debtor for its inability to sustain its business.” She explained that the competitor’s “advertisements were only factually likely, as opposed to legally certain, to affect [the debtor’s] customer contracts and goodwill.”

Citing the Supreme Court for having “repeatedly held that actions that interfere with the debtor’s property do not necessarily violate the automatic stay,” Judge Kahn held that “the stay provision should not be construed so broadly as to impose sanctions on [the competitor] for its conduct here.”

Focusing on the relationship between advertising and the automatic stay, Judge Kahn said,

Construing “exercise control” to include any action that affects consumer choice would prohibit any advertising (indeed, any competition) with a debtor during bankruptcy — an unimaginable result.

Unlike the bankruptcy court, Judge Livingston saw no distinction between “legitimate” advertising and “improper” advertising. She was “not convinced that this distinction is tenable as the Bankruptcy Code does not distinguish between ‘improper’ and ‘legitimate’ actions that violate the automatic stay.”

Being “skeptical” that the competitor exercised control over estate property, Judge Kahn affirmed the district court, finding, “at least, a ‘fair ground of doubt’ that [the competitor] violated the automatic stay.”