With an increasing number of bankruptcy cases centering on massive financial frauds, bankruptcy courts in recent years have drastically extended the definition and scope of “property of the estate.” Not surprisingly, this broader definition has also led to an increased application of the automatic stay, sometimes extending the stay to third-party actions that were not even brought against debtors.[1] This newfound broad scope of the stay’s application has proven to be problematic. Fortunately, subjects of stay violation motions are not without redress given the right factual scenarios.
As a general rule, the Bankruptcy Code’s automatic stay is strictly enforced.[2] In fact, the reach of the automatic stay is so extensive that violations are generally held to be either void or voidable.[3] Regardless of the effect of stay violations, courts realize that the stay’s force should not be universal. In these instances, courts recognize equitable exceptions to the automatic stay, such as the doctrine of laches.[4]
Doctrine of Laches and the Automatic Stay
“Laches” is an equitable defense that when used properly, a defendant can establish that a plaintiff “has inexcusably slept on its rights so as to make a decree against the defendant unfair, and that the defendant has been prejudiced by the plaintiff’s unreasonable delay in bringing the action” (the “laches analysis”).[5] Laches can generally be used as an affirmative defense in all forms of litigation, but it has a special application within the context of the automatic stay in bankruptcy.
One of the more prominent examples of laches being applied in the bankruptcy context is the Seventh Circuit’s decision in Matthews v. Rosene,[6] wherein a chapter 13 debtor under the Bankruptcy Act sought to nullify a three-year-old state court judgment for being in violation of the automatic stay.[7] However, the state court judgment had actually been entered on a counterclaim raised by one of the debtor’s creditors after the debtor had instituted its own state court declaratory judgment action.[8]
The Matthews court denied the debtor’s attempt to nullify the state court judgment under both factors of the laches analysis.[9] First, the court found that the debtor had “unreasonably and inexcusably delayed asserting his claim” by waiting nearly three years to challenge the state court judgment.[10] Moreover, the court found that the creditor “would be seriously prejudiced” if the judgment were declared void.[11] In supporting its decision to deny the debtor’s attempt to nullify the judgment, the court explained that the automatic stay, while “designed to benefit a debtor by preventing harassment and frustration of rehabilitation efforts through pursuit by creditors in individual actions,” can be suspended “when equitable considerations weigh heavily in favor of the creditor and the debtor bears some responsibility for creating the problems.”[12] Thus, while the creditor’s actions may have violated the automatic stay, equity prevented the debtor from benefiting from this delay.
Modern Application of Laches as a Defense to Stay Violation Motions
While traditionally acknowledged by courts as an equitable defense where parties were not even aware of a pending bankruptcy, the extension of the automatic stay’s scope in Ponzi scheme bankruptcies has shed new light on the defense’s use. Most recently, it was used to defeat a stay violation motion filed by the liquidating trustee for Bernard L. Madoff Investment Securities LLC.[13]
The Madoff Ponzi scheme involved several feeder funds, which invested in and received distributions from Madoff Investment Securities. Several of these funds eventually became the subject of a fraudulent transfer action (the “avoidance action”) by the liquidating trustee.[14] Prior to the liquidating trustee filing the avoidance action, the New York State Attorney General (NYAG) instituted a separate state court action against the funds on behalf of New York investors.[15] The liquidating trustee initially made no attempt to block the state court action.[16]
More than three years after filing the state court action and after a protracted legal battle, the funds reached a settlement with the NYAG for $410 million (the “settlement agreement”).[17] However, shortly after this resolution, the liquidating trustee filed a motion in bankruptcy court seeking to block the settlement agreement and state court action as being violative of the automatic stay.[18] The liquidating trustee argued that the money funding the settlement (the “settlement funds”) was “in fact ‘stolen’ customer property paid by Madoff Securities” to the funds.[19] According to the liquidating trustee, the settlement funds being utilized to satisfy the NYAG’s claims were the same funds that were being sought to be returned to the estate through the avoidance action.[20]
The court denied the liquidating trustee’s motion on two separate bases, but principally premised the denial on the fact that laches barred the liquidating trustee’s claim.[21] In reaching its conclusion, the court focused on both factors of the laches analysis. First, the court pointed out that the liquidating trustee, although fully aware of the state court action, waited more than three years to file his motion.[22] Second, the liquidating trustee filed his motion only after the NYAG and the funds were settled, and if granted, the relief sought in the motion would cause immense prejudice to all parties that were involved.[23] In this particular instance, the court noted that the liquidating trustee’s inaction especially prejudiced the state court claimants as the vast majority of them had refrained from bringing their own independent claims against the funds because of the state court action.[24]
Conclusion
As illustrated by the Madoff decision, the doctrine of laches remains a viable defense to unreasonable and unjustifiable delays by a debtor or trustee in filing stay violation motions, especially when such delays would unnecessarily prejudice creditors and third parties. To avoid the defense’s use, debtors and trustees should be diligent in bringing stay violation motions, making sure that they do not prejudice creditors and third parties. In turn, creditors and third parties should be cognizant of the defense’s availability, using it to their advantage under the proper circumstances.
[1] See In re Bernard L. Madoff Inv. Sec. LLC, 740 F.3d 81 (2d Cir. 2014) (staying federal action against non-debtor participants in Madoff Ponzi scheme).
[2] See In re Adams, 212 B.R. 703, 711 (Bankr. D. Mass. 1997).
[3] See Matthews v. Rosene, 739 F.2d 249, 251 (7th Cir. 1984) (finding stay violation to be “void”); see also Easley v. Pettibone Michigan Corp., 990 F.2d 905, 910 (6th Cir. 1993) (finding stay violation to be “voidable”).
[4] See Matthews, supra n.3, at 251 (recognizing doctrine of laches as a defense to stay violation motion).
[5] See Securities Inv. Prot. Corp. v. Bernard L. Madoff Inv. Secs. LLC (In re Madoff Secs.), 491 B.R. 27, 33 (S.D.N.Y. 2013).
[6] See Matthews, supra n.3.
[7] Id. at 250.
[8] Id.
[9] Id. at 251.
[10] Id.
[11] Id.
[12] Id.
[13] See In re Madoff Secs., supra n.5.
[14] Id. at 31.
[15] Id.
[16] Id.
[17] Id. at 32.
[18] Id.
[19] Id.
[20] Id.
[21] Id.
[22] Id. at 35.
[23] Id.
[24] Id.