In a 4/3 decision, the New York Court of Appeals held there was no federal preemption of a non-debtor third party’s tortious interference claims against other non-debtor third parties.
The importance of the November 24 opinion cannot be understated. If New York law applies, a third party who importunes a debtor to breach its contract with a lender can be hauled into state court to face tortious interference claims.
The dissenters expressed their “fear [that] state litigation may disincentivize lawyers and potential secondary lenders from assisting debtors who wish to file for bankruptcy but need legal counsel and financial assistance to do so.”
The majority did not have the same concerns. For them, establishing liability “against debt counseling organizations . . . seems speculative” because plaintiffs “may have difficulty establishing the elements of [tortious interference] claims.”
Violation of Loan Covenants
The plaintiff in state court had provided almost $150 million in financing for a housing project. The loan and related agreements prohibited the borrower from incurring any debt other than short-term trade debt. To remain a special-purpose, bankruptcy-remote entity that would always be single-asset real estate debtor, the borrower was prohibited from acquiring any other assets or from transferring any direct or indirect interest in the project without the lender’s consent.
The lender alleged that third parties (1) loaned $50,000 to the owner of the project to hire counsel; (2) acquired an indirect 49% interest in the project, and (3) transferred three apartments to the project’s owner so it would not be a single-asset real estate entity. All three actions allegedly breached the owner’s contracts with the lender.
The project’s owner filed a chapter 11 petition. The lender filed a motion to modify the automatic stay along with a motion to dismiss for a bad faith filing. The lender withdrew the motion to dismiss but won an auction for the property by submitting an $86 million credit bid. The lender and other creditors voted in favor of the debtor’s chapter 11 plan, which the bankruptcy court confirmed.
Before the sale in bankruptcy court, the lender had filed suit in state court against the third parties, alleging that their actions amounted to tortious interference with contract by causing the project’s owner to breach its agreements with the lender.
The state trial court denied the third parties’ motions for summary judgment based on federal preemption, but the intermediate state appellate court reversed, holding that the lender’s claims were preempted by federal law. The lender appealed as of right to the New York Court of Appeals, the highest court in the New York State court system.
The Majority Opinion
The third-party defendants insisted that the tortious interference claims were preempted by federal law. Otherwise, they argued, potential liability would discourage lending to or counseling of a debtor, thus chilling bankruptcy filings.
Writing for the majority, Associate Judge Leslie E. Stein said that the third parties’ “preemption arguments are not wholly implausible.” She nonetheless decided that the third parties did not overcome the presumption against preemption.
In her 23-page opinion, Judge Stein laid out the three types of federal preemption: express preemption, field preemption, and conflict preemption. There was no express preemption, and she said that field preemption “does not merit extended discussion.”
Field preemption arises when federal law is so comprehensive that no room is left for state legislation.
Judge Stein found nothing in the Bankruptcy Code to suggest that Congress intended “to interfere with the authority of state courts to provide traditional tort remedies for claims brought by a non-debtor against alleged non-debtor tortfeasors for interference with contractual agreements that exist independently of a bankruptcy proceeding.” [Emphasis in original.] The defendants admitted that the Bankruptcy Code has no remedy for the lender’s claims against the third parties.
For Judge Stein, the “more complex” question was implied preemption arising from the principles of conflict preemption. There again, she said the third parties could point to no specific provision in the Bankruptcy Code that would have preemptive effect.
While authorities are divided, Judge Stein admitted that a majority of courts hold that tort claims are preempted if they are premised on a bankruptcy filing or wrongful conduct in the course of bankruptcy proceedings. Permitting a tort suit in state court based on a wrongful bankruptcy filing, she said, “risks subverting the Bankruptcy Court’s authority to adjudicate the validity of bankruptcy filings.”
The case on appeal was different, Judge Stein said, “because no question is raised as to the propriety of the bankruptcy proceedings.” The claims, she said, were “premised upon conduct that occurred prior” to bankruptcy and were “separate from” the bankruptcy proceedings. Furthermore, there was no risk of interference with the bankruptcy court’s control over the bankrupt estate.
Judge Stein distinguished cases from the Ninth Circuit finding preemption with regard to claims that filing bankruptcy was an abuse of process or that asserting claims amounted to malicious prosecution.
Judge Stein said that concerns about chilling a debtor’s ability to file bankruptcy were “more appropriately addressed through the proper application of our tort law.”
In sum, Judge Stein held that the third-party defendants “have failed to meet their heavy burden of establishing that federal bankruptcy law preempts plaintiff’s tortious interference claims that are based on pre-petition conduct and asserted against non-debtor defendants.”
The Dissenters
Associate Judge Jenny Rivera dissented in an opinion for herself and two other judges. She began her 33-page opinion by noting how the lender could have sought relief from the automatic stay or sanctions for the debtor’s improper conduct.
The tort claims, Judge Rivera said, “arise from, and seek damages caused solely by, the bankruptcy filings. Without the bankruptcy filings there would have been no automatic stay, which means no delay, and no damages.”
The lender could prevail on tort claims, Judge Rivera said, “only if it establishes that defendants caused these damages from debtors’ alleged bad-faith filings and misuse of the bankruptcy system.”
Judge Rivera pointed out how Congress provided remedies for bad-faith filings, such as dismissal or modification of the automatic stay. More emphatically, she would have held that “the Bankruptcy Code provides the exclusive remedies for these alleged injuries.”
The lender filed suit in state court about one month before buying the property at a bankruptcy auction. Simultaneously seeking remedies in state court and bankruptcy court was “exactly the type of dual proceedings Congress sought to preempt.”
By purchasing the property and obtaining a $24 million judgment against guarantors, Judge Rivera said that the lender “obtained everything our federal and state legal systems allow.”
Observations
In this writer’s view, the question is this: Should or must all disputes regarding a debtor’s conduct be funneled into bankruptcy court with remedies limited to those prescribed in the Bankruptcy Code?
The ability of the bankruptcy court to adjudicate tortious interference claims can be limited. Although not mentioned by either the majority or dissent, the bankruptcy court might not have been able to hold a trial or enter a final judgment had the lender sued the third parties in bankruptcy court. It is even possible that the bankruptcy court might not have subject matter jurisdiction of the lender’s claims against the third parties if there was no conceivable effect on the estate.
Beyond the question of the proper court, there is the issue of remedy. What remedy does the Bankruptcy Code afford for a lender’s claims against a third party?
The dissent evidently believes that modification of the automatic stay or a bad-faith dismissal would have been adequate remedies. Both would be remedies at the expense of the debtor. But what about remedies against the third parties for importuning the debtor to breach contract? The debtor was bankrupt. Claims against the debtor for breach of contract were essentially worthless.
The lender’s counsel adroitly drafted the complaint in state court by asserting claims based only on the third parties’ prebankruptcy conduct, and not on the filing of the petition or anything that happened after filing. If the third parties indeed tortuously interfered with the contract under state law before bankruptcy, why should they be immunized by the debtor’s bankruptcy?
In a 4/3 decision, the New York Court of Appeals held there was no federal preemption of a non-debtor third party’s tortious interference claims against other non-debtor third parties.
The importance of the November 24 opinion cannot be understated. If New York law applies, a third party who importunes a debtor to breach its contract with a lender can be hauled into state court to face tortious interference claims.
The dissenters expressed their “fear [that] state litigation may disincentivize lawyers and potential secondary lenders from assisting debtors who wish to file for bankruptcy but need legal counsel and financial assistance to do so.”
The majority did not have the same concerns. For them, establishing liability “against debt counseling organizations . . . seems speculative” because plaintiffs “may have difficulty establishing the elements of [tortious interference] claims.”