By: Donald L Swanson
(b) The filing of a [bankruptcy] petition . . . does not operate as a stay— . . . (4) . . . of the commencement or continuation of an action or proceeding by a governmental unit . . . to enforce such governmental unit’s or organization’s police and regulatory power.
- 11 U.S.C. § 362(b)(4) (emphasis added).
An opinion analyzing and applying the police power exception of § 362(b)(4) is Milk Industry Regulatory Office of the Commonwealth of Puerto Rico v. Ruiz (In re Ruiz), Case No. 22-1761, First Circuit Court of Appeals (decided November 21, 2024).
Here is a summary of that opinion.
Milk Production Regulation
The Milk Industry Regulatory Office of Puerto Rico (the “Regulator”) regulates the production and distribution of milk under Puerto Rico law by:
- granting dairy farmers licenses to operate;
- allocating milk quotas to licensed farmers; and
- policing the standards and quality of milk, with broad investigative and enforcement powers.
Under Puerto Rico law, (i) only dairy farmers licensed by the Regulator may produce milk for public consumption, (ii) the Regulator sets a milk production quota for each licensed farmer in accordance with market needs, and (iii) milk quotas may be sold, leased, or used as collateral by licensed dairy farmers.
Farmer/Regulator Facts
Debtor is a dairy farmer in Puerto Rico.
In 2015, Debtor files Chapter 12 bankruptcy in the U.S. Bankruptcy Court for Puerto Rico, which bankruptcy proceeding is still open.
After the bankruptcy filing, Regulator begins investigating Debtor’s milk production practices and finds evidence of “milk trafficking,” which refers to a dairy farmer:
- selling raw milk produced by others; or
- lying about the amount of milk produced.
One punishment for milk trafficking can be revocation of a farmer’s dairy license.
On August 18, 2018, Debtor receives a notice of complaint from Regulator, threatening to revoke Debtor’s license—based on evidence of milk trafficking.
Then, Regulator issues a final administrative decision revoking Debtor’s license and ordering Debtor to dispose of Debtor’s milk quota through a public sale. But Regulator then agrees to reinstate Debtor’s license pending Debtor’s appeal of the revocation decision to the Puerto Rico Supreme Court.
Debtor’s appeal fails.
Debtor then fails or refuses to sell the milk quota voluntarily. So Regulator begins the process of selling Debtor’s milk quota, without Debtor’s participation, by public auction.
In response, Debtor files an adversary proceeding against Regulator, claiming the proposed auction sale violates the automatic bankruptcy stay. In that proceeding, the Bankruptcy Court:
- declares that the police power exception in §362(b)(4) does not apply;
- enjoins Regulator from auctioning Debtor’s milk quota;
- finds that Regulator violated the automatic stay by taking steps to auction the milk quota without first obtaining relief from stay; and
- reserves the issue of potential damages for later determination.
Regulator appeals to the District Court, which affirms the Bankruptcy Court rulings.
And so, Regulator appeals for a second time—to the First Circuit Court of Appeals.
First Circuit Ruling
The First Circuit Court of Appeals reverses, declaring that Regulator’s plan to auction Debtor’s milk quota “falls squarely within the police power exception in § 362(b)(4).”
What follows is a summary of the First Circuit’s rationale for its reversal.
–Property of the Bankruptcy Estate
Section 362(a) of the BankruptcyCode creates an automatic stay that prohibits creditor action against property of the bankruptcy estate.
In this case, the automatic stay would apply to Debtor’s milk quota, unless that quota is covered by the police power exception. That’s because:
- Debtor’s milk quota is, under Puerto Rico law, both (i) property of Debtor’s bankruptcy estate because it can be sold, leased or used as collateral, and (ii) highly regulated; and
- under the Puerto Rico regulatory scheme, Debtor’s milk quota must be sold, either (i) voluntarily by Debtor within 60 days, or (ii) involuntarily by the Regulator under the governing regulations.
–A Risk of the Police Power Exception
The police power exception in § 362(b)(4) exempts from the automatic stay “the commencement or continuation of an action or proceeding by a governmental unit . . . to enforce such governmental unit’s or organization’s police and regulatory power.”
It ensures that government agencies can still enforce laws “affecting health, welfare, morals and safety” despite a bankruptcy filing and that debtors are not automatically protected in bankruptcy from such regulatory actions.
An illustration of how the police power exception works is In re Universal Life Church, Inc., 128 F.3d 1294, 1297 (9th Cir. 1997), which declares:
- “When a governmental unit decides to undertake an enforcement action and believes 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 risk is this: by acting without relief from stay, the agency runs the risk that a court will later find its action outside the exception’s ambit and, thus, in violation of the bankruptcy stay.
–Statutory Text of the Police Power Exception
Regulator’s planned auction of Debtor’s milk quota, after the revocation of Debtor’s license, “fits comfortably within the statutory text of § 362(b)(4)”:
- the revocation of Debtor’s license was certainly a proceeding by a governmental unit, to enforce its police or regulatory power over milk safety and marketing;
- the judgment revoking Debtor’s license did not produce a “money judgment”; and
- the planned auction was a step in the enforcement of the judgment that revoked Debtor’s dairy license.
–The Pecuniary Purpose and Public Policy Tests
Courts have devised a pecuniary purpose test for application of the police power exception:
- under this test, the focus is on whether the governmental proceeding relates primarily to protecting the government’s pecuniary interest (the police power exception would not apply) or to matters of public safety (the police power exception would apply); and
- in this case, the revocation of Debtor’s dairy license and auction of Debtor’s milk quota are focused on public safety—not on a pecuniary interest (since auction proceeds will go to a lienholder or to the Debtor, not to the Regulator).
Courts have also devised a public policy test for application of the police power exception:
- under this test, the focus is on whether an industry is regulated to protect public health and safety; and
- in this case, the health and safety dimensions of the regulatory requirements are evident.
A question often arises on whether both of these two tests (pecuniary purpose and public policy) must be apparent for the policy power exception to apply, but:
- in this case, such a question is not relevant because both tests are satisfied.
Further, the police powers protected under § 362(b)(4) are not limited to matters directly involving public health and safety:
- they extend more broadly to regulatory efforts to protect public welfare.
–The Role of the Lienholder
There is no doubt that Regulator’s proceeding to revoke Debtor’s dairy license was protected from the automatic stay by the police power exception.
Nevertheless, Debtor argues that auctioning Debtor’s milk quota is not protected because of the involvement of a lienholder and its pecuniary interest.
However, such argument is misplaced. An incidental or coincidental benefit to a creditor does not transform a police power action into something different.
Conclusion
Here is a “thank you” to the First Circuit Court of Appeals for its instructive In re Ruiz opinion on the police power exception of § 362(b)(4) to the automatic stay provisions of § 362(a).
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