Bankruptcy Case Dismissals Negating Bankruptcy Stipulations

Over one month ago, we had a big hearing in a big fight over the following facts:

A.) There was an adversary proceeding in a chapter 11 case (“Case 1”).

B.) The adversary proceeding was settled during the chapter 11 case.¹

C.) The non-debtor party defaulted under the stipulation.

D.) The chapter 11 case was dismissed without preserving any entered orders.²

E.) Two years later, the same debtor filed a chapter 7 case (“Case 2”).

F.) The Case 2 chapter 7 trustee is suing for the debtor’s rights under the Case 1 stipulation.

We say, “No way!”

Why?

Bankruptcy Code § 349

Bankruptcy Code § 349(b)(2) and (3) provide:

(b) Unless the court, for cause, orders otherwise, a dismissal of a case other than under section 742 of this title . . . .

(2) vacates any order, judgment, or transfer ordered, under section 522(i)(1), 542, 550, or 553 of this title; and

(3) revests the property of the estate in the entity in which such property was vested immediately before the commencement of the case under this title.

Section 349(b)’s objective is to “undo the title 11 case, insofar as practicable, and to restore all property rights to the position they occupied at the beginning of such case.”³ The return to pre-case status includes post-petition agreements⁴ and stipulations.⁵

In Acolyte Elec. Corp. v. City of N.Y.,⁶ Bankruptcy Judge Holland described his nightmare scenario of § 349’s effect:

A.) the debtor wins an adversary proceeding;

B. ) the debtor collects its judgment from the defendant;

C.) the debtor cannot confirm or consummate a plan of reorganization;

D.) the court grants a party’s motion to dismiss the case;⁷

E.) § 349(b)(3) revests all of the bankruptcy estate’s property into the entity which owned such property immediately before the case began;

F.) this includes “[a]ny interest in property that the estate acquires after the” case began.⁸ i.e.: the debtor’s recovery from the defendant.

Judge Holland added, “that Congress had intended [the statute] be interpreted so as to include this possibility should not be decreed by any rational court.”⁹ However, the issue is not what a rational court would do. The issue is what Congress directed. And that is precisely what Congress directed.¹⁰

To us, this means the Case 2 trustee has no rights under the Case 1 stipulation, which is now ineffective.

The trustee and Bankruptcy Court disagree with us. We are waiting for a promised adverse decision. The Bankruptcy Court expressed it anticipated our appealing the decision.

Supreme Support

They didn’t intend to; however, this week the Supreme Court supported our position.

Addressing an unrelated issue, in Czyzewski v. Jevic Holding Corp.,¹¹ Justice Breyer outlined § 349:

Insofar as the dismissal sections of Chapter 11 foresee any transfer of assets, they seek a restoration of the pre-petition financial status quo. . . .

Nothing else in the Code authorizes a court ordering a dismissal to make general end-of-case distributions . . . that do not help to restore the status quo ante or protect reliance interests acquired in the bankruptcy . . .¹²

“Reliance interests acquired in the bankruptcy” may be open to definition. However, how can a court protect a “reliance interest” of a debtor who abandons the proceeding after it obtains the interest?

The “reliance interest” of a non-debtor counter-party to a property sale is not the same as a party settling an adversary proceeding. The “bankruptcy forum” is a different playing field from state court. It creates different concerns and strategies. Bankruptcy courts have an innate desire to see successful chapter 11 cases. A party with a successful counterclaim against a debtor may only obtain pennies of a recovery. Settling in bankruptcy court has different considerations than a state court settlement.

Preserving Bankruptcy Orders

On dismissal, bankruptcy courts can make orders survive “for cause.” Non-debtor settlers should have the opportunity to show why cause doesn’t exist to extend their settlement.¹³ As shown above, the considerations for settling in a bankruptcy case disappear on that case’s dismissal. That differs from buying property for fair value. Those considerations are the same, bankruptcy or not.

Interpreting 349(b) to involuntarily subject non-debtor parties to in bankruptcy stipulations invites debtor chicanery. A debtor files a chapter 11 in partial response to depleting litigation. There’s a post-petition settlement. Then the case is dismissed. Absent an order continuing the settlement order, should the debtor be allowed to keep the benefit? We think not.

Stay tuned for results. Your comments and thoughts are always welcome.

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