What to Do if Your Civil Litigation Client Files Bankruptcy

Schuricht_David_webYou’re a litigator representing a plaintiff or a defendant in a lawsuit in Superior Court. One day, you learn that your client, either in propia persona or through other counsel, has filed a bankruptcy petition. What should you do? The answer depends partly on whether your client is a plaintiff (or cross-complainant) or a defendant (or cross-defendant) in the lawsuit, although some considerations are common to both situations, and in either case, the answer definitely is not to continue with the litigation as though nothing has changed. Here are some pointers:

Impact of the Automatic Stay

If you represent a defendant or cross-defendant who has filed bankruptcy, chances are that the litigation (or the part in which your client is a defendant) is stayed by the bankruptcy filing. See 11 U.S.C § 362[1] respecting the scope and effect of the “automatic stay,” including the (relatively few) exceptions to its applicability. If your case is stayed, you should file and serve a notice of stay (explaining that the case is stayed by your client’s bankruptcy) in the court where the litigation is pending.

Unless your case fits within one of the exceptions, the automatic stay prohibits the prosecution of the action against the defendant debtor until the stay terminates or the bankruptcy court makes an order granting “relief from stay” that permits the action to proceed. Unless the plaintiff’s claim is nondischargeable,[2] if your client eventually receives a bankruptcy discharge, the discharge permanently enjoins the plaintiff from continuing or commencing an action to recover the claim from your debtor client as a personal liability.[3]

What if the plaintiff obtains an order “granting relief from stay” from the bankruptcy court, allowing the plaintiff to continue prosecuting the litigation in state court? If that happens and you are going to continue as debtor’s counsel in the litigation, then you’ll want to pay attention to the points discussed below, especially the points about getting your employment approved by, and your fees and other charges allowed by, the bankruptcy court.

Causes of Action that Become Property of the Bankruptcy Estate

If your client is a plaintiff or cross-complainant, you need to be aware that: (1) the automatic stay does not stay a proceeding that was initiated by the debtor;[4] and (2) the cause of action you have been prosecuting is now, in all likelihood, property of the bankruptcy estate.[5]

When you have been representing the debtor in prosecuting a cause of action that now has become property of the debtor’s bankruptcy estate, it is a good idea (particularly if your client is in pro per in the bankruptcy case) to remind your client that the cause of action needs to be scheduled (listed) as an asset on Schedule B (a list of the debtor’s personal property) in the bankruptcy case.

While the existence of the lawsuit will certainly come to light if the bankruptcy court is asked to approve your employment for the purpose of prosecuting it (see below), some debtors may not realize that the cause of action is an asset that needs to be scheduled as such in the bankruptcy—and the failure to schedule an asset can come back to bite a debtor who might assume, after a Chapter 7 case is closed without the cause of action in question having been “administered” by the trustee, that the lawsuit again belongs to him or her.

If the cause of action bears fruit later and wasn’t scheduled, the trustee may be able to take it (or its proceeds) even long after the bankruptcy case is closed. In some cases, judicial estoppel has been successfully asserted as a defense to a claim after a debtor’s failure to schedule it in the bankruptcy case.

Need for Approval of Counsel’s Employment and Compensation

The employment (or retention) of an attorney to represent the bankruptcy estate (i.e., to represent a Chapter 7 bankruptcy trustee, a Chapter 13 debtor or a Chapter 11 debtor-in-possession or trustee[6]) in state court generally requires the bankruptcy court’s approval.[7] If you represent a plaintiff who has filed bankruptcy, you’ll probably want to contact the bankruptcy estate’s representative (the trustee in a Chapter 7 case or in a Chapter 11 case where a trustee has been appointed; and the debtor—your client—or, better yet, your client’s bankruptcy counsel, in a Chapter 13 case or in a Chapter 11 where there is no trustee), to find out whether the bankruptcy estate wishes to retain you as counsel to continue to prosecute the lawsuit in state court.

If you delay in applying to the bankruptcy court for approval of your retention by the bankruptcy estate, you will be “at risk” of not getting paid for any legal services you may provide between the time the bankruptcy petition was filed and the time your employment is approved. If you fail to get bankruptcy court approval, you probably won’t be paid for your services, at least not by the bankruptcy estate.

In addition, in most situations, your charges (both fees and expense reimbursement) must be approved by the bankruptcy court before you can be paid.[8] This means that an application for compensation will have to be filed and set for hearing in the bankruptcy court and that you will be entitled to receive payment only to the extent your application is approved.[9]

Extension of Deadlines

Respecting deadlines, you should know that federal bankruptcy law (Code § 108) extends certain deadlines for the trustee (or—in a Chapter 13 case or in a Chapter 11 where no trustee has been appointed—the debtor) to file any pleading, notice or demand in a state court action, provided the relevant deadline did not expire before the bankruptcy petition was filed.

Removal to the Bankruptcy Court

Federal law confers upon state court litigants the right to remove to federal court (in practice, this usually means to the bankruptcy court, which is an “arm” of the district court) most civil actions “related to” a bankruptcy case.[10] If the debtor in a bankruptcy case is a party to state court litigation, it’s a safe bet that the litigation is “related to” the bankruptcy and is a candidate for removal.[11] Whether to remove a cause of action or resist removal by an adverse party, can, of course, be an important tactical question involving a number of factors.

Need for Approval of Settlements

Don’t forget that when you are representing an estate representative, any settlement or compromise will need to be approved by the bankruptcy court before it will bind your client.[12] Be sure to make the adverse party aware of this when you are involved in settlement negotiations, and always include a term in the settlement agreement making the settlement contingent on bankruptcy court approval.

Accounts Receivable for Prepetition Legal Services

Finally, if you have unpaid billings based on services you provided before the bankruptcy was filed, don’t forget that the automatic stay applies to you, the same as to any other creditor. Once your client has filed a bankruptcy petition, you can’t demand that the debtor bring your billings for prepetition fees current. You may be able to keep the funds in your trust account depending on when the funds were deposited and when the fees to be paid were incurred.

You may want to file a timely proof of claim in the bankruptcy case for the amount of your outstanding prepetition charges if you want to receive a distribution from the estate, but there are some potentially adverse consequences of doing so.[13]

Finally, unless the debtor voluntarily enters into a reaffirmation agreement with you that complies with the strict requirements of Code § 524(c) & (d), your client’s debt to you for pre-filing services will very likely be discharged if your client receives a discharge in the bankruptcy case–even if you continue to provide services to your client after the bankruptcy case is closed.

While all of these issues deserve further discussion, it is hoped that this article will put you on the right path toward determining what you should do when your litigation client morphs into a bankruptcy debtor.

David Schuricht is a partner in the Walnut Creek law firm of Katzen & Schuricht, where his practice focuses on bankruptcy law. Mr. Schuricht is a 1974 graduate of Boalt Hall School of Law, and he has been actively practicing in California for nearly 40 years.

[1] Unless otherwise indicated, all subsequent statutory references in this article are to Title 11 of the United States Code ( “Code”).

[2] See Code § 523 & 1328.

[3] Code § 524(a).

[4] Brown v. Armstrong, 949 F.2d 1007 (8th C. 1991).

[5] See Code § 541.

[6] Chapter 9 (municipality) and Chapter 12 (family farmer) bankruptcy cases are relatively rare (at least, with respect to Chapter 12, in our area), so they aren’t further mentioned in this article.

[7] Code § 327.

[8] Code § 330.

[9] Id. FRBP 2016.

[10] See 28 U.S.C. §§ 1334 & 1452.

[11]  A.H. Robins Co. v. Piccinin, 788 F.2d 994, 1002, ftnt. 11 (4th C. 1986) questioned on other grounds in Chord Assocs., LLC vs. Protech 2003-D. LLC 2010 U.S. Dist. LEXIS 28465 (E.D.N.Y. 2010); LSM Hotel, LLC vs. Serhan (In re LSM Hotel, LLC), 2011 Bankr. LEXIS 635 (B.C.S.D. Cal. 2011).

[12] See Federal Rule of Bankruptcy Procedure (“FRBP”) 9019.

[13] See FRBP 3002 & 3003.

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