The U.S. Supreme Court Is Poised to Determine Whether a Creditor’s Passive Possession of Debtor’s Property (Legally Obtained Pre-petition), Violates the Automatic Stay -- Which Should Resolve a Split among the Circuits

There is a split among the circuits as to whether a creditor’s continued retention of a debtor’s assets, seized pre-petition, violates the automatic stay. The question is whether the creditor’s passive possession of such asset is “an act … to exercise control over property of the estate” within the meaning of the Bankruptcy Code’s automatic stay provision, 11 U.S.C. § 362(a)(3).  Most Circuits (Second, Seventh, Eighth, Ninth and Eleventh) have said yes, requiring a secured creditor to return property or risk paying damages for violating the stay. Now the Third Circuit, in In re Denby-Peterson, 941 F.3d 115 (3d Cir. 2019), has joined the Tenth and D.C. Circuits in finding no violation of the automatic stay if a creditor, upon notification of the bankruptcy, fails or refuses to return the seized property.  Thus, in order for a debtor (or trustee) in the Third Circuit to regain possession of the asset, absent agreement by the secured creditor, an adversary proceeding seeking turnover will have to be initiated.  The facts in Denby-Peterson are as follows.

Joy Denby-Peterson purchased a Corvette which was repossessed after she defaulted on her car loan.  After repossession, she filed a chapter 13 bankruptcy petition in New Jersey,   notified her creditors of the filing, and demanded the return of the Corvette.  When the Corvette was not returned, Ms. Denby-Peterson filed a motion for turnover and sought sanctions for the creditor’s purported violation of the automatic stay.  The Bankruptcy Court ordered turnover of the Corvette, but denied the debtor’s request for sanctions.  This ruling was affirmed by the District Court for the District of New Jersey.  Upon further appeal, the Third Circuit joined the minority view that the automatic stay and turnover provisions of the Bankruptcy Code do not impose an affirmative obligation on a creditor holding seized assets to return them, absent a formal proceeding for turnover.

At issue in Denby-Peterson was whether the creditor’s continued possession constituted “any act … to exercise control over property of the estate.”  See, 11.U.S.C. § 362(a)(3).  Although the Bankruptcy Court ordered the return of the Corvette pursuant to Section 542(a), it held that the creditor had not violated the stay.  It noted that the “minority” circuits were critical of a “self-effectuating” turnover if the automatic stay was held to apply.  That is, Section 542(a) would not be necessary and could be rendered ineffectual if turnover was automatic.    Id. at 121.  The Third Circuit acknowledged that property of the estate includes property in which a debtor holds an equitable interest, and that the purpose of the automatic stay is two-fold:  1) to give a debtor a respite from creditors and 2) to prevent any one creditor from obtaining payment to the detriment of other creditors.  But in construing the automatic stay provisions, the Third Circuit agreed with the District Court that “any act … to exercise control…” was solely prospective.  That is, the mere “exercise of control” is not the event which is stayed; rather, it is an “act” to exercise control that is stayed.  Id. at 125.   Thus, the Third Circuit agreed with the minority position that the text of Section 362(a)(3) requires a post-petition affirmative act to violate the stay.   As to the Corvette, the “act” of repossession occurred pre-bankruptcy.  Post-bankruptcy, “the creditors merely passively retained the same possession and control.”  Id. at 126.  Moreover, given that one policy goal of the automatic stay is to maintain the status quo, the creditors’ continued post-petition possession of the Corvette simply maintained the pre-petition status quo.  Id.  As to the interplay between the Code’s automatic stay and turnover provisions, the Third Circuit viewed Section 542(a) as not being self-effectuating.  Rather, a creditor’s obligation to turn over estate property  is effectuated by judicial action -- it is the debtor’s burden to bring an adversary proceeding to determine whether the property is subject to turnover.  Id. at 128.

Before the Third Circuit ruled in Denby, the Tenth Circuit, addressing similar language in Section 362(a)(4), confirmed that Section 362(a)(3) requires affirmative conduct.  In re Garcia, 740 Fed. Appx. 163, 164 (10^th Cir. 2018).   The United States Supreme Court denied certiorari there in May of 2019.

But more recently, the Seventh Circuit in In re Fulton, 926 F.3d 916 (7^th Cir. 2019) ruled that the City of Chicago violated the automatic stay by refusing to release a debtor’s car which had been impounded for unpaid parking tickets.  One rationale for that ruling was that under Section 363(e), a creditor has the burden of requesting stay relief, and “if a creditor is allowed to retain possession, then this burden is rendered meaningless – a creditor has no incentive to seek protection of an asset of which it already has possession.”  Id. at 924 (internal quotation omitted).    The United States Supreme Court recently accepted certiorari of In re Fulton on December 18, 2019, possibly signaling concern with the 7^th Circuit’s ruling.   The Supreme Court may be guided by its prior decision in Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 21 (1995), in which it considered the interplay between the Code’s automatic stay and turnover provisions, and held that a bank’s withholding of funds in a debtor’s bank account, pending a determination of the bank’s setoff rights, was not an act that violated the automatic stay.  Pending the Supreme Court’s ultimate decision, for now it’s important that practitioners be aware of the circuit court precedent in their particular jurisdictions to properly guide their clients on this significant issue.  Stay tuned!