Skip Page Banner  
Skip Navigation

Bankruptcy Court Must Determine Whether Creditor Acted in Bad Faith for Sanctions

Monday, October 7, 2013
By Diane Davis

Oct. 4 --The U.S. District Court for the Eastern District of New York Sept. 17 declined to enter a sanctions award against a creditor because the bankruptcy court needs to determine whether the creditor acted in bad faith in violating an order the debtor and creditor entered into regarding the demolition of the debtor's building or erection of a fence surrounding the debtor's building (MA Salazar, Inc. v. Inc. Vill. of Atlantic Beach, E.D.N.Y., No. 2:12-cv-03458-ADS, 9/17/13).

Granting the debtor's appeal in part, and denying it in part, Judge Arthur D. Spatt remanded the case to the bankruptcy court for further findings on the automatic stay and whether it was lifted or ever existed in the first place, and whether the court's inherent authority supported sanctioning the creditor for proceeding with demolition.

The court directed the bankruptcy court to clarify whether it lifted the automatic stay or the stay never existed in the first place as an exception for police and regulatory powers. The bankruptcy court must also consider under its inherent authority whether it should have sanctioned the creditor for proceeding with demolition and acted in bad faith. 

Property in State of Disrepair

Debtor MA Salazar Inc. owns a parcel of property in New York that is used as a mixed use commercial and residential building. Following a trial, the debtor was found guilty of maintaining unsafe premises in violation of the New York State Property Maintenance Code.

The debtor filed an order to show cause in state court, seeking a temporary restraining order (TRO) prohibiting the demolition of the building. The court denied the request for a TRO because the property had fallen into a state of disrepair and the extent of the disrepair rendered the project unsafe. 

Chapter 11 Filing

Subsequently, the debtor filed for Chapter 11 protection, indicating that the filing of the petition was “necessitated by the pending demolition of the Building by the Village.”

On Oct. 21, 2011, the Inc. Village of Atlantic Beach's mayor Stephen R. Mahler sent a letter to the bankruptcy court stating that the Village was “mindful” of the automatic stay and would delay demolition, but wanted to disconnect the utilities in the building. The bankruptcy court issued an order authorizing the Village to discontinue utility service to the building and allowing the debtor to either consent to the demolition of the building, or erect a fence surrounding the building (fence order). Under the fence order, it would be unlawful for any person to enter, remain, or reside on the debtor's property. It also obligated the debtor, in the event that it became aware of any person entering, remaining, or residing on the property to take all necessary steps to remove them from the property.

Subsequently, the debtor filed an affirmation attesting to the fact that a fence had been erected around the building. 

Police, Regulatory Power Exception

The Village then moved for the entry of an order vacating the stay in effect preventing the Village from demolishing the building. The debtor opposed the motion.

The bankruptcy granted the Village's motion, and instructed it to submit an order to that effect. According to the bankruptcy court, the case was a “poster child” for the “police and regulatory power” exception to the automatic stay provision of the Bankruptcy Code. The bankruptcy court reasoned that the stay was inapplicable for the reasons set forth in the Village's papers.

Less than 24 hours later, with the fence order still in effect, and without a formal order regarding the automatic stay, the Village entered onto the property and began the demolition of the building. The Village never submitted a proposed order to the bankruptcy court regarding the automatic stay.

The debtor then submitted a proposed order to the bankruptcy court requesting that the automatic stay be vacated. The bankruptcy court entered an order that “the automatic stay is vacated to the extent requested in the motion so as to allow the Village to demolish the structure located on the Debtor's Property.” 

Debtor Seeks Sanctions

Subsequently, the debtor filed a motion under Bankruptcy Code Section 362(a) and 362(k), seeking sanctions against the Village for violating the automatic stay and to hold the Village in contempt for violating the fence order.

The bankruptcy court concluded that the Village's action was within the police power and, therefore, the automatic stay did not apply. The court also expressed reservations about sanctioning the Village for violating the automatic stay. Further, the court noted that Section 362(k) authorizes recovery of damages for individuals, not corporations such as the debtor.

The bankruptcy court denied the debtor's motion for sanctions, noting that there was no order that could hold the Village in contempt of relative to Section 362 because it was signed after the building was gone. The court also indicated that imposing sanctions with respect to the fence order would not be equitable because that order was ambiguous as to the issue of demolition. 

Arguments on Appeal

The debtor appealed to the district court, arguing that its commencement of the Chapter 11 case triggered an automatic stay. The debtor contended that the Village's actions in demolishing the building prior to entry of the lift stay order foreclosed the debtor's ability to seek further judicial intervention to stop the demolition of the building. According to the debtor, while a corporate debtor may not obtain damages under Section 362(k), a bankruptcy court retains the power to find, and sanction for, violations of the automatic stay under Section 105.

The debtor also contended that the bankruptcy court erred in finding that the Village was not in contempt of the fence order.

The Village, however, argued that it did not violate the automatic stay because no such stay was in effect in the first instance because it was acting under its police powers. The Village also contended that the debtor failed to preserve its request seeking sanctions under Section 105 for violating the automatic stay. The Village asserted that it did not violate the fence order. 

Declines to Consider Sanctions

The district court concluded that the debtor failed to show that a theory based on the imposition of sanctions under Section 105 with respect to the automatic stay was properly before the bankruptcy court. The debtor failed to raise and preserve an objection during the bankruptcy proceedings, the court said, and cannot now raise it on appeal. The court will not consider an “unpreserved issue unless failure to do so will result in manifest injustice,” the court said. Because no manifest injustice is apparent, the court declined to consider whether sanctions were warranted under Section 105(a) with respect to the automatic stay.

Alternatively, the debtor contended that the bankruptcy court retained its inherent authority to sanction the Village for violating the automatic stay, which, in the debtor's view, was in place at the time of the demolition. “Inherent-power sanctions ordinarily require a clear showing of bad faith on the part of the party to be sanctioned,” the court said. Imposition of sanctions under a court's inherent powers requires a specific finding that an attorney acted in bad faith, and are appropriate only if there is clear evidence that the conduct is “(1) entirely without color and (2) motivated by improper purposes,” the court said. 

Bankruptcy Court Needs to Clarify

According to the court, it appears that the bankruptcy court did not consider the issue of bad faith, but rather declined to award sanctions with respect to the automatic stay on the ground that there was no formal prior order of the court for which the Village could be held in contempt.

The court directed the bankruptcy court to clarify whether it lifted the automatic stay or the stay never existed in the first place. The bankruptcy court is directed to consider whether, pursuant to its inherent authority, it should have sanctioned the Village for proceeding with the demolition in that fashion, and whether the Village acted in bad faith. 

Violated Fence Order

With regard to the fence order, the court found that because the demolition required entry of persons onto the debtor's property, the Village violated the fence order. The bankruptcy court's finding to the contrary is reversed, the court said. Whether the bankruptcy court had the authority to issue the fence order, and thereby halt demolition efforts, presents a separate question the parties failed to adequately address, the court said. 

Impose Sanctions?

The court determined that absent a violation of the specific provision of the Bankruptcy Code, Section 105(a) does not provide an independent basis for relief for the debtor.

The bankruptcy court, however, retains the inherent authority to enforce its own order, the court said. Therefore, the bankruptcy court should determine whether under its inherent authority the Village acted in bad faith in violating the fence order.

The court granted the debtor's appeal in part, denied in part, and remanded to the bankruptcy court for further findings, including whether:

(1) that court lifted the automatic stay or the stay never existed in the first place;

(2) that court's inherent authority supported sanctioning the Village for proceeding with the demolition without submitting a proposed order to that court regarding the stay; and

(3) that court's inherent authority supported sanctioning the Village for violating the Fence Order.

Robert J. Lester of Lester & Associates, P.C., Garden City, N.Y., represented the appellant/debtor; Michael Anthony Miranda, Maurizio Savoiardo, and Robert E. Hewitt III of Miranda Sambursky Slone Sklarin Verveniotis LLP, Mineola, N.Y., represented the appellee/creditor; and Stan Yuon Yang on behalf of the Office of U.S. Trustee, Central Islip, N.Y.

To contact the reporter on this story: Diane Davis in Washington at ddavis@bna.com

To contact the editor responsible for this story: Jay Horowitz at jhorowitz@bna.com

To view additional stories from Bloomberg Law® request a demo now