Supreme Court Holds Passive Retention of Collateral Does Not Violate Automatic Stay

January 26, 2021

On January 15, 2021, the Supreme Court unanimously ruled in City of Chicago v. Fulton that a secured party in possession of a debtor’s collateral does not violate the automatic stay by passively retaining possession of the collateral after a debtor commences a bankruptcy case.

When a debtor files a bankruptcy case, the Bankruptcy Code protects the debtor by imposing an automatic stay on efforts to collect prepetition debts outside the bankruptcy forum. The automatic stay’s prohibitions include “any act . . . to exercise control over property” of the bankruptcy estate. The issue in City of Chicago was whether a creditor violates the automatic stay by retaining possession of a debtor’s property after a bankruptcy petition is filed. Prior to the Supreme Court’s decision, the circuit courts of appeal had split on the issue.

In City of Chicago, the city of Chicago had impounded defendant Fulton’s car based on outstanding motor vehicle fines. When Fulton (and other similar debtors) filed a Chapter 13 bankruptcy petition, Fulton requested that the city return his vehicle. The city refused and the bankruptcy court held that the city’s refusal violated the automatic stay, which ruling was affirmed by the Seventh Circuit, which concluded that “by retaining possession of the debtors’ vehicles after they declared bankruptcy,” the city had acted “to exercise control over” respondents’ property in violation of the automatic stay.

The Supreme Court reversed the Seventh Circuit and held that the City of Chicago did not violate the automatic stay by refusing to return Fulton’s car after the petition was filed. Thus, the passive retention of collateral held by a creditor as a result of a prepetition seizure does not violate the automatic stay.

The core of the Supreme Court’s ruling was that the automatic stay only “prohibits affirmative acts that would disturb the status quo of estate property.” The automatic stay provision prohibits only “affirmative acts” that “disturb the status quo” of the debtor’s estate property at the time of filing. Under Section 362, the filing of a bankruptcy petition causes a “stay” of “any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate.” 11 U.S.C.A. § 362(a)(3). The automatic stay preserves the status quo of the estate by preventing one creditor from seizing assets before others. Thus, secured lenders are not disturbing the status quo by retaining property lawfully repossessed or seized before the petition date.

The City of Chicago ruling is important protection for secured creditors who have repossessed or taken possession of debtors’ collateral prior to a bankruptcy filing. But it is not necessarily the end to disputes between debtors and creditors over pre-bankruptcy repossessions. The Supreme Court’s ruling did not discuss how bankruptcy courts should address actions by debtors to compel turnover of estate property under Section 542(a) of the Bankruptcy Code. Under that section, a debtor may be able to compel a creditor in possession of collateral to return it to the debtor. But turnover actions are fact-specific and depend on the nature of the claims alleged by the debtor and counterclaims of the creditor. Thus, while it remains to be seen whether debtors will be able to use turnover actions to recover repossessed collateral, it is clear that the debtor’s threat of seeking sanctions for post-petition possession of collateral is gone.

For more information on this alert or other restructuring & finance litigation matters please contact:

Stephen Selbst at +1 212 592 1405 or [email protected]
Gabrielle Fromer at +1 212 592 1575 or [email protected]

© 2021 Herrick, Feinstein LLP. This alert is provided by Herrick, Feinstein LLP to keep its clients and other interested parties informed of current legal developments that may affect or otherwise be of interest to them. The information is not intended as legal advice or legal opinion and should not be construed as such.