In a case involving multiple parties and proceedings, the Fifth Circuit has affirmed lower court rulings which prohibited one non-debtor from suing a second non-debtor and awarded sanctions against a party that told a state court to disregard the Bankruptcy Court's orders. In the Matter of PFO Global, Incorporated, Case No. 20-10885 (5th Cir. 2/9/22), which can be found here. While the result may sound extreme, it appears to be an unintended consequence of an agreed order entered years earlier.
A Procedural Muddle
Key to understanding the opinion is understanding the relationship between three groups of parties. Pro Fix Optical (PFO) had a contract with VSP Labs, Inc. (VSP). VSP sued PFO in state court in California and PFO counterclaimed. Before the case could make it to trial, PFO filed bankruptcy. In the bankruptcy, Hillair Capital Investments, Inc. and Hillair Capital Management, LLC (Hillair)purchased the assets of the Debtor, including the counterclaims. Hillair was a major lender to the Debtor. At this point, VSP had claims against PFO, the Debtor, and Hillair had counter-claims against VSP.
Hillair asked the California state court to sever its counterclaims from claims that were subject to the automatic stay. VSP then asked the bankruptcy court to lift the stay to allow it to offset its claims against the counterclaims. The parties submitted an agreed order. The agreed order said that VSP could liquidate its claims against PFO in state court. If VSP was to prevail, it had two rights. First, it could offset its claims against the Hillair counterclaims. To the extent that VSP's claims exceeded the Hillair claims, it could assert the excess by filing a proof of claim in the PFO bankruptcy case. The critical language in the order stated "no money damages or other amounts of any kind may be recovered from Hillair under any circumstances on account of any claims that have been or could have been asserted in the California Action."
The order made sense in the context of a sale free and clear of liens where Hillair had acquired the counterclaims while PFO remained liable on the original VSP claims.
Things became more complicated when VSP concluded during discovery that Hillair had directed PFO to breach its agreement with VSP. VSP asked the California state court for leave to amend its claims to assert new claims against both PFO and Hillair.
Hillair then went to the Bankruptcy Court and asked for an order prohibiting VSP from asserting direct claims against it in the California State Court action. The Bankruptcy Court granted this relief and entered what was known as the Enforcement Order. The Enforcement Order found that the original agreed order lifting the stay prohibited VSP from asserting direct claims against Hillair.
The California State Court then asked for briefing on the effect of the Enforcement Order. VSP filed a supplemental brief asserting that the Enforcement Order had no effect on its proposed claims. Hillair then moved for sanctions against VSP in Bankruptcy Court asserting that VSP had ignored the Bankruptcy Court's orders (which it clearly had). The Bankruptcy Court awarded sanctions. VSP moved for reconsideration and lost.
At that point, VSP appealed the Bankruptcy Court's orders interpreting the Lift Stay Order and awarding sanctions. The District Court affirmed and VSP appealed to the Fifth Circuit.
Was There Jurisdiction?
On appeal to the Fifth Circuit, VSP argued that the Bankruptcy Court lacked subject matter jurisdiction to preclude VSP, a non-debtor, from asserting claims against Hillair, a second non-debtor. On the surface, this argument had some appeal, since the Northern Pipeline case had found that the Bankruptcy Court lacked jurisdiction to determine certain claims between non-debtors.
As a reminder, Bankruptcy Courts have three types of jurisdiction: claims arising under the Bankruptcy Code, claims arising in a case under the Bankruptcy Code and claims related to a case under the Bankruptcy Code. Related to jurisdiction extends to matters which could have a conceivable effect on the estate being administered in bankruptcy.
The Fifth Circuit found that lifting the automatic stay fell within "arising under" jurisdiction because 11 U.S.C. 362(d), which authorizes lifting the stay, is part of the Code.
The Court then found that the Bankruptcy Court had "related to" jurisdiction over VSP's claims against Hillair. Its rationale was that if VSP prevailed in its claims against Hillair, this result would reduce the amount of claims that VSP would have against PFO, the Debtor. The Fifth Circuit found that Under Stern v. Marshall, the Bankruptcy Court would have lacked authority to enter a final order on these related to claims absent consent. However, because the order was an agreed order, consent was clearly present.
Did the Fifth Circuit Get It Right?
The Fifth Circuit may or may not have reached the right result, but it appears that its reasoning was flawed. Allowing VSP to pursue Hillair could certainly have a conceivable effect on the estate being administered in bankruptcy. However, the part of the order that VSP complained about prevented it from pursuing affirmative claims against Hillair. It takes more imagination to see how precluding VSP from pursuing affirmative claims against Hillair would have an effect on the bankruptcy estate. Perhaps Hillair would have been able to assert indemnity claims against the estate if VSP prevailed and those indemnity claims would have an impact on the estate. That seems like more of a reach, especially if those facts did not appear in the record.
However, there may be a better alternative rationale, at least in part. The agreed order made perfect sense in the context of a sale free and clear of liens. When Hillair purchased the counterclaims, it did not assume liability for VSP's claims That is the essence of a sale free and clear of liens. In this light, the prohibition against pursuing direct claims against Hillair was necessary to implement the order for sale free and clear of liens and thus would be covered by "arising under" jurisdiction.
The problem with this rationale is that the parties didn't contemplate that VSP might discover that it had independent claims against Hillair, ones that didn't arise from purchase of the counterclaims. It seems likely that the parties did not contemplate that existence of independent claims when they drafted the Lift Stay Order or that they would have any reason to even contemplate this result. In this context, it might have been reasonable for VSP to approach the Bankruptcy Court to modify its Lift Stay Order to allow VSP to pursue its independent claims. It appears that VSP did make this approach and that the Bankruptcy Court said no. That seems like an abuse of discretion to me. Would the outcome have been different if VSP had appealed based on an abuse of discretion? Probably not. This is so because courts of appeals are reluctant to reverse orders based upon an abuse of discretion.
At the end of the day, I am appalled that VSP told the California State Court that it could ignore the Bankruptcy Court's orders. However, I am also left wondering why the Bankruptcy Court refused to modify its order. It seems clear to me (someone who had no participation in the case) that the Lift Stay Order did not anticipate VSP discovering independent claims against VSP. The Lift Stay Order made perfect sense in the original context but led to jarring consequences later.
I am left with two final conclusions. The first is that bankruptcy jurisdiction is simultaneously straightforward and incredibly complex at the same time. Most of the time, it is easy to apply "arising under," "arising in" and "related to." Then there are mind-splitting cases like the present one where it is easy to go down a rabbit hole and fall into a Through the Looking Glass world. The second conclusion is that in real life, it is impossible to anticipate every contingency that may arise. Courts should be willing to be flexible in interpreting orders that were not intended to deal with a specific situation. (Caveat: There may be other facts that are not apparent from the opinion that invalidate my conclusions).
This case just leaves a bad taste in my mouth and makes my head hurt. On rare occasions, I have opined that the Fifth Circuit reached a terribly erroneous result. This is not one of those cases. It is a bad result but not necessarily a bad opinion.
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