October 13, 2020

Regulator or Creditor: When is Enforcement of Consumer Protection Laws Exempt from the Automatic Stay, and Who Makes That Determination?

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Can state regulatory agencies move ahead with lawsuits against businesses who file for bankruptcy in order to enforce consumer protection and business laws, or does the automatic stay’s broad injunctive sweep capture those actions? The answer depends on whether the state is acting in its regulatory capacity or simply like another creditor – and the distinction is not always clear.

The intersection of the automatic stay and the “police power” exception to it surfaced recently when, on September 30, 2020, New York’s Attorney General filed a lawsuit in the Supreme Court of the State of New York, County of New York against Town Sports International, LLC (“Town Sports”), a sports club and gym operator that recently sought chapter 11 bankruptcy protection in the United States Bankruptcy Court for the District of Delaware.1  The complaint alleges that Town Sports committed fraud and engaged in deceptive acts and practices in violation of various applicable state laws when, among other things, Town Sports failed to honor some members’ cancellation requests and continued charging monthly fees despite Town Sports’ gyms being closed due to the Covid-19 pandemic.2  In its request for relief, the New York Attorney General asked the court to order Town Sports to transfer a $250,000 bond to the New York Attorney General, grant restitution for affected customers in New York, disgorge all ill-gotten gains, and impose monetary penalties.3

Given Town Sports’ pending bankruptcy case, a court will need to determine whether the attorney general’s lawsuit runs afoul of the automatic stay, which bars the initiation or continuation of most litigation against the debtor, or whether it fits within the “police power” exception to the automatic stay.  Under that exception, actions are not stayed to the extent they seek only “the enforcement of a judgment other than a money judgment, obtained in an action or proceeding by the governmental unit to enforce such governmental unit’s or organization’s police or regulatory power.”4  Indeed, the New York Attorney General expressly cited that exception in the complaint it filed against Town Sports in arguing the automatic stay did not apply to its lawsuit.5  Town Sports, on the other hand, disagreed and proceeded to submit a letter to the New York court arguing that the attorney general’s suit was stayed by its bankruptcy filing.

In resolving this dispute, the first question will be which court is entitled to resolve automatic stay disputes like this one: the state court or the bankruptcy court?  Courts are split on this question, which is further complicated by the bankruptcy court’s congressionally enacted – and limited – jurisdictional scheme and the Rooker-Feldman doctrine.6  In short, Congress appears to have provided bankruptcy courts and state courts with concurrent jurisdiction over some proceedings while a bankruptcy case is ongoing, including lawsuits that are related to the bankruptcy case, like the one filed by New York’s Attorney General.7  Some circuits and bankruptcy courts have ruled that, as a result, state courts do have jurisdiction to decide whether the automatic stay enjoins a proceeding  before them from moving forward.8  But other courts, including the Ninth Circuit, for example, have disagreed and instead concluded that such a decision is within the exclusive province of bankruptcy courts.9  It remains to be seen whether the state court will take up the issue independently or will defer to the bankruptcy court in determining whether the stay applies to the Town Sports lawsuit here.

Even if the attorney general’s lawsuit is allowed to proceed, some limitations will remain as to the extent of relief that the attorney general will be able to obtain.10  As noted above, the Bankruptcy Code permits the pursuit only of judgments “other than … money judgment[s]” from the automatic stay’s injunctive reach.  Courts have grappled with this apparent exception-to-the-exception in several different ways.  But all focus, to some degree, on the extent to which the state agencies are exercising their police powers, and seeking non-monetary relief, as opposed to acting like an ordinary creditor and seeking monetary relief.

In United States v. Nicolet, Inc., for instance, the Third Circuit noted that “the Bankruptcy Code does not set out criteria for determining when a regulatory agency is seeking the impermissible ‘enforcement of a money judgment.’”  Instead, each court must determine whether a particular action fits “the ‘paradigm’ for such a proceeding…where the plaintiff attempts to seize the debtor’s property to satisfy the judgment.”11  Other circuits have approached this issue similarly.

The Second Circuit, in SEC v. Brennan, for example, vacated a federal district court judge’s order requiring a debtor to repatriate assets from an offshore asset protection trust in connection with an SEC-prosecuted action.  The court drew a distinction between the entry of a money judgment in a case brought by a government regulator, which the court allowed to proceed, and collection of that judgment, which the court did not allow to proceed, holding: “. . .up to the moment when liability is definitively fixed by entry of judgment, the government is acting in its police or regulatory capacity–in the public interest. . .[h]owever, once liability is fixed and a money judgment has been entered, the government necessarily acts only to vindicate its own interest in collecting its judgment.”12

Some courts have opted to deploy one of two different tests to determine whether a government unit is acting within its police powers or merely as a regular creditor: the “pecuniary purpose” test and the “public policy” test.  Under the pecuniary purpose test, “reviewing courts focus on whether the governmental proceeding relates primarily to the protection of the government’s pecuniary interest in the debtor’ property and not to matters of public safety. Those proceedings which relate primarily to matters of public safety are excepted from the stay.” 13 Under the public policy test, on the other hand, “reviewing courts must distinguish between proceedings that adjudicate private rights and those that effectuate public policy. Those proceedings that effectuate a public policy are excepted from the stay.”14

Ultimately, the question of whether or not the Town Sports lawsuit will be allowed to proceed will likely come down to whether the New York Attorney General is deemed to largely be pursuing a money judgment, or not.  If the court (whether the New York state court or Delaware bankruptcy court) determines that she is, the action will likely be deemed barred by the automatic stay.  If, on the other hand, the New York Attorney General is deemed to be seeking consumer or other regulatory relief, the suit, or at least certain aspects of it, may be allowed to proceed.  Either way, the ruling may impact the extent to which other states seek to obtain consumer or regulatory relief against entities in bankruptcy, particularly in the context of consumer protection laws impacted by the Covid-19 shutdowns.

1 Aisha Al-Muslim, State Sues New York Sports Clubs Owner Over Fees for Closed Gyms, Wall St. J.: WSJ Pro Bankruptcy (Sept. 30, 2020, 6:31 PM), https://www.wsj.com/articles/state-sues-new-york-sports-clubs-owner-over-fees-for-closed-gyms-11601505075.

2 State of New York v. Town Sports International Holdings, Inc., at 9 & 20-23, No. 451969-2020 (N.Y. Sup. Ct. verified petition filed Sept. 30, 2020) [hereinafter Petition].  Town Sports International Holdings, Inc. has not filed for bankruptcy.

3 Id. at 24-25.

4 11 U.S.C. § 362b(4).

5 Petition, supra note 2, at 4 n.8.

6 Michael L. Bernstein & George W. Kuney, Bankruptcy in Practice 55 (Charles J. Tabb, 5th ed. 2015).

7 See 28 U.S.C. §§ 157(a), 1334(a-b).

8 See Singleton v. Fifth Third Bank (In re Singleton), 230 B.R. 533 (6th Cir. BAP 1999); see also Siskin v. Complete Aircraft Servs. (In re Siskin), 258 B.R. 554 (Bankr. E.D.N.Y. 2001).

9 See Gruntz v. County of Los Angeles (In re Gruntz), 202 F.3d 1074 (9th Cir. 2000).

10 Bernstein & Kuney, supra note 6, at 162-63.

11 857 F.2d 202, 209 (3d Cir. 1988 (quoting Penn Terra Ltd. v. Dep’t of Envtl. Resources, 733 F.2d 267, 272 (3d Cir. 1984))).

12 230 F.3d 65, 71 (2d Cir. 2000).

13 Chao v. Hospital Staffing Serv., Inc., 270 F.3d 374, 385-86 (6th Cir. 2001).

14 Id.

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