On July 15, 2013, the US Court of Appeals for the Second Circuit, in Residential Capital, LLC v. Federal Housing Finance Agency (In re Residential Capital, LLC), ruled by summary order that the automatic stay under section 362(a) of the Bankruptcy Code may apply to certain non-debtor entities if a suit against those entities would have an immediate adverse economic consequence for the debtor's estate. Although the Second Circuit's decision does not have precedential effect, litigants should be aware that proceedings against companies that are corporate parents or affiliates of a debtor in bankruptcy may be subject to the automatic stay, if that action would have an immediate adverse economic consequences for the debtor's estate.

On May 14, 2012, after the mortgage securitizer Residential Capital, LLC (ResCap) filed a petition for bankruptcy under Chapter 11, actions directly against ResCap were automatically stayed under section 362 of the Bankruptcy Code. One of these actions involved the Federal Housing Finance Agency (FHFA), conservator of Freddie Mac, which sued ResCap and its non-debtor corporate parents and affiliate (Non-debtor Affiliates) in 2007 for violating federal and state laws in connection with ResCap's sale of mortgage-backed securities to Freddie Mac. Because ResCap was protected by the automatic stay, FHFA amended its complaint to remove ResCap as a defendant, but continued its suit against the Non-debtor Affiliates.

On May 25, 2012, ResCap filed an adversary proceeding in the US Bankruptcy Court for the Southern District of New York, seeking a declaratory judgment that under section 362(a) of the Bankruptcy Code, the automatic stay applies to the FHFA action against the Non-debtor Affiliates. Alternatively, ResCap requested that the court exercise its equitable powers under section 105(a) of the Bankruptcy Code to extend the stay to the Non-debtor Affiliates. The US District Court for the Southern District of New York withdrew the case from the Bankruptcy Court to the District Court.

In an unwritten bench decision, the District Court denied ResCap's motion to stay the FHFA action. The District Court held that the automatic stay does not apply to the Non-debtor Affiliates under section 362, because it applies only to debtors and their property. The District Court also held that it was precluded from granting ResCap's request for a stay under section 105(a) because of the federal prohibition against judicially-imposed stays of agency-conservator actions under section 4617(f) of the Housing and Economic Recovery Act of 2008 (HERA).

ResCap appealed the District Court's ruling to the Second Circuit.

In remanding the case to the District Court, the Second Circuit noted its decision in Queenie, Ltd. v. Nygard, International in which it ruled that although section 362's automatic stay does not normally apply to non-debtors, it could apply to a claim against a non-debtor entity if the claim had "immediate adverse economic consequences for the debtor's estate." In that case, the Second Circuit held that the automatic stay applied to an action against a debtor's wholly owned non-debtor subsidiary.

In In re Residential Capital, LLC, the Second Circuit determined that the District Court denied applying section 362 to the Non-debtor Affiliates categorically, without engaging in a fact-finding inquiry as to whether an action against them would have immediate adverse economic consequences for ResCap's estate. Therefore, the Second Circuit remanded the case to the District Court, ordering it to supplement the record on that issue. The Second Circuit also stated it would not discuss whether section 4617(f) of the HERA bars application of section 362(a)'s automatic stay until the District Court has determined whether the automatic stay applies in this case.

On August 12, 2013, the District Court supplemented the record and held that ResCap would not be subject to any immediate adverse economic consequences as a result of the litigation against the Non-debtor Affiliates. Therefore, it ruled that the automatic stay does not apply to the Non-debtor Affiliates.

Even though In re Residential Capital, LLC technically does not have precedential effect, litigants should be aware that proceedings against companies that are corporate parents or affiliates of debtors in bankruptcy may be subject to the automatic stay if the action would have an immediate adverse economic consequence for the debtor's estate. This decision clarifies that the Second Circuit's earlier decision in Queenie is not limited to staying actions against wholly owned subsidiaries of the debtor, but may also apply to stay actions against other types of non-debtor entities that would result in immediate adverse economic consequences for the debtor's estate.

For more information on the automatic stay, see Practice Note, Automatic Stay: Overview.