Section 105 of the Bankruptcy Code is an omnibus provision phrased in such general terms as to be the basis for a broad exercise of power in the administration of a bankruptcy case. The Bankruptcy Code states that the Bankruptcy Court may “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of the Code.”

The §105 power can be used by debtors and estates to obtain injunctions to cease suits against nondebtors, enjoin sales of property, or it may be used to prevent any action that would interfere with a successful bankruptcy reorganization. In essence, the Bankruptcy Court extends the automatic stay under §362(a) to nondebtors.

For lenders and lessors, the most common use of the §105 power has been to enjoin state or federal court actions against non-bankrupt guarantors of a corporate debt or non-bankrupt partners of a partnership debtor. The debtors often ask courts to enjoin collection action against guarantors for two common reasons.

First, it is often asserted that the guarantor, often an insider, is a potential source for funding a Chapter 11 plan. Litigation against the guarantor on claims for which the debtor is primarily liable, so the argument goes, will create waste in the form of litigation costs and a disincentive to fund the plan if the guarantor is forced to transfer its funds to the creditor who has the guaranty, rather than to the estate for the benefit of all creditors. See, e.g., Chase Manhattan Bank v. Third Eighty-Ninth Assocs. (In re Third Eighty-Ninth Assocs.) 138 B.R. 144, 146 (S.D. N.Y. 1992).

A second claim made by debtors to enjoin actions against guarantors is that the time necessary to defend a collection action, in consulting with lawyers and considering strategy, is time that the guarantor does not have to commit to assisting in the debtor’s reorganization. See, e.g., A.H. Robins Co. v. Piccinin (In re A.H. Robins Co.) 788 F.2d 994, 1008 (4th Cir. 1986); In re Ionosphere Clubs, Inc. 111 B.R. 423, 433 (Bankr. S.D. N.Y. 1990).

Whether these debtor arguments will convince the court to extend a bankruptcy stay as against a guarantor will depend on the facts of the case. See, e.g., In re Lahman Mfg. Co. 33 B.R. 681, 683 (Bankr. S.D. 1983), where the guarantor intended to sell personal property and commit sale proceeds to reorganization; continuation of collection lawsuit would impair the sale and possibly reduce proceeds. See Minnelusa Co. v. A.G. Andrikopoulous (In re Minnelusa Co.) 169 B.R. 225, 227 (Bankr. M.D. Fla. 1994), where the proposed contribution by the guarantor was only $100,000, the creditor sought to be enjoined was owed $300,000 from the guarantor and the evidence suggested the guarantor’s net assets were $1.5 million, the court did not extend the stay.

In addition, in the debtor’s quest to extend the stay to prevent a lawsuit against the guarantor, the debtor may also contend that any funds expended defending the guaranty action would be “deadweight” loss. The argument is that if the debtor’s plan will pay the creditor in full, or if the guaranty were subject to defenses, such as the invalidity of the underlying debt, all such maters should be dealt with in the debtor’s bankruptcy. This argument, coupled with a contention that the guarantor’s attention would be diverted from the reorganization, is also made by the guarantor.

These same arguments are often made with respect to the liability of a general partner of a debtor that is a partnership. In most states, general partners of any partnership are liable for the debts of the partnership, unlike the liability of guarantors, in which there is a separate contract independently bartered for and given to the creditor. Unlike the guarantor, the co-liability of partners is not subject to negotiation or contract as it arises by operation of non-bankruptcy law. However, the general partner of a partnership has a different argument than the guarantor to extend the stay since the partner did not agree by contract that it would be separately or independently liable.

Moreover, the general partner may also contend that pursuant to §723 of the Bankruptcy Code, the bankruptcy trustee has a direct right against the general partners with respect to the general partner’s assets and therefore a general partners’ assets are potentially subject to administration in the debtor’s bankruptcy any way and therefore the stay should be extended to the general partner. Pursuant to Bankruptcy Code §723(b) a Bankruptcy Court may require general partners, prior to determination of an exact deficiency, “to provide the estate with indemnity for, or assurance of payment of, any deficiency recoverable from such partner, or not to dispose of property.”

In addition, Federal Rule of Bankruptcy Procedure Rule 1007(g) specifically states that a debtor’s general partners must file financial information with the Bankruptcy Court on request by the court. Therefore, a general partner of a partnership does have further arguments regarding obtaining an injunction prohibiting a creditor from proceeding against the general partner because of his or its unique status.

On the other hand, the creditor’s argument against an injunction prohibiting the creditor to proceed against a guarantor or partner is in most instances stronger than that of the debtor. It has a bargained-for, non-bankruptcy right to pursue the guarantor independent of the debtor’s bankruptcy case.

Moreover, if the Bankruptcy Code intended to stay actions against nondebtors, the drafters would have specifically done so. By way of example, in the Chapter 13 context, there is a Chapter 13 co-debtor automatic stay with respect to consumer debt so that actions against co-signors and co-obligors are automatically stayed by the debtor’s bankruptcy [11 U.S.C. §1301(a)].

In addition, the effect of a discharge under Bankruptcy Code §524 only discharges the debts of a debtor and not third-party nondebtors. Therefore, a creditor has a very strong argument against the enforcement of an injunction to stay collection activity against nondebtors because if Congress had intended to extend the stay to nondebtors, it would have drafted such provisions into the Bankruptcy Code.

This background brings us to the recent Ninth Circuit Court of Appeals case of In re Excel Innovations, Inc., 2007 W.L. 2555941 (USCA 9th Cir.), 48 Bankr.Ct. Dec. 212 decided on September 7, 2007. The issue in Excel Innovations had nothing to do with attempting to stay an action against a nondebtor partner or guarantor.

The importance of this case has to do with what the appropriate standard is for the Bankruptcy Court to decide to issue a stay against a third-party nondebtor. This case involved a complex factual scenario whereby the debtor attempted to obtain a preliminary injunction staying an arbitration between two nondebtor parties. The debtor wanted this stay of the arbitration because, depending upon the ruling in the arbitration, the ruling could have a major effect on the debtor and the bankruptcy estate.

The traditional method in which a court decides whether an injunction will or will not issue requires four prerequisites. These prerequisites are: 1.) a substantial likelihood that the movant will prevail on the merits, 2.) a substantial threat that the movant will suffer irreparable injury if the injunction is not granted, 3.) that the threatened injury to the movant outweighs the threatened harm an injunction may cause the party opposing the injunction, and 4.) the extent in which the public interest is involved in issuing the injunction.

Applying this traditional analysis, courts balance these four factors to decide whether an injunction should or should not be issued and the burden of proof and persuasion is on the moving. The overwhelming presence of one of the factors may lead a court to issue, or to deny, an injunction without a particularly strong showing on the others. The authority of the various circuits throughout the country that have decided whether injunctions should issue staying actions against nondebtors have applied the usual preliminary injunction standard discussed above. See Am. Imaging Servs. v. Eagle-Picher Indus. Inc. (In re Eagle-Picher Indus. Inc.) 963 F.2d 855 (6th Cir. 1992); A.H. Robins Co. v. Piccinin 788 F.2d at 1008 (4th Cir. 1986); Commonwealth Oil Ref. Co. v. EPA (In re Commonwealth Oil Ref. Co.) 805 F.2d 1175, 1188-1189 (5th Cir. 1986).

The Second, Third and Eighth Circuits similarly applied the traditional standard with respect to stays that are not automatic under §362(a). See NLRB v. Superior Forwarding, Inc. 762 F.2d 695, 699 n.3 (8th Cir. 1985); Wedgewood Inv. Fund v. Wedgewood Realty Group, Ltd. (In re Wedgewood Realty Group, Ltd.) 878 F.2d 693, 700-01 (3rd Cir. 1989); Manville Corp. v. Equity Sec. Holders Comm. (In re Johns-Manville Corp.) 801 F.2d 60, 68-69 (2nd Cir. 1986).

On the other hand, the Seventh Circuit has held that the moving party need not show irreparable harm but instead must show an interference with the effective reorganization of the debtor and this may in and of itself create the irreparable harm. See Fisher v. Apostolou 155 F.3d 876, 882 (7th Cir. 1998); In re L&S Indus., Inc. 989 F.2d 929, 932 (7th Cir. 1993). The Seventh Circuit is joined in that view by the First Circuit, which also has stayed a nondebtor action without applying or discussing the usual preliminary injunction standard. See In re G.S.F. Corp. 938 F.2d 1467, 1474-76 (1st Cir. 1999) overruled on other grounds by Conn. Nat’l. Bank v. Germain 503 U.S. 249 (1992).

In the case, In re Excel, it was the Ninth Circuit’s turn to weigh in. The court stated a debtor seeking to stay an action against a nondebtor must show a reasonable likelihood of a successful reorganization. The inquiry for a preliminary injunction necessarily focuses on the outcome of a later proceeding, at which time the merits of the questions giving rise to the litigation will be decided and the injunction may or may not be dissolved. Within the confines of the adversary proceeding filed to get the injunction by the moving party (typically the debtor or trustee) there is no later proceeding at which time the debtor’s claims will reach final disposition. The relevant future proceeding is the debtor’s reorganization.

Because the debtor’s claim in Excel is ultimately that arbitration would harm its ability to reorganize, the Ninth Circuit ruled it makes sense to require a showing of a reasonable likelihood of a successful reorganization to satisfy that first prerequisite under the traditional approach discussed above. The Ninth Circuit stated that most courts have applied the usual preliminary injunction standard to applications to stay actions against nondebtors under §105(a). In granting or denying such an injunction, the Bankruptcy Court must consider whether the debtor has a reasonable likelihood of a successful reorganization, the relative hardship of the parties, and any public interest concerns if relevant.

Therefore, in this particular case, the Ninth Circuit analyzed whether the injunction should or should not issue using the traditional prerequisites for an injunction and found that although the Bankruptcy Court recited the usual preliminary injunction standard in its ruling on the injunction, it failed to properly apply it because the Bankruptcy Court had ignored debtor’s likelihood of success and the alleged harm to nondebtors in proceeding with its arbitration. Thus, the Ninth Circuit sent the case back to the Bankruptcy Court for this determination.

Actions that are stayed against nondebtors pursuant to a court’s §105 power are frustrating to creditors. However, the court looks at whether the actions by the creditor against the nondebtors will harm the successful reorganization of a debtor. As discussed above, the method and approach a court will take when it is faced with making that decision may vary from jurisdiction to jurisdiction and from case to case depending upon the facts and the balancing act done by the court.

Although more often times than not the §105 power will not be used to stay actions against nondebtors, it can happen. Therefore, creditors should be aware of the proper standards to be used in connection with such proceedings depending upon the jurisdiction involved in the proceedings until such time as the United States Supreme Court resolves this issue and determines one standard for all courts to use.

Andrew K. Alper is a partner with the law firm of Frandzel Robins Bloom & Csato, LC in Los Angeles. Alper has been representing equipment lessors, funding sources and other financial institutions since 1978. Alper obtained his Bachelor of Arts degree in Political Science, Magna Cum Laude, from the University of California at Santa Barbara and received his Juris Doctor from Loyola Marymount University School of Law making the Dean’s List.

Alper’s practice emphasizes the representation of equipment lessors and funding sources in all aspects of equipment leasing including litigation, documentation, bankruptcy and transactional matters. Besides representing equipment lessors and funding sources, Alper represents banks and other financial institutions in the area of commercial litigation, insolvency, secured transactions, banking law, real estate and business litigation.