A Review of Proactive Remedies to Prevent a Debtor’s Dissipation of Assets During Litigation (Injunctive Relief and Other Remedies in a Post-Grupo Mexicano World)January 26, 2011 | Michael F. Schmitz, Esq.
When unsecured creditors file suit, their ultimate objective is to obtain an enforceable money judgment. With heavy dockets and backlogged courts, adjudication from complaint to judgment can often take months, if not years. As such, creditors should explore all potential remedies available to prevent the dissipation of the debtor’s assets during litigation, especially where such dissipation is threatened by the debtor or otherwise suspected.
I. Preliminary Injunctions
United States courts have traditionally frowned upon the use of a preliminary injunction by an unsecured creditor to enjoy a debtor from disposing of its assets pending adjudication of a contract claim for money damages.
Since 1892, United States courts have consistently refused to grant unsecured creditors preliminary injunctions to restrain debtors from transferring assets. In Campbell v. Ernest, 19 N.Y.S. 123, 64 Hun 188, 22 Civ. Proc. R. 218 (1892), an action on contract by an unsecured creditor for the recovery of money only, the court held that “the plaintiff in such an action has no rights as against the property of the defendant until he obtains a judgment, and until then he has no legal right to interfere with the defendant in the use and sale of the same."
In Grupo Mexicano de Desarrollo, S.A. v. Alliance Bond Fund, 527 U.S. 308, 119 S. Ct. 1961, 144 L. Ed. 2d 319 (1999), the Supreme Court reaffirmed the general rule that an unsecured creditor suing to collect a debt was not entitled to preliminary injunctive relief to prevent the debtor's dissipation of assets prior to judgment. In a 5-4 decision, the majority first noted that Rule 65 could not be extended to grant preliminary injunctive relief beyond that provided under "traditional principles of equity jurisdiction.” Id., 527 U.S. at 319, quoting 11A Wright, Miller and Kane, Federal Practice and Procedure § 2941, at 31 [2d ed]. Under those established equitable principles, the majority held that federal courts do not have the authority to interfere with a debtor's use of unencumbered property during the pendency of a creditor's money action on the debt. The majority reasoned that no provisional injunctive remedy was available because of "the substantive rule that a general creditor (one without a judgment) had no cognizable interest, either at law or in equity, in the property of his debtor, and therefore could not interfere with the debtor's use of that property.” Id., at 527 U.S. at 319-320).
Grupo Mexicano and its progeny allow three exceptions to the general prohibition against a creditor’s use of preliminary injunctions to freeze assets during litigation.
1. Grupo Mexicano does not apply where the injunction relates to the property at issue in the case.
The holding in Grupo Mexicano has been limited to use of a preliminary injunction to freeze assets of a defendant that are unrelated to the case, merely to ensure the defendant will have money to pay a future judgment.
Subsequent courts have refused to extend Grupo Mexicano to situations where the injunction sought relates to property at issue. For example, in Cangelosi v. Silar Advisors, LP (In re USA Commer. Mortg. Co.), 2010 U.S. App. LEXIS 18788 (9th Cir. Nev. Sept. 8, 2010), the court held that Grupo Mexicano was not applicable because the preliminary injunction sought related to property at issue in the case. Likewise, in Credit Agricole Indosuez v Rossiyskiy Kredit Bank, 94 NY2d 541, 548, 729 N.E.2d 683, 708 N.Y.S.2d 26 (2000), the court recognized an exception to the general rule, noting that a preliminary injunction would be warranted where "the suit involve[s] claims of the plaintiff to a specific fund, rightly regarded by the court as the subject of the action . . ., making a preliminary injunction appropriate under the express wording of that provision."
2. Grupo Mexicano does not apply where a creditor has a security interest in the assets subject to the preliminary injunction.
The holding in Grupo Mexicano has been limited to use of a preliminary injunction by unsecured creditors. Subsequent courts have held that, where the creditor has a security interest in assets subject to the preliminary injunction, Grupo Mexicano does not apply. See, e.g., Motorola, Inc. v. Abeckaser, 2009 U.S. Dist. LEXIS 40660, at fn. 4 (E.D.N.Y. May 14, 2009); III Finance Ltd. v. Aegis Consumer Funding Group, Inc., No. 99 CIV. 2579, 1999 U.S. Dist. LEXIS 10070, 1999 WL 461808, at 4 n.1 (S.D.N.Y. July 2, 1999) (distinguishing Grupo Mexicano on the grounds that the plaintiff "claims a security interest in the assets subject to the preliminary injunction").
3. Grupo Mexicano does not apply where the creditor seeks more than just money damages.
A third exception to Grupo Mexicano exists where the Plaintiff seeks more than just money damages. For example, in S. New Eng. Tel. Co. v. Global Naps, Inc., 595 F. Supp. 2d 155, 160, 2009 U.S. Dist. LEXIS 3343 (D. Mass. 2009), the court found Grupo Mexicano to be inapposite because the creditor sought injunctive relief to set aside the fraudulent conveyance, and not merely money damages. Likewise, in Credit Agricole Indosuez, supra, 94 N.Y.2d at 544-546, under the New York injunction statute, CPLR 6301, a preliminary injunction would be warranted where "the equitable relief in the case was granted under procedures independent of CPLR 6301."
II. Other Remedies
Given the general prohibition against the use of a preliminary injunction by an unsecured creditor to freeze a debtor’s assets during litigation, a savvy unsecured creditor needs to explore all other potential remedies to preserve the debtor’s assets during litigation, especially where the debtor has threatened to dissipate its assets, or such dissipation is suspected.
Courts are generally more receptive to statutory prejudgment attachment than the use of preliminary injunction.
Most states have provisions for prejudgment attachment. Such prejudgment attachment statutes can effectively provide the same relief as a preliminary injunction, and the judicial prohibition of Grupo Mexicano does not apply to these statutory provisions.
For example, in Scratch Golf Co. v. Dunes West Residential Golf Props., 361 S.C. 117, 123, 603 S.E.2d 905, 2004 S.C. LEXIS 236 (S.C. 2004), the court reversed the grant of a preliminary injunction freezing the debtor’s assets, but remanded the case for consideration of whether prejudgment attachment was appropriate.
Like a preliminary injunction to freeze assets, prejudgment attachment enables a creditor to preserve the value of a potential judgment after a court action is filed but before it has been concluded by preventing debtors from transferring, encumbering, dissipating or concealing assets available to satisfy the judgments. Such a remedy is temporary, and can only be pursued in connection with a complaint on the underlying claim.
Prejudgment attachment is purely a statutory remedy, and the prejudgment attachment statutes are subject to strict construction. As a cautionary note, a creditor must follow statutory guidelines in applying for prejudgment attachment, and the penalties for abusing this process are severe and might result in liability for "wrongful attachment.”
Most states include relatively onerous notice and hearing requirements in their prejudgment attachment statutes. At the hearing, the court will look to several issues, namely: whether the plaintiff has a right to attach, in general; whether the plaintiff may attach particular property; whether the plaintiff will probably prevail in the action; and whether an individual defendant has a right to an exemption as to certain property. The creditor moving for prejudgment attachment has the burden of proof, and specifically must prove that the claim is one on which an attachment may issue; the probable validity of the underlying claim; and that the attachment is not sought for any purpose other than to secure recovery on the underlying claim.
Lastly, before such an order issues, most prejudgment attachment statutes require the undertaking of a bond. The purpose of the bond is to secure any damages the debtor may incur should the attachment later be found to have been wrongful.
The appointment of a receiver can effectively prevent the debtor from dissipating assets.
A receiver is an "officer of the court" who is appointed by the court to manage a business, often to protect the debtor company for the benefit of all of its creditors. A receiver is usually sought by a creditor, and is typically appointed early in a case. A receiver may be appointed under either federal or state statutes; a federal receivership might be indicated where assets are located in more than one jurisdiction.
A receiver is analogous to a bankruptcy trustee. The receiver controls all the debtor’s assets and operates the business. If possible, the receiver will attempt to turn the business around, or in the alternative, liquidate the assets of the business. Appointment of a receiver is an extraordinary remedy, and such relief is granted only in cases of clear necessity.
Receiverships have several advantages. Primarily, in most cases, the cost of a receivership is often lower than a bankruptcy. Further, a receivership action has fewer procedural rules and statutory regulations than a bankruptcy, and therefore there is greater flexibility within a receivership than a proceeding under the Bankruptcy Code.
Bankruptcy law, however, is more developed, and therefore bankruptcy is a more predictable process than a receivership. Further, if not checked by the court, the receiver’s fees and expenses can become more costly than an involuntary bankruptcy. Further, the Receiver is a “Super Creditor,” who will get paid first, even before secured creditors. Lastly, creditors, and specifically the petitioning creditor, can be liable for receiver’s fees and expenses, if the assets of the debtor are not sufficient to cover the cost of the receivership.
An involuntary bankruptcy can be used to marshal and preserve the debtor’s assets.
In appropriate cases, if a creditor suspects that a debtor is dissipating assets and intends to not pay debts, the creditors can force the debtor into bankruptcy by filing for an "involuntary bankruptcy" under Section 303 of the Bankruptcy Code.
If successful, forcing the debtor into an involuntary bankruptcy compels the distribution of the debtor's assets for the benefit of all the creditors in accordance with bankruptcy laws. However, creditors must be judicious in their use of involuntary bankruptcy as a remedy, because the filing of an involuntary bankruptcy tends to severely and adversely affect the debtor's financial reputation and business operations. If the petition for involuntary bankruptcy is dismissed, the court will likely award the debtor its costs and reasonable attorneys’ fees for defending the suit. Further, if the court finds that the petition for involuntary bankruptcy was filed "in bad faith," it may award the debtor his actual damages caused by your filing as well as punitive damages.
Although Grupo Mexicano reaffirmed the limitations to the use of preliminary injunctions by unsecured creditors to freeze debtors’ assets during litigation, there are exceptions to Grupo Mexicano which allow such injunctive relief in certain limited circumstances. Further, there are other remedies available which could allow a creditor to marshal and preserve the debtor’s assets during litigation, especially where the creditor suspects that the debtor will transfer assets so as to render any judgment meaningless.