In Ritchie Capital Management v. McGladrey & Pullen, 2020 IL App (1st) 180806, 155 N.E.3d 597, reh’g denied (Apr. 29, 2020), appeal denied, 159 N.E.3d 935 (Ill. 2020), the Illinois Appellate Court affirmed a state trial court’s order dismissing, as time-barred, a complaint filed more than nine years after the cause of action had accrued. In doing so, the appellate court found that the plaintiffs’ claims had not been “automatically” stayed pursuant to Section 362 of the Bankruptcy Code. As a result, the statute of limitations applicable to those claims had not been tolled.

Background

In October 2008, a group of hedge funds known collectively as the “Lancelot Funds” filed for bankruptcy protection under Chapter 7 of the Bankruptcy Code. During the Chapter 7 case, several investors filed lawsuits related to the Lancelot Funds, seeking recovery from nondebtor third parties based on claims arising out of alleged professional malpractice. The Chapter 7 trustee administering the Lancelot Funds’ bankruptcy estate opposed the investor actions under Section 541 of the Bankruptcy Code, arguing that the investors’ claims against a group of accounting firms and their principals (collectively referred to herein as McGladrey) who had audited the Lancelot Funds pre-bankruptcy were property of the bankruptcy estate. The trustee asserted, therefore, that the investors’ lawsuits were barred by operation of the automatic stay of Section 362 of the Bankruptcy Code. Nonetheless, one group of investors known as “McKinley” proceeded with its state court action against McGladrey for professional malpractice and negligent misrepresentation.

In July 2009, the bankruptcy court ruled that McKinley’s claims against McGladrey were property of the debtors’ estate under Section 541 of the Bankruptcy Code and, consequently, were subject to the automatic stay. The bankruptcy court further opined that the trustee would be entitled to injunctive relief even if the investors’ claims were not estate property because such claims were “substantially related to the estate.” In so finding, the bankruptcy court cited its general equity powers under Section 105 of the Bankruptcy Code, which authorizes bankruptcy courts to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions” of the Code.  The bankruptcy court provided this alternative basis for its holding based on substantial similarities between the trustee’s action against McKinley and the case of Fisher v. Apostolou, 155 F.3d 876 (7th Cir. 1998). In Fisher, a Chapter 7 trustee successfully sought to enjoin allegedly defrauded investors from pursuing a non-debtor party against whom the trustee had commenced an adversary proceeding in the bankruptcy case. Reviewing the bankruptcy court’s injunction, the Fisher court rejected the application of the automatic stay to the investors’ claims, but affirmed the bankruptcy court’s use of its general equity powers under Section 105 to enjoin the claims. In citing to Fisher, the bankruptcy court applied Section 105 and issued an order enjoining McKinley’s claims, finding that such injunctive relief was warranted in order to “promote the general policies of bankruptcy and an orderly administration of the estate.” The injunctive order was subsequently dissolved in September 2015.

We next fast forward to May 2017, less than two years following dissolution of the bankruptcy court’s injunction. At that time, Ritchie Capital Management, yet another group of investment companies that had invested in the Lancelot Funds, commenced its own state court action against McGladrey asserting claims including fraud, misrepresentation, and professional malpractice. Because more than nine years had passed since McGladrey had engaged in the alleged malpractice, McGladrey sought to dismiss the action, arguing that the applicable two-year statute of limitations and the five-year statute of repose each imposed by the Illinois Code of Civil Procedure barred Ritchie’s claims. The trial court agreed, dismissing Ritchie’s complaint with prejudice in December 2017 and finding that Ritchie should have brought its claims within the applicable statutes of limitations that had begun to run in 2008, when the alleged wrongdoing occurred. The trial court rejected Ritchie’s argument that the automatic stay of the Bankruptcy Code applied to actions against McGladrey, noting that McGladrey was not the party that had filed for bankruptcy protection; therefore, the automatic stay of Code Section 362 did not “automatically” extend to actions against McGladrey. The trial court further found that the bankruptcy court’s injunction that was directed specifically to McKinley in no way enjoined Ritchie’s claims, nor did that injunction extend the automatic stay to any party other than McKinley. The trial court concluded that, by failing to file its suit earlier and present the bankruptcy court with the opportunity to stay the case, Ritchie had sat on its rights. After the trial court denied Ritchie’s motion to reconsider, Ritchie appealed.

Discussion

On appeal, Ritchie argued that its complaint against McGladrey had been timely filed because, pursuant to the bankruptcy court’s injunction against McKinley, all claims against McGladrey arising out of McGladrey’s audits of the Lancelot Funds (including Ritchie’s claims) were property of the bankruptcy estate and therefore barred by the automatic stay. Section 13-216 of the Illinois Code tolls the statute of limitations for a civil action “when the commencement of an action is stayed by injunction, order of a court, or statutory prohibition.” Arguing that the automatic stay provisions of the Bankruptcy Code operated as a “statutory prohibition” under Section 13-216, Ritchie asserted that the applicable statute of limitations had been tolled until the dissolution of the bankruptcy court’s injunction in September 2015. Thus, Ritchie argued, its action against McGladrey was timely because it had been filed before the two-year statute of limitations expired in September 2017. Ritchie further asserted that McGladrey did not have to file for bankruptcy in order for claims against McGladrey to become property of the Lancelot Funds’ estate. Alternatively, Ritchie disputed the trial court’s conclusion that Ritchie should have filed its claims when they arose, at which time the bankruptcy court might have been called upon to exercise its Section 105 authority and enter an order staying such claims; Ritchie argued that because such claims were void ab initio, Ritchie’s filing of these claims in state court would have exposed Ritchie to possible bankruptcy court sanctions.

The appellate court rejected Ritchie’s arguments and affirmed the dismissal. First, the court found that the automatic stay had not tolled the statute of limitations. The appellate court reiterated that the bankruptcy court’s injunction, on which Ritchie heavily relied, had provided two alternative justifications for barring McKinley’s suit against McGladrey: the automatic stay of Section 362; and the bankruptcy court’s general equity powers under Section 105. The appellate court then noted that in Fisher (the case cited by the bankruptcy court in support of its decision to exercise its Section 105 equity powers), the U.S. Court of Appeals for the Seventh Circuit had rejected the application of the automatic stay “under remarkably similar circumstances.” Comparing the facts underlying Ritchie’s action against McGladrey to the facts in Fisher, the appellate court adopted the Fisher court’s holding and found that Ritchie’s claims might have been subject to an injunction by the bankruptcy court under Section 105 of the code; such claims were not, however, automatically stayed pursuant to Section 362 of the code. Consequently, Ritchie fell short in its argument that the automatic stay had triggered Section 13-216 of the Illinois Code and tolled the applicable statute of limitations under Illinois law.

Ritchie also ran into trouble in connection with its alternative argument.  In that regard, the appellate court found that Ritchie’s claims were not barred by the bankruptcy court’s earlier McKinley injunction under Section 105 of the Bankruptcy Code. Ritchie had argued that the injunction expressly forbade all investors from pursuing claims against McGladrey while the Chapter 7 trustee was pursuing a claim against McGladrey. Thus, Ritchie argued, it was not “obligated” to file its suit upon learning of McGladrey’s alleged wrongdoing, because such a suit was void ab initio and would have exposed Ritchie to sanctions. The appellate court rejected these arguments and noted that a number of parties had brought actions against McGladrey following entry of the McKinley injunction. Most significantly, the appellate court noted that another group of plaintiffs known as the “Tradex” plaintiffs had commenced a suit against McGladrey in Illinois state court after the McKinley injunction had been entered. In that case, the bankruptcy court had issued a separate order staying the Tradex suit without entering any sanctions against the Tradex plaintiffs. The appellate court concluded that, “as demonstrated by the bankruptcy court’s orders involving the McKinley plaintiffs’ and the Tradex plaintiffs’ claims, Section 105 injunctions are case specific,” and thus Ritchie’s failure to file suit had deprived both the trustee and the bankruptcy court of the opportunity to intervene.  Accordingly, the appellate court found that the bankruptcy court’s injunction against McKinley did not extend to Ritchie, and held that Ritchie’s claims were time-barred.

Conclusion

Following Ritchie, parties holding potential claims against non-debtor third parties that are arguably “related to” the bankruptcy estate must weigh the risks and benefits of actively prosecuting such claims. The mere fact that a bankruptcy trustee could pursue such claims as property of the bankruptcy estate under Section 541 of the Bankruptcy Code will not be enough to argue that such claims are conclusively barred by the automatic stay. In fact, the court’s decision in Ritchie demonstrates that it is not sufficient to show that the bankruptcy trustee has already pursued other, similar claims as property of the estate. Parties wishing to preserve their claims should consider affirmatively commencing an action to give the trustee and the bankruptcy court an opportunity to intervene; the decision in Ritchie should provide them with adequate cover in the event that a zealous trustee might seek sanctions. Furthermore, potential litigants should not assume that their claims are automatically barred by a bankruptcy court’s Section 105 injunction staying similar claims against non-debtor third parties. To the contrary, the Ritchie decision illustrates that injunctions issued pursuant to the bankruptcy court’s general equity powers are case specific.

Rudolph J. Di Massa Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors’ rights.

Malcolm Bates, an associate with the firm, practices in the area of business reorganization and financial restructuring.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.