Klein serves as a cautionary tale to “think twice”—and perhaps consult bankruptcy counsel—before taking actions that could potentially implicate estate property.
Before a debtor files for bankruptcy, creditors often scramble to seize its assets, a process dubbed the “race to the courthouse.” Once the debtor files for bankruptcy, the automatic stay (11 U.S.C. § 362) is intended to halt this race, level the playing field and promote the goal of equality of distribution.
In In re Klein, 669 B.R. 877 (Bankr. C.D. Cal. 2025), the United States Bankruptcy Court for the Central District of California held that a sanctionable violation of the automatic stay occurred when certain parties filed state court actions in an effort to take possession of or exercise control over the estate’s “bundle of rights,” comprising (1) the debtor’s 50 percent interest in an LLC and (2) an avoidance action already commenced by the trustee concerning that interest.
Background
Chapter 11 debtor Leslie Klein held a 50 percent membership interest in Life Capital Group LLC. Prior to his petition date, the debtor released his rights to distributions from the residual proceeds of certain life insurance policies governed by the terms and conditions of Life Capital’s operating agreement. The face value of these policies was said to exceed $30 million. On January 23, 2025, the Chapter 11 trustee of the debtor’s estate laid claim to these rights in an adversary proceeding against Life Capital and others to avoid the debtor’s release of those rights as a preference and/or fraudulent transfer.
More than a month later, Leslie Klein & Associates Inc. (LKA) and EKLK Foundation filed an action in California state court asserting rights in the same insurance proceeds at issue in the adversary proceeding. That same day, EKLK filed another action in California state court asserting an interest in the same proceeds.
In response to the state court actions, the trustee moved for an order enforcing the automatic stay and imposing sanctions against the debtor, LKA, EKLK and certain other parties (collectively, respondents). The trustee argued that the respondents violated the stay by asserting competing claims outside the Bankruptcy Court to take control of insurance proceeds in which the estate had already asserted an interest. The respondents argued that the actions did not implicate estate property because they allegedly were entitled to the proceeds prior to any distribution to the debtor who, at best, had only an indirect interest in the proceeds.
The Bankruptcy Court’s Ruling
The bankruptcy court evaluated whether the respondents violated 11 U.S.C. § 362(a)(3), which stays “any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate.” The court noted that it is not necessary to succeed in gaining control over estate property to run afoul of Section 362(a)(3). Rather, the mere act to obtain possession of or exercise control over estate property can violate the stay even if it is not successful.
The court looked to the Ninth Circuit Court of Appeals’ three-part test to determine whether a creditor has violated Section 362(a)(3), set forth in In re Bialac, 712 F.2d 426, 429 (9th Cir. 1983): (1) whether a property interest existed; (2) if so, whether the property is “of the estate” under 11 U.S.C. § 541; and (3) “if the property was altered in any manner contrary to the relevant provisions of 11 U.S.C. § 362(a).”
Here, the court found that all three elements were satisfied. First, the debtor’s 50 percent interest in Life Capital was “property,” as were the trustee’s legal claims asserted in the adversary proceeding. Second, this property was “of the estate” and consisted of the estate’s “bundle of rights” in the ownership interest and adversary proceeding claims. Third, respondents altered that bundle of rights in a manner contrary to the provisions of Section 362(a). Specifically, by filing the state court actions, which claimed superior rights in the insurance proceeds, respondents “assert[ed] competing interests in the very same property that the Trustee is seeking to recover for the benefit of the estate.”
Accordingly, the court held that the respondents violated Section (a)(3). In addition, the court held respondents in civil contempt, finding no “objectively reasonable basis” for respondents to believe that that their actions did not violate the stay. Monetary sanctions were to be assessed in subsequent proceedings.
Conclusion
Klein serves as a cautionary tale to “think twice”—and perhaps consult bankruptcy counsel—before taking actions that could potentially implicate estate property. As the court pointed out in Klein, the respondents could have properly pursued the state court actions—and avoided the trouble they found themselves in—had they sought and obtained stay relief rather than attempt an “end run” around the trustee and bankruptcy court.
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