Dismissals of Bankruptcies Filed in Bad Faith Whats the Standard

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Dec/Jan 2004

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The term "bad
faith" is one that creditors tend to throw out unabashedly. To some,
every bankruptcy is in bad faith because the debtor is not satisfying its
obligations. Those obligations, however, become a part of the bankruptcy
estate and are satisfied through bankruptcy proceedings as Congress
intended—that debtors could restructure their debts without the
consent of their creditors. Reorganizing without creditor consent is
crucial to the success of reorganization proceedings, as demonstrated by
the global movement to adopt insolvency laws similar to the U.S. Bankruptcy
Code.

Yet even the Code has its limits, as Congress
certainly did not intend to create a system for abuse. There are those that
will abuse any legal system and otherwise act in bad faith. The problem with bad faith is
defining it, as there is a fine line between utilizing the provisions of
the Code and abusing them. Without a definition, parties have been left to
argue over the appropriate standard.

<h4>Defining Bad Faith</h4>

Though the Code contemplates dismissal of a
bankruptcy case "for cause," bad faith is not enumerated as
cause. See 11
U.S.C. §1112. Similarly, the Code contains no requirement that
bankruptcy petitions must be filed in good faith. Nonetheless, most courts
have expressly interpreted §1112(b) to include dismissal of a chapter
11 case due to "the lack of good faith in its filing." See, e.g., In re Humble Place Joint Venture, 936 F.2d 814, 816-17 (5th Cir. 1991). Other courts have
held that "an implicit prerequisite to the right to file [a chapter
11 petition] is good faith on the part of the debtor, the absence of which
may constitute cause for dismissal...." Carolin
Corp. v. Miller, 886 F.2d 693, 698 (4th Cir.
1989) (citing In re Winshall Settlor's
Trust, 758 F.2d 1136, 1137 (6th Cir. 1985)).

Indeed, "[e]very bankruptcy statute since
1898," including the current Code, has "incorporated literally,
or by judicial interpretation, a standard of good faith for the
commencement, prosecution and confirmation of bankruptcy
proceedings." In re Little Creek
Develop. Co., 779 F.2d 1068, 1071-72 (5th Cir.
1986). This good-faith requirement exists (1) to prevent the "abuse
of the bankruptcy process by debtors whose overriding motive is to delay
creditors without benefiting them in any way" and (2) as a means to
protect "the jurisdictional integrity of the bankruptcy courts"
by making the Code only available to debtors with "clean
hands." Id. at
1072.

In determining whether to dismiss a bankruptcy for
lack of good faith, most courts apply a totality-of-the-circumstances
inquiry. While there is no specific test or exhaustive list of factors for
determining bad faith, courts often consider factors that evidence the intent to abuse the judicial
process and the purposes of reorganization. See, e.g., Rollex v. Associated
Materials Inc., 14 F.3d 240 (4th Cir. 1994).
In particular, certain courts consider factors that demonstrate an intent
to "delay or frustrate the legitimate efforts of secured creditors to
enforce their rights," Albany Partners
Ltd. v. Westbrook (In re Albany Partners Ltd.),
749 F.2d 670, 674 (11th Cir. 1984), such as when a debtor files for
bankruptcy to prevent a shareholder lawsuit with no intent of effectuating
a valid reorganization plan. Cedar Shore Resort
Inc. v. Mueller, 235 F.3d 375 (8th Cir. 2000).

While a specific bad-faith test has not been
established, courts have identified certain factors that necessitate the
dismissal of a particular case as a bad-faith filing. These factors
include, but are not limited to, whether:

<ol><li>The bankruptcy estate is composed of one asset
(which is often a single tract of real property);
</li><li>The secured creditor's liens encumber the
tract of real property;
</li><li>There are typically no employees other than the
principals of the debtor;
</li><li>The debtor has little or no cash flow;
</li><li>No available sources of income are available to
sustain a reorganization plan;

</li><li>Few, if any, unsecured creditors exist (and whose
claims are relatively small);
</li><li>The property has been scheduled for foreclosure due
to lack of debt payments;
</li><li>Bankruptcy was filed as the last option to prevent
loss of the property; and
</li><li>Allegations are made of wrongdoing by the debtor or
its principals.
</li></ol>

See Little Creek, 779 F.2d
at 1073.

Satisfaction of each factor is not necessary to
establish bad faith. Instead, when the "conglomerate" of such
is met, dismissal is appropriate, as "[r]esort[ing] to the protection
of the bankruptcy laws is not proper" when "there is no hope of
rehabilitation...." Id.; see, also, C-TC 9th Avenue
Partnership v. Norton Co., 113 F.3d 1304 (2d
Cir. 1997) (dismissing chapter 11 bankruptcy proceeding because debtor
never had any intention of reorganizing).

It is important to note that the lack of intent to
act in bad faith does not necessarily result in retention of an alleged
bad-faith filing. In fact, the enumerated grounds for dismissing a
bankruptcy case resemble certain bad-faith factors without a requisite
level of intent. See 11 U.S.C. §1112(b).

<h4>When Bad Faith Doesn't Exist, But Dismissal Is Otherwise Appropriate</h4>

In addition to a finding of bad faith, a bankruptcy
court may also dismiss a "case for cause, if it is in the best
interest of the creditors and the estate." See In re Primestone Investment Partners L.P., 272 B.R. 554, 555 (D. Del. 2002). Specifically, §1112(b)
states that "on request of a party in interest...and after notice and
a hearing, the court may...dismiss a case" under chapter 11 for
cause, including for a "continuing loss to or diminution of the
estate and [an] absence of a reasonable likelihood of
rehabilitation...." 11 U.S.C. §1112(b)(1). In fact, once a
court determines that "there is an absence of a reasonable likelihood
of rehabilitation" or that a "debtor is suffering continuing
losses without the prospect for reorganization," dismissal is
appropriate pursuant to §1112(b)(1). See
In re Abijoe Realty Corp., 943 F.2d 121 (1st
Cir. 1991); see, also, In re Lumber Exchange
Building L.P., 968 F.2d 647 (8th Cir. 1992).

In Lumber Exchange, the debtor borrowed more than $20 million from its lender,
secured by a mortgage on the debtor's building and by an assignment
of rents and leases. See Lumber Exchange, 968 F.2d at 648. Upon filing bankruptcy, the debtor
valued its building at only $7 million, leaving the lender with a $13
million deficiency claim. The remaining claims in the debtor's
bankruptcy totaled only $1 million, nearly half of which was due to trade
creditors. Upon the lender's request for relief from the stay or, in
the alternative, dismissal of the case, the debtor filed a plan in which it
classified the lender's deficiency claim separately from the other
general unsecured claims in the case.

The facts in Lumber Exchange evidenced that the lender would
not accept any treatment not providing for surrender of the building or
payment in full of its claim. Therefore, the debtor could only confirm a
plan under the cramdown provisions of 11 U.S.C. §1129, which require
that an impaired class accept its treatment of the plan. Allowing separate
classification of the lender's deficiency claim enabled the debtor to
create a separate class of unsecured creditors made up of trade creditors
that could accept the plan; however, if such a classification were
improper, the debtor could not confirm its plan.

<blockquote><blockquote>
<hr>
<big><center>
Courts have generally held that the Code grants authority to dismiss a bankruptcy case that was filed in bad faith.
</center></big>
<hr>
</blockquote></blockquote>

The Eighth Circuit followed the Fifth Circuit's
decision in Greystone in stating that "[a] debtor may classify substantially
similar claims separately for 'reasons independent of the
debtor's motivation to secure the vote of an impaired, assenting
class of claims.'" Id. at 649 (quoting Phoenix Mutual
Life Ins. Co. v. Greystone III Joint Venture, 948
F.2d 134, 139 (5th Cir. 1991)). Therefore, because the debtor had
demonstrated no legitimate reason for separate classification, the court
concluded "that separate classification was a thinly veiled attempt
to manipulate the vote to assure acceptance of the plan by an impaired
class and meet the requirements of 11 U.S.C. §1129(a)(10)." Id. at 650. In addition, since
the debtor could not propose a confirmable plan that did not improperly
classify creditors, the Eighth Circuit held that the bankruptcy court
properly dismissed the case. Id.

As demonstrated by case law, the standards for
dismissing in the best interests of creditors and the standards for
bad-faith dismissal are often similar. A case like Lumber Exchange may draw motions
to dismiss for bad faith and/or under §1112(b)'s enumerated
grounds. The difference is the intent, but even the lack of an improper
intent does not mean that a court should retain a bankruptcy case.

<h4>Conclusion</h4>

Courts have generally held that the Code grants
authority to dismiss a bankruptcy case that was filed in bad faith. Bad
faith, however, is often tricky to demonstrate.

Fortunately, Congress enacted §1112(b) and
stated the circumstances where dismissal is appropriate regardless of
whether any evidence of intent exists. These grounds are often the relief
needed for dismissing or converting a case that just doesn't belong
in chapter 11.

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Wednesday, December 1, 2004 - 12:00

Bankruptcy Rule

2004