Too Much, Too Soon: Properly Timing a Chapter 11 Case’s Bad-Faith Dismissal

Having just lost a state court suit to the tune of $1.5 million with the winner about to collect on the $1.5 million, a debtor with a substantial income files a skeletal chapter 11 petition. One creditor, the state court victor, holds more than 65 percent of the total debt, and the initial list of exempt assets is long and their value considerable. Within 69 days of the petition’s filing and with 51 days left for the debtor to propose a reorganization plan, even these verities are apparent from the skimpy record. On these facts, may the bankruptcy court dismiss the case on the basis of a “lack of good faith,” which is § 1112‌(b)’s implicit requirement?

In Sullivan v. Harnisch (In re Sullivan),[1] the Ninth Circuit Bankruptcy Appellate Panel (BAP) reversed a bankruptcy court that had said “yes,” finding reversible error and an abuse of discretion in three related failings. First, the bankruptcy court had dismissed the debtor’s case without considering whether dismissal or conversion would be in the best interests of the creditors and the estate, according undue weight to one vociferous and intransigent creditor. Second, the “very scant” record, including the “bare bones petition,” could not yet definitively substantiate the court’s inferences of bad faith. Third, no definite event had yet rendered impossible, at worst only improbable, the confirmation of a debtor-authored plan. Too much, too soon was the BAP’s message, which was contrary to other courts’ conclusions when confronting similar facts.

Governing Standards
Pursuant to § 1112‌(b)‌(1), a bankruptcy court has a mandatory obligation to convert a chapter 11 case to chapter 7 or dismiss the case, “whichever is in the best interests of creditors and the estate,” upon a finding of “cause.”[2] Section 1112 does not define the term “cause,” and “bad faith” (or “lack of good faith”) is not listed among its 16 examples.[3] Nonetheless, since Congress did not regard this list as “exhaustive,”[4] and given the fact that a chapter 11 plan must be proposed in “good faith,”[5] courts have consistently held the absence of “good faith” to constitute “cause” under § 1112‌(b).[6] Generally, this requirement has been invoked to “deter filings that seek to achieve objectives outside the legitimate scope of the bankruptcy law.”[7] In the chapter 11 context, either preservation of a going concern or the maximization of an estate’s nonexempt assets must be the debtor’s intended end for no “bad faith” to be imputed.[8]

One universally applicable paragraph cabins this discretion[9]: § 1112‌(b)‌(2), which forbids conversion or dismissal if three conditions are met.[10] First, a court “find‌[s] and specifically identif‌[ies] unusual circumstances,” indicating that the proposed choice will not serve “the best interests of creditors and the estate.”[11] Second, the debtor or another party-in-interest establishes the reasonable likelihood of a plan’s timely submission per § 1121‌(e) and prompt confirmation pursuant to § 1129‌(e).[12] Third, “a reasonable justification” for any omission or action that constituted the court’s reason for dismissal or conversion and is not listed in § 1112‌(b)‌(4)‌(A) is provided, and a reasonably timed cure is effected.[13]

Background
Pre-petition, the debtor, Joseph W. Sullivan, once the chief executive officer of two private-investment firms, had been involved in a multi-year litigation in New York state court with his former employers (the “appellees”).[14] Ultimately, the latter won an approximately $1.5 million judgment,[15] and on Feb. 4, 2014, the debtor filed a “bare bones” chapter 11 petition.[16] Eight days later, Sullivan filed a chapter 11 status report and a supporting declaration,[17] and six days after that, the debtor filed his schedules and statement of financial affairs.[18] His assets totaled $747,985, his secured debt was $2,007,347, and his total liabilities were $2,238,383.[19] The judgment amounted to 75.18 percent of the debtor’s secured debt and 67.42 percent of his total debt.

Fifteen days after the petition date, the appellees filed a motion to dismiss the case as a bad-faith filing under § 1112‌(b)‌(2),[20] primarily relying on four reasons. First, the debtor had filed the petition in order “to delay, hinder, or interfere” with the judgment’s enforcement. The appellees emphasized their role as the debtor’s predominant creditor, the fact that the petition was filed soon after they commenced collection, and the absence of a business to reorganize, which is chapter 11’s “proper purpose.”[21] Second, they derided the filing as “a strategic move in a two-party dispute,” the judgment filing’s singular objection.[22] Third, the debtor had “no reasonable probability of confirming a [c]hapter 11 plan,” as they intended to vote against any plan that allotted them less than 100 percent.[23] Finally, they insisted that the debtor’s obligations were chiefly consumer.[24] The appellees presented no evidence beyond their appended declarations and the incorporated state court documents.[25]

Naturally, the debtor countered. Acknowledging his yearly salary to be $200,000, he reiterated his insolvency, his hopes to preserve his marital home and the need for a birthing spell to prepare a fair and equitable reorganization or liquidation plan.[26] As to the appellees’ specific allegations, he made five ripostes: (1) Ample case law justified separately classifying the appellees’ claim in any future plan; (2) despite the appellees’ firm determination, many equally resolute creditors had eventually found “common ground” with other debtors; (3) because his case involved more than $400,000 in other claims, it was not a two-party dispute; (4) his one major debt, having resulted from a judgment regarding a business dispute, was essentially a business one, and many of his smaller debts sprung from that judgment; (5) based on the documents that were thus far submitted, he lacked the means to satisfy the judgment, in part due to ever-accruing interest; and (6) an individual is eligible to reorganize under chapter 11 as long as that person satisfies § 1115.[27]

The bankruptcy court first found that the debtor’s sole purpose was to stop the appellees from collecting on their judgment.[28] It characterized the case as a two-party dispute, stressing the case’s filing 89 days after the judgment’s issuance and just after the appellees had commenced collection (and obtained a lien of $70,000 on the debtor’s home).[29] Furthermore, since nothing would likely be available for distribution to the debtor’s unsecured creditors and the debtor would likely be unable to modify his mortgage, the court determined that his drafting of a confirmable plan was rendered unachievable due to the appellees’ resistance.[30]

The BAP’s Ruling
Upon the debtor’s appeal, the BAP reiterated its definition of “a lack of good faith” and elaborated on a standard to guide any § 1112‌(b) inquiry. Citing to well-established precedent, it explained that the former can only be found if a debtor either “seeks to use a [c]hapter 11 filing to unreasonably deter and harass creditors” or to achieve an end that is contrary to chapter 11’s objectives.[31] The BAP clarified that even if “cause” is found on this basis, a bankruptcy court has an “independent obligation under § 1112,” irrespective of the parties’ contentions.[32] It must initially determine whether dismissal, conversion or appointment of a trustee is “in the best interests of creditors and the estate,” and thereupon identify any “unusual circumstances” indicating that either conversion or dismissal is not in the estate’s and creditors’ “best interests.”[33]

In the BAP’s view, the debtor’s goals for filing — to prevent the appellees from seizing his liquid assets ahead of other creditors, save the equity in his New York house and orderly liquidate his assets if he could craft no confirmable plan — were “legitimate reasons to file for bankruptcy.”[34] Likewise, the debtor’s intention to recover as a preferential transfer more than $70,000 that was removed from his account by the appellees’ pre-petition collection was appropriate.[35] In light of the case’s inchoate state, these purposes evinced the debtor’s ostensible “good faith.” Having so presumed, the BAP gave three reasons why his case’s dismissal had been improperFirst, the BAP faulted the bankruptcy court for not gauging the viability of two other options — conversion or allowing a debtor to propose a plan — that the sparse record did not clearly foreclose.[36] Per § 1112‌(b)‌(2), before it could dismiss the case, the bankruptcy court had to find that conversion was not in the creditors’ best interests. Based on the existing record, one conceivable hurdle, § 707‌(b), did not bar involuntary conversion.[37] Based on that same “very scant” compendium, nothing proved the case’s ineligibility for conversion.[38] In sum, the factual findings compelled by § 1112‌(b)‌(2) were absent from the bankruptcy court’s ruling.

Second, the appellees’ examples of “bad faith” had not been sufficiently proven early in the debtor’s case. Although the bankruptcy court found that the debtor had filed his case solely to stop the appellees’ collection efforts, the bankruptcy court had made “no finding” that the debtor’s attempt was “unreasonable” or “intended to harass [the] Appellees.”[39] Once more, the record was bereft of any substantial support for such a necessarily fact-intensive deduction.[40] The BAP could not excuse the bankruptcy court’s failure to weigh in full “the debtor’s financial status [and] motives,” which included a history of substantial withdrawals from retirement accounts and credit cards, large loans from family members, and escalating financial and legal fees.[41] Instead, emphasizing the debtor’s intent to preserve his New York home and three expensive vehicles, it had simply expressed disbelief in his insolvency.[42] Moreover, although the bankruptcy court implicitly determined that the case was merely a two-party dispute, as the “[d]‌ebtor had one creditor,” his schedules indicated the existence of much other debt, none of which could be deemed illegitimate based on the “evidence before” the court.[43] Proof was equally lacking to refute the debtor’s contention that the judgment’s interest alone “made his financial survival outside of bankruptcy impossible.”[44]

Third, the BAP highlighted possibilities that were not fully considered by the bankruptcy court and not “given adequate time for development.”[45] As of the date that the motion to dismiss was filed, the debtor had yet to offer any plan, and the evidence available, even if harshly construed, was “only suggestive of plan futility.”[46] With certain ineffectiveness not yet self-evident, the appellees’ “jeremiads,” which they, like other debtors’ strident creditors, may eventually set aside due to “[e]‌conomic considerations and rationality,” could not “unequivocally establish the debtor’s bad faith.”[47] The bankruptcy court was thus “premature” in concluding that the debtor could not fashion a 100 percent plan, negotiate a lower distribution or cram down a lesser plan in the future, all of which were still viable options.[48] To wit, determining a plan’s non-confirmability required a more fully developed record than the bankruptcy court had in Sullivan.[49]

Opposing Views
Although the Sullivan court’s distaste for premature dismissal has been expressed before,[50] other courts may have seen the four facts apparent from even the meager Sullivan record: (1) a debtor’s ownership of but one substantial asset; (2) a petition’s filing soon after a calamitous judgment and on the eve of a creditor’s collection labors; (3) a debt distribution in which one creditor, having just defeated the debtor in another tribunal, holds the vast majority of the secured and unsecured debt; and (4) a debtor possessed of a substantial income and whose claimed exemptions evidence an intent to preserve a more-than-comfortable lifestyle[51] — as sufficiently cumulative indicia of “bad faith.”[52] Thus, when “virtually all of the indebtedness runs to secured creditors,” as in Sullivan, chapter 11’s invocation has been deemed an abuse of the bankruptcy court’s jurisdiction.[53] For decades, moreover, dismissals have often been ordered when a debtor appears to intend to obtain some strategic advantage over a creditor via the Code.[54] In addition, when the debtor’s overriding motive has been to utilize the automatic stay and not to reorganize so as to stay in business, other courts have readily found “bad faith.”[55] In Sullivan, even the BAP conceded that the debtor had admitted to the latter.

Analysis
Plainly read, Sullivan’s import is twofold. First, dismissal or conversion “for cause” is barred by § 1112‌(b)‌(2) if no findings are (or can be) made as to what option is in the best interests of the whole creditor body. This conclusion follows naturally from § 1112‌(b)’s plain language and chapter 11’s aims. In contrast, its second holding — while the right “bad faith” factors had been cited, dismissal had been too precipitate — will likely produce debate and uncertainty. As long as confirmation is still possible and cold hard facts have not yet proved false a debtor’s more optimistic projections, Sullivan declares that a case should not be dismissed for bad faith based on one creditor’s conclusion-littered motion. When the right time to do so has come and gone, many will have to wonder, especially in light of other courts’ more favorable responses to similarly “premature” requests.