Days apart, the Fourth Circuit and a bankruptcy court in Delaware reached opposite results on motions to dismiss a solvent debtor’s petition as a bad faith filing. Whether the debtor was an individual or the filing was defensive (as opposed to offensive) may explain the difference.
The debtors’ sincerity and ethics (or lack thereof) may also explain the opposite outcomes.
In Delaware, Bankruptcy Judge Laurie Selber Silverstein dismissed a corporate chapter 11 petition, basing her legal conclusions on Integrated Telecom Express Inc., 384 F.3d 108 (3d Cir. 2004), where the Third Circuit theorized that a bankruptcy could be dismissed for bad faith if the filing did not serve a valid bankruptcy purpose and if the petition was filed to obtain a tactical advantage.
The debtor in Judge Silverstein’s case was a car-rental franchisor that had spent $2.7 million in attorneys’ fees attempting to cut off a franchisee in Los Angeles. The litigation was a near total failure, because the Fourth Circuit upheld rulings in the lower court to the effect that the franchisee had a royalty-free right to use the debtor’s trademark, among other things. The judgment also precluded the debtor from establishing other franchises in Los Angeles.
Soon after filing the chapter 11 petition, the debtor moved to reject the executory contract with the Los Angeles franchisee. The franchisee countered with a motion to dismiss the petition, which Judge Silverstein granted in her Feb. 13 opinion, saying that the burden of showing a good faith filing by a preponderance of the evidence rests on the debtor.
At trial, the debtor conceded it was solvent. The extent of the debtor’s net worth was unclear because the debtor had scheduled the value of its most important assets as “unknown.”
Judge Silverstein went further into the balance sheet, noting that the $3 million in secured debt was owed to a non-bankrupt affiliate having common ownership with the debtor. While unsecured debt to affiliates was “significant,” Judge Silverstein found that unsecured debt to third parties was “comparatively insignificant.”
Rejecting the debtor’s unsupported allegation that cash flow was negative, Judge Silverstein concluded that the debtor was not in “financial distress.” She also found that non-financial evidence pointed to a bad faith filing.
Judge Silverstein said that the “primary purpose” of the chapter 11 case was to reject the Los Angeles franchise and thereby open the door to signing up a new franchisee who would pay royalties. She said that bankruptcy was “nothing more than a straightforward attempt to take value that belongs to [the franchisee] and give it to [the debtor’s owner].”
Emphasizing her finding that the filing did not have a legitimate bankruptcy purpose, Judge Silverstein said she had “no doubt” that the attempted reorganization was “just another chapter in the attempt to terminate the [Los Angeles] franchise.”
In contrast, the Fourth Circuit upheld a bankruptcy court’s denial of the principal creditor’s motion to dismiss a solvent individual’s chapter 7 filing.
The debtor had the misfortune of having been an outside advisor for seven years to Ponzi schemer Allen Stanford. The receiver for Stanford sued the debtor and won a $1.275 million judgment.
Coincident with the receiver’s domestication of the judgment in California, where the debtor owned property, the debtor filed a chapter 7 petition in Maryland. The bankruptcy judge denied the receiver’s motion to dismiss the petition for “cause” as a bad faith filing under Section 707(a). The district court upheld the bankruptcy court, as did the Fourth Circuit in a Feb. 21 opinion by Circuit Judge J. Harvie Wilkinson, III.
Like Judge Silverstein, Judge Wilkinson said that dismissing a petition as a bad faith filing is based on the “totality of the circumstances.” He could not find grounds for upsetting the bankruptcy court’s exercise of discretion.
Like Judge Silverstein, Judge Wilkinson surveyed the facts in detail. The debtor in the Fourth Circuit was more sympathetic than the corporate debtor in Delaware.
Like Delaware, however, the Maryland debtor was solvent. According to the bankruptcy court, the Maryland debtor had assets of more than $5.3 million, but most were exempt. The debtor had turned his nonexempt assets, consisting of a boat and two cars, over to his trustee.
On the liability side, the judgment to the Stanford receiver represented 90% of the debtor’s unsecured debt. Some $150,000 in unpaid legal fees formed the bulk of the third-party debt.
In terms of income and expenses, the debtor was living off a pension, rental income and Social Security because he had been unable to gain employment after his connection with Stanford become public information.
Of significance, the debtor had been spending $12,000 a month to care for his incapacitated wife. Otherwise, the debtor’s expenses were modest.
The Stanford receiver argued for dismissal, saying the case was a two-party dispute where the debtor was attempting to shield his exempt assets. Indeed, the bankruptcy judge found that the “primary motivation” was to fend off the judgment.
Judge Wilkinson, however, ruled that the debtor had not “abused the bankruptcy process.”
Like Judge Silverstein, Judge Wilkinson said that dismissal is proper if the debtor has “‘abused the provisions, purpose, or spirit of bankruptcy law.’” He added, though, that dismissal is “reserved for cases of real misconduct.”
Unlike the debtor in Delaware, the bankruptcy judge found the Maryland debtor to be “candid, forthcoming, timely, and cooperative.” Judge Wilkinson said it was “simply not a case that [the debtor] filed for bankruptcy solely to avoid the judgment.” The debtor, he said, had $150,000 in third-party debt.
Finally, and significantly, Judge Wilkinson said that protecting exempt assets is not an abuse, because forcing a debtor to use exempt assets to satisfy a debt “would also undercut the entire exemption scheme that Congress designed.”
Although the ability to repay a debt “may be a relevant factor,” Judge Wilkinson held that it is not a “per se bar to bankruptcy relief.”