Keeping the Faith: Recent Dismissals for Bad Faith

Several bankruptcy courts have recently reaffirmed the good faith requirement in all chapter 11 bankruptcy cases.[1] Most notably, the chapter 11 petitions of both the National Rifle Association (NRA) and Stream TV Networks, Inc.[2] were recently dismissed pursuant to 11 U.S.C. § 1112(b) after the courts found that the petitions were filed in bad faith.[3]

In the case of the NRA, the U.S. Bankruptcy Court for the Northern District of Texas dismissed the chapter 11 case in an order filed on May 11, 2021.[4] The Texas Bankruptcy Court specifically concluded that the NRA had filed the petition in an attempt to avoid a New York state regulatory scheme and gain an unfair litigation advantage.[5]

The NRA, a 150-year-old charitable nonprofit corporation chartered under the laws of New York, was the subject of a nearly 15-month investigation by the New York Attorney General (NYAG) into the organization’s operations and internal affairs. Following the investigation, on August 6, 2020, the NYAG  filed a complaint in a New York state court.[6] The complaint, naming both the NRA and certain individual officers as defendants, alleged, among other things, a breach of fiduciary duties, exploitation of the organization for individuals’ financial gain, violation of internal bylaws and the concealment of relevant financial information. The NYAG most notably requested the dissolution of the NRA.[7]

The NRA began its effort to relocate from New York to Texas shortly thereafter by forming Sea Grit LLC, a wholly owned Texas subsidiary that would act as a transition vehicle to facilitate the organization’s move to Texas.[8] On Jan. 15, 2021, the NRA and Sea Grit filed voluntary petitions under chapter 11 in the Northern District of Texas. Ackerman McQueen, the NRA’s largest unsecured creditor, the NYAG and the Attorney General for the District of Columbia all filed motions to dismiss the petitions.[9]

The Texas Bankruptcy Court referenced 11 U.S.C. § 1112(b) in its analysis, which requires a court to dismiss a case brought under chapter 11 if “cause” exists, unless the court decides that the appointment of a trustee under 11 U.S.C. § 1104(a) is in the best interest of the creditors and the estates.[10] Section 1112(b) defines “cause” to include a nonexhaustive list of items, and while bad faith is not explicitly included, bankruptcy courts have repeatedly held that “cause” includes a “finding that the debtor’s filing for relief [was] not in good faith.”[11]

Following precedent from the Fifth and Third Circuits, the Texas Bankruptcy Court highlighted the two most important inquiries in a bad-faith analysis: (1) whether the petition was filed for a valid bankruptcy purpose; and (2) whether the petition was filed merely to gain an advantage in litigation.[12] Specifically, a bankruptcy case shall be dismissed if it is filed with the purpose of obtaining an unfair litigation advantage. Not only does such purpose conflict with the spirit of the Bankruptcy Code, it may also interfere with another jurisdiction’s ability to regulate activities within its own state.[13]

The Texas Bankruptcy Court concluded that the purpose for filing the petitions was not to maintain a going-concern value, as the NRA had claimed, but instead to avoid the potential dissolution of the organization in connection with the NYAG’s ongoing lawsuit.[14] Such purpose not only provides an unfair litigation advantage to the NRA, but also deprives the state of New York from regulating nonprofit entities incorporated under their laws.[15]

In arriving at its conclusion, the Texas Bankruptcy Court refuted several other arguments espoused by the NRA. Most notably, it rejected the NRA’s claim that dismissing the chapter 11 case due to the ongoing lawsuit in New York state court violates federal preemption laws. The Texas Bankruptcy Court clarified that its decision resulted from a totality-of-the-circumstances analysis, not a per se rule of dismissal in the instance of an ongoing state regulatory action against the debtor. The NRA presented little to no evidence to support a good-faith purpose for filing given the NYAG’s action to dissolve the organization, the ability of the NRA to relocate to Texas outside of a bankruptcy proceeding, and the NRA’s status as “a solvent and growing organization.”[16]

While the NRA might be one of the most notable examples of a bad-faith bankruptcy filing, it is not the only nor the most recent. On May 17, 2021, the U.S. Bankruptcy Court for the District of Delaware dismissed a chapter 11 case filed by Stream TV, holding that the case was filed in bad faith under 11 U.S.C. § 1112(b).[17] In a virtual bench ruling, the Delaware Bankruptcy Court stated that Stream TV’s bankruptcy filing was just a “last ditch” effort to delay the transfer of the company’s assets pursuant to an omnibus agreement, which provided that the secured lenders of Stream TV would not foreclose on Stream TV’s assets and instead would release all claims against Stream TV upon the transfer of the company’s assets to SeeCubic, Inc., an entity formed by Stream TV’s secured lenders.[18]

Stream TV filed its chapter 11 petition during ongoing litigation between the company and SeeCubic regarding the effectiveness of the omnibus agreement. Within days of Stream TV’s bankruptcy filing, the Delaware Chancery Court issued a permanent injunction that validated the omnibus agreement between the parties and effectively gave Stream TV’s creditors ownership of its assets. In discussing the bad faith analysis under 11 U.S.C. § 1112(b), the Delaware Bankruptcy Court highlighted Stream TV’s attempt to use its chapter 11 case to gain a “tactical litigation advantage” in the relevant adversary proceeding.

While the facts surrounding Stream TV’s dismissal are distinct from those of the NRA, the overall message is the same: Bankruptcy courts will not provide an unfair escape from pending litigation. In both cases, the bankruptcy courts exercised their power to dismiss a chapter 11 case filed in bad faith — serving as a warning for all potential future debtors.