In the service of the Bankruptcy Code’s goals of giving debtors a "fresh start" and ensuring that estate assets are fairly and equally distributed among similarly situated creditors, the Bankruptcy Code contains an array of advantageous provisions that either do not exist under non-bankruptcy law or are more difficult to deploy. These include, among other things, the ability to reject burdensome contracts, to avoid preferential or fraudulent transfers, and to limit the amount of certain types of creditor claims. These powers are particularly important in chapter 11 cases, where a successful outcome may not be possible without them.

Chapter 11, however, and the powers given by the Bankruptcy Code to debtors-in-possession and bankruptcy trustees are not available to every entity that is technically eligible to file for relief. As illustrated by a ruling recently handed down by the U.S. Bankruptcy Court for the District of Delaware—In re Rent-A-Wreck of America, Inc., 580 B.R. 364 (Bankr. D. Del. 2018)—chapter 11 is open only to debtors that file for bankruptcy in "good faith." The court dismissed a chapter 11 case as having been filed in bad faith because the debtor was not in financial distress and had filed for bankruptcy solely to reject a franchise agreement that it had been unable to terminate outside bankruptcy.

Dismissal of a Chapter 11 Case for Bad Faith

Section 1112(b) of the Bankruptcy Code provides that a chapter 11 case may be dismissed or converted to a chapter 7 liquidation for "cause." Section 1112(b)(4) sets forth a nonexclusive list of grounds that constitute cause, including, among other things, "the absence of a reasonable likelihood of rehabilitation," failure to file or confirm a chapter 11 plan within the time fixed by the Bankruptcy Code or the court, or the inability to effectuate "substantial consummation of a confirmed plan."

Although "bad faith" is not listed in section 1112(b)(4), courts have consistently found that the absence of good faith in connection with the filing of a chapter 11 case is cause for dismissal or conversion. The good faith filing requirement is designed to ensure that the burdens imposed by bankruptcy on creditors are justified by fulfillment of chapter 11’s objectives: preserving going concerns and maximizing assets available to satisfy creditors. The basic thrust of the good faith inquiry has traditionally been whether, in view of the totality of the circumstances, the debtor needs chapter 11 relief. See C-TC 9th Ave. P’ship v. Norton Co. (In re C-TC 9th Ave. P’ship), 113 F.3d 1304, 1309–10 (2d Cir. 1997) (dismissal was warranted if "there was no reasonable likelihood that the debtor intended to reorganize and no reasonable probability that it would eventually emerge from bankruptcy proceedings"); NMSBPCSLDHB, L.P. v. Integrated Telecom Express, Inc. (In re Integrated Telecom Express, Inc.), 384 F.3d 108, 119–20 (3d Cir. 2007) (the test focuses on "whether the petition serves a valid bankruptcy purpose . . . [or] whether the petition is filed merely to obtain a tactical litigation advantage"); In re Premier Automotive Services, Inc., 492 F.3d 274, 279–80 (4th Cir. 2007) (a chapter 11 filing was made in "subjective bad faith" where the debtor had no demonstrable need to organize and was not experiencing financial difficulties and where the filing revealed solvent business with no unsecured creditors and few, if any, secured creditors). But see In re Capitol Food Corp. of Fields Corner, 490 F.3d 21, 26 (1st Cir. 2007) (declining to address whether section 1112(b) imposes the "good faith" requirement, but ruling that the debtor’s use of chapter 11 to obtain "time-out" and delay foreclosure of its leasehold interest did not mean that the petition had been filed solely to obtain a tactical litigation advantage, which many courts have found to be a hallmark of bad faith).

For example, in Integrated Telecom, the Third Circuit focused on two inquiries bearing on the question of good faith: (i) whether the filing serves a "valid bankruptcy purpose, e.g. by preserving a going concern or maximizing the value of the debtor’s estate," or (ii) whether the case was filed "merely to obtain a tactical litigation advantage." Integrated Telecom, 384 F.3d at 119–20 (citing In re SGL Carbon Corp., 200 F.3d 154, 165 (3d Cir. 1999)). The Third Circuit further explained that a debtor’s desire to invoke the powers conferred by the Bankruptcy Code, such as the ability to limit lease rejection damages or otherwise benefit from provisions "that have the effect of redistributing value from one interest group to another," does not establish good faith, nor is it a valid bankruptcy purpose in the absence of financial distress. Id. at 127–29. Otherwise, the court emphasized, any entity willing to "undergo" (and bear the cost of) a bankruptcy filing could use the Bankruptcy Code’s redistributive mechanisms to its advantage, a concept that is "antithetical to the structure and purposes of the Bankruptcy Code." Id. at 129.

Faced with a motion to dismiss a bankruptcy filing for bad faith under section 1112(b), the debtor bears the burden of establishing that the petition was filed in good faith. SGL Carbon, 200 F.3d 162 n.10.

Rent-A-Wreck

David Schwartz is one of the two founders of budget automobile rental franchise Rent-A-Wreck of America, Inc. ("RAWA"). In 2007, Schwartz sued J.J.F. Management Services, Inc. ("JJFMS"), which had purchased the other founder’s interest in RAWA, in federal district court seeking a declaratory judgment that, on the basis of a 1985 agreement, he had a royalty-free Rent-A-Wreck franchise covering the Los Angeles region. The litigation resulted in several rulings from the district court and the U.S. Court of Appeals for the Fourth Circuit in Schwartz’s favor. JJFMS protracted the litigation by, among other things, failing to comply with the terms of the ongoing franchise relationship and defying various court orders. In June 2017, the district court found JJFMS in contempt.

JJFMS, as the parent of RAWA, caused RAWA and its wholly owned operating subsidiary Bundy American, LLC ("Bundy" and, collectively, the "Debtors") to file for chapter 11 protection in the District of Delaware one month later. Shortly afterward, the Debtors filed a motion to reject seven franchise agreements, including the agreement with Schwartz.

Schwartz objected to the rejection motion. He also moved to dismiss the Debtors’ chapter 11 cases as having been filed in bad faith. According to Schwartz, the bankruptcy filing was merely a continuation of the district court litigation, a two-party dispute that did not belong in bankruptcy court. He argued that JJFMS was attempting to use the Bankruptcy Code to do what it had failed to do in the litigation—strip him of his franchise rights. Schwartz also argued that the Debtors were not in any financial distress.

The Debtors countered that they had filed for bankruptcy to maximize the value of the Rent-A-Wreck trademark, to reject burdensome franchise agreements, and to relieve their balance sheet of significant debt, all of which are valid reasons for a chapter 11 filing. They also claimed that, by rejecting Schwartz’s exclusive franchise agreement, they could both eliminate significant continuing litigation expense and open the Los Angeles territory to new royalty-paying franchisees.

According to the Debtors, even if their sole motive for filing for chapter 11 was to reject the Schwartz franchise agreement, the petitions would have been filed in good faith because it is not bad faith to file for bankruptcy in order to make use of the specific powers given to debtors by the Bankruptcy Code.

The Bankruptcy Court’s Ruling

The bankruptcy court granted the motion to dismiss, finding that the Debtors had filed their chapter 11 cases in bad faith.

The court rejected the Debtors’ argument that they merely had to show a "valid reorganizational purpose," rather than financial distress, as an element of good faith. It examined a number of factors bearing on the latter, including solvency, cash reserves, cash position, liquidity and the ability to pay debts as they mature, recent financial performance and profitability, the proportion of debt owed to insiders, and the threat of litigation. The court held that the Debtors were not in financial distress when they filed for bankruptcy protection.

The court found, among other things, that: (i) the companies were not insolvent (although insolvency is not a prerequisite to bankruptcy relief); (ii) the Debtors acknowledged that their unsecured debt did not drive the decision to file for bankruptcy; (iii) the Debtors’ only secured debt, while substantial, was owed to their ultimate corporate parent, JJFMS, which had taken no steps to collect on the debt even though it had matured in 2011; (iv) the Debtors failed to provide any specific evidence of their current cash position, liquidity, or ability to pay debts as they matured; and (v) litigation in which the Debtors were involved did not pose a significant threat to their financial situation. The court concluded that "[t]he lack of credible facts demonstrating financial distress supports a finding that these cases were not filed in good faith."

According to the bankruptcy court, the nonfinancial evidence also supported a finding of bad faith. It showed that the Debtors’ alleged motivations for filing for bankruptcy—maximizing trademark value, reducing debt, and rejecting unfavorable franchise agreements—were merely a pretext. The "primary purpose of the bankruptcy filing," the court wrote, "is to reject . . . Schwartz’s franchise agreement so Debtors can open the Los Angeles territory to multiple royalty-paying franchisees." Moreover, the court noted, the bankruptcy filings accelerated rather than eliminated further litigation with Schwartz by exchanging "one set of issues for another and the expense of civil litigation for that of bankruptcy litigation."

The court explained that the good faith inquiry is "particularly sensitive" if the bankruptcy case "seeks to distribute value directly from a creditor to a company’s shareholders." In this case, the court wrote, the Debtors’ purpose in filing for chapter 11 "is nothing more than a straightforward attempt to take value that belongs to [Schwartz] and give it to Bundy" and JJFMS, rather than to creditors. Thus, the court emphasized, the Debtors’ chapter 11 cases were a prime example of the situation the Third Circuit warned against in Integrated Telecom: "the use of the Bankruptcy Code—and, in particular, its redistributive provisions—when a party is willing to pay the freight of a bankruptcy case."

Outlook

Good faith acts as the gatekeeper in chapter 11 in two ways. First, any chapter 11 petition that a debtor files in bad faith can be dismissed under section 1112(b). Second, section 1129(a)(3) expressly provides that every chapter 11 plan must be "proposed in good faith," a provision which has been construed to require that a plan be proposed with honesty and good intentions and with a basis for expecting that a reorganization or liquidation, as the case may be, can be effected.

Rent-A-Wreck indicates that the good faith filing requirement demands that the debtor be under some level of financial distress. The extent of the financial distress required varies, and a bankruptcy court has considerable discretion in determining what qualifies.

ent-A-Wreck is an unusual case. The debtor initially failed to present any evidence of financial distress because it took the position that merely citing a "valid reorganizational purpose" was sufficient. This meant that the court was required to conduct its own examination of the debtor’s affairs—an analysis which laid bare, in the court’s view, the debtor’s ulterior motive in filing for chapter 11. The good faith inquiry in other cases may be a closer call.

The Rent-A-Wreck court cautioned that its holding should be limited to the facts of cases like the one before it, in which borderline "patently abusive" debtors were attempting "to avoid the results of their own provocative actions." It noted that, "[i]n another circumstance, a financially distressed debtor’s recognition of the outcome of litigation and/or a desire to avoid future litigation may serve as a legitimate basis for the filing of a bankruptcy case."