Troubled economic times predictably result in an escalation in bankruptcy filings. As the economy began to worsen last year, the U.S. Court of Appeals for the Fifth Circuit issued a reminder that courts can—and will—penalize parties that tax an already busy bankruptcy court system with bad faith filings.

In an en banc decision, the Fifth Circuit held that a bankruptcy court did not abuse its discretion by imposing $90,000 in monetary sanctions following the bad faith filing of two bankruptcy petitions. In re Yorkshire LLC (Knight v. Luedtke, et al.), No. 07-20644 (5th Cir. Aug. 8, 2008).

Under the facts of this case, a business disagreement culminated in the filing of a state court action. Subsequent to this filing, the president/manager of two companies and his counsel filed voluntary petitions for bankruptcy relief on behalf of a limited partnership and its sole general partner, a limited liability company. The filings were made shortly before a scheduled change of venue hearing in the state court action and a business meeting at which the removal of the president/manager from any position of authority would be discussed.

The bankruptcy court found that the appellants prepared the bankruptcy petitions in secret and without consulting any other person with authority to act on behalf of the companies. The bankruptcy court further found that counsel conducted little, if any, due diligence about whether bankruptcy was appropriate under the circumstances and who was vested with the authority to make such decisions on behalf of the debtor companies. All parties stipulated that, at all times, the debtor companies were solvent.

Bad Faith Elements

When imposing sanctions on the appellants, the bankruptcy court relied on the court’s “inherent authority to regulate the practice of litigants and lawyers appearing before it,” as well as Bankruptcy Rule 9011(c).

On appeal, the Fifth Circuit noted that appellants did not act in the best interest of the companies, concealed their actions from the debtor companies and their creditors, and filed “to inflict injury … with a bad motive and with no meaningful thought being given to the purposes of chapter 11 bankruptcy.” In upholding the bankruptcy court’s decision, the Fifth Circuit further determined that the appellants’ arguments all lacked merit and none went to the foundation of the bankruptcy court’s order, the bad faith nature of the filing.

Affirming the bankruptcy court’s imposition of sanctions, the Fifth Circuit remarked upon the bankruptcy court’s careful consideration of evidence. The bankruptcy court specifically found that the appellants acted in bad faith by using the bankruptcy filing as a means to inflict injury on others after becoming frustrated by the exhaustion of available state court remedies. The Fifth Circuit determined that the bankruptcy court was well within the purview of its powers to impose sanctions following this specific finding of bad faith.

The Fifth Circuit further held that the amount of sanctions should be limited to an amount sufficient to deter similar conduct. To calculate the amount of sanctions, the bankruptcy court used as a starting point the amount of attorneys’ fees incurred by the debtor companies, as well as the appellants’ annual income and net worth. The Fifth Circuit concluded the sanctions imposed were appropriate.

The bad faith use of the chapter 11 process for a personal vendetta is regarded seriously by the courts and may lead to the imposition of large monetary sanctions that go well beyond attorneys’ fees incurred by the debtors.