Two circuit courts of appeal recently addressed whether a company filing chapter 11 for the sole purpose of retaining vital leases did so in good faith. In In re Capitol Food of Fields Corner, the First Circuit, in a matter of first impression on the issue of chapter 11’s implied good-faith filing requirement, declined to address the broader question, concluding that even if there is a good-faith filing requirement, a prima facie showing of bad faith could not be met because the debtor articulated several legitimate reasons for the necessity of reorganizing under chapter 11. In In re Premier Automotive Services, Inc., the Fourth Circuit concluded that the debtor’s chapter 11 filing was objectively futile and therefore undertaken in bad faith. The rulings are emblematic of the broad discretion given to bankruptcy courts in examining whether a debtor’s motivation in seeking chapter 11 protection comports with the purposes and policy of chapter 11. They also illustrate that the inquiry is necessarily fact-intensive and case-specific.

Chapter 11’s Good-Faith Requirements

Chapter 11 of the Bankruptcy Code has been interpreted to create two separate good-faith requirements in connection with a debtor’s ability to avail itself of the protections of the Bankruptcy Code. First, section 1129(b)(3) expressly provides that every chapter 11 plan must be “proposed in good faith and not by any means forbidden by law.” This provision 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. In keeping with that mantra, bankruptcy courts are required to determine whether a chapter 11 plan, viewed in light of the totality of the circumstances, fairly achieves a result consistent with the purposes of the Bankruptcy Code.

However, a bankruptcy court may be called upon to make a good-faith ruling well before confirmation of a chapter 11 plan. Bankruptcy Code section 1112(b)(4) delineates a catalogue of abuses or failures, including continuing loss to or diminution of the estate, inability to effectuate a plan, or unreasonable delay by the debtor, that can lead to the outright dismissal of a chapter 11 case or its conversion to a chapter 7 liquidation. Courts have consistently found that the prosecution of a chapter 11 case in “bad faith”—although not listed as one of the examples— constitutes “cause” for dismissal or conversion.

The good-faith filing requirement is designed to ensure that the burdens imposed 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 the debtor needs chapter 11 relief. The debtor’s solvency may be relevant to the analysis, but it does not end the inquiry— the Bankruptcy Code does not establish insolvency as a prerequisite to filing for chapter 11 (or any form of bankruptcy relief). Courts must examine the totality of the circumstances in assessing the debtor’s good or bad faith in any given case.

Capitol Food

Capitol Food Corporation of Fields Corner held a commercial lease from Fields Station Realty Trust dating to 1965. The lease provided for rental payments well below market rates and allowed Fields Station to terminate the leasehold within 30 days should business operations of a “food market” on the premises cease.

In 2005, Capitol Food discontinued operations on the property but subleased the store to Ethnic and American Foods, Inc., d.b.a. America’s Food Basket (“AFB”), which also operated a “food market” on the property. AFB ceased operations on December 26, 2005, in conjunction with a chapter 7 filing. Capitol Food received a notice of default from Fields Station on December 27 demanding the default be cured by January 26, 2006, or the leasehold would be forfeited.

In order to comply with the lease, Capitol Food attempted to resume “food market” operations by purchasing the AFB sublease from the chapter 7 trustee and applying for necessary local health permits. When it became apparent that the health permits would not be received in time to cure the default, Capitol Food, although solvent, filed a chapter 11 petition on January 27 in Massachusetts to avoid the loss of the leasehold. Two weeks later, Capitol Food reopened the food market, having obtained the necessary health permits.

Fields Station filed a motion to dismiss the case under section 1112(b) or for relief from the automatic stay, alleging that Capitol Food had filed its chapter 11 petition in bad faith. The bankruptcy court denied both motions. After the district court upheld the ruling on appeal, Fields Station appealed to the First Circuit.

The court of appeals determined that Fields Station failed to make a prima facie showing of bad faith, while declining to address whether section 1112(b) imposes a “good faith” requirement. Examining whether Capitol Food’s filing served a valid reorganization purpose, the court emphasized that a business need not be insolvent to file a bankruptcy petition as long as some type of financial distress exists. “Imminent or threatened foreclosure on the debtor’s interests in real property essential to successful reorganization efforts,” the court observed, is “precisely the sort of imminent financial distress for which debtors routinely seek chapter 11 protection.”

The court concluded that Capitol Food’s filing was designed to preserve its business as a going concern and maximize the assets recoverable by unsecured creditors. Faced with the loss of its principal form of cash flow—the sublease— Capitol Food made a valid decision to transform itself from a nonoperational sublessor to a market operator. Potential loss of the lease threatened Capitol’s reorganization efforts, creating an immediate and present need for chapter 11 protection. Capital Food’s use of chapter 11 to obtain a “timeout” and delay foreclosure, the court reasoned, did not mean that the petition was filed solely to obtain a tactical litigation advantage, which many courts have found to be a hallmark of bad faith.

Premier Automotive Services

For 40 years, Premier Automotive Services, Inc., an automobile import-export company, operated on Lot 90 of the Dundalk Marine Terminal, owned by the Maryland Port Administration (the “MPA ”), under an array of leases. Premier’s most recent lease expired June 30, 2002. Extensive negotiations on a new lease remained unsettled due to Premier’s rejection of a vehicle throughput requirement requiring it to move 1,700 vehicles per acre per year. Premier remained as a holdover tenant. Unable to resolve the lease issues, the MPA offered Premier a month-to-month lease not containing the throughput requirement in February 2004, which Premier rejected. In April 2004, the MPA once again offered a three-year lease with two one-year options, noting that every other vehicle tenant had committed to the throughput. Once again, no agreement was reached on the lease. In January 2005, the MPA entered into a long-term lease on Lot 90 with another tenant. On March 29, 2005, the MPA notified Premier of the termination of the lease, effective May 1, 2005.

Premier filed a chapter 11 petition in Maryland on April 29, 2005. Invoking the automatic stay as a bar to termination of the lease, Premier filed an adversary proceeding against the MPA , alleging various constitutional violations, and filed a complaint with the Federal Maritime Commission (“FMC”), alleging a number of violations of the Federal Shipping Act. Consolidating a number of matters, including the MPA ’s motion for summary judgment in the adversary proceeding, the bankruptcy court dismissed Premier’s chapter 11 case as having been filed in bad faith because its sole purpose was to halt or delay eviction proceedings. It also ruled that the stay did not apply because Premier’s leasehold interest had expired prior to the bankruptcy filing. That determination was upheld by the district court, which consolidated the bankruptcy appeal with the FMC action (the latter having been dismissed by an administrative law judge and refiled in federal court by Premier). Premier appealed to the Fourth Circuit.

Premier fared no better in the court of appeals. The absence of good faith, the court explained, requires a showing of “objective futility” and “subjective bad faith,” both of which were present in the case before it. Premier had no realistic possibility of an effective reorganization—it had never filed a chapter 11 plan, and it acknowledged that any prospective plan was part of its litigation strategy against the MPA . A reorganization based on litigation alone, the court emphasized, is illusory and even with relief could not lead to an effective reorganization. According to the Fourth Circuit, the dispute between Premier and the MPA belonged in state court rather than bankruptcy court.

The court also concluded that the filing was made in “subjective bad faith,” observing that:

Premier had no demonstrable need to organize when it filed the petition: it was not, the bankruptcy court found, “experiencing financial difficulties.” Indeed, Premier’s bankruptcy filings reveal a solvent business with no unsecured creditors and few, if any, secured creditors.This fact alone may justify dismissal of Premier’s Chapter 11 petition.

Premier’s “hostage” tactics, the court emphasized, signaled its bad faith and attempt to “commandeer” the bankruptcy process for the sole purpose of invoking the automatic stay against the MPA .

Analysis

Capitol Food and Premier Automotive both address the propriety of using chapter 11 for the purpose of retaining a lease. The fact that the courts reached different conclusions merely underscores the fact-intensive nature of a good-faith determination and the broad scope of a court’s discretion in rejecting strategies that are inconsistent with the goals and policies underlying chapter 11. Although not expressly incorporated into the Bankruptcy Code, good faith endures as the standard for legitimate recourse to chapter 11.

Section 1112(b) was amended by BAPCPA to limit the court’s discretion to dismiss or convert a chapter 11 case, instead of directing the appointment of a chapter 11 trustee or examiner, in cases where there is a reasonable likelihood that the debtor can timely confirm a plan and where “cause” amounts to an act or omission by the debtor for which there is a reasonable justification and which can be remedied within a reasonable period of time. The court’s discretion to dismiss or convert a case based upon a debtor’s bad faith in seeking chapter 11 protection, however, does not appear to be limited by this change.