Was the Bankruptcy Filed in Bad Faith?

Was the Bankruptcy Filed in Bad Faith?

September 16, 2014 | Sherrard Roe Voigt & Harbison Blog I Ryan T. Holt

It’s never good news to learn that someone who owes you money filed bankruptcy. Bankruptcy often means taking a haircut on how much you’ll be paid. It causes a “time out” to other actions you may be taking, including executing on a judgment, prosecuting a pending lawsuit, or taking possession of collateral. Bankruptcy also means spending time and money in bankruptcy court, and it can sometimes be more than a year before you begin seeing payments.

For these reasons, it may be appropriate to try to get the bankruptcy dismissed. Our bankruptcy laws, however, are forgiving. The system is designed to give debtors who play by the rules a “fresh start” for most types of debt. Bankruptcy judges also tend to want to give debtors time to get their affairs in order and can be hesitant to dismiss a bankruptcy early in the case. How do you know if it’s a worthwhile use of resources to try to get the case dismissed?

One reason a bankruptcy can be dismissed is if it was filed in “bad faith.” The concept of bad faith, always abstract, is even harder to define in bankruptcy. A bankruptcy is filed in bad faith if various factors suggest the debtor isn’t willing to play by the rules or is manipulating the system to unfairly prejudice its creditors. There is no easy definition; instead, you “know it when you see it” compared to other cases where courts have found bad faith.

A good case to know is In re Laguna Associates Ltd. P’ship, 30 F.3d 734 (6th Cir. 1994). Laguna involved an apartment complex in Michigan. The builder promised the lender not to transfer the property except under limited conditions. The builder created a new entity, named Laguna Associates, and transferred the property to it. Laguna filed bankruptcy. The lender filed a motion for stay relief (i.e., to “unfreeze” the bankruptcy stay in order to foreclose). The bankruptcy court held that the bankruptcy was filed in bad faith, and the Sixth Circuit agreed.

The Sixth Circuit began by explaining that “bad faith” is reason to dismiss a bankruptcy or to grant relief from the bankruptcy stay. The court then laid out the following non-exclusive factors that may suggest a bankruptcy was filed in bad faith:

1. the debtor has one asset;
2. the pre-petition conduct of the debtor has been improper;
3. there are only a few unsecured creditors;
4. the debtor’s property has been posted for foreclosure, and the debtor has been unsuccessful in defending against the foreclosure in state court;
5. the debtor and one creditor have proceeded to a standstill in state court litigation, and the debtor has lost or has been required to post a bond which it cannot afford;
6. the filing of the petition effectively allows the debtor to evade court orders;
7. the debtor has no ongoing business or employees; and
8. the lack of possibility of reorganization.

In Laguna, the court focused on the fact that Laguna had only one asset (the apartment), had few unsecured creditors, and did not have the cash flow necessary to reorganize. In essence, the courts seemed upset that the builder engaged in corporate maneuvering in an attempt to circumvent the deal. The builder created the new business entity, transferred the property to it, and filed bankruptcy one day later—all to forestall the lender from foreclosing. The courts saw through the maneuvering and did not let the builder use bankruptcy to accomplish it.

A case we recently handled provides another data point. The creditor made a large down payment to a farm to buy several million dollars of hay, and this obligation was secured by farm equipment. When the farm failed to deliver, the creditor attempted to foreclose. Just days before a hearing on possession, the farm filed bankruptcy. The farm had few unsecured creditors and was mostly current on other debts. It admittedly filed bankruptcy to forestall foreclosure. The farm also omitted assets on its bankruptcy schedules and wrote several bad checks. Based on these circumstances, the bankruptcy court dismissed the bankruptcy.

In sum, although the bankruptcy laws are forgiving, it may be worth trying to get a bankruptcy dismissed. Laguna and similar cases can help you build a case for bad faith.