The list of companies which have availed themselves of the protection from creditors provided by the U.S. Bankruptcy Code includes two of the Big Three auto makers, several major airlines and, in the Great Recession of 2007-08, almost too many financial services companies to remember.
Millions of individual debtors have also sought relief under Chapters 7 and 13 and, less frequently, 11 of the Code.
In the corporate sphere, the Code contains an array of provisions aimed at giving a distressed debtor protection from claims of creditors while it attempts to remain in operation. A company may, among other things, sell certain assets free and clear of creditors’ claims and reject contracts (such as labor agreements) it considers onerous.
Meanwhile, creditors are precluded from pursuing claims outside of the bankruptcy process. Many of these provisions also apply to a personal bankruptcy filed under Chapter 11 or Chapter 13 of the Code.
To obtain relief from debt under the Code, however, a debtor must file “in good faith”.
Good Faith in Business Bankruptcies
Given the number of major companies incorporated in Delaware, it’s not surprising that the Bankruptcy Court there regularly deals with corporate reorganizations and liquidations. In a recent decision, In re Rent-A-Wreck of America, the court examined the question of good faith in the context of one such case.
The Underlying Dispute
The genesis of the decision is a protracted dispute between the debtor, Rent-A-Wreck of America Inc. and David Schwartz, a California automobile dealer who established the first “Rent-A-Wreck” operation in Los Angeles in 1973. Although Schwartz eventually sold the company, he continued to operate a single location under the “Wreck” name.
A Maryland federal court determined that Schwartz had the rights of a franchisee to use the “Wreck” name, pursuant to an implied contract formed by the parties’ course of dealing. Shortly thereafter Rent-A-Wreck filed its Chapter 11 petition and sought court permission to reject a number of franchise agreements, including the implied one with Schwartz. Schwartz filed an objection to the contract motion, but also moved to dismiss the bankruptcy case.
In his filing, Schwartz asserted that Rent-A-Wreck was using the Bankruptcy Code solely to gain leverage in the Maryland litigation and not any legitimate purpose. Schwartz noted that if it succeeded in voiding his contract, Rent-a-Wreck would be free to pursue multiple franchise opportunities in the Los Angeles area.
Court Examines Good Faith Factors
The court began by noting that “good faith” is not defined in the Code, and that there are no universally accepted factors pertinent to its determination. However the approach in a number of federal circuits is to evaluate whether, based on objective evidence, the filing serves a legitimate end such as preserving the value of a financially distressed but still viable concern or the value of its assets. Fundamental to this determination is an inquiry into whether the debtor is experiencing material financial distress.
Based on Rent-a-Wreck’s financial statements and testimony from its principals, the court found that no such distress existed. The debtor was not demonstrably insolvent and was not struggling to pay its debts as they matured. Indeed, it had little overall debt beyond some loans from affiliates, none of which were then in default.
The court then sought to ascertain Rent-a Wreck’s motive in filing for protection under the Code. The court concluded that it was evident that the reorganization of Rent-A-Wreck’s debts was at best a peripheral goal.
As Schwartz claimed, the filing was an effort to gain a tactical advantage in the Maryland litigation. The court granted his motion to dismiss, though Rent-a-Wreck has reportedly filed a motion for reconsideration and, if unsuccessful, may pursue further appeals.
Good Faith in Consumer Bankruptcies
While less common since potential Chapter 7 consumer filings became subject to income testing, bad faith challenges are occasionally made in consumer cases.
In the 1983 case of Flygare v. Boulden, the Tenth U.S. Circuit Court of Appeals (whose jurisdiction includes Colorado) articulated a list of factors to be considered in determining whether a Chapter 13 “wage earner” plan is being proposed in good faith. These include:
– The total payments to creditors and whether they leave the debtor enough for living expenses;
– The debtor’s employment history and prospects;
– The proposed duration of the plan;
– Whether there are inaccuracies in the debtor’s filings and, if so, whether they appear to be deliberate;
– Whether any creditors would receive preferential treatment;
– Whether any mortgages or other liens are proposed to be modified;
– Any history of prior filings;
Examination of these factors is essential before a chapter 13 case is even filed, as it can make the difference between the successful confirmation of a chapter 13 plan or its dismissal by the court.
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