Strategic Filing: Chapter 11 Bankruptcy for Litigation Advantage?

It Depends on the Facts

Debtors often use Chapter 11 bankruptcy for litigation advantages. Whether or not they succeed depends on the facts and circumstances of the individual bankruptcy case. The following sample case helps to illustrate how a court may rule.

Case Study

Catherine, Jules, and Jim founded and each owned one-third of a company. The company thrived initially, but as the company grew, the owners fell out, with Catherine on one side and Jules and Jim on the other. Lawsuits were filed.

Using a provision of their state-specific corporation laws, Jules and Jim voted for the corporation to buy out Catherine. A simple resolution, right? No. There were disputes over valuation of the shares, payment terms, and the correct interest rate to be applied. The night before the state court was to adjudicate judgment on the valuation, the company filed a Chapter 11 case. As a result, the company halted resolution of the valuation issue for the time being and potentially made the bankruptcy court the new decision maker. Catherine moved for dismissal. This chess-like form of litigation can be used in any number of scenarios, but it is used frequently when competing ownership interests exist in a business.

So, what can Catherine do? The company’s solvency is irrelevant. The primary issue is whether the filing serves a legitimate reorganization purpose, this is a fact-intensive inquiry. Judicial opinions on such dismissal motions will characterize the issue as the debtor’s “good faith” or lack thereof.¹ To survive the dismissal motion, the debtor company must be experiencing at least some level of financial difficulty such that, if it did not file for bankruptcy relief at that time, it would need to file in the future. The financial difficulty must be more than a mere possibility. The court will look at the facts to determine if the debtor’s filing was in good faith under these circumstances. Typically, debtors will be required to submit a “Plan of Reorganization” identifying, among other things, creditors, their priority status, and how the debtor plans to repay them over time.

[Editor’s note: For more on solvent debtors, please see A Chapter 11 Debtor Need Not Be Broke.]

Resolution: Real-Life Case Study of Bankruptcy for Litigation Advantage

In a reported case with facts analogous to the Catherine v. Jules & Jim scenario, the party in Catherine’s position won a dismissal.² The dismissal of the company’s Chapter 11 case was even affirmed on appeal because the company was solvent, meeting all of its obligations to creditors. This underscores the requirement for those filing Chapter 11 to be actually struggling. Additionally, the state court litigation was to be decided under state law only and did not affect the company’s access to assets.³ An underlying premise of the ruling was that where the debtor had no other need or use for the bankruptcy court, the use of bankruptcy to provide an alternate forum shall not be permitted.⁴

An oft-litigated dismissal scenario is where the company filed for Chapter 11 protection because it had lost in the state or federal court and wished to appeal but also wished to avoid paying a sizable supersedeas bond (stay of legal proceedings) required to proceed.⁵ In other words, they hope to use the bankruptcy for litigation advantage. Filing such a case is filed in good faith may depend on

• Whether the lawsuit winner is the sole creditor of the debtor
• Whether the posting of the bond would place the debtor into financial difficulty
• Whether the debtor has made timely progress toward filing a confirmable reorganization plan

A comparison of those cases confirms that dismissal motions are fact-intensive discretionary calls by the bankruptcy court.

We think you’ll also like:

• The “A&P” Chapter 22 Bankruptcy Saga: A Canary in the Coal Mine
• 90 Second Lesson: What is a “UCC Article 9” Sale?
• 90 Second Lesson: Early Warning Signs of a Troubled Loan

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

• Basic Concepts Applicable to All Borrowers & Lenders
• The Nuts & Bolts of a Chapter 11 Plan
• Buying & Selling IP

This is an updated version of an article originally published on May 16, 2019. It has recently been edited by Joseph Wittman]

©2022. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.

1. See Commercial Bankruptcy Litigation (Jonathan P. Friedland & Elizabeth B. Vandesteeg, eds, 4th ed. 2015) ¶¶ 4.6 – 4.9.
2. Fraternal Composite Services, Inc. v. Karczewski, 315 B.R. 253 (Bankr. N.D.N.Y. 2004)
3. Id.
4. Id. at 258 (citing In re Muskogee Environmental Conservation Company, 236 B.R. 57, 68 (Bankr. N.D. Okla. 1999)).
5. See In re Hyatt, 479 B.R. 880 (Bankr. D. N.M. 2012) (collecting cases).