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Fancy Filing: Can They File a Chapter 11 Bankruptcy Case Just to Gain a Litigation Advantage?

The Answer Is: It Depends

Debtors often use bankruptcy filing to gain an advantage in litigation. Whether or not they succeed depends on the facts and circumstances of the bankruptcy case. Let’s look at a sample case to determine how a court might rule.

Case Study

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

[Editor’s Note: For more information on how this situation could have been avoided, please see Common Issues and Strategies in Business Breakups.]

Using a provision of the state corporation laws, Jules and Jim voted for the corporation to buy out Catherine. Simple resolution? No, for there were fights over valuation of the shares, over payment terms and the correct interest rate to be applied. The night before the state court could pronounce judgment on the valuation, the company filed a Chapter 11 case. The company had thus halted resolution of the valuation issue for the time being and had made the bankruptcy court the potential new decision maker. Catherine moved for dismissal of the case.

[Editor’s Note: The bankruptcy court is no stranger to valuation disputes, for more information, please read Valuation: The Pillar of Corporate Restructuring.]

Her prospects? The fact that the debtor company is solvent does not decide the matter. The primary issue is whether the filing serves a legitimate reorganization purpose, which is a fact-intensive inquiry. Often, judicial opinions on such dismissal motions will characterize the issue as the debtor’s “good faith” or lack thereof.[i] 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 debtor’s filing was in good faith under these circumstances.

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

Resolution: Real Life Case Study

In a reported case with facts analogous to the Catherine v. Jules & Jim scenario, the party in Catherine’s position won a dismissal.[ii]  The dismissal of the company’s Chapter 11 case was affirmed on appeal because the company was solvent, meeting all of its obligations to creditors. Additionally, the state court litigation was to be decided under state law only, and did not affect the company’s access to assets.[iii]  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.[iv]

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 required to proceed.[v]  Whether 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 debtor into financial difficulty, and whether the debtor has made timely progress toward filing a confirmable reorganization plan.  Comparison of those cases confirms that dismissal motions are fact-intensive discretionary calls by the bankruptcy court.

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

About The DailyDAC Editors

The editors and editorial board of DailyDAC include preeminent restructuring and insolvency professionals, journalists, and editors. They are devoted to providing reliable and plain English education and deal intelligence about assignments, corporate bankruptcy, receiverships, out-of-court workouts and similar topics.

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