Daily Development for Friday, September 24, 2004
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin Kansas City, Missouri dirt@umkc.edu
BANKRUPTCY; SOLVENCY; BAD FAITH: The bankruptcy court erred in failing to
dismiss for bad faith a bankruptcy case filed by a financially healthy and
solvent tenant debtor with no intention of reorganizing or liquidating as a
going concern, with no reasonable expectation that Chapter 11 proceedings would
maximize the value of the debtors estate for creditors, and solely to take
advantage of a provision of the Bankruptcy Code that limits landlords claims on
long-term leases.
In re Integrated Telecom Express, Inc., 2004 U.S. App. LEXIS 19523 (3rd Cir.,
Sept. 20, 2004).
In this case, the landlord contended that the tenant-debtors Chapter 11
bankruptcy petition should be dismissed for having been filed in bad faith
because the debtor-tenant was highly solvent and cash rich, never in financial
distress, and filed its petition for the sole purpose of limiting the landlords
recovery under 502(b) (6) of the Bankruptcy Code in order to increase the
distribution to the debtors shareholders at the landlords expense. (Under sec.
502(b)(6) of the Bankruptcy Code, a landlords claim for early termination of a
lease is limited to the rent due under the lease for the greater of one year or
15 percent, not to exceed three years.) According to the court, [t]hese
corroborations are supported by the record.
The court noted that, at the time of the debtors bankruptcy filing, the debtor
had almost $107 million in cash and other assets while its only indebtedness,
outside of the landlords discounted claim of approximately $26 million, was for
miscellaneous liabilities of approximately $430,000. The court also referred to
a smoking gun resolution approved by the debtors board of directors, which
authorized a letter from the debtors law firm [Murray and Murray -- no relation
to the author] to the landlord threatening a bankruptcy filing in order to avail
itself of certain provisions of the Bankruptcy Code -- specifically including
the 502(b)(6) cap on the landlords damages - if the landlord did not enter
into a settlement of lease obligations for $8 million.
Both the bankruptcy court and the Federal district court rejected the landlords
request to dismiss the debtors bankruptcy bad-faith claim, ruling that the
debtor was in financial distress and that, in any event, filing the Chapter 11
petition was in accordance with the fiduciary obligations to its shareholders
and the debtors expressed intention to take advantage of the 502(b) (6) cap
was not a sufficient basis to dismiss the petition as a matter of law.
(Imposition of the cap effectively reduced the landlords claim from $26 million
to $4.3 million.) The bankruptcy court cited other cases for the proposition
that a solvent debtor could avail itself of the 502(b)(6) cap, including
Platinum Capital Inc. v. Sylmar Plaza, L.P. (In re Sylmar Plaza), 314 F3d 1070
(9th Cir. 2002), cert denied, 123 S.Ct. 2097 (2003), which the bankruptcy court
described as almost on all fours with the situation before me. (See the
discussion of this case in the comments below.)
The Third Circuit reversed the holdings of the bankruptcy court and the district
court, ruling that under the facts of this case the debtors Chapter 11 petition
was filed in bad faith because the debtor was financially sound, had no
intention of reorganizing or liquidating as a going concern, had no reasonable
expectation that the bankruptcy filing would maximize the value of the debtors
estate for creditors, and was commenced solely to take advantage of a Bankruptcy
Code provision limiting the rights of landlords. The court noted that the burden
is on the debtor to establish that its petition is filed in good faith, and that
the prime purposes of Chapter 11 are to preserve going-concern value and
maximize the value of the debtors estate for the benefit of creditors (and not,
as is the instant case, to distribute value directly from a creditor to a
companys shareholders). In this connection, the court cited cases holding that
a petition filed without a valid reorganizational p urpose and merely to obtain
a tactical legal advantage would constitute bad faith and constitute cause for
dismissal. The court noted that these principles applied equally to a
liquidating Chapter 11 plan (as occurred in this case). The court reasoned that
[w]hile the owners of [the debtor] may never recover the full value of their
investments, they stand to reap a substantial gain through bankruptcy, at the
expense of the companys sole creditor. . The court found further that the
debtor was not in fact in any financial distress, and noted that the fact that
there is no insolvency requirement for a bankruptcy filing does not mean that
all solvent firms should have unfettered access to Chapter 11.
Furthermore, according to the court, there was no value for [the debtors]
assets that was threatened outside of bankruptcy by the collapse of [the
debtors] bankruptcy model, but that could be preserved or maximized in an
orderly liquidation under Chapter 11.
The court distinguished Sylmar Plaza, supra, which the court found (in a rather
strained analysis) differed from the instant case because it involved a
situation where the Bankruptcy Code was used to maximize value for creditors as
a whole and although the debtors appear to have come out solvent in Sylmar
Plaza, there is no indication that they would have come out solvent had the
banks claim not been limited, or that solvency was a foregone conclusion when
the petition was filed.
With respect to the issue of filing a bankruptcy petition for the purpose of
taking advantage of the § 502(b)(6) cap on a landlords damages, the court
stated that 502(b)(6) and the legislative policy underlying that provision
assume the existence of a valid bankruptcy, which, in turn, assumes a debtor in
financial distress. The question of good faith is therefore antecedent to the
operation of 502(b) (6).” In this case, the court found that always allowing a
tenant to file bankruptcy for the sole purpose of avoiding its lease whenever
the landlords state law remedy exceeded the 502(b)(6) cap was not countenanced
by the Bankruptcy Code or its legislative history and that, [s]uch a rule would
not only obviate the need for a good faith requirement, but would be
antithetical to the structure and purposes of the Bankruptcy Code.
Finally, the court dismissed the debtors assertion that a pending securities
class action necessitated the filing of a Chapter 11 petition, because the
debtors maximum liability (pursuant to a settlement agreement and available
insurance proceeds) was limited to a $5 million reserve. In fact, the court
stated that [r]ather than pursuing a valid bankruptcy purpose . . . [the
debtor] filed for Chapter 11 in part to gain a litigation advantage over the
securities class, a use of Chapter 11 that we emphatically rejected.
Reporters Comment 1: The lender believes that the debtor has abused the
bankruptcy process by filing sham bankruptcy proceeding solely for the purpose
of avoiding the payment of all or a portion of the mortgage loan (including
default interest), or solely for the purpose of avoiding its obligations under a
long-term lease of real estate, the lender may seek to have the automatic stay
lifted shortly after commencement of the case, in order to proceed with a
foreclosure or other enforcement action. If unsuccessful at this juncture, the
lenders next opportunity to move for dismissal would be when the debtor submits
a plan that the lender deems unconfirmable. If the lender has the good fortune
of having the judge rule in its favor, the debtor will have had its day in court
and no more. However, this hope recently was dealt a severe blow by the Ninth
Circuit Court of Appeals. In Sylmar Plaza, supra, the Ninth Circuit upheld the
confirmation of the debtors (a limited par tnership and associated individuals)
Chapter 11 reorganization plan, which was filed by the solvent debtor-mortgagor
for the sole purpose of avoiding approximately $1 million of default interest
due on a mortgage loan from the debtors to the mortgage lender.
The Ninth Circuit rejected lenders argument that the debtor's bankruptcy
reorganization plan was not filed in good faith. The court noted that the
Bankruptcy Code does not define "good faith," and that good faith is determined
case-by-case based on "the totality of the circumstances." The court also stated
that "insolvency is not a prerequisite to a finding of good faith, and the fact
that "a creditor's contractual rights are adversely affected does not by itself
warrant a bad faith finding." The court also stated that, "[the lender proposed
per se rule would inject unnecessary rigidity into the good faith inquiry."
The lender had objected to confirmation of the debtors plan, arguing that it
had not been proposed in good faith as a matter of law, because it had no
independent economic significance and was filed for the sole purpose of avoiding
$1 million of default interest owed to the lender.
The lender also asserted that the plan was discriminatory because it provided
for payment of 10% post-petition interest to all other unsecured creditor
classes, while paying only 8.87% interest to Platinum on the unsecured portion
of its claim. With respect to the disparity in the interest rate paid to other
creditors and the rate paid to the lender, the court ruled that as an
"unimpaired" creditor (i.e., a creditor that received payment in full of its
claim) it had no standing to contest its treatment under the plan because, under
the Bankruptcy Code, it was conclusively presumed to have accepted the plan.
Reporters Comment 2: Although the Ninth Circuit showed great deference to the
bankruptcy courts factual findings on the issue of the debtors good faith,
based on existing case law this was certainly at the very least a close
call. The debtor expressly acknowledged filing for the sole purpose of avoiding
payment of $1 million in default interest, which it would have been
contractually liable to pay if the bankruptcy court had permitted the pending
state foreclosure action to proceed. The court also acknowledged that the
debtors plan would leave it solvent while permitting it to avoid paying
post-petition interest to the lender at the contractual default rate.
Furthermore, the debtor admitted that the individual debtors had transferred the
real estate collateral to the debtor limited partnership at the same time they
defaulted under their mortgage loan obligations to the lender, in clear and
deliberate violation of the due-on-sale clause in the mortgage. It is difficult
to imagine a more egregious factual situation, and one is left to wonder what
possible set of circumstances would persuade the Ninth Circuit to rule that a
debtors Chapter 11 petition had been filed in bad faith. Fortunately there is
case law to the contrary (see Comment 3. below), at least in those situations
where a solvent tenant files a bankruptcy petition solely to limit the
landlords damages under 502(b)(6) of the Bankruptcy Code. But the message to
lenders subject to the Ninth Circuits jurisdiction appears to be: It doesnt
really matter what the debtors motives are, we arent going to rule that the
filing was in bad faith.
Reporters Comment 3:. Many bankruptcy judges are hostile to the concept of a
bad-faith filing and will seldom dismiss a bankruptcy case on such grounds.
Bankruptcy courts often shy away from the concept of bad faith, even if
objective standards are satisfied. However, a number of courts have recognized
the burdens imposed on secured creditors, especially in single-asset cases. Some
courts are responsive to motions to dismiss single-asset cases or to modify the
stay on the grounds that the case was filed in bad faith, while other courts
may, upon recognizing the filing a having been made in bad faith, allow the
debtor no more than the 120-day exclusive period in which to file a plan of
reorganization. However, the case law in this area has been less than uniform.
These are the factors some courts consider in finding bad faith:
1. The debtor has few or no unsecured creditors; 2. There has been a previous
bankruptcy petition by the debtor or a related entity; 3. The prepetition
conduct of the debtor has been improper; 4. The petition effectively allows the
debtor to evade court orders; 5. There are few debts to non-moving creditors; 6.
The petition was filed on the eve of foreclosure; 7. The foreclosed property is
the sole or major asset of the debtor; 8. The debtor has no ongoing business or
employees; 9. There is no possibility of reorganization; 10. The debtor's income
is not sufficient to operate; There was no pressure from nonmoving creditors;
11. Reorganization essentially involves the resolution of a party dispute; 12. A
corporate debtor was formed and received title to its major assets immediately
before the petition (the "new debtor syndrome"); and 13. The debtor filed solely
to create the automatic stay.
The secured creditor should consider moving for dismissal immediately after the
debtor files the bankruptcy petition. The creditors motion for dismissal may be
heard simultaneously with the debtors motion to use cash collateral. This
hearing is the first opportunity to present to the judge the creditors
interests and efforts, or inability, to work out a solution to the case. The
creditor may try to persuade the judge that the filing is made in bad faith or
that reorganization is futile. Although it is unlikely that the case will be
dismissed at such an early stage, the judge may set a strict time limit for
extensions to the exclusivity period and may deny any motions without prejudice.
Reporters Comment 4: Fortunately, other federal courts, under circumstances
similar to those found in Sylmar Plaza, supra, have found that the mortgagee was
entitled to the default rate of interest stated in the loan documents. For
example, in In re 139-141 Owners Corp., 306 B.R. 763 (2004), the bankruptcy
court for the Southern District of New York, citing prior authority in the
Second Circuit (and in other jurisdictions), rejected the courts holding in
Sylmar Plaza, supra. The court ruled that while in most circumstances it is
within the courts equitable power to limit or prevent the collection of the
contractual default rate by the mortgagee in order to provide an equitable
distribution” to creditors, this is not a statutory right and is inappropriate
and inequitable, and therefore should not be invoked, where the debtor is
solvent and the rights of unsecured creditors are not adversely affected. The
bankruptcy court cited the Second Circuits prior ruling in Rusk in
v. Griffiths, 269 F.2d 827 (2nd Cir. 1959), cert. denied, 361 U.S. 947 (1960),
which enforced the creditors right to the contractual default interest rate
where the debtor was solvent. The court in 139-141 Owners Corp. stated that,
Ruskin remains effective to date in the Second Circuit and is recognized by
other circuits, 139-141 Owners Corp., supra at 771, and cited numerous decisions
upholding the creditors right to contractual default interest where there were
no countervailing equitable considerations. Id. (See, e.g., In re Vest Assocs.,
217 B.R. 696, 702-03 (Bankr. S.D.N.Y. 1998). The developing consensus is a
presumption of favor in the contract default rate subject to equitable
considerations . . . If a debtor is solvent, there is much more leeway to grant
the default rate because other creditors will not be injured. The court found
that in this case the equities did not warrant the exercise of the courts
equitable discretion to nullify the creditors contractual right to collect
default interest, for the following reasons: the debtor was solvent at all
times, (the value of the debtors assets was more than twice its liabilities);
its income was more than sufficient to pay its obligations as they became due,
including debt service on both the first mortgage and second mortgage in effect
on the property; the debtor defaulted in the payment of both mortgages for the
sole purpose of diverting income to pay for the debtors other business
ventures; the debtor did not file its bankruptcy proceeding to become
profitable, to protect other creditors, or to prevent a foreclosure sale that
would wipe out equity in the property; and any prohibition of the creditors
right to collect interest at the stated default rate would be of sole benefit to
the debtor and would create an unwarranted windfall. See also In re Liberate
Techs, 2004 Bankr. LEXIS 1339 (Bankr. N.D. Cal. Sept. 8, 2004), (dismissing, for
lack of good faith, Chapter 11 petition filed solely to take advantage of claim
for future rent under 502(b)(6) and stating that, [u]se of the section 502(b)(6)
cap, while not establishing bad faith, also does not establish the requisite
need for chapter 11 relief, and [t]here is no evidence that Congress determined
that state landlord-tenant law should be superseded by federal law except where
necessary to help an entity with genuine financial problems.
Editors Comment: Dont get too excited about the Third Circuits love for
landlords in bankruptcy. In Solow v. PPI Enterprises (U.S.), Inc., 324 F.3d 197
(3d Cir. 2003), the DIRT DD for 7/10/03, the Third Circuit permitted use of
Bankruptcy to take advantage of special tenant lease protections even when there
was no other rationale for a bankruptcy filing and even where the court declared
that the primary purpose of the filing was to cap [landlords claim] under
Bankruptcy Code Sction 502(b)(6).
In Solow, tenant filed for bankruptcy protection under Chapter 11 four years
after defaulting on a commercial office lease, and four years into a state court
lawsuit for damages for such default. At the time, tenant had no active business
and one employee. It did have a significant asset - stock representing a 2 per
cent share in the ownership of a major American food company, which ultimately
it sold in apparently unrelated proceedings to Landlord, who paid $11 million
for the stock and sold it a few months later for $30 million. Further, landlord
alleged, tenant had considerably manipulated its dealings with interrelated
parties in order to create claims that would preempt claims by landlord.
Although the trial court found as a matter of fact that the primary purpose of
the filing was to cap landlord's claim under Bankruptcy Code Section 502(b)(6),
the court found that this was doing nothing more than using the Code as it was
intended. It was even an appropriate use of Chapter 11 (reorganization), since,
even though there was no business to reorganize, the dilution of the landlord's
interest was part of a process of reorganizing the assets of the parent company,
which also was in insolvency proceedings in England.
The Solow landlord was not permitted to make a claim that it could object to the
plan as an impaired creditor because invocation of Section 502(b)(6) rights did
not result in an impairment of the party against whom they are invoked.
The Reporter for this item was Jack Murray of First American Title Insurance,
Chicago office.
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