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 debtor’s estate for creditors, and solely to take advantage of a provision of the Bankruptcy Code that limits landlord’s 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-debtor’s 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 landlord’s recovery under § 502(b) (6) of the Bankruptcy Code in order to increase the distribution to the debtor’s shareholders at the landlord’s expense. (Under sec. 502(b)(6) of the Bankruptcy Code, a landlord’s 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 debtor’s bankruptcy filing, the debtor had almost $107 million in cash and other assets while its only indebtedness, outside of the landlord’s 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 debtor’s board of directors, which authorized a letter from the debtor’s 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 landlord’s 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 landlord’s request to dismiss the debtor’s 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 debtor’s 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 landlord’s 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 debtor’s 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 debtor’s 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 debtor’s estate for the benefit of creditors (and not, as is the instant case, to distribute value directly from a creditor to a company’s 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 company’s 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 debtor’s] assets that was threatened outside of bankruptcy by the collapse of [the debtor’s] 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 bank’s 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 landlord’s 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 landlord’s 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 debtor’s assertion that a pending securities class action necessitated the filing of a Chapter 11 petition, because the debtor’s 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.”

Reporter’s 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 lender’s 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 debtor’s (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 lender’s 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 debtor’s 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.

Reporter’s Comment 2: Although the Ninth Circuit showed great deference to the bankruptcy court’s factual findings on the issue of the debtor’s 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 debtor’s 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 debtor’s 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 landlord’s damages under § 502(b)(6) of the Bankruptcy Code. But the message to lenders subject to the Ninth Circuit’s jurisdiction appears to be: It doesnt really matter what the debtor’s motives are, we aren’t going to rule that the filing was in bad faith.

Reporter’s 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 creditor’s motion for dismissal may be heard simultaneously with the debtor’s motion to use cash collateral. This hearing is the first opportunity to present to the judge the creditor’s 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.

Reporter’s 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 court’s holding in Sylmar Plaza, supra. The court ruled that while in most circumstances it is within the court’s equitable power to limit or prevent the collection of the contractual default rate by the mortgagee in order to provide an â€Éequitable 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 Circuit’s prior ruling in Rusk in
v. Griffiths, 269 F.2d 827 (2nd Cir. 1959), cert. denied, 361 U.S. 947 (1960), which enforced the creditor’s 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 creditor’s 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 court’s equitable discretion to nullify the creditor’s contractual right to collect default interest, for the following reasons: the debtor was solvent at all times, (the value of the debtor’s 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 debtor’s 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 creditor’s 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.

Editor’s Comment: Don’t get too excited about the Third Circuit’s 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 [landlord’s 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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