Bankruptcy offers a temporary sanctuary for parties seeking relief from a variety of problems – financial crisis, lawsuits, collection actions, repossessions, foreclosure, and pandemics.
Filing bankruptcy before a money judgment is entered or on the eve of a foreclosure sale is – often to the consternation of creditors – perfectly valid. Creditors often complain that the debtor is acting in bad faith, and the bankruptcy court should toss the case. Those arguments almost always fail.
But not all bankruptcy cases survive long enough for a debtor to reorganize. When a case is truly filed in "bad faith," the bankruptcy court can and often will dismiss it. So when a Bankruptcy Court in Texas recently dismissed the Chapter 11 case filed by the National Rifle Association, it provided an opportunity to look at what constitutes a bad faith filing under the Bankruptcy Code.
The NRA was sued by the New York Attorney General, who alleged the NRA had committed a variety of illegal acts in violation of New York's laws governing not-for-profits. The New York Attorney General has the power to bring enforcement actions against charities like the NRA and, if successful, one of the potential remedies is the dissolution of the charity. The NRA sought to avoid the enforcement action – and particularly the specter of dissolution – by filing bankruptcy and moving to Texas.
When a party files a bankruptcy petition, it must do so for a valid bankruptcy purpose; otherwise, it is a bad faith filing. Valid bankruptcy purposes include avoiding foreclosure, avoiding having to shutter operations, reducing operating costs, addressing burdensome contracts and leases, streamlining and consolidating litigation, attempting to preserve a business as a going concern, or simply obtaining a breathing spell to deal with creditors. A petition filed merely to obtain a tactical litigation advantage is a bad faith filing.
To determine good faith versus bad faith, the courts must consider the totality of the circumstances based on the debtor's financial condition, motives, and the local financial realities. No single factor is dispositive. Since the court must evaluate and decide the issue, witness testimony – particularly from the parties who decided to file the case – is a critical factor. The burden is on the party seeking dismissal to prove bad faith by the debtor. If that party can muster enough evidence to suggest bad faith, then the burden shifts to the debtor to prove that it was acting in good faith.
After a 12-day trial with 23 witnesses, the Bankruptcy Court found that the NRA's bankruptcy petition was not filed in good faith based on the totality of the circumstances. The NRA was not in financial distress and had funds to pay all their creditors in full. The NRA filed their petition to gain an unfair litigation advantage in the New York Attorney General enforcement action. New York might still be able to get a money judgment, but the NRA wanted to take dissolution off the table. The enforcement action was different than a lawsuit by a disgruntled vendor. It was to enforce New York's regulatory scheme for charities, and the NRA was using bankruptcy to try to avoid that regulatory scheme. This was not a legitimate bankruptcy purpose.
The lesson for creditors is that, although infrequent, there are circumstances when a bankruptcy court will dismiss a case. If the debtor has filed a case for a patently improper purpose, you may get it dismissed. But to pursue dismissal and succeed, you need to be prepared to go to trial and present compelling evidence of bad faith to the court through documents and witness testimony.
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This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.