The term "bad faith" is one that creditors tend to throw out unabashedly. To some, every bankruptcy is in bad faith because the debtor is not satisfying its obligations. Those obligations, however, become a part of the bankruptcy estate and are satisfied through bankruptcy proceedings as Congress intended—that debtors could restructure their debts without the consent of their creditors. Reorganizing without creditor consent is crucial to the success of reorganization proceedings, as demonstrated by the global movement to adopt insolvency laws similar to the U.S. Bankruptcy Code.

Yet even the Code has its limits, as Congress certainly did not intend to create a system for abuse. There are those that will abuse any legal system and otherwise act in bad faith. The problem with bad faith is defining it, as there is a fine line between utilizing the provisions of the Code and abusing them. Without a definition, parties have been left to argue over the appropriate standard.

Defining Bad Faith

Though the Code contemplates dismissal of a bankruptcy case "for cause," bad faith is not enumerated as cause. See 11 U.S.C. §1112. Similarly, the Code contains no requirement that bankruptcy petitions must be filed in good faith. Nonetheless, most courts have expressly interpreted §1112(b) to include dismissal of a chapter 11 case due to "the lack of good faith in its filing." See, e.g., In re Humble Place Joint Venture, 936 F.2d 814, 816-17 (5th Cir. 1991). Other courts have held that "an implicit prerequisite to the right to file [a chapter 11 petition] is good faith on the part of the debtor, the absence of which may constitute cause for dismissal...." Carolin Corp. v. Miller, 886 F.2d 693, 698 (4th Cir. 1989) (citing In re Winshall Settlor's Trust, 758 F.2d 1136, 1137 (6th Cir. 1985)).

Indeed, "[e]very bankruptcy statute since 1898," including the current Code, has "incorporated literally, or by judicial interpretation, a standard of good faith for the commencement, prosecution and confirmation of bankruptcy proceedings." In re Little Creek Develop. Co., 779 F.2d 1068, 1071-72 (5th Cir. 1986). This good-faith requirement exists (1) to prevent the "abuse of the bankruptcy process by debtors whose overriding motive is to delay creditors without benefiting them in any way" and (2) as a means to protect "the jurisdictional integrity of the bankruptcy courts" by making the Code only available to debtors with "clean hands." Id. at 1072.

In determining whether to dismiss a bankruptcy for lack of good faith, most courts apply a totality-of-the-circumstances inquiry. While there is no specific test or exhaustive list of factors for determining bad faith, courts often consider factors that evidence the intent to abuse the judicial process and the purposes of reorganization. See, e.g., Rollex v. Associated Materials Inc., 14 F.3d 240 (4th Cir. 1994). In particular, certain courts consider factors that demonstrate an intent to "delay or frustrate the legitimate efforts of secured creditors to enforce their rights," Albany Partners Ltd. v. Westbrook (In re Albany Partners Ltd.), 749 F.2d 670, 674 (11th Cir. 1984), such as when a debtor files for bankruptcy to prevent a shareholder lawsuit with no intent of effectuating a valid reorganization plan. Cedar Shore Resort Inc. v. Mueller, 235 F.3d 375 (8th Cir. 2000).

While a specific bad-faith test has not been established, courts have identified certain factors that necessitate the dismissal of a particular case as a bad-faith filing. These factors include, but are not limited to, whether:

1. The bankruptcy estate is composed of one asset (which is often a single tract of real property);
2. The secured creditor's liens encumber the tract of real property;
3. There are typically no employees other than the principals of the debtor;
4. The debtor has little or no cash flow;
5. No available sources of income are available to sustain a reorganization plan;
6. Few, if any, unsecured creditors exist (and whose claims are relatively small);
7. The property has been scheduled for foreclosure due to lack of debt payments;
8. Bankruptcy was filed as the last option to prevent loss of the property; and
9. Allegations are made of wrongdoing by the debtor or its principals.

See Little Creek, 779 F.2d at 1073.

Satisfaction of each factor is not necessary to establish bad faith. Instead, when the "conglomerate" of such is met, dismissal is appropriate, as "[r]esort[ing] to the protection of the bankruptcy laws is not proper" when "there is no hope of rehabilitation...." Id.; see, also, C-TC 9th Avenue Partnership v. Norton Co., 113 F.3d 1304 (2d Cir. 1997) (dismissing chapter 11 bankruptcy proceeding because debtor never had any intention of reorganizing).

It is important to note that the lack of intent to act in bad faith does not necessarily result in retention of an alleged bad-faith filing. In fact, the enumerated grounds for dismissing a bankruptcy case resemble certain bad-faith factors without a requisite level of intent. See 11 U.S.C. §1112(b).

When Bad Faith Doesn't Exist, But Dismissal Is Otherwise Appropriate

In addition to a finding of bad faith, a bankruptcy court may also dismiss a "case for cause, if it is in the best interest of the creditors and the estate." See In re Primestone Investment Partners L.P., 272 B.R. 554, 555 (D. Del. 2002). Specifically, §1112(b) states that "on request of a party in interest...and after notice and a hearing, the court may...dismiss a case" under chapter 11 for cause, including for a "continuing loss to or diminution of the estate and [an] absence of a reasonable likelihood of rehabilitation...." 11 U.S.C. §1112(b)(1). In fact, once a court determines that "there is an absence of a reasonable likelihood of rehabilitation" or that a "debtor is suffering continuing losses without the prospect for reorganization," dismissal is appropriate pursuant to §1112(b)(1). See In re Abijoe Realty Corp., 943 F.2d 121 (1st Cir. 1991); see, also, In re Lumber Exchange Building L.P., 968 F.2d 647 (8th Cir. 1992).

In Lumber Exchange, the debtor borrowed more than $20 million from its lender, secured by a mortgage on the debtor's building and by an assignment of rents and leases. See Lumber Exchange, 968 F.2d at 648. Upon filing bankruptcy, the debtor valued its building at only $7 million, leaving the lender with a $13 million deficiency claim. The remaining claims in the debtor's bankruptcy totaled only $1 million, nearly half of which was due to trade creditors. Upon the lender's request for relief from the stay or, in the alternative, dismissal of the case, the debtor filed a plan in which it classified the lender's deficiency claim separately from the other general unsecured claims in the case.

The facts in Lumber Exchange evidenced that the lender would not accept any treatment not providing for surrender of the building or payment in full of its claim. Therefore, the debtor could only confirm a plan under the cramdown provisions of 11 U.S.C. §1129, which require that an impaired class accept its treatment of the plan. Allowing separate classification of the lender's deficiency claim enabled the debtor to create a separate class of unsecured creditors made up of trade creditors that could accept the plan; however, if such a classification were improper, the debtor could not confirm its plan.

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Courts have generally held that the Code grants authority to dismiss a bankruptcy case that was filed in bad faith.

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The Eighth Circuit followed the Fifth Circuit's decision in Greystone in stating that "[a] debtor may classify substantially similar claims separately for 'reasons independent of the debtor's motivation to secure the vote of an impaired, assenting class of claims.'" Id. at 649 (quoting Phoenix Mutual Life Ins. Co. v. Greystone III Joint Venture, 948 F.2d 134, 139 (5th Cir. 1991)). Therefore, because the debtor had demonstrated no legitimate reason for separate classification, the court concluded "that separate classification was a thinly veiled attempt to manipulate the vote to assure acceptance of the plan by an impaired class and meet the requirements of 11 U.S.C. §1129(a)(10)." Id. at 650. In addition, since the debtor could not propose a confirmable plan that did not improperly classify creditors, the Eighth Circuit held that the bankruptcy court properly dismissed the case. Id.

As demonstrated by case law, the standards for dismissing in the best interests of creditors and the standards for bad-faith dismissal are often similar. A case like Lumber Exchange may draw motions to dismiss for bad faith and/or under §1112(b)'s enumerated grounds. The difference is the intent, but even the lack of an improper intent does not mean that a court should retain a bankruptcy case.

Conclusion

Courts have generally held that the Code grants authority to dismiss a bankruptcy case that was filed in bad faith. Bad faith, however, is often tricky to demonstrate.

Fortunately, Congress enacted §1112(b) and stated the circumstances where dismissal is appropriate regardless of whether any evidence of intent exists. These grounds are often the relief needed for dismissing or converting a case that just doesn't belong in chapter 11.