Bankruptcy and the Bad Faith Filing
| Jurisdiction | United States,Federal |
| Citation | Vol. 10 No. 10 Pg. 12 |
| Pages | 12 |
| Publication year | 1997 |
William Thomas Thurman and Brett P. Johnson, J.
Nationwide, the number of bankruptcy filings is exploding. In the year ending June 30, 1997, U.S. bankruptcy filings increased 26.4% over the previous year.[1] Utah too is experiencing a record increase which is outpacing the national rate: Utah's prior one - new record for number of petitions filed was surpassed in the first ten months of 1997. Additionally, through the end of October 1997, 43% of personal bankruptcy filings were individual reorganizations under Chapter 13 - a ratio that gives Utah one of the highest percentages of Chapter 13 filings in the nation.[2] For Utah attorneys, the climbing rate of bankruptcy filings necessarily means that bankruptcies will increasingly affect all types and many stages of litigation. Growing numbers of us will therefore encounter the bankruptcy system. In light of this reality, attorneys should be aware of an issue of increasing importance in bankruptcy law- dismissal of bankruptcy petitions for bad-faith filing. The dismissal of a reorganization petition on bad-faith grounds is a significant victory for a creditor and a significant hardship for a debtor. Such dismissals are therefore the focus of this Article.
In section I, we offer some brief background on the bankruptcy system's evolution and the statutory protections available to creditors. In section II, we explain the judicially-created remedy of dismissal for bad-faith filing. In sections III through V we discuss, in detail, several of the most commonly encountered "badges of bad faith."
I. BACKGROUND
This country's founding fathers recognized the importance of the right to file bankruptcy. Article I of the United States Constitution provides that Congress has the power to establish "uniform Laws on the subject of Bankruptcies throughout the United States."[3] The courts and Congress therefore carefully protect the right to file bankruptcy. One long-standing example of this protection is the common law rule that a person cannot waive by agreement their right to file bankruptcy.[4] Despite the importance and protection given bankruptcy-related rights, many debtors who secure bankruptcy relief are commonly perceived to be abusing the bankruptcy system to achieve improper purposes. Moreover, creditors often complain that the current bankruptcy system has "fostered abuse."[5] One of the most frequently cited examples of abuse involved Paul Bilzerian, a former Wall Street financier, who spent millions building a Florida mansion and then filed bankruptcy to take advantage of Florida's unlimited homestead exemption.[6]
Despite these exceptional cases, it has arguably become more difficult for debtors to abuse the bankruptcy system. Congress has significantly reformed the bankruptcy laws over the course of this century, and particularly during the past two decades. Congress enacted the modern Bankruptcy Code (the "Code") in 1978. The Code revamped the bankruptcy laws, supplanted the former system established by the Bankruptcy Act of 1898, and better articulated the bankruptcy laws, making them more concise and comprehensible. Change to the bankruptcy laws has continued. Most significantly, on October 22, 1994, Congress passed the Bankruptcy Reform Act of 1994.[7] As a partial consequence of these changes, debtor relief has increased and the number of filings, both in Utah and nationwide, has swelled.
These reforms have sought to improve the bankruptcy system's ability to meet the often cited but vaguely defined dual purposes of the bankruptcy system: "[F]acilit[ing] rehabilitation or reorganization of [the debtor's] finances and promoting] a 'fresh start' through the orderly disposition of assets to satisfy . . . creditors."[8] Bankruptcy reform has also reduced the potential for debtors to use the bankruptcy system to "get away with something." For example, the Code's use of independent trustees for debtors filing under Chapters 7, 12, and 13 has dramatically increased scrutiny of debtor finances.[9] Similarly, in Chapter 11 cases where the debtor is left in possession, a court may appoint an independent trustee at the request of either the U.S. trustee or any party in interest "for cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor.'"[10] If the court does not appoint a trustee, it may alternatively appoint an examiner to investigate the Chapter 11 debtor-in-possession or its management.[11] Beyond scrutiny of debtors by trustees and examiners, increasingly severe penalties await persons who commit any one of many offenses that constitute bankruptcy fraud.[12] Congress is considering further reforms: The bankruptcy system may soon involve random audits of filings to check for fraud and abuse, a national registry to track repeat filers, and limits on repeat filings under Chapter 13.[13]
Creditors too play a large role in policing debtors in bankruptcy cases. For example, creditors have the right to put the debtor under the microscope of examination;[14]to challenge or seek revocation of the debtor's discharge or the discharge of an individual debt;[15]and to recover their collateral through a lift of stay.[16]
In addition to this wide-ranging statutorily-mandated scrutiny of debtors is an increasingly employed judge-made check on the filing of reorganization petitions-namely, the requirement that all bankruptcy petitions be filed in good faith. A growing number of courts are dismissing bankruptcy petitions that are filed in "bad faith."
II. WHAT IS A BAD-FAITH FILING?
The requirement that all bankruptcy petitions be filed in good-faith is a judge-made constraint applicable mainly to petitions for reorganization-primarily petitions filed under Chapters 11 and 13. While the Code explicitly requires debtors to propose plans of reorganization in good faith,[17] the Code contains no definition of "bad-faith filing," nor is there any express mandate that bankruptcy petitions be filed in good faith. Indeed, the Code contains no definition of "good" or "bad faith" at all. Although no explicit statutory good-faith filing requirement exists, bankruptcy relief is considered an equitable remedy and courts have imposed by judicial interpretation the requirement that debtors file petitions in good faith. In fact, every federal circuit that has addressed the issue has imposed a good-faith filing requirement for reorganization petitions.[18]
In general terms, a reorganization petition's "dismissal or conversion [to Chapter 7 for bad-faith filing] is a determination , that, even though the court has jurisdiction over the case, proceeding with the case ... would not be in the interests of justice."[19] One court explained that "[s]uch a standard furthers the balancing process between the interests of debtors and creditors which characterizes so many provisions of the bankruptcy laws and is necessary to legitimize the delay and costs imposed upon parties to a bankruptcy."[20] Depending on the chapter under which the would-be debtor is seeking relief, a court will look to one of several Code sections to support the good-faith filing requirement. The two most frequently employed Code sections are 1112(b) and 1307(c), which permit dismissal or conversion of Chapter 11 and Chapter 13 petitions "for cause." Courts frequently find that bad faith constitutes "cause" under these sections.[21] In addition to dismissal and conversion to a Chapter 7, a finding of bad faith can also justify the granting of relief from the automatic stay, an award of sanctions against the debtor and/or its counsel, and sometimes retroactive "annulment" of the automatic stay.[22]
When a court addresses the bad-faith filing issue, the court applies a "sniff test": if the court smells something fishy, dismissal is likely. The bad-faith-filing test is a sniff test because most courts, including the Tenth Circuit, have found that the good or bad faith of a reorganizing petition requires consideration of the "totality of the circumstances" and therefore does not hinge on any single factor.[23] In considering the totality of the circumstances, courts look for many so-called "badges of bad faith." Commonly cited badges of bad faith include:
(1) a debtor's ownership or interest in only one asset;
(2) improper prepetition conduct by the debtor;
(3) the presence of few unsecured creditors;
(4) the posting of the debtor's property for foreclosure coupled with an unsuccessful fight against the foreclosure in state court;
(5) the debtor and the principal creditor have litigated to a standstill in state court and the debtor has lost or been required to post a bond;
(6) the debtor evaded court orders by filing the petition;
(7) the debtor lacks an ongoing business or employees;
(8) the timing of the petition's filing is overly strategic;
(9) the debtor's motive for filing the petition is improper; and
(10) the debtor's actions negatively affected creditors, both before and after the debtor filed the petition.[24]
As one can see from the length of this noninclusive list, a huge range of factors is relevant and the bankruptcy court can pick among them to support or deny a finding of bad faith. Moreover, these factors are necessarily examined in light of the overall purposes of the bankruptcy system, which are ill-defined, evolving, and variable from courtroom to courtroom.[25] In short, one can identify no precise test by which a bankruptcy filing can be labeled a bad-faith filing.
Despite the absence of a precise test, several general considerations run throughout the bad-faith filing cases. First, courts will not permit debtors to file reorganization petitions '"solely to frustrate the legitimate efforts of a legitimate creditor to enforce [its] rights.'"[26] Frustration of creditors' rights can of course take a...
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