United States: Patently Abusive Chapter 11 Cases Filed By Non-Financially Distressed Companies Dismissed For Bad Faith

In the service of the Bankruptcy Code's goals of giving debtors a "fresh start" and ensuring that estate assets are fairly and equally distributed among similarly situated creditors, the Bankruptcy Code contains an array of advantageous provisions that either do not exist under non-bankruptcy law or are more difficult to deploy. These include, among other things, the ability to reject burdensome contracts, to avoid preferential or fraudulent transfers, and to limit the amount of certain types of creditor claims. These powers are particularly important in chapter 11 cases, where a successful outcome may not be possible without them.

Chapter 11, however, and the powers given by the Bankruptcy Code to debtors-in-possession and bankruptcy trustees are not available to every entity that is technically eligible to file for relief. As illustrated by a ruling recently handed down by the U.S. Bankruptcy Court for the District of Delaware—In re Rent-A-Wreck of America, Inc., 580 B.R. 364 (Bankr. D. Del. 2018)—chapter 11 is open only to debtors that file for bankruptcy in "good faith." The court dismissed a chapter 11 case as having been filed in bad faith because the debtor was not in financial distress and had filed for bankruptcy solely to reject a franchise agreement that it had been unable to terminate outside bankruptcy.

Dismissal of a Chapter 11 Case for Bad Faith

Section 1112(b) of the Bankruptcy Code provides that a chapter 11 case may be dismissed or converted to a chapter 7 liquidation for "cause." Section 1112(b)(4) sets forth a nonexclusive list of grounds that constitute cause, including, among other things, "the absence of a reasonable likelihood of rehabilitation," failure to file or confirm a chapter 11 plan within the time fixed by the Bankruptcy Code or the court, or the inability to effectuate "substantial consummation of a confirmed plan."

Although "bad faith" is not listed in section 1112(b)(4), courts have consistently found that the absence of good faith in connection with the filing of a chapter 11 case is cause for dismissal or conversion. The good faith filing requirement is designed to ensure that the burdens imposed by bankruptcy on creditors are justified by fulfillment of chapter 11's objectives: preserving going concerns and maximizing assets available to satisfy creditors. The basic thrust of the good faith inquiry has traditionally been whether, in view of the totality of the circumstances, the debtor needs chapter 11 relief. See C-TC 9th Ave. P'ship v. Norton Co. (In re C-TC 9th Ave. P'ship), 113 F.3d 1304, 1309–10 (2d Cir. 1997) (dismissal was warranted if "there was no reasonable likelihood that the debtor intended to reorganize and no reasonable probability that it would eventually emerge from bankruptcy proceedings"); NMSBPCSLDHB, L.P. v. Integrated Telecom Express, Inc. (In re Integrated Telecom Express, Inc.), 384 F.3d 108, 119–20 (3d Cir. 2007) (the test focuses on "whether the petition serves a valid bankruptcy purpose . . . [or] whether the petition is filed merely to obtain a tactical litigation advantage"); In re Premier Automotive Services, Inc., 492 F.3d 274, 279–80 (4th Cir. 2007) (a chapter 11 filing was made in "subjective bad faith" where the debtor had no demonstrable need to organize and was not experiencing financial difficulties and where the filing revealed solvent business with no unsecured creditors and few, if any, secured creditors). But see In re Capitol Food Corp. of Fields Corner, 490 F.3d 21, 26 (1st Cir. 2007) (declining to address whether section 1112(b) imposes the "good faith" requirement, but ruling that the debtor's use of chapter 11 to obtain "time-out" and delay foreclosure of its leasehold interest did not mean that the petition had been filed solely to obtain a tactical litigation advantage, which many courts have found to be a hallmark of bad faith).

For example, in Integrated Telecom, the Third Circuit focused on two inquiries bearing on the question of good faith: (i) whether the filing serves a "valid bankruptcy purpose, e.g. by preserving a going concern or maximizing the value of the debtor's estate," or (ii) whether the case was filed "merely to obtain a tactical litigation advantage." Integrated Telecom, 384 F.3d at 119–20 (citing In re SGL Carbon Corp., 200 F.3d 154, 165 (3d Cir. 1999)). The Third Circuit further explained that a debtor's desire to invoke the powers conferred by the Bankruptcy Code, such as the ability to limit lease rejection damages or otherwise benefit from provisions "that have the effect of redistributing value from one interest group to another," does not establish good faith, nor is it a valid bankruptcy purpose in the absence of financial distress. Id. at 127–29. Otherwise, the court emphasized, any entity willing to "undergo" (and bear the cost of) a bankruptcy filing could use the Bankruptcy Code's redistributive mechanisms to its advantage, a concept that is "antithetical to the structure and purposes of the Bankruptcy Code." Id. at 129.

Faced with a motion to dismiss a bankruptcy filing for bad faith under section 1112(b), the debtor bears the burden of establishing that the petition was filed in good faith. SGL Carbon, 200 F.3d 162 n.10.


David Schwartz is one of the two founders of budget automobile rental franchise Rent-A-Wreck of America, Inc. ("RAWA"). In 2007, Schwartz sued J.J.F. Management Services, Inc. ("JJFMS"), which had purchased the other founder's interest in RAWA, in federal district court seeking a declaratory judgment that, on the basis of a 1985 agreement, he had a royalty-free Rent-A-Wreck franchise covering the Los Angeles region. The litigation resulted in several rulings from the district court and the U.S. Court of Appeals for the Fourth Circuit in Schwartz's favor. JJFMS protracted the litigation by, among other things, failing to comply with the terms of the ongoing franchise relationship and defying various court orders. In June 2017, the district court found JJFMS in contempt.

JJFMS, as the parent of RAWA, caused RAWA and its wholly owned operating subsidiary Bundy American, LLC ("Bundy" and, collectively, the "Debtors") to file for chapter 11 protection in the District of Delaware one month later. Shortly afterward, the Debtors filed a motion to reject seven franchise agreements, including the agreement with Schwartz.

Schwartz objected to the rejection motion. He also moved to dismiss the Debtors' chapter 11 cases as having been filed in bad faith. According to Schwartz, the bankruptcy filing was merely a continuation of the district court litigation, a two-party dispute that did not belong in bankruptcy court. He argued that JJFMS was attempting to use the Bankruptcy Code to do what it had failed to do in the litigation—strip him of his franchise rights. Schwartz also argued that the Debtors were not in any financial distress.

The Debtors countered that they had filed for bankruptcy to maximize the value of the Rent-A-Wreck trademark, to reject burdensome franchise agreements, and to relieve their balance sheet of significant debt, all of which are valid reasons for a chapter 11 filing. They also claimed that, by rejecting Schwartz's exclusive franchise agreement, they could both eliminate significant continuing litigation expense and open the Los Angeles territory to new royalty-paying franchisees.

According to the Debtors, even if their sole motive for filing for chapter 11 was to reject the Schwartz franchise agreement, the petitions would have been filed in good faith because it is not bad faith to file for bankruptcy in order to make use of the specific powers given to debtors by the Bankruptcy Code.

The Bankruptcy Court's Ruling

The bankruptcy court granted the motion to dismiss, finding that the Debtors had filed their chapter 11 cases in bad faith.

The court rejected the Debtors' argument that they merely had to show a "valid reorganizational purpose," rather than financial distress, as an element of good faith. It examined a number of factors bearing on the latter, including solvency, cash reserves, cash position, liquidity and the ability to pay debts as they mature, recent financial performance and profitability, the proportion of debt owed to insiders, and the threat of litigation. The court held that the Debtors were not in financial distress when they filed for bankruptcy protection.

The court found, among other things, that: (i) the companies were not insolvent (although insolvency is not a prerequisite to bankruptcy relief); (ii) the Debtors acknowledged that their unsecured debt did not drive the decision to file for bankruptcy; (iii) the Debtors' only secured debt, while substantial, was owed to their ultimate corporate parent, JJFMS, which had taken no steps to collect on the debt even though it had matured in 2011; (iv) the Debtors failed to provide any specific evidence of their current cash position, liquidity, or ability to pay debts as they matured; and (v) litigation in which the Debtors were involved did not pose a significant threat to their financial situation. The court concluded that "[t]he lack of credible facts demonstrating financial distress supports a finding that these cases were not filed in good faith."

According to the bankruptcy court, the nonfinancial evidence also supported a finding of bad faith. It showed that the Debtors' alleged motivations for filing for bankruptcy—maximizing trademark value, reducing debt, and rejecting unfavorable franchise agreements—were merely a pretext. The "primary purpose of the bankruptcy filing," the court wrote, "is to reject . . . Schwartz's franchise agreement so Debtors can open the Los Angeles territory to multiple royalty-paying franchisees." Moreover, the court noted, the bankruptcy filings accelerated rather than eliminated further litigation with Schwartz by exchanging "one set of issues for another and the expense of civil litigation for that of bankruptcy litigation."

The court explained that the good faith inquiry is "particularly sensitive" if the bankruptcy case "seeks to distribute value directly from a creditor to a company's shareholders." In this case, the court wrote, the Debtors' purpose in filing for chapter 11 "is nothing more than a straightforward attempt to take value that belongs to [Schwartz] and give it to Bundy" and JJFMS, rather than to creditors. Thus, the court emphasized, the Debtors' chapter 11 cases were a prime example of the situation the Third Circuit warned against in Integrated Telecom: "the use of the Bankruptcy Code—and, in particular, its redistributive provisions—when a party is willing to pay the freight of a bankruptcy case."


Good faith acts as the gatekeeper in chapter 11 in two ways. First, any chapter 11 petition that a debtor files in bad faith can be dismissed under section 1112(b). Second, section 1129(a)(3) expressly provides that every chapter 11 plan must be "proposed in good faith," a provision which has been construed to require that a plan be proposed with honesty and good intentions and with a basis for expecting that a reorganization or liquidation, as the case may be, can be effected.

Rent-A-Wreck indicates that the good faith filing requirement demands that the debtor be under some level of financial distress. The extent of the financial distress required varies, and a bankruptcy court has considerable discretion in determining what qualifies.

ent-A-Wreck is an unusual case. The debtor initially failed to present any evidence of financial distress because it took the position that merely citing a "valid reorganizational purpose" was sufficient. This meant that the court was required to conduct its own examination of the debtor's affairs—an analysis which laid bare, in the court's view, the debtor's ulterior motive in filing for chapter 11. The good faith inquiry in other cases may be a closer call.

The Rent-A-Wreck court cautioned that its holding should be limited to the facts of cases like the one before it, in which borderline "patently abusive" debtors were attempting "to avoid the results of their own provocative actions." It noted that, "[i]n another circumstance, a financially distressed debtor's recognition of the outcome of litigation and/or a desire to avoid future litigation may serve as a legitimate basis for the filing of a bankruptcy case."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Mark G. Douglas
Similar Articles
Relevancy Powered by MondaqAI
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Mondaq Sign Up
Gain free access to lawyers expertise from more than 250 countries.
Email Address
Company Name
Confirm Password
Mondaq Newsalert
Select Topics
Select Regions
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions