On February 13, 2018, Judge Silverstein of the Delaware Bankruptcy Court granted a motion to dismiss the Rent-A-Wreck of America bankruptcy case (Bankr. D. Del. case 17-11592). Judge Silverstein’s opinion is available here (the “Opinion”).
In summarizing her holding, Judge Silverstein provides: These privately-owned debtors are not in financial distress (or at least they have not proven they are), and they seek to use 11 U.S.C. § 365 to redistribute value from a long-time adversary to enrich their ultimate shareholder. The one entity that may be adversely affected by the Debtors’ bankruptcy filing is the Movant, David Schwartz. Mr. Schwartz was held by the Maryland District Court, and affirmed by the Fourth Circuit, to be the the holder of an implied-in-fact royalty and fee-free franchise in West Los Angeles. Opinion at *7. He argues that the Debtors filed bankruptcy for the sole purpose of rejecting his franchise, and are not filed in good faith, but are instead a continuation of the Maryland District Court litigation. Opinion at *12
The Debtors argued that they filed for bankruptcy protection to maximize the value of the Rent-A-Wreck trademark, to reject burdensome franchise agreements, and to relieve Debtors’ balance sheet of significant debt, all of which Debtors posit constitute valid reorganizational purposes. Opinion at *12.
Judge Silverstein began her analysis of this case by reviewing the inquiry of the Debtors’ good faith as directed by precedential holdings of the Third Circuit. Opinion at *14. The Third Circuit considers two primary factors to determine good faith – first, whether the petition serves a valid bankruptcy purpose, second, whether the petition was filed to gain a tactical advantage. Id. The main precedential opinion cited by Judge Silverstein is In re Integrated Telecom Express, Inc., 384 F.3d 108 (3d Cir. 2004).
According to the Opinion, good faith is a predicate to a debtor’s ability to use provisions of the Bankruptcy Code, and financial distress is a part of if not itself a predicate to—a good faith analysis. Opinion at *15. Judge Silverstein continues: The ability to use the redistributive
provisions of the Bankruptcy Code assumes the existence of a valid bankruptcy, which, in turn, assumes a debtor in financial distress. Id. In this case, the Debtors never represented that they were insolvent, and Judge Silverstein, accordingly, determined that they were solvent. Opinion at *18. Neither did the Debtors provide evidence indicating that they were unable to pay their debts as they came due. Opinion at *19. Judge Silverstein determined that, in sum, the lack of credible facts demonstrating financial distress supports a finding that these cases were not filed in good faith. Opinion at *26.
Pursuant to the Opinion, Judge Silverstein understood the Debtors’ argument that their filing was in good faith as follows: the rejection of the Schwartz franchise agreement maximizes Debtors’ assets thus permitting them to stay in business, satisfying both prongs of the bankruptcy purpose. Opinion at *28. Judge Silverstein disagreed, quoting Integrated Telecom:
To be filed in good faith, a petition must do more than merely invoke some distributional mechanism in the Bankruptcy Code. It must seek to create or preserve some value that would otherwise be lost—not merely distributed to a different stakeholder—outside of bankruptcy.
Opinion at *28 (quoting Integrated Telecom, 384 F.3d at 128-29) (emphasis in Opinion). Judge Silverstein concludes my opining that the Debtors bankruptcy filing was made for the purpose of redistributing the value of the Rent-A-Wreck trademark in the Los Angeles territory from Mr. Schwartz to Bundy. Opinion at *29. Accordingly, the primary, if not sole, beneficiaries of that value would be the Debtors’ equity holders, not its creditors. Judge Silverstein states that she has “no doubt these petitions were just another chapter in the attempt to terminate Mr. Schwartz’s franchise and obtain the benefits for JJFMS.” Opinion at *36.
Judge Silverstein provides in the Opinion, that 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. Opinion at *36. I note, however, that the thread running throughout the Opinion is the requirement that a debtor be financially distressed in order to take advantage of the relief provided by the Bankruptcy Code. Financial distress is a broad term, that can be applied to entities ranging from those suffering a liquidity crisis with substantial equity – to those suffering from over-leverage or long-term non-profitability. In these situations, and countless others, the Bankruptcy Code can provide relief. It is important, however, to ensure that your company can satisfy the Court’s scrutiny of whether a petition was filed in good faith – recognizing that the burden of proof is on the debtor.
John Bird practices with the law firm Fox Rothschild LLP and is resident in Portland, Oregon. You can reach him at 302-622-4263, or email@example.com.