Fourth Circuit Affirms Chapter 11 Dismissal

Facts

The debtor had leased a marine terminal in Baltimore from the Maryland Port Administration ('MPA'), a state agency. Prior to the expiration of the debtor's lease on June 30, 2002, the parties failed to negotiate a renewal, and the debtor remained in possession as an at will holdover tenant on a month-to-month basis. When extensive negotiations over the next two years failed, the MPA entered into a lease with a third party for the debtor's property, terminating the debtor's month-to-month tenancy. One day before the designated end of its tenancy, on April 29, 2005, the debtor filed a Chapter 11 petition, triggering the statutory automatic stay contained in Bankruptcy Code ('Code') ' 362(a), and, in a separate suit, alleging a variety of constitutional violations against MPA and other state officials.

The Litigation

The bankruptcy court dismissed the debtor's suit, after a few hearings, vacated the stay and dismissed the debtor's Chapter 11 petition. As it found, the debtor had filed the bankruptcy petition in bad faith 'for the sole purpose of halting and/or delaying [the debtor's] ultimate eviction ' by MPA.' 2007 WL 1721951, at *2. Moreover, the debtor's expired lease was no longer 'property of the estate' under Code ' 541(b): a 'bankruptcy court has no authority to resuscitate a lease of real property that expired by its own terms prepetition,' it reasoned. Id.

The debtor then sued MPA in the Federal Maritime Commission, based on the same facts, alleging violations of the Federal Shipping Act. The administrative law judge also dismissed that suit. When the debtor filed a second suit in the District Court for injunctive relief, the court consolidated the complaint against the Federal Maritime Commission and the debtor's appeal from the bankruptcy court's decision dismissing the Chapter 11 petition, rejecting all of the debtor's arguments. Id., at 3.

The Judicially Created Good Faith Doctrine

Courts have consistently conditioned a debtor's right to file a Chapter 11 petition on its 'good faith.' Michigan Nat'l Bank v. Charfoos (In re Charfoos), 979 F.2d 390, 392 (6th Cir. 1992). A bankruptcy judge thus has the right to 'conduct a threshold inquiry into the good faith' of the debtor. 2007 WL 1721951, at *3, citing Carolin Corp. v. Miller, 886 F.2d 693, 702 (4th Cir. 1989). This good faith requirement 'prevents abuse of the bankruptcy process by debtors whose overriding motive is to delay creditors without benefiting them in any way or to achieve reprehensible purposes.' In re Little Creek Dev. Co., 779 F.2d 1068, 1072 (5th Cir. 1986).

No Need for Reorganization Relief

To dismiss a Chapter 11 petition, the Fourth Circuit requires a showing of 'objective futility' and 'subjective bad faith.' Carolin, 886 F.2d at 700-01. The debtor argued here that it was seeking a fair lease from MPA, and that it had filed the Chapter 11 petition in good faith because it needed the leased property in order to remain in business. 2007 WL 1721951, at *4. The Court of Appeals found, however, that the debtor 'clearly had no 'realistic possibility of an effective reorganization.” Id., citing Carolin, 886 F.2d at 698. First, the debtor 'never filed a proposed plan of reorganization,' but merely asserted that its 'plan for reorganization is this litigation.' Id. Not only had the debtor lacked any 'cognizable property interest in its expired lease,' it has also had 'no right to judicially compel the negotiation,' making 'its reorganization-qua-litigation strategy ' wholly illusory.' Id. Because the debtor could not reorganize effectively, even if it were to obtain the litigation relief it sought, the debtor's lease dispute belonged in the state courts.

The record here also confirmed the debtor's 'impermissible purpose':

[The debtor] had no demonstrable need to reorganize when it filed its petition: it was not, the bankruptcy court found, even 'experiencing financial difficulties.' Indeed, [the bankruptcy filing revealed] a solvent business entity with no unsecured creditors and few, if any, secured creditors. This fact alone may justify dismissal of [the debtor's] Chapter 11 petition. As one of our sister circuits has noted, courts 'have consistently dismissed Chapter 11 petitions filed by financially healthy companies with no need to reorganize under the protection of Chapter 11.' In re SGL Carbon Corp., 200 at F.3d 154, 166 (3d Cir. 1999). Id.

Thus, the debtor's financial condition is critical in any bad faith filing dispute. See, e.g., PPI Enter. 324 F.3d 197 (debtor's insolvency precluded dismissal); Integrated Telecom Express, 384 F. 3d 108 (3d Cir. 2004) (dismissal ordered; debtor financially healthy; cash rich; motivated by desire to impair landlord's rights for benefit of shareholders); In re SGL Carbon Corp., 200 F.3d 154, 167 (3d Cir. 1999) (dismissal ordered; financially healthy debtor filed Chapter 11 petition 'solely to gain tactical litigation advantages.').

A Failed Litigation Strategy

The Fourth Circuit found other evidence of bad faith. First, the parties had been merely unable to agree on the terms of a new lease; and there had been no failure by MPA to negotiate in good faith. Second, the debtor's asserted claims against MPA turned on state contract law, but the debtor had not commenced any state court litigation prior to filing its Chapter 11 petition. Indeed, the 'eleventh-hour filing of [the debtor's] bankruptcy petition ' ' just one day before the company was legally obligated to quit the premises' ' confirmed the debtor's bad faith.

Holding an asset hostage is not a permissible use of the bankruptcy process, however. Chapter 11 is not a procedural vehicle which may be commandeered solely for 'the purpose of invoking [its] automatic stay.'

Id., at *5 citing Carolin, 886 F.2d at 702. See also In re Bal Harbour Club, Inc., 316 F.3d 1192-1193-95 (11th Cir. 2003) (dismissal of Chapter 11 case proper when debtor 'abused ' bankruptcy process' and 'judicial process'; 'initiation of litigation to frustrate ' acquisition of' real property).

Expired Lease Not Part of Debtor's Estate

The debtor also had no property interest to protect when it commenced its Chapter 11 case. 'A mere possessory interest under an expired lease is insufficient to trigger an automatic stay under [Code] ' 362(a)'. Id., at 5. Code ' 362(b)(10) 'excludes from its protection' commercial 'real property leases that expire 'before the commencement of or during the case'.' Id. Not only had the lease here expired three years prior to bankruptcy, but the debtor's later month-to-month tenancy had been terminable at MPA's will. MPA had told the debtor that its month-to-month tenancy would end on May 1, 2005. Thus, the lease here expired shortly after the commencement of the case, entitling MPA to evict the debtor. Moreover, because the month-to-month tenancy had expired on May 1, 2005, 'the bankruptcy estate had no interest in the lease on that day.' Id., citing Code ' 541(b)(2) (terminated commercial lease not part of debtor's estate.).

Baseless Constitutional Claims

Finally, the circuit court affirmed the lower court's findings that the debtor's constitutional claims were 'unsupportable attempts to circumvent the bankruptcy law's various bars to' the Chapter 11 filing. Id. at 6. First, there is no constitutionally protected property right 'to have another [party] agree to contract on commercially disadvantageous terms.' Id. Nor was the debtor legitimately entitled to a new lease. Id. Indeed, the lower courts found that MPA's 'actions bespeak accommodation, not arbitrary and unjustifiable governmental action.' Id., at *7. In short, the debtor's 'various constitutional claims are not only tenuous at best, but carry us far afield from the purposes of bankruptcy law '. To allow resort to the bankruptcy process for plainly meritless constitutional claims advanced solely to thwart lawful eviction would do nothing but subvert the purposes of a Chapter 11 reorganization.' Id. at *8.

Conclusion: Facts Govern

The successful lessor in Premier Automotive had persuasive facts. In Capitol Food Corp., supra, handed down by the First Circuit nine days earlier, the court stressed 'the fact-intensive nature of the good faith question.' 2007 WL 1616646, at *2. 'Catastrophic business events' and true 'imminent financial distress,' however, will still probably sustain a Chapter 11 filing in the face of a bad faith attack. Id. at *3. So, too, will an overly litigious lessor with no facts and overheated rhetoric. Id.

Michael L. Cook, a member of this newslettter's Board of Editors, is a partner at Schulte Roth & Zabel LLP in New York.

The Fourth Circuit, on June 15, 2007, affirmed the dismissal of a Chapter 11 reorganization petition filed by a tenant debtor in a commercial lease dispute. Maryland Port Administration v. Premier Automotive Services, Incorporated (In re Premier Automotive Services, Incorporated), ___ F.3d ___, 2007 WL 1721951 (4th Cir. 6/15/07). As the Court of Appeals explained, the tenant had filed its Chapter 11 petition 'in order to forestall eviction on an obviously expired lease ' to prevent the [lessor] from evicting the debtor from the [lessor's] property,' seeking to tie up the landlord 'in endless, fruitless litigation.' Id., at *1. According to the court, the Chapter 11 filing here 'demonstrate[s], unfortunately, how the good and useful ends of the bankruptcy process can be badly abused.' Id.

The Federal Courts' Growing Skepticism to Litigious Commercial Tenants

Federal courts have increasingly rejected extortionate litigation by commercial tenants in the bankruptcy context. In re Integrated Telecom Express, Inc., 384 F.3d 108 (3d Cir. 2004) (held, solvent debtor tenant filed Chapter 11 petition in bad faith; had no present need for bankruptcy relief; could not use Chapter 11 solely to cap commercial lessor's lease rejection damages); In re Liberate Technologies, Inc., 314 B.R. 206 (Bankr. N.D. Cal. 2004) (same; debtor had cash well in excess of liabilities). But see In re PPI Ent. (U.S.) Inc., 324 F. 3d 197 (3d Cir. 2003) (held, no cause for dismissal when insolvent debtor filed Chapter 11 petition to cap landlord's damage claim); Fields Station LLC v. Capitol Food Corp. of Fields Corner (In re Capitol Food Corp. of Fields Corner), ___ F.3d ___ 2007 WL 1616646, *3-5 (1st Cir. 6/6/07) held, because lessor failed to make 'prima facie showing' of bad faith filing, 'bankruptcy court did not abuse its discretion in denying ' motion to dismiss the Chapter 11 petition ” despite debtor's solvency, it was financially troubled; had been 'deprived of its principal source of cash flow'; 'non-monetary default' under lease 'threatened to extinguish its lucrative leasehold'; debtor 'had a present need for Chapter 11 protection to avoid business disruption and economic dismemberment.'; debtor's operation 'restored a reliable and adequate cash flow [to] pay its past and ongoing debts to unsecured creditors [and] continue its timely rental payments' to the lessor.).

Facts

The debtor had leased a marine terminal in Baltimore from the Maryland Port Administration ('MPA'), a state agency. Prior to the expiration of the debtor's lease on June 30, 2002, the parties failed to negotiate a renewal, and the debtor remained in possession as an at will holdover tenant on a month-to-month basis. When extensive negotiations over the next two years failed, the MPA entered into a lease with a third party for the debtor's property, terminating the debtor's month-to-month tenancy. One day before the designated end of its tenancy, on April 29, 2005, the debtor filed a Chapter 11 petition, triggering the statutory automatic stay contained in Bankruptcy Code ('Code') ' 362(a), and, in a separate suit, alleging a variety of constitutional violations against MPA and other state officials.

The Litigation

The bankruptcy court dismissed the debtor's suit, after a few hearings, vacated the stay and dismissed the debtor's Chapter 11 petition. As it found, the debtor had filed the bankruptcy petition in bad faith 'for the sole purpose of halting and/or delaying [the debtor's] ultimate eviction ' by MPA.' 2007 WL 1721951, at *2. Moreover, the debtor's expired lease was no longer 'property of the estate' under Code ' 541(b): a 'bankruptcy court has no authority to resuscitate a lease of real property that expired by its own terms prepetition,' it reasoned. Id.

The debtor then sued MPA in the Federal Maritime Commission, based on the same facts, alleging violations of the Federal Shipping Act. The administrative law judge also dismissed that suit. When the debtor filed a second suit in the District Court for injunctive relief, the court consolidated the complaint against the Federal Maritime Commission and the debtor's appeal from the bankruptcy court's decision dismissing the Chapter 11 petition, rejecting all of the debtor's arguments. Id., at 3.

The Judicially Created Good Faith Doctrine

Courts have consistently conditioned a debtor's right to file a Chapter 11 petition on its 'good faith.' Michigan Nat'l Bank v. Charfoos (In re Charfoos), 979 F.2d 390, 392 (6th Cir. 1992). A bankruptcy judge thus has the right to 'conduct a threshold inquiry into the good faith' of the debtor. 2007 WL 1721951, at *3, citing Carolin Corp. v. Miller , 886 F.2d 693, 702 (4th Cir. 1989). This good faith requirement 'prevents abuse of the bankruptcy process by debtors whose overriding motive is to delay creditors without benefiting them in any way or to achieve reprehensible purposes.' In re Little Creek Dev. Co., 779 F.2d 1068, 1072 (5th Cir. 1986).

No Need for Reorganization Relief

To dismiss a Chapter 11 petition, the Fourth Circuit requires a showing of 'objective futility' and 'subjective bad faith.' Carolin, 886 F.2d at 700-01. The debtor argued here that it was seeking a fair lease from MPA, and that it had filed the Chapter 11 petition in good faith because it needed the leased property in order to remain in business. 2007 WL 1721951, at *4. The Court of Appeals found, however, that the debtor 'clearly had no 'realistic possibility of an effective reorganization.” Id., citing Carolin, 886 F.2d at 698. First, the debtor 'never filed a proposed plan of reorganization,' but merely asserted that its 'plan for reorganization is this litigation.' Id. Not only had the debtor lacked any 'cognizable property interest in its expired lease,' it has also had 'no right to judicially compel the negotiation,' making 'its reorganization-qua-litigation strategy ' wholly illusory.' Id. Because the debtor could not reorganize effectively, even if it were to obtain the litigation relief it sought, the debtor's lease dispute belonged in the state courts.

The record here also confirmed the debtor's 'impermissible purpose':

[The debtor] had no demonstrable need to reorganize when it filed its petition: it was not, the bankruptcy court found, even 'experiencing financial difficulties.' Indeed, [the bankruptcy filing revealed] a solvent business entity with no unsecured creditors and few, if any, secured creditors. This fact alone may justify dismissal of [the debtor's] Chapter 11 petition. As one of our sister circuits has noted, courts 'have consistently dismissed Chapter 11 petitions filed by financially healthy companies with no need to reorganize under the protection of Chapter 11.' In re SGL Carbon Corp., 200 at F.3d 154, 166 (3d Cir. 1999). Id.

Thus, the debtor's financial condition is critical in any bad faith filing dispute. See, e.g., PPI Enter. 324 F.3d 197 (debtor's insolvency precluded dismissal); Integrated Telecom Express, 384 F. 3d 108 (3d Cir. 2004) (dismissal ordered; debtor financially healthy; cash rich; motivated by desire to impair landlord's rights for benefit of shareholders); In re SGL Carbon Corp., 200 F.3d 154, 167 (3d Cir. 1999) (dismissal ordered; financially healthy debtor filed Chapter 11 petition 'solely to gain tactical litigation advantages.').

A Failed Litigation Strategy

The Fourth Circuit found other evidence of bad faith. First, the parties had been merely unable to agree on the terms of a new lease; and there had been no failure by MPA to negotiate in good faith. Second, the debtor's asserted claims against MPA turned on state contract law, but the debtor had not commenced any state court litigation prior to filing its Chapter 11 petition. Indeed, the 'eleventh-hour filing of [the debtor's] bankruptcy petition ' ' just one day before the company was legally obligated to quit the premises' ' confirmed the debtor's bad faith.

Holding an asset hostage is not a permissible use of the bankruptcy process, however. Chapter 11 is not a procedural vehicle which may be commandeered solely for 'the purpose of invoking [its] automatic stay.'

Id., at *5 citing Carolin, 886 F.2d at 702. See also In re Bal Harbour Club, Inc., 316 F.3d 1192-1193-95 (11th Cir. 2003) (dismissal of Chapter 11 case proper when debtor 'abused ' bankruptcy process' and 'judicial process'; 'initiation of litigation to frustrate ' acquisition of' real property).

Expired Lease Not Part of Debtor's Estate

The debtor also had no property interest to protect when it commenced its Chapter 11 case. 'A mere possessory interest under an expired lease is insufficient to trigger an automatic stay under [Code] ' 362(a)'. Id., at 5. Code ' 362(b)(10) 'excludes from its protection' commercial 'real property leases that expire 'before the commencement of or during the case'.' Id. Not only had the lease here expired three years prior to bankruptcy, but the debtor's later month-to-month tenancy had been terminable at MPA's will. MPA had told the debtor that its month-to-month tenancy would end on May 1, 2005. Thus, the lease here expired shortly after the commencement of the case, entitling MPA to evict the debtor. Moreover, because the month-to-month tenancy had expired on May 1, 2005, 'the bankruptcy estate had no interest in the lease on that day.' Id., citing Code ' 541(b)(2) (terminated commercial lease not part of debtor's estate.).

Baseless Constitutional Claims

Finally, the circuit court affirmed the lower court's findings that the debtor's constitutional claims were 'unsupportable attempts to circumvent the bankruptcy law's various bars to' the Chapter 11 filing. Id. at 6. First, there is no constitutionally protected property right 'to have another [party] agree to contract on commercially disadvantageous terms.' Id. Nor was the debtor legitimately entitled to a new lease. Id. Indeed, the lower courts found that MPA's 'actions bespeak accommodation, not arbitrary and unjustifiable governmental action.' Id., at *7. In short, the debtor's 'various constitutional claims are not only tenuous at best, but carry us far afield from the purposes of bankruptcy law '. To allow resort to the bankruptcy process for plainly meritless constitutional claims advanced solely to thwart lawful eviction would do nothing but subvert the purposes of a Chapter 11 reorganization.' Id. at *8.

Conclusion: Facts Govern

The successful lessor in Premier Automotive had persuasive facts. In Capitol Food Corp., supra, handed down by the First Circuit nine days earlier, the court stressed 'the fact-intensive nature of the good faith question.' 2007 WL 1616646, at *2. 'Catastrophic business events' and true 'imminent financial distress,' however, will still probably sustain a Chapter 11 filing in the face of a bad faith attack. Id. at *3. So, too, will an overly litigious lessor with no facts and overheated rhetoric. Id.

Michael L. Cook, a member of this newslettter's Board of Editors, is a partner at Schulte Roth & Zabel LLP in New York.