• Bankruptcy Cases Dismissed Based on Premature Filing
  • July 26, 2005 | Author: Brian D. Geldert
  • Law Firm: Weil, Gotshal & Manges LLP - New York Office
  • In In re Schur Management Co., the United States Bankruptcy Court for the Southern District of New York recently held that the chapter 11 petitions filed by two financially viable debtors seeking only to protect their assets from a potentially adverse judgment in connection with an imminent trial in a personal injury lawsuit, lacked an "intent to reorganize" or "reorganizational purpose" and, therefore, were prematurely filed. Accordingly, the court held that the petitions lacked good faith as required by the jurisprudence underlying section 1112(b) of the Bankruptcy Code. In addition, the court found that the debtors' request to suspend pursuant to section 305(a)(1) of the Bankruptcy Code, the bankruptcy proceedings pending the outcome of the litigation was not in the best interests of both the debtors and their creditors. The bankruptcy court concluded that dismissal of the chapter 11 cases, without prejudice, was the appropriate relief in this case and left open the opportunity for the debtors to file for relief under chapter 11 of the Bankruptcy Code in the future.

    Sections 1112 and 305(a)(1) of the Bankruptcy Code

    One of the fundamental purposes of chapter 11 of the Bankruptcy Code is to provide a company with an opportunity to reorganize and rehabilitate its business operations in times of financial distress. To that end, certain companies have sought the protections afforded by the Bankruptcy Code when facing substantial litigation and the prospect of insurmountable liability resulting from adverse judgments being rendered in lawsuits that pose serious threats to the operation of those companies' businesses. There are, however, certain fundamental principles that a potential debtor must satisfy before it will be afforded the protective and rehabilitative benefits of a chapter 11 filing. Section 1112(b) of the Bankruptcy Code sets forth various bases for dismissal of chapter 11 cases, among other things, and balances the rehabilitative interests of debtors with the rights of creditors. To further the balancing of interests, courts have construed section 1112(b) to require that a chapter 11 petition be filed in good faith. If good faith is lacking in the commencement of a chapter 11 case, the debtor faces dismissal of its case. Courts have found a lack of good faith when, for example, actual bad faith or malicious purposes motivated the filing of the chapter 11 petition. In addition, courts have dismissed chapter 11 cases finding a lack of good faith when the petitions are prematurely filed, such as when a company has no present need to reorganize under the protections of the Bankruptcy Code.

    In other instances, a court may decline to dismiss a chapter 11 case, electing only to suspend the bankruptcy proceedings pursuant to section 305(a)(1) of the Bankruptcy Code even when good faith is present. Section 305(a)(1) provides the court with a discretionary mechanism by which the court may either dismiss or suspend a bankruptcy case if "the interests of creditors and the debtor would be better served by such dismissal or suspension." Although section 305(a)(1) of the Bankruptcy Code provides the court with the option to dismiss a bankruptcy case, dismissal on good faith grounds is not ordinarily based on this section, but instead on the ability of the court to dismiss a case for cause under section 1112(b) of the Bankruptcy Code.

    Factual Background

    915 Sherman Avenue Corporation ("Sherman") is a holding company for an apartment complex located in Bronx County, New York. Schur Management Company, Ltd. ("Schur" and, together with Sherman, the "Debtors"), a holding company for real estate properties owned by the Schur family, manages numerous real estate properties. In March 1990, Schur entered into a management agreement with Sherman to act as the managing agent for the apartment complex.

    On October 11, 1996, Annette Casull-Garcia ("Casull") was allegedly injured at the apartment complex owned by Sherman and managed by Schur. Subsequently, she sued both Debtors seeking damages totaling $10 million in Bronx County Supreme Court (the "State Court Litigation").

    At the time of the commencement of the State Court Litigation, the Debtors believed that their insurance policies would provide adequate coverage in the event a jury rendered an adverse judgment in the State Court Litigation. Specifically, the Debtors anticipated that a general liability insurance policy would cover the first $1 million of any judgment and excess policies would cover any judgment exceeding $1 million. Prior to the commencement of the chapter 11 cases, however, the Debtors' general liability insurance carrier was forced into liquidation, an event that, coupled with the Debtors' uncertainty as to the extent of any excess coverage, caused the Debtors to fear significant exposure if Casull were to prevail in the State Court Litigation.

    On November 26, 2004, prior to the impending trial in the State Court Litigation, the Debtors filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code seeking to protect their assets and fiduciary accounts they hold for others. The only significant debt listed by both Debtors was a contingent, disputed and unliquidated liability in the amount of $1 million owed to Casull in the event the Debtors were ultimately found liable in the State Court Litigation. The only other liabilities listed by the Debtors in the schedules accompanying their bankruptcy petitions totaled $14,075 while Schur reported revenues in excess of $2 million for the fiscal year ending December 31, 2003 and Sherman reported net profits of over $70,000 in 2004.

    Casull, without the assistance of counsel, filed a motion objecting to the commencement of the chapter 11 cases claiming that the cases would hamper her efforts to obtain a judgment in, or fair settlement of, the State Court Litigation. Although the Debtors consented to the modification of the automatic stay (a stay that acts to enjoin, among other things, the continuation of prepetition litigation against a debtor during the pendency of a bankruptcy case) to allow the State Court Litigation to proceed, they objected to the dismissal of the bankruptcy cases and, in the alternative, argued that if the court were to grant any relief, suspension of the bankruptcy cases for the duration of the State Court Litigation, not dismissal, was the appropriate remedy.

    The Bankruptcy Court's Decision

    The court's decision centered on the premise that dismissal "is to be used sparingly to avoid denying bankruptcy relief to statutorily eligible debtors except in extraordinary circumstances." In considering the dismissal of the cases based on prematurity, the court had to determine whether there is a present need for a reorganization. "The mere possibility of a future need to file, without more, does not establish that a petition was filed in good faith." The court concluded that the Debtors had not articulated any current need for the protections of the Bankruptcy Code in light of the financial viability of their business and the absence of any current detriment to their operations arising from the State Court Litigation.

    The court rejected the Debtors' contention that fear of an adverse judgment that they could not pay warranted the protections of a chapter 11 filing. The court concluded that the Debtors' estimation of their potential liability to Casull in the first instance, was based purely on speculation, not to mention the fact that the effect, if any, that any such judgment may have on otherwise financially viable entities, was similarly purely conjecture.

    By contrast, the court noted that this position does not dictate that all debtors must await the entry of an adverse judgment prior to commencing a case under the Bankruptcy Code. The court pointed out that there are circumstances, not present in the instant case, where it would be appropriate to commence a bankruptcy case prior to an adverse judgment being entered, such as when the litigation itself poses a threat to the debtor's financial viability or continued business operations or when a debtor seeks to avoid the preclusive effect that an adverse judgment would have on the value of its enterprise. In this case, unlike the aforementioned circumstances and, as illustrated by the Debtors' willingness to allow the State Court Litigation to proceed in that forum, the Debtors had no immediate need for bankruptcy protection because both the litigation and the potential for an adverse judgment had "absolutely no effect" on the Debtors' business operations or financial well-being. The court stated that if an adverse judgment is rendered in the future, and if such judgment impaired the Debtors' ability to survive, or there were some other need for chapter 11 relief, the Debtors could at that time seek the protections afforded by the Bankruptcy Code.

    The bankruptcy court also rejected the Debtors' attempt to distinguish the leading case on dismissal for prematurity, In re SGL Carbon. In SGL Carbon, the court dismissed a chapter 11 petition filed by a debtor in response to pending antitrust litigation. The Debtors in Schur Management argued that unlike the debtor in SGL, they "have not created a cash reserve out of which to pay the possible future liability." The court here concluded, however, that the ability to pay a potential judgment is only one factor to be considered.

    The court also rejected the Debtors' arguments that a judgment would disrupt their ability to protect the fiduciary accounts maintained in the management of their real estate holdings, causing them to make late payments and irreparably impairing their reputation. The court noted that under New York law, such accounts are not the property of landlords and a judgment, if any, should have little effect on their ability to manage these accounts.

    Further, the court rejected the Debtors' contention that suspension pursuant to section 305(a)(1) of the Bankruptcy Code was more appropriate than dismissal. Applying the standard for suspension under section 305(a)(1) of the Bankruptcy Code, the court looked at whether suspension was in the best interests of both the Debtors and their creditors and whether the Debtors and their creditors would be "better served" by suspension. The court concluded that the Debtors failed to demonstrate how suspension was in the best interests of creditors and there was no need for creditors to wait to be paid when the Debtors had the present ability to meet all of their current obligations, given the Debtors' positive cash flow and projected revenues of approximately $13,000 per month compared to only $14,075 in total outstanding debt.

    The court further noted that at this juncture of the State Court Litigation, it could not be assumed that these otherwise financially viable Debtors would be forced into bankruptcy if, and when, an adverse judgment is rendered against them in the State Court Litigation. The court reasoned that, when the possible results of the State Court Litigation include victory for both debtors, the presence of such non-bankruptcy issues is a factor in denying a request for suspension of the bankruptcy proceedings.

    Moreover, the court considered the public interest and noted that by allowing suspension in prematurely filed cases similar to these cases, any company facing an adverse jury verdict could file for bankruptcy protection, invoking all of the attendant consequences, unnecessarily burdening debtors, creditors and the courts with needless expense to the detriment of all such parties. The court also cautioned that permitting a premature chapter filing to be suspended could influence the State Court Litigation, albeit subtlety, resulting in the possibility that these and other debtors would use a bankruptcy filing as an improper litigation tactic.

    Although the court dismissed the Debtors' bankruptcy cases, it was careful to point out that its finding of a lack of good faith did not indicate the presence of actual bad faith or malicious purposes, noting in cases of premature filings, as was the case here, the question is simply whether there is a "valid 'intent to reorganize' or 'reorganizational purpose' to the filing."

    Conclusion

    Although the Bankruptcy Code provides an avenue for businesses to reorganize and rehabilitate their operations and financial affairs when facing significant litigation and potentially unsustainable damage awards, there are limits as to when such protections can be invoked. The protections afforded to creditors by the Bankruptcy Code, such as requiring cases to be commenced in good faith under section 1112(b) or evaluating both debtors' and creditors' interests in determining whether to suspend the proceedings pursuant to section 305(a)(1) of the Bankruptcy Code, reinforce the reorganizational and rehabilitative goals of chapter 11. Companies not currently suffering financial hardship and adverse effects on business operations resulting from litigation or threat of an adverse judgment should keep in mind that at least in the Southern District of New York, they may not be able to sustain a chapter 11 filing until such events demonstrably and adversely affect the company's business and provide an appropriate predicate for a filing and the attendant efforts to reorganize and rehabilitate the business operations.

    In re Schur Mgmt. Co., 323 B.R. 123 (Bankr. S.D.N.Y. 2005).
    In re SGL Carbon, 200 F.3d 154 (3d Cir. 1999).