In In re Rent-A-Wreck of America, Case No. 17-11592 (LSS) (Bankr. D. Del. Feb. 13, 2018), U.S. Bankruptcy Judge Laurie Silverstein of the District of Delaware dismissed voluntarily filed bankruptcy cases on the grounds they were not filed in good faith, finding that the privately owned debtors had not proven they were in financial distress and had sought to use 11 U.S.C. Section 365 to redistribute value from a long-time adversary to their ultimate stockholder.

The debtors, Rent-A-Wreck of America Inc., and its wholly owned subsidiary, Bundy American LLC, were in the business of selling and administering franchises for “Rent-A-Wreck.” Both debtors were part of a much larger group of private companies owned by JJF Management Services Inc. The debtors had been locked in litigation with David Schwartz, one of the co-founders of a predecessor to Rent-A-Wreck. Schwartz assigned the Rent-A-Wreck trademark to Bundy, but excluded the Los Angeles County territory where Schwartz operated an auto sales business and used the Rent-A-Wreck trademark himself. As a result of prior litigation between Schwartz and the debtors, a court had determined that Schwartz had an implied-in-fact, royalty-free and fee-free franchise agreement to operate a Rent-A-Wreck used car rental business in Los Angeles for his lifetime. The exact terms of the implied franchise agreement had not been determined, and Rent-A-Wreck and Schwartz continued to fight, with Rent-A-Wreck's ultimate goal being to oust Schwartz from the Los Angeles territory.

After the debtors had filed voluntary petitions under Chapter 11, they moved to reject the executory agreement with Schwartz. He opposed the motion and filed his own motion to dismiss the bankruptcy cases on the grounds that the debtors were not in financial distress and the bankruptcy proceedings were merely a pretext to obtain the Los Angeles territory from him.

The debtors argued that they did not have to prove financial distress as an element of good faith. Instead, it was sufficient for them to show that they had a valid reorganizational purpose in filing their bankruptcy petitions. By rejecting Schwartz's royalty-free, exclusive agreement, the debtors were hoping to eliminate the risk of continuing litigation with Schwartz and at the same time open up his Los Angeles territory to new, royalty-paying franchisees.

Silverstein rejected the debtors' arguments. She began with the premise that the Bankruptcy Code imposes a good-faith requirement on petitioners filing a bankruptcy case under Chapter 11. Whether a petitioner has met the requirement is a fact-intensive inquiry in which courts examine the totality of the circumstances to see where a petition falls along a spectrum ranging from clearly acceptable to patently abusive. The focus is on whether the petition serves a valid bankruptcy purpose or is filed to obtain a tactical advantage. A debtor's desire to invoke the powers conferred by the Bankruptcy Code does not by itself establish good faith, nor does it constitute a valid bankruptcy purpose. On the other hand, the ability to use the redistributive powers of the Bankruptcy Code assumes a debtor in financial distress. Thus, Silverstein wrote, financial distress is a predicate to a finding of good faith.

The analysis of financial distress is itself a fact specific inquiry. Silverstein identified a number of factors that courts consider, including the debtor's solvency; cash reserves; recent financial performance and profitability; the proportion of debt owed to insiders; estimates of actual or likely liability; the threat of litigation; whether a debt is fixed, substantial and imminent; current cash position or liquidity; ability to raise capital; and overdue debts or the ability to pay debts as they become due.

Silverstein analyzed each of the factors and concluded that the record did not demonstrate that the debtors were in financial distress at the time the bankruptcy petitions were filed. First, the debtors did not file their cases because they were insolvent. They never claimed insolvency and did not provide evidence of the value of their most significant assets, so the court could not conclude that they were insolvent. Second, the debtors did not file their bankruptcy cases because of their unsecured debt. There was no evidence that the debtors were not paying their operational debts as they came due. Third, the debtors' secured debt, while substantial, was owed to the management company that owned Rent-A-Wreck, JJF Management Services. Although the debt was in default, there was no evidence that JJF Management had undertaken any actions to collect on the debt. Fourth, the schedules reflected significant debt to affiliated entities, and comparatively insignificant debt to unaffiliated entities. Fifth, the debtors did not provide specific evidence of their current cash position or liquidity, so there was no basis to find that they were experiencing cash flow problems. Sixth, the debtors did not analyze their current ability to pay their debts as they came due prior to filing their bankruptcy cases. Seventh, the debtors did not present any evidence regarding their exploration of third party financing, either prior to or after the bankruptcy filing. Finally, there was no evidence of an unmanageable number of large claims or even a judgment that the debtors would be unable to satisfy.

In sum, Silverstein said she could not conclude that the debtors were in financial distress when they filed their petitions. They were solvent, they were not facing pressure from unaffiliated creditors, nor were they facing material litigation. It was unclear whether they were cash flow positive or not. The lack of credible evidence demonstrating financial distress lead her to find that the debtors were not in financial distress and therefore the cases were not filed in good faith.

Silverstein also concluded that the non-financial evidence supported a finding that the cases were not filed in good faith. Silverstein found that the primary purpose of the bankruptcy filings was to reject Schwartz's franchise agreement, so that the debtors could open up the Los Angeles territory to multiple royalty-paying franchises. She rejected the debtors' argument that maximizing the value of a debtor's assets in and of itself was a valid reorganizational purpose. Rather, the purpose of Chapter 11 is to maximize the property available to satisfy claims of creditors, not merely to redistribute value from a creditor to the company's shareholders. In this case, the debtors sought to take the value that belonged to Schwartz and give it to the debtors. Given the debtors' solvency and the paucity of unaffiliated debt, the primary if not sole beneficiary of that value would be the ultimate owner of the debtors, JJF Management, and not the creditors of the estates.

Silverstein noted that her decision was limited. In other circumstances, a financially distressed debtor's recognition of the outcome of litigation or a desire to avoid future litigation might serve as a legitimate basis for the filing of a bankruptcy case. But here, the debtors were just seeking to use the Bankruptcy Code to terminate Schwartz's franchise for the benefit of the debtors' owner. Accordingly, the bankruptcy petitions fell “on the dark side of the spectrum ranging from the clearly acceptable to the patently abusive,” and would be dismissed. Silverstein's opinion underscores the importance of a finding of financial distress as a prerequisite for relief under the Bankruptcy Code.

Barry M. Klayman is a member in the commercial litigation group and the bankruptcy, insolvency and restructuring practice group at Cozen O'Connor. He regularly appears in Chancery Court.

Mark E. Felger is co-chair of the bankruptcy, insolvency and restructuring practice group at the firm.