Bankruptcy provides an array of tools to reorganize a company’s affairs and restructure its debts, including the automatic stay, centralizing most disputes in one court, free and clear asset sales, the rejection of burdensome contracts, and, ultimately, the discharge of claims. However, to utilize the process, a debtor must file the case in good faith. The term “good faith” is not defined in the Bankruptcy Code. Courts have held it means the case must have a valid reorganization purpose. This issue was addressed in a recent decision by Bankruptcy Judge Laurie Selber Silverstein of the United States Bankruptcy Court for the District of Delaware in In re Rent-A-Wreck of America, Inc., et al., Case No. 17-11592. The Court directed dismissal of the debtors’ chapter 11 bankruptcy cases because the debtors lacked financial distress and had filed bankruptcy as part of a continuing two-party dispute with a franchisee.
The opinion details a decade-long dispute between the debtors in the cases, Rent-A-Wreck of America, Inc. (“RAWA”) and its wholly owned subsidiary, Bundy American, LLC, and David Schwartz, the founder and prior owner of “Bundy Rent-A-Wreck.” Schwartz first started using that name in 1973 in connection with his car sales business in Los Angeles. There was no formal franchise agreement between RAWA and Schwartz.
RAWA was acquired by J.J.F. Management Services, Inc. (“JJFMS”) in 2006 when JJFMS purchased all outstanding RAWA stock and took RAWA private. JJFMS’s principal, John J. Fitzgerald, Jr., was an owner, the president, CEO, and chairman of the JJFMS board of directors, and director and chairman of RAWA’s board of directors.
After the sale closed, RAWA demanded Schwartz either provide evidence of a franchise agreement or stop holding himself out as a RAWA franchisee. Litigation ensued in Maryland Federal District Court. For his part, Schwartz sought a declaratory judgment that he held a royalty-free Rent-A-Wreck franchise. After two jury trials, motions for judgment notwithstanding the verdict, and two decisions issued by the Fourth Circuit on appeal, it was adjudicated that Schwartz did indeed hold an implied-in-fact royalty and fee-free franchise agreement to run a Rent-A-Wreck used car rental business in West Los Angeles for his lifetime.
RAWA was later held in contempt by the Maryland Court for intentionally diverting prospective customers from Schwartz’s business. Fitzgerald reportedly proclaimed at the outset of the litigation that he would make Schwartz “sweat at virtually every stage of the proceedings.”
On July 24, 2017, approximately one month after RAWA was held in contempt of the Maryland Court’s order, the Debtors—RAWA and one of its affiliates—filed their chapter 11 bankruptcy cases in Bankruptcy Court in the District of Delaware. The Debtors filed a motion to “reject” seven franchise contracts, including the “implied” agreement with Schwartz, under Bankruptcy Code section 365, which permits a debtor to “reject” burdensome leases and executory contracts. Schwartz then objected to the Motion to Reject and moved to dismiss the bankruptcy cases, asserting the filings were merely a continuation of the Maryland Court litigation.
The Bankruptcy Court’s analysis began by noting that a bankruptcy case may be dismissed for cause, including a lack of good faith. Third Circuit decisions focus on two inquiries: (i) whether the petition serves a valid bankruptcy purpose by preserving a going concern or maximizing the value of the debtor’s estate, and (ii) whether the petition is filed to obtain a tactical advantage.
On the first element, a valid bankruptcy assumes a debtor in financial distress. The Court carefully reviewed the Debtors’ financial metrics as of the petition date, such as solvency, cash reserves, recent financial performance, proportion of debt to insiders, and others. The Court concluded the Debtors were not experiencing the financial distress necessary to support a finding of good faith.
Turning to the second element, the Court concluded the cases were filed to obtain a tactical advantage in the Debtors’ litigation with Schwartz. Specifically, the Court found that the Debtors’ primary purpose for the filings was to reject Schwartz’s franchise agreement so the Debtors could take over the Los Angeles territory. The Court ultimately concluded that while this situation did not present the classic “two party dispute,” it certainly resembled one. The Court granted Schwartz’s motion to dismiss.
Judge Silverstein’s Rent-A-Wreck opinion joins numerous decisions by bankruptcy and appellate courts rejecting the idea that the bankruptcy process can be used by non-financially or artificially distressed debtors to strip rights and claims of a creditor and transfer value to one or more shareholders. A healthy debtor cannot use bankruptcy solely to, for example, cap a landlord’s claim against it, strip liens from its assets, or, in this case, reject a valid contract it views as onerous.
After reviewing the history of the Debtors’ dispute with Schwartz and their financial circumstances, the Court concluded the Debtors were attempting improperly to use the bankruptcy process as a sword rather than a shield. As the Court concluded in its opinion: “These bankruptcy petitions fall on the dark side of the spectrum ranging from the clearly acceptable to the patently abusive.”
A version of this article was originally published here by The Legal Intelligencer.
Andrew C. Kassner is the Chairman and Chief Executive Officer of Drinker Biddle, responsible for overseeing the firm’s management, strategic direction and commitment to client service.
Joseph N. Argentina (LAW ’09) represents creditors, creditor committees, and debtors in myriad creditor-debtor contexts, including general collection matters, foreclosures, bankruptcy reorganizations and liquidations, state and federal court receiverships, assignments for the benefit of creditors, and out of court debt restructurings.