Bad Faith and Cause for Relief from the Automatic Stay
Written by: Frank Hammond
Cable Huston; Portland, Ore.
Bad faith, including efforts to use bankruptcy to fraudulently thwart or prefer creditors, is grounds for relief from the automatic bankruptcy stay. The courts have extended this reasoning to include single asset and similar cases presenting “new debtor syndrome.” The question remains how far this doctrine extends.
Cause
Filing the bankruptcy petition automatically stays “any act to create, perfect, or enforce any lien against property of the estate.” 11 U.S.C. §362(a)(4). But the bankruptcy court can grant relief from the stay for “cause.” 11 U.S.C. §362(d)(1). Whether sufficient cause exists is within the court’s discretion based on the facts of each case. In re Delaney-Morin, 304 B.R. 365, 369 (9th Cir. BAP 2003). “’Cause’ is an intentionally broad and flexible concept…” In re Brown, 311 B.R. 409, 412-13 (E.D. Pa. 2004).
Factors to consider in determining whether the automatic stay should be modified for cause include: (1) an interference with the bankruptcy; (2) good or bad faith of the debtor, (3) injury to the debtor and other creditors if the stay is modified; (4) injury to the movant if the stay is not modified; and (5) the relative proportionality of the harms from modifying or continuing the stay.
In re A Partners LLC, 344 B.R. 114, 127 (Bankr. ED Ca. 2006) (emphasis added).
Bad faith can be sufficient to justify relief from the automatic stay for cause, although other factors might, in a specific case, mitigate against lifting the stay. But “bad faith” means “an abuse of the bankruptcy process [that] is offensive to the integrity of the bankruptcy system.” In re Yukon Enterprises Inc., 39 B.R. 919, 922 (Bankr. CD Cal 1984). Attempts to use the bankruptcy system to thwart creditors and hide assets would qualify as bad faith.
New Debtor Syndrome and 11 U.S.C. §262(d)(4)
Single-asset cases often, but not always, result in a finding of bad faith. See, e.g., In re Laguna Associates Limited Partnership, 30 F.3d 734, 738 (6th Cir. 1994). The courts refer to the facts of such cases as “new debtor syndrome,” and find bad faith in such cases. The following factors are often found in cases presenting new debtor syndrome:
(1) transfer of distressed property into a newly created corporation; 2) transfer occurring within a close proximity to the bankruptcy filing;(3) transfer for no consideration; (4) the debtor has no assets other than the recently transferred property; (5) the debtor has no or minimal unsecured debt; (6) the debtor has no employees and no ongoing business; and (7) the debtor has no means, other than the transferred property, to service the debt on the property.
In re Duvar Apt. Inc., 205 B.R. 196, 200 (9th Cir. BAP 1996). The question naturally arises whether this doctrine extends to other, similar cases. Collapsing the corporation may be one such example.
Collapsing the Corporation and Individual Chapter 11
Under BAPCPA, a small business owner would find it difficult and prohibitively expensive to file two bankruptcies (e.g., chapter 7 for the business and chapter 13 for the individual). See Scott, N., “Finding a Home in Chapter 11,” Oregon State Bar Debtor-Creditor Newsletter, 13, 14 (Winter 2008). One solution to such a situation might be to collapse the business entity into the individual. The individual would assume all debts of the business in return for receiving all of its assets. The individual would then file for chapter 11 and a discharge. Id.
Great care must be used in framing such a transaction. The collapse contains elements similar to those courts have relied on to find new debtor syndrome. Further, security agreements commonly forbid transfer of assets without the secured creditor’s permission. If the transaction could be construed as an effort to hinder or defraud creditors, or favor one creditor over all others, then it would smack of bad faith. A bankruptcy court might therefore order relief from the stay to allow a secured creditor to enforce its interest in assets that might otherwise be critical to the chapter 11 plan’s success. Cf. Id. (“This theory stands limited liability practice on its head and raises a multitude of practical, legal and, potential ethical issues.”)
Conclusion
Bad faith is a ground for relief from the automatic stay. Efforts to thwart the bankruptcy process through fraud would clearly constitute bad faith. But courts have extended the bad faith doctrine to include cases presenting new debtor syndrome. The question remains whether the doctrine would apply to cases where a business collapsed into an individual chapter 11 debtor. Because of the risk that the doctrine would apply, great care should be used in structuring such transactions to avoid violating the security agreement, thwarting the interests of creditors or preferring one secured creditor over the others.