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What does it mean to have filed for Chapter 11 in “bad faith”?

August 14, 2023 Paul Evangelista


A Chapter 11 Bankruptcy can be dismissed by the bankruptcy court for any of a number of reasons identified in Section 1112(b)(4) of the Bankruptcy Code. However, the Third Circuit, and therefore New Jersey, does not consider the list exhaustive, and may dismiss a case for other reasons, including dismissal of a case which was filed in “bad faith”.

The court can consider many factors when deciding if a bankruptcy was filed in good faith, and ultimately decides on the totality of the circumstances – that is, it decides based on a weighing of all relevant aspects of the case. Bad faith does not necessarily mean the debtor’s intentions are the sole issue. Rather, it refers to limitations that courts have placed on Chapter 11 filings in order to ensure that the bankruptcies are occurring within the legitimate scope of bankruptcy laws and not for improper purposes.


What kind of factors does the Court look at for a bad faith dismissal?

Bankruptcy Courts are concerned about debtors using bankruptcy filings merely as a tool to stall other, legitimate litigation, such as foreclosure, through abuse of the automatic stay. As a result, if a property is in foreclosure, and the owner files for Chapter 11 bankruptcy, courts will frequently allow the presumption that the filing is in order to forestall the foreclosure. However, this alone is not usually sufficient to cause a case to be dismissed. The court will also look at whether or not the property in question is the sole asset of the business. A Chapter 11 bankruptcy filed for a debtor with a single asset will frequently trigger close scrutiny by the Court. This is especially true if the proportion of liens and other encumbrances on the property result in more secured creditors than unsecured creditors, or if the secured creditor liens in aggregate constitute significantly more debt than those of the unsecured creditors.


Courts also look for so-called “new debtor syndrome,” where a single asset is transferred by an entity to a new entity right before the new entity files for Chapter 11. A business could potentially have filed immediately after recording their deed to that single real estate asset. In many cases, formation of the business entity was for the sole purpose of acquiring title and then filing a Chapter 11 petition for the automatic stay. Such an entity might have never been engaged in any business previously, does not exhibit business activity at the time of filing the petition, had no income and has no income, does not sell any goods or provide any services, and appears to exist solely to isolate the property and its creditors by appearing in bankruptcy court. Likewise, there are likely to be no or few employees aside from the principals, no cash flow, no bank accounts, no business documents, and no stationery, or office equipment, and no business activity other than the handling of litigation. The chain of title may be unclear on the single property, or the debtor business may not hold legal title at all. Finally, the financial problems of the debtor business might be best described as a dispute between the business and its secured creditors that is properly resolved in state court, such as in foreclosure proceedings.

If the debtor in the Chapter 11 does not appear to have a viable business that it can restore through reorganization, and the debtor only owns a single property that is subject to foreclosure, then the bankruptcy filing is almost surely a filing made as a tool of litigation in that foreclosure. Where a debtor seeks to obtain time and interfere with a creditors legitimate attempt to take title of the property due to loan arrearages on that property, then the debtor can be assumed to be filing bankruptcy for the purpose of achieving the automatic stay on the foreclosure proceedings. Courts generally consider this an improper use of the bankruptcy code, where there is not a real likelihood that a reorganization could restore a business, as it cannot where there is no existing business to be restored.

Where there is no viable business to be reinstated, the case might still not be dismissed for bad faith if the debtor can demonstrate that their Chapter 11 reorganization will maximize the value of the estate, and that such value would be lost outside of bankruptcy. That is, the debtor would need to show that only through bankruptcy can the value of the estate be maximized. If the creditors with secured interests in the property had other means to increase the value of the estate, such as through powers they hold as parties in other actions, like a related foreclosure case, then a Chapter 11 single asset debtor likely cannot demonstrate the ability to maximize the value of the estate through bankruptcy reorganization. In the Third Circuit, and therefore New Jersey, a debtor can only use bankruptcy laws as a shield, and not a sword, and circumstances in which a brand new business entity who acquires a debt-ridden property, and then takes that debt, property, and the creditors to bankruptcy court is likely using the bankruptcy code improperly, and thus be found to have made a bad faith filing.


[1] See generally: In Re YJ Sons & Co., Inc., 212 B.R. 793 (D.N.J. 1997)

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