January 30, 2023

Volume XIII, Number 30


January 27, 2023

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Abstention as an Alternative: Bankruptcy Court Is Not Always the Best Place to Be

When a debtor files a Chapter 11 case at the 11th hour in order to obtain a stay of pending foreclosure actions, receivership proceedings or other non-judicial creditor debt-enforcement action, it may appear that creditors will be forced to pursue their claims in bankruptcy court no matter how inconvenient that may be. However, creditors may have an option to pursue their rights and remedies outside the bankruptcy court through a motion for abstention. Under Section 305 of the United States Bankruptcy Code, a bankruptcy court may dismiss a case or suspend all hearings in the bankruptcy case when the interests of the debtor and creditors would be better served. This means that if a debtor has filed for bankruptcy seemingly to harass and delay creditors, creditors may file a motion for abstention and have the debtor's bankruptcy case dismissed, so that the creditors' rights may instead be determined in an alternative forum, such as an ongoing state court proceeding.

A bankruptcy court will look at a number of criteria to determine whether abstention is appropriate in any given case. These factors include (1) the economy and efficiency of administration; (2) whether another forum is available to protect the interests of both parties or there is already a pending proceeding in state court; (3) whether federal proceedings are necessary to reach a just and equitable solution; (4) whether there is an alternative means of achieving an equitable distribution of assets; and (5) the purpose for which bankruptcy jurisdiction has been sought. Ultimately, a successful motion for abstention must show (1) the availability of an alternative forum to determine creditors' rights and (2) that the debtor's bankruptcy filing was not made in good faith.

Recent Illinois Bankruptcy Court Case

A recent case in the bankruptcy court for the Northern District of Illinois demonstrates how a motion for abstention can allow the court to dismiss a bad faith bankruptcy filing in favor of dispute resolution in an alternative forum. In that case, the Chicago-based debtor and owner of one of the nation's largest resorts (consisting of a 90-plus-room hotel, indoor and outdoor water parks, a skate park, a conference center and a campground) missed numerous loan payments. Six mortgage foreclosure notices were filed against the properties and land parcels connected with the resort in Minneapolis federal court. Two months after the debtor lost the Minneapolis suits, certain of its creditors in Wisconsin instituted an action in state court to recover on their secured loans. When a receiver was appointed to oversee some of the property, the debtor promptly filed a Chapter 11 bankruptcy case in Chicago, listing assets of $1 million to $10 million and debts of $10 million to $50 million.

One of the major creditors filed a motion for abstention in response. It was anticipated that many of the major creditors would support the motion for abstention because they had an opportunity to participate in the Wisconsin foreclosure proceeding. In fact, all creditors participating in the Wisconsin proceeding consented to the appointment of a receiver. What were the benefits to the abstention? Not only was the Wisconsin proceeding the fastest route to maximize recovery for the creditors, but that scenario also allowed prospective buyers of the campground to deal with the court-appointed receiver, rather than the Chapter 11 debtor. The creditor's motion for abstention addressed the following two key issues:

  1. Availability of an Alternative Forum

    According to In re RAI Marketing Services, Inc., a suitable alternative forum exists if, in that forum, there "are pending arrangements that will equitably satisfy the creditors and not be unduly burdensome or prejudicial to the debtor," so the continuation of the bankruptcy proceeding will be "duplicitous and uneconomical."

    In the recent Chapter 11 case in Illinois, the Wisconsin foreclosure proceeding provided a mechanism to satisfy the creditors' claims through a priority scheme of payments that is similar to the Bankruptcy Code. Additionally, the receiver was not constrained by the administrative expenses or the delays involved in a bankruptcy case, thus making this alternative forum more convenient and economical to the creditors.

  2. Absence of Bankruptcy Purpose

    Another factor considered by the courts in determining whether abstention is appropriate is the purpose for which bankruptcy jurisdiction has been sought. According to In re 801 South Wells Street Limited Partnership (citing Grogan v. Garner), a central theme of the Bankruptcy Code "is to provide a procedure by which certain insolvent debtors can reorder their affairs, make peace with their creditors, and enjoy a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt." Where the debtor's Chapter 11 filing lacks a valid reorganizational purpose, it therefore lacks good faith. This bad faith means that there is no real bankruptcy purpose, and abstention by the bankruptcy court may be appropriate.

    In the Illinois case, the bankruptcy was filed with improper purpose, because it was made so that the debtor could control the forum in which the pending disputes would be heard. The debtor had no equity in the property, as the mortgagee's debt exceeded the value of the real estate. Therefore, reorganization seemed unlikely and no "fresh start" could be accomplished through bankruptcy proceedings under the circumstances.

Dismissal of the Bankruptcy Case

Finally, this combination of bad faith filing and alternative forum can lead to dismissal of a bankruptcy case. It is the debtor who has the burden of establishing that its bankruptcy case was filed in good faith. In determining whether a petition was filed in bad faith, courts look at whether reorganization is the proper course of action in that specific case. Courts consider the following indicia of bad faith: (1) the debtor has only one asset, the property; (2) the debtor has few unsecured creditors whose claims are small in relation to the claims of the secured creditors; (3) the debtor has few employees; (4) the property is subject to a foreclosure action as a result of arrearages on the debt; and (5) the timing of the filing evidences an intent to delay or frustrate the legitimate efforts of the debtor's secured creditors to enforce their rights.

In the Illinois case, the debtor had only a single asset (the resort) worth far less than the debt it secured, and was not conducting present business. Thus, there was no business to reorganize. The debtor had also filed for bankruptcy a mere day before the Wisconsin court was set to appoint a receiver. These facts were sufficient to raise the specter of bad faith on the part of the debtor.

The bankruptcy court subsequently granted the motion for abstention and dismissed the Chapter 11 case in order to permit the foreclosure and receivership proceedings pending in Wisconsin to move forward.

In light of this outcome, creditors should be aware that when a debtor files for bankruptcy, you are not necessarily limited to having your rights determined by the bankruptcy court. You need not let a debtor get away with using a bad faith bankruptcy filing to your detriment. Instead, a motion for abstention can allow the court to dismiss the bad faith bankruptcy filing and allow you and the other creditors to pursue your rights in another forum leading to a more efficient and economical outcome.

Editor's Note: Brooke E. Wehrenberg, who contributed to this article, is a recent graduate of the University of Michigan Law School. Brooke is currently serving as a summer intern at Much Shelist, working primarily on matters involving litigation and dispute resolution.

© 2023 Much Shelist, P.C.National Law Review, Volume , Number 212

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