Judge Silverstein Tosses Bad Faith Filing in Rent-A-Wreck of America But Doesn’t Award Sanctions – Finds That a Filing to Employ the Powers of the Code is Alone Insufficient to Support Good Faith

In re Rent-A-Wreck of America, Inc., 580 B.R. 364 (Bankr. D. Del. 2018)

In this February 13, 2018 Opinion, Judge Silverstein of the Delaware Bankruptcy Court dismissed the voluntary chapter 11 proceedings filed by Rent-A-Wreck of America, Inc. (“RAWA”) and its wholly owned subsidiary, Bundy American, LLC (“Bundy”, and together with RAWA, the “Debtors”).  Judge Silverstein found that the Debtors did not file their petitions in good faith as required by 11 U.S.C. § 1112(b).  While the Court found that the Debtors’ actions in commencing the cases fell “on the dark side of the spectrum[,]” which ranges from “the clearly acceptable to the patently abusive[,]” the Court very recently followed up its dismissal decision in mid-May and refused to sanction the Debtors’ behavior.  580 B.R. at 388.

Bundy distributes franchises for the operation of RAWA’s vehicle rental businesses.  Its predecessor was created by, among others, David Schwartz. Through a poorly (and in some circumstances, non-existent) documented arrangement, Mr. Schwartz operated a RAWA franchise in Los Angeles, California (the “LA Franchise”) and controlled the related trademark. Following a 2006 RAWA stock acquisition by J.J.F. Management Services, Inc. (“JJFMS”), the company went private.  Significant litigation subsequently ensued between Mr. Schwartz, on one hand, and RAWA, Bundy, and JJFMS, on the other, regarding the LA Franchise, the mark, and the parties’ obligations to each other.  Ultimately, Mr. Schwartz was deemed to have an implied-in-fact royalty and fee-free franchise agreement to run the LA Franchise for his lifetime.  The contours of the parties’ obligations to each other remained unclear and required court intervention absent consensus.

Consensus was not to be reached however.  In April 2016, RAWA intentionally diverted prospective customers from Mr. Schwartz’s LA Franchise.  A Maryland District Court held RAWA in contempt of court for its actions.  Shortly thereafter, the Debtors filed for chapter 11 protection and moved to reject Mr. Schwartz’s franchise agreement.  Mr. Schwartz objected to the rejection and sought dismissal of the Debtors’ proceedings, challenging the Debtors’ good faith, including its financial distress.  The Debtors opposed the dismissal, asserting that a showing of financial distress is not necessary to show good faith.  Rather, the Debtors contended that only a “valid reorganizational purpose” is needed.  Id. at 373.  The Debtors argued, among other things, that rejecting Mr. Schwartz’s franchise agreement to maximize the value of the RAWA Los Angeles territory constituted such a purpose and also that there were other value maximizing and debt restructuring motivations unrelated to Mr. Schwartz.

Following a multi-day trial and post-trial submissions, the Court granted Mr. Schwartz’s dismissal request.  When ruling, Judge Silverstein applied the “good faith standard” for bankruptcy filings, as imposed by 11 U.S.C. § 1112(b) and as articulated by the Third Circuit in In re SGL Carbon Corp. 200 F.3d 154, 160-162 (3d Cir. 1999).  Judge Silverstein quoted SGL Carbon by remarking that “[a] good faith standard protects the jurisdictional integrity of the bankruptcy courts by rendering their equitable weapons . . . available only to those debtors and creditors with clean hands.” Id. (citations omitted).  Judge Silverstein noted that there are two central inquiries to the good faith standard:  1) whether a valid bankruptcy purpose is served, and 2) whether the petition is filed to obtain a tactical advantage.  See In re Integrated Telecom Express, Inc., 384 F.3d 108, 118 (3d Cir. 2004) (citing SGL Carbon, 200 F.3d at 162).

The Court found that the Debtors’ primary motivation in filing for chapter 11 protection was to utilize the Code to reject Mr. Schwartz’s franchise agreement, thus allowing the Debtors to open royalty-paying franchises in Los Angeles.  In addition, the evidence adduced indicated that the Debtors were in no financial distress as of the petition date.  While Judge Silverstein found the Debtors’ purpose – to invoke the rejection powers of the Code – did not constitute bad faith per se, Her Honor held that it did not constitute per se good faith either.  Rather, according to the Court, there must be financial distress (or another basis for good faith) or a party could use the Code’s considerable powers to redistribute value and impose great hardship on creditors without the intent of preserving a going concern or maximizing estate value.

Here, given the solvency of the Debtors and the lack of unaffiliated debt, the Court found that the beneficiaries of the bankruptcy were equity, not creditors.  Moreover, to the extent that a debt restructuring was necessary as asserted, it could be accomplished outside the bankruptcy.  And to the extent the Debtors’ alleged value maximizing propositions were required, attempts to do so could and should have been made before the bankruptcy commenced.  Here, it was clear to the Court that the bankruptcy filing was another avenue for the prepetition litigation and that based on the totality of the circumstances, the cases fell “on the dark side of the spectrum.”  580 B.R. at 388.  Importantly, however, Judge Silverstein limited her decision by making it clear that in certain situations a financially distressed debtor’s recognition of the outcome of litigation and/or a desire to avoid future litigation may serve as a good faith basis for the filing of a bankruptcy petition.