On March 26, 1999, the Ninth Circuit Court of Appeals decided, in an as of yet nonfinal decision, In re Jonathan Barnes Leavitt, the standard of bad faith as "cause" to dismiss a Chapter 13 bankruptcy petition with prejudice. Bad faith is a generic term utilized to describe a category of unfair and inequitable practices which could lead to a finding that the petition under a Chapter 13 bankruptcy was filed in bad faith, resulting in not only a denial of the confirmation of the Chapter 13 bankruptcy plan but a dismissal with prejudice. As explained below, bad faith requires more than simply a showing that the bankruptcy petition was filed in order to stop a pending foreclosure or receivership action.
Creditor, Carlos Soto ("creditor") was Jonathan Barnes Leavitt's ("debtor") business partner. Unbeknownst to the creditor, the debtor secretly set up a new entity in which he claimed sole ownership. He also set up new bank accounts and filed fictitious business name statements, as well as securing a separate business license. He also cancelled the partnership's business license and insurance. Subsequently, he diverted partnership funds from the partnership accounts to the new business. After setting up his secret business, the debtor advised the creditor that he wished to dissolve their partnership. The creditor found himself without a business or a license, while the debtor continued without interruption to do business through his new business entity.
The creditor sued the debtor in California Superior Court for fraud, conversion of partnership assets, breach of fiduciary duty and breach of contract. Following a jury verdict in his favor, the parties entered into a stipulation for judgment in the amount of $227,893.83. Prior to the formal entry of the judgment, however, the debtor filed his Chapter 13 petition.
Debtor listed earnings of $72,000 per year, plus several thousands of dollars in business profits in his schedules. The debtor also scheduled out plan payments to several creditors but not to the creditor. Included in the plan payments were payments for administrative, secured and priority creditors, as well as payments on two newer vehicles totalling approximately $715, transportation costs, piano lessons, school supplies and food expenses.
The creditor moved to dismiss the Chapter 13 bankruptcy on the grounds that the debtor filed it in bad faith for the improper purpose of avoiding the judgment, the debtor's failure to file the Chapter 13 schedules or plan timely, his proposed plan's zero allocation to the judgment debt, and misrepresentations and excessive expenses in the schedules.
A hearing was held by the bankruptcy court, at which time the court advised the debtor that his plan would not be confirmed unless it allocated at least 30 percent of his income to the creditor's judgment debt. The bankruptcy court gave the debtor ten days to file an amended plan. Notwithstanding the court's instructions, the debtor filed an amended plan, but only allocated three percent to the unsecured creditors, including the creditor's judgment debt.
Following the evidentiary hearing, the debtor admitted that certain assets from his schedules were omitted and that certain listed expenses contained inaccuracies. He admitted that he was the sole owner of a health care merchandise business (not previously disclosed) and that his estimate of the value of his waterproofing business (the secret business) was approximately $140,000 more than he testified its value was at the time of the hearing. He also admitted that he made cash payments to relatives totalling $16,000, that after he filed the petition, he took $36,000 of receivables and $10,000 from relatives to purchase a home in his wife's name. Neither the monies nor the home mortgage were disclosed in the bankruptcy petition or to the bankruptcy trustee. He further borrowed $12,000 from his mother-in-law to pay business expenses. He overstated his transportation, food and living expenses, and wrote himself two checks totalling $10,000, the first on the day before the evidentiary hearing and the second, four days after the first check. Finally, he failed to disclose payment to trade creditors made within 90 days before the filing of the Chapter 13 petition.
The bankruptcy court granted creditor's motion to dismiss the petition. The court retained jurisdiction to determine whether the dismissal should be with or without prejudice. A granting of a dismissal with prejudice would mean that the debtor could not refile a bankruptcy petition. Granting a petition without prejudice means that he could refile the bankruptcy petition. The court ultimately dismissed the bankruptcy with prejudice.
The debtor appealed to the Bankruptcy Appellate Panel ("BAP") arguing that the bankruptcy court failed to make specific findings of bad faith or "cause," and that the court's finding of bad faith was erroneous because he presented evidence that his omissions and other admissions were inadvertent and not made with a dishonest motive, and that it did not prejudice the creditor because he was unaware of those omitted items. The BAP affirmed the bankruptcy court's ruling. The debtor appealed to the Ninth Circuit.
The Ninth Circuit began its opinion by generally describing the various ways in which a Chapter 13 bankruptcy can be concluded: (1) discharge; (2) conversion to a Chapter 7 case; or (3) dismissal of the case for "cause." This case only involved the dismissal.
A dismissal of a bankruptcy case with or without prejudice is authorized by 28 U.S.C. § 349(a), which provides:
(Emphasis added).
In general, dismissals are ordered without prejudice to carry on the remedial purpose of the Bankruptcy Code and to restore property rights, insofar as is practical, to the same position as when the case was first filed, without affecting the disposition of debts. However, the Ninth Circuit pointed out that the language of the code stating: "unless the court, for cause, orders otherwise," is interpreted as meaning--unless the court dismisses the case with prejudice. A dismissal with prejudice will bar further bankruptcy proceedings between the parties and is a complete adjudication of the issues.
The Ninth Circuit indicated that "cause" for dismissal under section 349 has not previously been specifically defined by the Bankruptcy Code. In Chapter 13 cases, 28 U.S.C. §§ 1307(c)(1) through (10) provide that the court may dismiss or convert a case depending on the best interest of creditors and the estate or for any of ten enumerated circumstances. Bad faith is not specifically listed as one of the circumstances; however, case law has established that it is in fact one of the grounds.
The Ninth Circuit proceeded to establish standards for determining when conduct meets the level of "bad faith" to constitute cause for dismissal of a Chapter 13 petition with prejudice. The court stated it involves the application of the "totality of the circumstances" and that the bankruptcy court should consider the following four factors:
- Whether the debtor "misrepresented facts in his [Petition or] Plan unfairly manipulated the Bankruptcy Code or otherwise [filed] his Chapter 13 [Petition or] Plan in an inequitable manner." (Citations omitted);
- "The Debtor's history of filings and dismissals," (Citations omitted);
- Whether the "Debtor only intended to defeat State Court litigation," (Citations omitted); and
- Whether egregious behavior is present
(Citations omitted).
The court rejected as another element that there must be a finding of fraudulent intent. The court opined that neither malice nor actual fraud is required to find a lack of good faith. The court will not require the bankruptcy judge to hear evidence of debtor's ill will directed at creditors or that the debtor was affirmatively attempting to violate the law.
The court found that after reviewing the four factors listed, the conclusion to dismiss the Chapter 13 bankruptcy with prejudice was reinforced. The court specifically found that the debtor's dishonesty pervaded the proceedings. He failed to disclose all of the assets and financial dealings; his schedules omitted assets and undervalued others. His expenses were inflated. Considering his income, his failure to pay an appropriate amount of at least 30 percent to secured creditors, including the creditor, and his failure to disclose approximately $36,000, were all facts suggesting that the bankruptcy filing was in bad faith.
In addition, the court found that debtor had filed a previous bankruptcy less than six years prior and had filed three more Chapter 13 petitions, which were all dismissed, all with the same goal to avoid payment of the creditor's judgment. He had filed at least one of the Chapter 13 petitions under a different social security number. The court had no trouble finding that the intention of the debtor was to avoid and defeat the state court litigation and that his egregious behavior, coupled with no justification or excuse, demonstrated his intention was to use the bankruptcy system in an inappropriate manner. Under the totality of the circumstances, the court found the record before it supported the finding of the bankruptcy court that the filing was in bad faith.
This case demonstrates one end of the spectrum on conduct which may constitute bad faith. Certainly, the simple filing of a bankruptcy petition to avoid entry of a state court judgment or to avoid foreclosure would not constitute bad faith. Notwithstanding the failure of the Ninth Circuit to identify a bright line test, this case should be considered as the standard by which you measure a debtor's conduct and motivation in your particular case before determining whether a motion to dismiss for cause has merit.
Mr. Ludwig is a Director in the firm's Banking and Financial Institutions, and Bankruptcy and Insolvency Departments, specializing in creditors' rights related ligitation.
E-mail:mbl@kpclegal.com.