An opinion issued by the United States Bankruptcy Court for the Northern District of Texas1 highlights that the ability to seek bankruptcy protection is not sacrosanct. Indeed, the widely publicized dismissal of the bankruptcy proceeding filed by the National Rifle Association ("NRA") offers important lessons for companies contemplating bankruptcy. Creditors opposing a bankruptcy filing may also leverage the NRA Court's rationale in support of dismissal motions.
The central thrust of Bankruptcy Court's decision is that entities filing for bankruptcy protection must do so in good faith and have a "valid bankruptcy purpose." More importantly, the NRA opinion instructs that bankruptcy courts will not accept a debtor's proffered reasons for the bankruptcy filing at face value and will closely scrutinize the evidence to confirm that the filing was justified.
Facts of the NRA Case
Following an investigation into the NRA's governance and internal controls, the Attorney General of New York ("NYAG") filed an action (the "NYAG Action") against the NRA seeking its dissolution as a New York non-profit entity. The NYAG alleged, among other things, that: (i) the NRA exceeded its authority by conducting its business in an illegal manner and abused its powers in contravention of New York public policy; and (ii) the members and directors in control of the organization wasted corporate assets and perpetuated the NRA for their personal benefit.
Thereafter, the NRA filed a bankruptcy proceeding in Texas asserting that the NYAG Action was not being litigated on a "fair, level playing field." The NYAG, as well as other parties in interest, moved to dismiss the bankruptcy (the "Motions to Dismiss") for cause under the provisions of the Bankruptcy Code on the grounds that the bankruptcy was filed in bad faith and not for any proper bankruptcy purpose.2
In its opposition to the Motions to Dismiss, the NRA offered several reasons why the filing was in good faith. The NRA argued that the bankruptcy was intended to establish a "centralized neutral forum to streamline, resolve and address all outstanding claims." The NRA also asserted that the automatic stay triggered by the bankruptcy filing offered the organization a breathing spell from ongoing litigation and allowed the NRA to resolve the litigation on a cost effective basis.
The NYAG, and other movants, presented a competing vision. The movants asserted that the true purpose of the filing was to avoid regulatory oversight and the potential dissolution of the entity in the NYAG Action.
Legal Standard for Dismissal of Chapter 11 Cases
Pursuant to Section 1112(b) of the Bankruptcy Code,3 a bankruptcy court is obligated to dismiss a Chapter 11 case if "cause" for dismissal is established unless the court concludes instead that the appointment of a trustee or examiner would be in the best interest of the bankruptcy estate. The Bankruptcy Code identifies a list of factors that may constitute "cause" for dismissal under section 1112(b)(4). Courts have also concluded that a dismissal is warranted if the bankruptcy filing was not in good faith. This good faith analysis may, in turn, consider whether the bankruptcy serves a valid "bankruptcy purpose."
Evidence Presented at Trial
Over the course of a 12 day trial on the Motions to Dismiss, the Bankruptcy Court heard testimony from twenty three witnesses, including the NRA's executive vice president (the "EVP"). The evidence demonstrated that the NRA was in its strongest financial position in years and had the ability to pay its creditors in full. The NRA's CFO testified that the organization had sufficient financial resources to fund the ongoing litigation.
Critically, the Court observed that the NRA's board had not voted on whether to file for bankruptcy. Because that decision was made solely by the EVP based upon a provision in his recently revised employment agreement, the Court found his testimony to be the most compelling evidence. During his cross-examination, the EVP acknowledged that the Chapter 11 filing was precipitated by the potential dissolution of the NRA if the NYAG Action was successful.
Dismissal of the Bankruptcy Case
The NRA Court concluded that the bankruptcy filing was not driven by financial difficulties or potential insolvency.4 Rather, the Court found that the true purpose of the filing was to deprive the NYAG of the "remedy of dissolution" and protection from judicial dissolution was not a valid bankruptcy purpose. In support of its holding, the Court reasoned that: (i) dissolution of the organization would be granted only if a New York court determined that it served the public interest; and (ii) the Bankruptcy Code was not intended to shield an organization from that type of threat.
Lessons Learned
The most important lesson from the NRA decision is that in examining good faith and ultimately, dismissal of a bankruptcy case, a bankruptcy court may not accept a debtor's proffered reasons for the filing at face value. Many Chapter 11 debtors offer a similar explanation for their bankruptcy filings, namely, the creation of a centralized forum to address, resolve and ultimately pay claims. Whether valid or pretextual, the NRA case suggests that courts will look beyond the proffered reasons and focus on testimony and other evidence to determine if the facts align with the stated purpose. Additionally, this case may stand for the proposition that bankruptcy may not be engaged to prevent dissolution of a company through regulatory action.
Prior to a bankruptcy filing, debtors should be prepared to present cogent, clearly defined grounds for the filing. Documents prepared before and after the bankruptcy filing, as well as witness testimony, should be consistent and on message. Additionally, articulation of a clear path to exit the bankruptcy case is also critical.
The NRA decision may also be engaged as a sword by creditors opposing a bankruptcy filing. If a debtor's stated reasons for the filing appear pretextual or unsupported by the facts and circumstances, opponents of the bankruptcy could implore the bankruptcy court to follow the NRA Court's example and take a deeper dive into the facts as part of its good faith analysis.
Footnotes
1 In re Nat'l Rifle Ass'n of Am., Case No. 21-30085 (HDH), 2021 19070738 (Bankr. N.D. Tex. May 11, 2021)
2 In the event that the Bankruptcy Court declined to dismiss the case, the movants requested alternate relief including the appointment of a chapter 11 trustee or examiner.
3 11 U.S.C. §1112(b)
4 Although these considerations were discussed in the opinion, it is important to note that the Bankruptcy Code does not require a debtor to be insolvent at the time of the filing.
Originally published 18, August 2021
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