Can a City File Bankruptcy to Deal With Police Misconduct Liability? — “Good Faith” Requirement (Part 3 of 3)

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11 U.S.C. Sec. 921(c) — “Good Faith” Requirement for Municipal Debtors

By Donald L. Swanson

“[I]t is unlikely that a city could file for bankruptcy solely for the purpose of shedding liability associated with unconstitutional police practices.”

–Conclusion in a Report, dated 8/21/2016 and titled: “Who Pays for Police Misconduct in Bankruptcy Cities?

This conclusion is undoubtedly accurate when a City is capable of paying the judgment. In such a context, a City’s bankruptcy filing would violate the “good faith” requirement of 11 U.S.C. § 921(c).

But this conclusion seems unlikely to prevail in the context of an exceedingly-large judgment amount against a City that can’t be paid.

Hypothetical

Imagine this hypothetical:

A City and its police officers are sued by a group of plaintiffs for violating the plaintiffs’ civil rights.
Jury verdicts are for many-millions of dollars—amounts that are multiple times the City’s annual budget.
Plaintiffs start executing on the judgements: garnishing the City’s checking accounts, attaching and selling the City’s office furniture, computers, police cars and fire trucks, etc.
The City has been trying for many months to pay the judgments:  seeking loans, seeking buyers for non-essential assets, raising taxes — but nothing works. The City, simply, cannot find enough money to pay the judgments.
So . . . in addition to the judgments remaining unpaid, the City is now unable to provide the basic services its citizens require.

In this hypothetical, it’s difficult to imagine how any court could find the City’s bankruptcy filing to lack “good faith.”

“Good Faith” in Chapter 11

The “good faith” standard is well-worn in the Chapter 11 context. Like Chapter 9, a Chapter 11 case can be dismissed because of the debtor’s lack of “good faith.”

In re Mense and Cottonsmith, LLC

For illustration and analogy, the 2014 Chapter 11 case of In re Mense and Cottonsmith, LLC,  seems helpful. In Mense and Cottonsmith, a business and its owner filed Chapter 11 bankruptcies to stop execution on a $3 million judgment. The debtors had appealed the judgment but couldn’t post a supersedeas bond to stop collection efforts during appeal.

The Bankruptcy Court’s discussion of “good faith” in Mense and Cottonsmith includes the following:

The “Good Faith” Standard:

–“The majority of bankruptcy courts tackling this issue have held that the filing of a chapter 11 petition as a litigation tactic to circumvent the requirement of an appeal bond in state court litigation is in bad faith.”

–“When a debtor files chapter 11 to dodge the requirement for an appeal bond, a court’s determination of good faith typically hinges on the following factors:

1. Whether the debtor is a viable business which would suffer severe disruption if enforcement of the judgment was not stayed; and the chapter 11 petition was filed to preserve its status as an ongoing concern and to protect its employees and creditors;
2. Whether the debtor had financial problems on the petition date, other than the adverse judgment;
3. Whether the debtor has relatively few unsecured creditors, other than the holder of the adverse judgment;
4. Whether the debtor has sufficient assets to post a bond to stay the judgment pending appeal;
5. Whether the debtor acted in good faith to exhaust all efforts to obtain a bond to stay the judgment pending appeal;
6. Whether the debtor intends to pursue an effective reorganization within a reasonable period of time, or whether the debtor is unwilling or unable to propose a meaningful plan until the conclusion of the litigation; and
7. Whether assets of the estate are being diminished by the combined ongoing expenses of the debtor, the chapter 11 proceedings, and prosecution of the appeal.”

Applying the “Good Faith” Standard:

The Court rules that neither Mense nor Commonsmith, LLC, filed bankruptcy in “good faith” and dismisses their bankruptcy cases. The Mense and Cottonsmith court explains its dismissal decision like this:

“Cottonsmith is not an operating business . . . has no employees, no cash flow, and no sources of income . . . no reasonable prospects for the conduct of business in the future . . . only 1 unsecured creditor besides Kayne . . . [T]he balance in the [bank] account has decreased from $1,400,000 to $1,118,082.70 . . . Cottonsmith’s bankruptcy was filed for the purpose of preventing Kayne . . . from seizing Cottonsmith’s cash which Mense is now using to pay his personal expenses and to fund the appeal.

“Mense does not operate [or manage] a business . . . He did not list any gross receipts or business expenses . . . and he admits that he has no employees. Mense invests in real estate projects and businesses while collecting social security. . . . It is undisputed that Mense is solvent. His schedules reveal a net worth in excess of $13.4 million. Other than Kayne’s judgment, Mense had no financial problems.

In re Ford

The 1987 case of In re Ford  provides a helpful contrast. Richard Ford files Chapter 11 bankruptcy after a $165,000 judgment is entered against him. He also files an appeal of the judgment but can’t post a supersedeas bond.

The Ford Court concludes that “the debtor did not lack good faith when he filed this petition under Chapter 11.” And the Court provides the following explanations:

–“[T]he debtor has several tracts of land which can be liquidated over a period of time to pay the Canton judgment should such payment become necessary. . . . the plan filed by the debtor proposes to pay the Canton judgment in full in an orderly manner.

–“This Court is impressed that the debtor has filed a Plan of Reorganization . . . offering to pay his creditors in full with an orderly liquidation of assets. . . . Ford’s assets are not immediately liquid, but liquidation of a portion of these assets is possible given a reasonable period of time.”

–“There is little to be gained by allowing a forced liquidation of the debtor’s one-third undivided interest in real property which this Court believes would result in chaotic dismemberment of the debtor’s assets with resulting damage to the debtor, his co-owners and creditors alike.”

–”Ford did not and does not now have sufficient cash presently available to him to pay the judgment or to post a supersedeas bond. . . . The Chapter 11 petition was not filed solely to avoid posting a supersedeas bond, but only to give the debtor time to liquidate his assets.”

Editorial Comments:

In the hypothetical above, a City might file a Chapter 9 bankruptcy Petition in “good faith.” Or it might not. The “good faith” of a City’s filing depends on all the circumstances.

I suggest that a City, whose circumstances are much like those of the In re Ford case, is likely to stay in bankruptcy. However, the closer the facts of a city’s bankruptcy get to those of Mense and Cottonsmith, the likelihood of a dismissal for lack of “good faith” becomes greater.

Note:  The first article in this series reviews the new study report linked above and explains the mediation connection.  The second article in this series considers the “insolvency” element for Chapter 9 eligibility.  A fourth article is “10 Practical Lessons for Cities Facing Bankruptcy.”

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