Bad Faith Bankruptcy Filing & Dismissal: An Illustration (In re Obstetric and Gynecologic Associates)

Bad faith intentions? (photo by Marilyn Swanson)

Dismissal of a bankruptcy—for bad faith filing—is a rarity.

So, how a bankruptcy court grapples with the bad faith issue . . . and ends up dismissing the bankruptcy . . . can provide a lesson for us all.

What follows is a summary of how a Chapter 11 bankruptcy is dismissed when the Court is convinced that the bankruptcy is intended for the benefit of a non-debtor . . . and not for the benefit of the debtor or its creditors.

The opinion is In re Obstetric and Gynecologic Associates, Case No. 22-01174, Southern Iowa Bankruptcy Court (issued March 29, 2023; Doc. 299).

Facts[Fn. 1]

Here’s what happened:

A “Harmed Minor” is born under the care of Debtor—during which a “medical incident” occurs;
The Harmed Minor’s Conservator brings a medical malpractice action against Debtor;
The malpractice action results in a $75.6 million judgment in favor of the Harmed Minor and against Debtor;
Debtor has professional liability insurance with policy limits of $12 million;
Debtor files its notice of appeal to the Iowa Supreme Court;
Debtor also files a motion, before the Iowa Supreme Court, requesting a stay of execution pending appeal—and it wants that stay, (i) without posting any bond, or (ii) with a bond of only $12 million; and
The Iowa Supreme Court denies Debtor’s stay request.

Debtor has a bad faith claim against its insurer because:

prior to trial and verdict, Harmed Minor’s Conservator made many demands to resolve the malpractice claim, in full, by payment of the $12 million policy limits;
Debtor made numerous demands to its insurer to settle all claims within the $12 million policy limits; but
the insurer never offered any money to settle the Harmed Minor’s malpractice claim.

Legal Machinations[Fn. 2]

Here’s how the post-judgment collection efforts and bankruptcy developments happen.

–Pre-bankruptcy Collection

The Harmed Minor’s Conservator informs Debtor’s counsel that efforts to collect on the judgment will be pursued unless settlement demands are met. Such demands include:

payment of the $12 million policy limits;
dismissal of the state court appeal;
assignment of all potential causes of action (including the claim against Debtor’s insurer); and
Debtor’s cooperation in any suits related to legal malpractice.

Debtor wants to settle, but settlement does not occur.

So, the Harmed Minor’s Conservator issues a general execution against Debtor’s assets, and the sheriff arrives at Debtor’s clinic on October 19, 2022, to execute.

–Bankruptcy Developments

On October 31, 2022, Debtor files its a voluntary Chapter 11 bankruptcy, declaring that bankruptcy is the only option for protecting Debtor’s assets, for Debtor to remain in business, and for Debtor to continue serving its patients.

Debtor then promptly files in the bankruptcy:

a Motion for Relief from Stay to allow the pending appeal to continue before the Iowa Supreme Court; and
a Joint Motion with Debtor’s insurer to escrow the $12 million policy proceeds.

The Harmed Minor’s Conservator objects to both motions.

The Court grants the stay relief (Doc. 231).

The Joint Motion to escrow policy proceeds is withdrawn by Debtor. However, Debtor’s insurer continues to press the Motion, and the Bankruptcy Court rules:

the insurance proceeds are not property of Debtor’s bankruptcy estate; and
Debtor’s insurer has no standing to pursue the motion (Doc. 230).

–Concurrent Activity

Meanwhile, in state court, the Harmed Minor’s Conservator files a show cause against Debtor’s insurer to require payout of the insurance policy proceeds.

In response, Debtor files an emergency motion for sanctions in the Bankruptcy Court (Doc. 72) against the Harmed Minor’s Conservator, alleging violation of the automatic stay.

The Bankruptcy Court denies this sanctions motion (Doc. 106), and Debtor appeals (Doc. 120).

–Motion to Dismiss

The Harmed Minor’s Conservator files a motion to dismiss Debtor’s bankruptcy, for cause in the form of bad faith. Supporting allegations include:

Debtor does not intend that the bankruptcy filing benefit creditors;
Debtor had non-bankruptcy options and does not understand the costs and burdens associated with its Chapter 11 case;
Debtor’s bankruptcy filing is a litigation tactic to avoid payment of a bond;
Debtor is financially healthy;
Debtor has no potential for reorganization;
Debtor’s bankruptcy is a two-party dispute; and
An appearance of impropriety exists between Debtor and its insurer.

Debtor objects.

Dismissing the Case[Fn. 3]

The Bankruptcy Court dismisses Debtor’s Chapter 11 bankruptcy, for cause in the form of bad faith. What follows is a summary of the Bankruptcy Court’s rationale for doing so.

–Purpose of Filing

An important good faith inquiry is whether Debtor filed the bankruptcy for a valid bankruptcy purpose.

The U.S. Supreme Court has identified two proper purposes for a Chapter 11 bankruptcy filing:

to preserve a going concern; and
to maximize property available to satisfy creditors.

The record reflects different motivations that are not acceptable:

Debtor simply disagrees with the malpractice judgment:
- “We want the State Court to proceed because we do not feel like it was justice”;
- “we feel like the judgment was reached in error and we would like the Supreme Court to review it and decide on the merits of the case”;
- the appeal will “vindicate” the doctor involved; and
Debtor’s primary motivation in the bankruptcy is to protect its insurer from collection efforts while the appeal is pending—as demonstrated by Debtor’s sanctions motion against the Harmed Minor’s Conservator.

This evidence is also relevant to the good faith issue. Debtor’s insurer:

paid pre-petition fees to Debtor’s bankruptcy professionals and offered to finance those fees post-petition;
offered Debtor favorable terms on its current insurance coverage when no one else would provide such coverage; and
offered to extend credit to Debtor in exchange for a security interest in Debtor’s personal property and in the potential bad faith claim against Debtor’s insurer.

The record demonstrates that Debtor’s bankruptcy filing exists to serve the self-interests of Debtor and its insurer—not the interests of creditors.

–Cause for Dismissal

“Cause” for dismissal under § 1112(b) includes “substantial or continuing loss to or diminution of the estate and the absence of a reasonable likelihood of rehabilitation” (see subpart (b)(4)(A)). Under such standard:

Debtor repeatedly informs the Court that it continues to explore whether it should propose reorganization or liquidation . . . and continues to ask for more time to continue that exploration—but there is no justification for delays in making this basic decision;
confirmation of a plan of reorganization, or a liquidating plan, under the requirements of §1129 is unlikely—the size of the malpractice judgment renders the possibility of reorganization unreasonable, if not entirely impossible; and
continuing delays and administrative expenses involved in pursuing a plan of reorganization or liquidation would likely result in less proceeds to distribute to creditors, not more.

–Two Party Dispute

Petitions in bankruptcy arising out of a two-party dispute are not in bad faith per se.

But the two-party fact is relevant to the bad faith analysis, especially when the bankruptcy filing is intended to frustrate or delay the legitimate efforts of a creditor to enforce its rights.

In this case, the two-party dispute is actually between the Harmed Minor’s Conservator and Debtor’s insurer—and Debtor’s bankruptcy filing and actions are an attempt to frustrate or delay enforcement of the judgment from Debtor’s insurance proceeds.

The involvement of Debtor’s insurer in this contested matter—and the identical arguments between Debtor and its insurer on this good faith issue—are curious.

The evidence shows that the interests and goals of the Debtor and its insurer are fundamentally aligned against the Harmed Minor’s Conservator—and that’s a two-sided dispute that can and should be resolved in state court.

Further, claims of other creditors in this case, beyond the malpractice judgment, are minimal—and Debtor faces no threat from those other creditors.

–Factors Favoring Debtor

Evidence shows that Debtor is unable to obtain a bond in sufficient amounts to support a stay pending appeal.

Additionally, based on the amount of the judgment and testimony as to Debtor’s financial circumstances, Debtor is not able to pay the malpractice judgment.

–Burden of Proof

The burden to show bad faith for dismissal of a Chapter 11 bankruptcy rests on the movant by a preponderance of the evidence.

However, once a movant has made a prima facie showing of bad faith, the burden shifts to the debtor to establish the good faith of its bankruptcy filing.

–Ruling

Evidence presented by the Harmed Minor’s Conservator establishes a prima facie case for dismissal of Debtor’s bankruptcy.

Debtor has failed to meet its burden to establish that (i) its bankruptcy is filed in good faith, (ii) the value of its estate is not diminishing, and (iii) it can obtain confirmation of a plan.

Accordingly, cause exists to dismiss this bankruptcy case.

That dismissal is, of course, on appeal.

Conclusion

Dismissal motions for Chapter 11 cases are fact-intensive. And each ruling in each case is unique to itself and its own set of facts.

However, the fact circumstances and legal analysis in the In re Obstetric and Gynecologic Associates opinion provide a window into the circumstances of that particular case.

The unusual combination in that case of a large judgment, a recalcitrant insurer and a bankruptcy intervention, illustrate how a bankruptcy court grapples with the bad faith analysis and reaches a dismissal conclusion.

—————

Footnote 1. Information in this “Facts” section are taken from the Harmed Minor’s “Objection to Debtor & Non-Debtor Insurer Joint Motion to Place Insurance Proceeds in Escrow” (Doc. 69).

Footnote 2. Information in this “Procedural Machinations” section are taken from the Judge’s “Memorandum of Decision” on dismissal of the case (Doc. 299).

Footnote 3. Information in this “Dismissing the Case” section are also taken from the Judge’s “Memorandum of Decision” on dismissal of the case (Doc. 299).

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