Franchisor Bankruptcy Case Dismissed as a Bad Faith Filing

by Foley & Lardner LLP

The United States Bankruptcy Court for the District of Delaware recently issued an opinion discussing the tension between using bankruptcy as a legitimate tool to maximize value versus using bankruptcy merely as a litigation tactic. In the case, In re Rent-A-Wreck of America, Inc., 580 B.R. 364 (Bankr. D. Del. 2018), Judge Laurie Selber Silverstein interpreted the facts before her to come down firmly on the litigation tactic side of the equation. On that basis, Judge Silverstein dismissed the case as a bad faith filing. Although the circumstances of the case likely are not common among companies contemplating bankruptcy, the case nevertheless provides a stark warning on the limitations of Chapter 11.

The case involved debtors Rent-A-Wreck of America, Inc. (“RAWA”) and its wholly-owned subsidiary Bundy America, LLC. (“Bundy,” collectively with RAWA, the “Debtors”). RAWA was essentially a holding company. Bundy America, LLC was a franchisor that sold and administered car rental franchises across the country. The Debtors were part of a larger group of private companies owned by J.J.F. Management Services, Inc. (“JJFMS”). JJFMS purchased the Debtors in 2006 by acquiring the stock of publically owned RAWA and taking it private. Before the 2006 acquisition even closed, the Debtors found themselves locked in litigation with David Schwartz, who founded the company in 1973. Schwartz operated a Rent-A-Wreck franchise in Los Angeles pursuant to an alleged unwritten franchise agreement between Schwartz and RAWA. The parties thereafter embarked on nine years of litigation regarding the terms of Schwartz’s relationship with the overall franchise enterprise, including two trips to the U.S. Fourth Circuit Court of Appeals and $2.7 million in attorneys’ fees and costs.

During the litigation, Schwartz secured an order of the U.S. District Court for the District of Maryland finding that Schwartz did, in fact, have an implied-in-fact royalty and fee-free franchise agreement to operate a Rent-A-Wreck business in Los Angeles. The parties continued to litigate various matters and in June of 2011, the District Court issued an order holding RAWA in contempt in relation to allegations that RAWA was intentionally interfering with Schwartz’s business. About a month after the contempt order was issued, the Debtors filed voluntary Chapter 11 bankruptcy petitions in the United States Bankruptcy Court for the District of Delaware. The Debtors thereafter filed a motion seeking to reject seven franchise agreements, including the agreement with Schwartz.

Schwartz responded by filing a motion to dismiss the bankruptcy cases pursuant to Bankruptcy Code section 1112(b), arguing that they were filed in bad faith. Schwartz argued that the Debtors were improperly using the bankruptcy filing to accomplish what they were unable to do in litigation; that is, free themselves of the confines of Schwartz’s franchise agreement. The Debtors responded that the bankruptcy cases were proper because they were using bankruptcy as a means to maximize the value of the Rent-A-Wreck trademark, which was RAWA’s primary asset.

The bankruptcy court engaged in a detailed analysis of the facts and the parties’ arguments. Among the findings of the court were: the Debtors did not file the case because of an inability to pay debts as they came due or because of any demonstrated financial distress, JJFMS and affiliates held all of the secured debt and a large amount of the unsecured debt, and the litigation with Schwartz did not pose a significant financial threat to the Debtors. The court also considered matters not related to the financial condition of the Debtors, including the use of bankruptcy as an apparent “straightforward attempt to take value that belongs to Mr. Schwartz and give it to Bundy.” The court concluded that, under the facts of the case, the desire to use bankruptcy to maximize the value of the trademark was simply not sufficient to show good faith. Rather, the Debtors had “simply exchanged one set of issues for another and the expense of civil litigation for that of bankruptcy litigation.” On the point of bankruptcy litigation, the court specifically noted that there is a good deal of case law uncertainty related to the effect of a trademark license rejection, including potential post-rejection rights retained by the licensee. Thus, even if the court were to grant the motion to reject the franchise agreements (which would include rejection of the trademark licenses), the parties likely would remain embroiled in litigation on that issue for years to come. As a result, the court granted Schwartz’s motion to dismiss on the grounds that the bankruptcy petitions fell “on the dark side of the spectrum from the clearly acceptable to the patently abusive.”

As noted above, the Rent-A-Wreck case presents facts that are fairly uncommon. Typically, companies filing bankruptcy have no problem demonstrating a financial condition appropriate for Chapter 11. That said, Judge Silverstein’s opinion is important as an outer-limit guidepost for the types of problems that bankruptcy can, and cannot, effectively address.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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