Chapter 11 of the Bankruptcy Code is designed to allow struggling companies to reorganize their debts and emerge as stronger, healthier companies or to liquidate in an orderly fashion. In either case, the company better be struggling, as made clear in a recent decision in In re Derma Pen, LLC, No. 14-11894, 2014 WL 7269762 (Bankr. D. Del. Dec. 19, 2014). In Derma Pen, the Bankruptcy Court for the District of Delaware dismissed Derma Pen, LLC’s (“Derma Pen”) chapter 11 case because it lacked a good faith attempt to reorganize or preserve value for creditors and instead was being used as a litigation tactic.
Background – In re Derma Pen, LLC
Formed in 2011, Derma Pen sells micro-needling and skin treatment devices and systems. Derma Pen entered into a sales distribution agreement (the “Agreement”) with 4EverYoung Limited (“4EY”) which allowed it to sell micro-needling devices domestically, and provided Derma Pen with ownership rights over the “DermaPen” trademark in the United States and the domain name “www.DermaPen.com” (together the “Trademark Assets”). 4EY owns the “DermaPen” trademark abroad and has a right of first refusal to purchase the Trademark Assets in the event that either party should terminate the Agreement.
In 2013, Derma Pen notified 4EY that it was exercising its right to terminate the Agreement. 4EY subsequently elected to exercise its right to purchase the Trademark Assets. Apparently upset with the proposed purchase price to be paid by 4EY (too low!), Derma Pen filed a complaint in the United States District Court of Utah against 4EY and other parties asserting various claims, including fraudulent inducement, unfair competition, trademark infringement and breach of contract (the “Utah Litigation”). The Utah District Court granted 4EY partial summary judgment on a number of these claims, and a jury trial was set to resolve the remaining issues. Three days before a jury trial was set to begin, Derma Pen filed for bankruptcy in the Delaware Bankruptcy Court. 4EY and another defendant in the Utah Litigation filed a motion to dismiss Derma Pen’s bankruptcy case and another motion seeking to transfer venue of the case to Utah.
The Bankruptcy Court’s Analysis
Section 1112(b) of the Bankruptcy Code allows the court to dismiss a chapter 11 bankruptcy case for cause. Under Third Circuit precedent, cause exists under Section 1112(b) unless the petition is filed in good faith, with the burden on the debtor to establish it is well-intentioned. In looking for good faith, the bankruptcy court focused on two factors: (1) whether the bankruptcy petition serves a valid bankruptcy purpose, and (2) whether the petition is filed merely to obtain a tactical litigation advantage.
In considering the first factor, the bankruptcy court stated that Derma Pen was “unquestionably” seeking to stay the Utah Litigation when it filed chapter 11. The question then became whether a chapter 11 petition filed to stay pending litigation against the debtor served a valid bankruptcy purpose. Section 362 of the Bankruptcy Code provides the debtor with an automatic stay against all creditors’ collection activity and lawsuits seeking to recover funds from the debtor. Citing to Third Circuit precedent, the bankruptcy court found that “the protection of the automatic stay . . . is not per se a valid justification for a Chapter 11 filing; rather it is a consequential benefit of an otherwise good faith filing.” Thus, the court concluded that the filing of a chapter 11 petition to stay the Utah Litigation, on its own, could not support a good faith filing.
Next, the court rejected Derma Pen’s argument that its bankruptcy filing was a good faith attempt to retain value that it would lose outside of the bankruptcy context. Derma Pen argued that Bankruptcy Code Section 365 would allow Derma Pen to reject the Agreement and Bankruptcy Code Section 363 would allow Derma Pen to sell the Trademark Assets to the highest bidder via a bankruptcy auction. (As a side note, this position assumes that a judicial determination by the Utah District Court would not provide a fair value for the Trademark Assets, and the bankruptcy court was unwilling to accept the proposition that the Utah District Court would be incapable of determining a fair valuation of the Trademark Assets.)
The bankruptcy court again held that good faith was not established by a debtor’s desire to take advantage of rights provided by the Bankruptcy Code. After reviewing the Third Circuit’s decisions in In re PPI Enter. (U.S.), Inc., 324 F.3d 197 (3d 2003) and In re Integrated Telecom Express, Inc., 384 F.3d 108 (3d Cir. 2004), the court noted that the absence of any financial distress and the timing of the filing undercut any argument that the bankruptcy was commenced in good faith because it could not necessarily preserve value to creditors that would have been lost outside of bankruptcy.
Here, the bankruptcy court concluded that Derma Pen was not financially distraught when it filed the chapter 11 petition. Acknowledging the well settled principle that a debtor need not be insolvent before filing for bankruptcy, the court noted that such a position does not “open the door to premature filing, nor does it allow for filing of a bankruptcy petition that lacks a valid reorganizational purpose.” Other than rising litigation costs, Derma Pen showed no indication that its operations were suffering from financial stress.
In analyzing the “totality of the facts and circumstances” surrounding the chapter 11 petition, the bankruptcy court ultimately held that Derma Pen’s bankruptcy filing was an improper attempt to re-start the Agreement and trademark litigation with the Utah District Court defendants in a new court. Derma Pen’s arguments failed to show that Derma Pen’s filing was a good faith attempt to reorganize or preserve value for the creditors, and the bankruptcy court dismissed Derma Pen’s chapter 11 petition.
Takeaway
A debtor embroiled in prepetition litigation may not use the Bankruptcy Code to achieve a tactical litigation advantage when the debtor is not also in serious financial distress as of the petition date.