Restructuring

Executive Summary

In May, 2021, Judge Harlin D. Hale of the United State Bankruptcy Court for the Northern District of Texas, dismissed the chapter 11 cases filed by the National Rifle Association.  The court found that the organization filed bankruptcy to gain an unfair litigation advantage and avoid a state regulatory action brought by the New York Attorney General, which is not a valid bankruptcy purpose.  This high-profile case demonstrates that although the bar is not high for an organization to procure protection from creditors under the U.S. Bankruptcy Code, a barrier of entry does stand.  In re National Rifle Association of America and Sea Girt, LLC, No. 21-30085 (Bankr. N.D. Tex. May 11, 2021).

Background

On August 6, 2020, the New York Attorney General (the “NYAG”) filed an enforcement action in New York state court against the National Rifle Association (the “NRA”), alleging the NRA violated various provisions of the New York Not-For-Profit Law and seeking, among other things, the dissolution of the NRA.  The enforcement action also listed certain current and former NRA officers as individual defendants, including its executive vice president Wayne LaPierre, seeking restitution of funds from these individuals.

On January 15, 2021, the NRA and its newly formed Texas subsidiary Sea Girt, LLC, jointly filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code in the Northern District of Texas.  As explained by the NRA’s filed documents, the chapter 11 filing aimed to (1) streamline and resolve all outstanding claims and litigations to preserve the NRA as a going concern and (2) enable the NRA to emerge from the bankruptcy as a Texas-domiciled non-profit.  Further, the NRA announced its intention to propose a plan that would pay all creditors’ allowed claims in full.

Following the petitions, several parties in interest filed motions to dismiss the chapter 11 cases, alleging bad faith, most notably the NYAG, the District of Columbia Attorney General, and Ackerman McQueen, Inc., one of the NRA’s most significant vendors.  In addition, a long term member, donor, and director of the NRA, Judge Phillip Journey, filed a motion under section 1104(c) of the Bankruptcy Code seeking the appointment of an examiner with expanded powers to investigate the governance of the NRA and the actions of its management. 

After weeks of discovery, Judge Hale held a 12-day hearing on the motions to dismiss and the motion to appoint an examiner, with 23 witnesses testifying.

He ultimately granted the motion to dismiss and denied the motion to appoint an examiner.

Bad Faith Filing: Legal Standards

Section 1112(b)(4) of the Bankruptcy Code provides a non-exhaustive list of “cause” to dismiss a bankruptcy case. Most courts, including the Fifth Circuit Court of Appeals, have held that the lack of good faith in filing constitutes a cause for dismissal.  In re Little Creek Dev. Co., 779 F.2d 1068, 1072-73 (5th Cir. 1986).  A case is not filed in good faith unless it has a valid bankruptcy purpose.  In re SGL Carbon Corp., 200 F.3d 154, 165 (3d Cir. 1999).  Bankruptcy courts examine whether a case is filed in good faith by examining the totality of the circumstances, including “the debtors’ financial condition, motives, and the local financial realities.” Little Creek, 779 F.2d at 1072.  Two inquiries are particularly relevant to the question of good faith: (1) whether the petition serves a valid bankruptcy purpose and (2) whether the petition is filed merely to obtain a tactical litigation advantage.  In re 15375 Mem’l Corp., 589 F.3d 605, 618 (3d Cir. 2009).

Bad Faith Filing: Court’s Holding

Relying on three main factors, the court found the primary purpose the NRA filed for bankruptcy was to avoid a potential dissolution in the NYAG’s enforcement action.

First, at the time of petition, not only was the NRA solvent, but it was also in the “strongest financial condition in years”.  In addition, the court found no evidence suggesting that the NRA filed bankruptcy to reduce operating cost, to address burdensome executory contracts and unexpired leases, or otherwise to obtain a breathing spell, each of which would have been a valid bankruptcy purpose.  As its chief financial officer testified, there was no financial reason for the NRA to file bankruptcy. 

Second, the court was not persuaded by the NRA’s claim that it filed bankruptcy to transfer domicile from New York to Texas.  The court pointed out that not only can the NRA transfer domicile outside of bankruptcy, this alleged purpose to file bankruptcy also failed to explain the timing, as the testimony during the trial showed that the transfer had been contemplated by the NRA leadership for a while. 

Third, existing litigation faced by the NRA did not pose an imminent financial threat to the NRA’s financial security.  Although the NRA claimed that the bankruptcy proceeding would streamline the litigation and reduce legal costs, it admitted that the costs of going through a bankruptcy case would also be high.  Furthermore, the NRA had not conducted an analysis of the cost of proceeding with litigation outside of bankruptcy versus the cost of the bankruptcy and proceeding with the litigation in bankruptcy, nor had the NRA had trouble affording the legal fees before filing the petition. 

These factors led the court to conclude that the NRA’s utilization of bankruptcy proceedings was for the sole purpose of avoiding New York State’s regulatory scheme.  This was confirmed by Mr. LaPierre’s testimony that the NRA would not have filed for bankruptcy, but for the NYAG’s lawsuit.

The court then held that avoiding a government regulatory regime was not a valid bankruptcy purpose, and therefore, the chapter 11 filing should be dismissed.  Recognizing that that the NYAG’s enforcement action to dissolve the NRA posed an existential threat to the organization, the court nevertheless held that bankruptcy proceedings are not a “sanctuary” against this type of threat.  Judge Hale distinguished the enforcement action specifically seeking dissolution and lawsuits that potentially pose a threat of significant financial liability.  Unlike the latter, which is the classic scenario where dissolution is only a collateral effect of litigation, the former type of actions is not shielded by the Bankruptcy Code.  The NRA’s bankruptcy filing was, therefore, not filed in good faith, but instead to gain an unfair advantage against the NYAG’s enforcement actions and to avoid a regulatory scheme, constituting a cause for dismissal.  

Motion to Appoint an Examiner or Trustee Denied

Following its analysis of section 1112(b)(1) of the Bankruptcy Code relating to dismissal, the court also considered whether to appoint an examiner or trustee but found that doing so was not in the best interest of creditors and the estate.  The court observed that “the NRA does not sell goods or services, and it would not be easy to find a suitable individual to serve in the role of trustee or examiner with expanded powers.”  Moreover, given the NRA’s political significance, appointing an examiner or trustee may deter certain members or donors from continuing to support the organization. 

However, Judge Hale did express his concerns over the corporate governance issues revealed before and during the bankruptcy case, including the lack of transparency.  For example, the court was especially concerned that the decision to file for bankruptcy was substantially made by Mr. LaPierre alone, with limited consultation with certain board members and without informing the majority of the board of directors or officers such as the chief financial officer and the general counsel.  Therefore, although the court dismissed the case without prejudice, the opinion noted that if the NRA filed bankruptcy again, the court would “immediately take up some of its concerns about disclosure, transparency, secrecy, conflicts of interests . . . which could cause the appointment of a trustee out of concern that the NRA could not fulfill the fiduciary duty required by the Bankruptcy Code for a debtor in possession.”

Takeaways

Although the good faith requirement in bankruptcy filings is a case-by-case inquiry, it is important that the court distinguished the governmental enforcement actions aiming to dissolve the organization from litigations that pose the risk of liabilities that threaten the existence of an organization.  Citing the former as the reason to file for bankruptcy may be viewed as inappropriate, absent other valid bankruptcy purposes, as shown by the dismissal of the NRA’s chapter 11 case.  On a side note, this case also highlights the importance of sound corporate governance during the time leading up to the filing of chapter 11 case.  Although the court did not reach this issue here, a bankruptcy case may be dismissed if it was not filed utilizing proper corporate governance.