HEADNOTE - Weil, Gotshal & Manges LLP

An A.S. PrAtt & SonS PublicAtion FebruAry/MArch 2013

heAdnote: deciSionS, deciSionSSteven A. Meyerowitz

hotel WhoSe chAPter 11 cASe WAS Filed in bAd FAith cAn “StAy” in bAnkruPtcyLee Jason Goldberg

bAnkruPtcy court SurPriSeS obServerS And trAnSFerS venue oF PAtriot coAl chAPter 11 cASeS to MiSSouriEric M. English

ForecloSure lAW in the WAke oF recent deciSionS on reSidentiAl MortgAge loAnS: the SituAtion in georgiAAshby Kent Fox, Shea Sullivan, and Amanda E. Wilson

truSt Me—A Security truStee’S dutieS to SubordinAted creditorS exAMinedMathew Cox and Bevis Metcalfe

the yeAr in bAnkruPtcy: PArt iCharles M. Oellermann and Mark G. Douglas

recent develoPMentS in buSineSS bAnkruPtcy cASeSJonathan M. Landers

Giordano’s court SendS inAPProPriAte MeSSAge on inveStigAtion oF SolicitAtion AllegAtionSFielden Fleming

editor-in-chieFSteven A. Meyerowitz

President, Meyerowitz Communications Inc.

ASSiStAnt editorCatherine Dillon

BOARD OF EDITORS

Pratt’s Journal of BankruPtcy law is published eight times a year by a.s. Pratt & sons, 805 fifteenth street, nw., third floor, washington, Dc 20005-2207, copyright © 2013 tHoMPson MEDIa GrouP llc. all rights reserved. no part of this journal may be reproduced in any form— by microfilm, xerography, or otherwise— or incorporated into any information retrieval system without the written permission of the copyright owner. requests to reproduce material contained in this publication should be addressed to a.s. Pratt & sons, 805 fifteenth street, nw., third floor, washington, Dc 20005-2207, fax: 703-528-1736. for permission to photocopy or use material electronically from Pratt’s Journal of Bankruptcy Law, please access www.copyright.com or contact the copyright clearance center, Inc. (ccc), 222 rosewood Drive, Danvers, Ma 01923, 978-750-8400. ccc is a not-for-profit organization that provides licenses and registration for a variety of users. for subscription information and customer service, call 1-800-572-2797. Direct any editorial inquires and send any material for publication to steven a. Mey-erowitz, Editor-in-chief, Meyerowitz communications Inc., Po Box 7080, Miller Place, ny 11764, [email protected], 631.331.3908 (phone) / 631.331.3664 (fax). Material for publication is welcomed— articles, deci-sions, or other items of interest to bankers, officers of financial institutions, and their attorneys. this publication is designed to be accurate and authoritative, but neither the publisher nor the authors are rendering legal, accounting, or other professional services in this publication. If legal or other expert advice is desired, retain the services of an ap-propriate professional. the articles and columns reflect only the present considerations and views of the authors and do not necessarily reflect those of the firms or organizations with which they are affiliated, any of the former or pres-ent clients of the authors or their firms or organizations, or the editors or publisher. PostMastEr: send address changes to Pratt’s Journal of Bankruptcy Law, a.s. Pratt & sons, 805 fifteenth street, nw., third floor, washington, Dc 20005-2207.

ISSN 1931-6992

Scott L. BaenaBilzin Sumberg Baena Price &

Axelrod LLP

Leslie A. BerkoffMoritt Hock & Hamroff LLP

Ted A. BerkowitzFarrell Fritz, P.C.

Andrew P. BrozmanClifford Chance US LLP

Kevin H. BuraksPortnoff Law Associates, Ltd.

Peter S. Clark II Reed Smith LLP

Thomas W. CoffeyTucker Ellis & West LLP

Michael L. CookSchulte Roth & Zabel LLP

Mark G. DouglasJones Day

Timothy P. DugganStark & Stark

Gregg M. FicksCoblentz, Patch, Duffy & Bass

LLP

Mark J. FriedmanDLA Piper

Robin E. KellerLovells

William I. Kohn Schiff Hardin LLP

Matthew W. LevinAlston & Bird LLP

Alec P. OstrowStevens & Lee P.C.

Deryck A. PalmerPillsbury Winthrop Shaw

Pittman LLP

N. Theodore Zink, Jr.Chadbourne & Parke LLP

99

Hotel whose chapter 11 case was filed in Bad faith can “stay” in Bankruptcy

LEE JASOn GOLDBErG

The author explores the decision by the U.S. Bankruptcy Court for the Northern District of Texas in In re 1701 commerce, llc, to allow a Chapter 11 debtor’s case to remain pending in the “public interest,”

notwithstanding the court’s finding that the case was filed in bad faith, constituting “cause” to dismiss it or grant relief from the automatic stay.

In In re 1701 Commerce, LLC,1 the u.s. Bankruptcy court for the north-ern District of texas allowed a chapter 11 debtor’s case to remain pend-ing in the “public interest,” notwithstanding the court’s finding that the

case was filed in bad faith, constituting “cause” to dismiss it or grant relief from the automatic stay. the rationale underlying the court’s decision shows that, for bad faith filings, additional considerations may come into play when a creditor seeks dismissal of a case or relief from the stay for cause. the decision, however, also introduces questions as to whether or how a court should balance the public interest in applying the law.

the diSPute

“a bankruptcy court is a court of equity…and is guided by equitable doctrines and principles except in so far as they are inconsistent with the

Lee Jason Goldberg is a Business Finance & restructuring associate in the new York City office of Weil, Gotshal & Manges LLP. He can be reached at [email protected].

Published by A.S. Pratt in the February/March 2013 issue of Pratt’s Journal of Bankruptcy Law.

Copyright © 2013 THOMPSOn MEDIA GrOUP LLC. 1-800-572-2797.

PrATT’S JOUrnAL OF BAnKrUPTCY LAW

100

[statute]…. a court of equity may in its discretion in the exercise of the jurisdiction committed to it grant or deny relief upon performance of a condition which will safeguard the public interest. It may in the public interest, even withhold relief altogether....”2

consistent with this supreme court pronouncement from over 70 years ago, bankruptcy courts are courts of equity, which are, among other things, tasked with safeguarding the public interest. Bankruptcy courts do so by requiring that cases be filed in good faith, which prevents abuse of the bank-ruptcy process, including by debtors seeking to unfairly delay creditors or achieve other improper purposes. what happens, however, when enforcing the good faith requirement ac-tually conflicts with the public interest? In deciding whether to grant relief predicated on such requirement, is it within a bankruptcy court’s discretion to take into account additional considerations that may implicate the public interest? In 1701 Commerce, the court waded into these murky waters when it considered motions to dismiss the case of debtor 1701 commerce, llc, or grant relief from the automatic stay based on the debtor’s purported bad faith in filing its chapter 11 case. In a surprising twist, the court turned the ordinary logic of providing relief from bad faith filings on its head by allowing the case to remain pending, despite its having been filed in bad faith, in order to protect the public interest.

bAckground

the 1701 Commerce case essentially involved a two-party dispute be-tween the senior and junior lenders to the respective owners of the sheraton fort worth Hotel and spa. Dougherty funding (the senior lender) loaned funds to borrower Presidio Hotel fort worth (a non-debtor) to enable the borrower to purchase and rehabilitate the sheraton hotel. later, Vestin origi-nations (the junior lender) also loaned funds to the borrower, and Vestin as-signed the loan to three of its affiliates. the relationship between the senior and junior lenders was governed by a subordination and intercreditor agree-ment. the hotel also received financial support and a commitment to the borrower for future financial support in the form of a twenty year tax agree-ment with the city of fort worth. a hotel management company operated

HOTEL CAn “STAY” In BAnKrUPTCY

101

the hotel pursuant to a contract with the borrower. after the borrower encountered financial difficulties, the junior lender created the debtor as a special purpose vehicle to take the place of the junior lender’s affiliates respecting the hotel. By assignment of deed of trust, the junior lender’s affiliates assigned their interests in the junior loan to the debtor, which the senior lender asserted violated the intercreditor agreement. the borrower subsequently defaulted on the senior and junior loans, and the senior lender and the debtor sent the borrower letters notifying it of its defaults. Prior to the foreclosure scheduled by the debtor, which the senior lender and the debtor tried unsuccessfully to thwart, the borrower transferred the hotel to the debtor by a deed in lieu of foreclosure. the borrower and its principals, as guarantors of the junior loan, received a release from the debtor of all claims and obliga-tions arising from the junior loan in exchange for the deed in lieu agreement, on the condition that the agreement was not later overturned by a court. Prior to learning about the transfer of the hotel to the debtor, the senior lender posted the hotel for foreclosure. the debtor obtained a temporary re-straining order in state court prohibiting the senior lender from foreclosing, and the parties argued in state court about whether any of their actions had run afoul of the intercreditor agreement. on the evening before the hearing on dis-solution or continuation of the tro, the debtor filed its chapter 11 petition. the senior lender sought dismissal of the debtor’s chapter 11 case pursu-ant to section 1112(b) of the Bankruptcy code or, alternatively, relief from the stay pursuant to section 362(d) of the Bankruptcy code, in each case citing the debtor’s alleged bad faith as the basis for the relief sought in the motions. section 362(d)(1) provides that the stay “shall” be lifted “for cause,” including a lack of adequate protection, and section 362(d)(2) provides that the stay shall be lifted if the debtor does not have equity in the property and the property is not necessary to an effective reorganization. section 1112(b) provides that the court “shall” convert to chapter 7 or dismiss a case “for cause” if one or more of the nonexclusive conditions listed in section 1112(b)(4) is met.

the court’S AnAlySiS

the court refused to lift the stay under section 362(d)(2), finding that there was equity in the hotel beyond the debt to the senior lender and that the


102

hotel was essential to the debtor’s reorganization. the court also found that the senior lender was adequately protected by an equity cushion. Instead, the court focused its analysis on the “for cause” provisions of sections 1112(b) and 362(d)(1), stating that courts in the fifth circuit and other circuits have long recognized that bad faith constitutes “cause” for purposes of dismissal under section 1112(b) or stay relief under section 362(d)(1) despite its not being listed in either statutory section. the court rejected the debtor’s asser-tion that bad faith required a finding of subjective bad faith. the court found many of the factors used by courts to identify a bad faith filing present in the case, including (i) the hotel was the debtor’s only asset, (ii) the hotel’s employees worked for the hotel management company, not the debtor (which did not have any employees), (iii) there appeared to have been improper prepetition conduct by the junior lender’s affiliates in the creation of the debtor and by the debtor and the junior lender’s affiliates in observing the requirements of the intercreditor agreement, (iv) the debtor filed bankruptcy on the eve of a hearing at which the tro barring foreclo-sure might have been dissolved, and (v) the bulk, if not all, of the unsecured claims scheduled by the debtor were actually debts owed by the hotel man-agement company. In addition, the court observed that this appeared to be a case of “new debtor syndrome,” where “a one-asset entity [was] created…on the eve of foreclosure to isolate the insolvent property and its creditors.” the court noted that in such cases, the inference of bad faith is particularly strong. the court, therefore, inferred that the primary purpose of placing the hotel in the debtor was to isolate the hotel and the problems associated with it from the other assets of the junior lender and its affiliates. after commenting that the fifth circuit had made clear that a bank-ruptcy court should not retain a case to become a venue for resolution of a state court dispute, the court stated that it was being asked to resolve what was really an inter-lender dispute between the senior and junior lenders, with the debtor being merely an appendage of the junior lender. the court also noted that similar inter-lender and two-party disputes had been dismissed for cause because of bad faith. for all of these reasons, the court concluded that the debtor filed its chapter 11 petition in bad faith. what happened next was unexpected, as


103

the court chose not to dismiss the case or lift the stay “for cause” based on the bad faith filing. Instead, based on considerations largely extrinsic to the parties to the case, the court adapted a creative remedy it had used in another case, conditioning continuation of the stay on the debtor’s deposit of a cer-tain sum in the court’s registry. If the debtor made such deposit, then the automatic stay would remain in place so long as the debtor obtained an order confirming its chapter 11 plan by a specified date. the court’s order also re-quired the debtor to make defined interim payments to the senior lender and provided for the distribution of the deposit. thus, while the senior lender benefited from an equity cushion, the decline in the hotel’s value between ap-praisals conducted in september and March, combined with the “vagaries of the marketplace,” had convinced the court that it could not allow the debtor to restructure the hotel’s debt without further protecting the senior lender’s position. the court instituted its remedy—rather than dismissing the case or lift-ing the stay—after concluding that it could protect the hotel and “ensure [the hotel’s] service of the public interest” by keeping the hotel within the court’s custody. the hotel would be insulated from the harm it could suf-fer as the focus of lawsuits in other forums, and the court could monitor and oversee the debtor’s operations, through the protections offered by the automatic stay and the ability to appoint, if necessary, a trustee to manage the hotel. the court further concluded that it could offer such protection while also protecting the senior and junior lenders’ interests. why did the court elect to retain the chapter 11 case in the “public interest,” though, when it had found that the case was filed in bad faith, constituting “cause” to dismiss it or lift the stay?

the court’S rAtionAle

citing two “exceptional cases,” In re Mirant Corp.3 and NLRB v. Bildisco & Bildisco,4 well known for promulgating a heightened, or “public inter-est,” standard for rejection of certain executory contracts, the court in 1701 Commerce held that “[a]s with any chapter 11 case, the court must consider the legitimate interests of others in deciding whether to grant either of the [m]otions.” the court cited no other cases—including any cases specifically


104

addressing bad faith in the dismissal or stay relief contexts—where the bank-ruptcy court was required to consider the legitimate interests of others in deciding a motion before it. the court observed that, generally, in bankruptcy matters, the “public in-terest” is served by preserving value and jobs where possible, thus alluding to the supreme court’s finding in Bildisco that the “fundamental purpose of reor-ganization is to prevent a debtor from going into liquidation, with an attendant loss of jobs and possible misuse of economic resources.” the court’s factual findings did not indicate that there was a risk of liquidation of the debtor; granting either motion, however, would return the parties to state court, where, the court found, the debtor’s hotel “and by extension the city [of fort worth]” would serve as a “fraying rope in a continuing tug of war” between the senior and junior lenders. Expecting the hotel to maintain, let alone improve, the quality of its operations in those circumstances was unrealistic. Even though the court found that the debtor had filed its chapter 11 petition in bad faith, constituting the requisite “cause” to dismiss the case or lift the stay, the court also found that the hotel had “significance for other par-ties whose interests deserve[d] deference from the court.” the main “other party” explicitly afforded deference by the court was the city of fort worth, which, according to the court, represented the “public interest” through a tax incentive agreement between fort worth and the non-debtor borrower. the court, noting that the tax incentive agreement reflected the hotel’s im-portance to fort worth’s plan for economic growth and development, took judicial notice of such plan and gave “deference” to the findings fort worth made in connection with it. the court found, therefore, that the public had a “significant interest” in the hotel’s operation as a “first class hotel” in ac-cordance with the tax incentive agreement. Implying that it was required to consider such interests by using the word “must,” the court implemented its own remedy—allowing the case to remain in chapter 11 but conditioning continuation of the automatic stay.

coMMent

the court did not need to make a bad faith finding to fashion its remedy, though. the senior lender had sought dismissal of the chapter 11 case under


105

section 1112(b) or, alternatively, relief from the automatic stay under sec-tion 362(d). under sections 1112(b)(1) and 362(d)(1), a bankruptcy court “shall,” respectively, dismiss the case or terminate, annul, modify, or condi-tion the stay if it finds “cause.” section 1112(b)(4) sets forth a nonexclusive list of what constitutes “cause” requiring a court to dismiss the case, but a finding of bad faith is not listed. similarly, section 362(d)(1) includes one example of “cause” that would warrant relief from the stay, but that example is not a finding of bad faith. the fifth circuit5 has noted that “for cause” is “not defined in the statute so as to afford flexibility to the bankruptcy court” and that “[n]umerous cases have found a lack of good faith to constitute ‘cause’ for lifting the stay to permit foreclosure or for dismissing the case.” Instead of enunciating a per se rule, the fifth circuit has set forth factors for courts to use to identify a bad faith filing and stated that “[d]etermining whether the debtor’s filing for relief is in good faith depends largely upon the bankruptcy court’s on-the-spot evaluation of the debtor’s financial condition, motives, and the local financial realities.” although the 1701 Commerce court found many of the bad faith factors present, the hotel was an “operating business” sharing many attributes of a single-asset real estate venture that “would invoke chapter 11 in good faith”6: there was a going concern to preserve (including by maintaining the hotel’s “first-tier flag”); there were employees to protect (while not the debtor’s em-ployees, the debtor’s bankruptcy filing jeopardized their jobs); and there was hope of rehabilitation (the court’s remedy was aimed at expediting such re-habilitation). In other words, the facts and circumstances of 1701 Commerce did not compel a bad faith finding. Because of the “flexibility” afforded by the undefined term “cause” in, and the “broad range of relief ” authorized by, section 362(d), the court could have implemented its remedy, balancing its unease regarding the debtor’s bankruptcy filing and desire to protect the senior lender’s position with the benefits of the debtor’s remaining in bankruptcy, including prevention of job loss and misuse of economic resources, without making a bad faith finding. such an approach would have vindicated the fundamental chapter 11 policy articulated by the supreme court in Bildisco—and echoed by the court in looking to the “public interest” (i.e., “preserving value and jobs”)—without implying, by finding bad faith, that the debtor had improperly resorted to the


106

protection of the bankruptcy laws. while the fifth circuit has indicated that the “public interest” is safe-guarded by bankruptcy courts’ enforcement of a standard of good faith, which prevents abuse of the bankruptcy process, the 1701 Commerce court’s deference to local economic policy in the name of the “public interest” raises questions as to which “public interest” should be considered in granting or denying relief. Indeed, the court’s consideration of the “public interest” in 1701 Commerce contrasts with the court’s rationale for refusing to consider the “public interest” in the context of other sections of the Bankruptcy code in both In re Pilgrim’s Pride Corp.7 and In re General Electrodynamics Corp.,8 where the court nonethe-less recognized the harm to communities that could result from permitting contract rejection or denying plan confirmation, respectively. In Pilgrim’s Pride, the court declined to apply a heightened, or “public in-terest,” standard to the debtors’ rejection of executory contracts, noting that “the more stringent Bildisco/Mirant test will be rarely applied.” the General Electrodynamics court, in determining that a chapter 11 plan was not con-firmable, found that the Bankruptcy code “makes no provision for the court to override the requirements of confirmation in favor of the public interest.”9

In both of those cases, the court grounded its refusal to consider the “public interest” in statutory construction and general bankruptcy policy. as for statutory construction, the court in Pilgrim’s Pride and General Elec-trodynamics observed that congress has stated when it wishes courts to consider the “public interest,” pointing to the part of the Bankruptcy code dealing with railroad reorganizations. while noting that “the court, in some contexts, may be able to take the public interest into account in the absence of specific statu-tory authority” (e.g., Mirant), the General Electrodynamics court cautioned that “it must still adhere to the specific terms of the [Bankruptcy] code.” similarly, the Pilgrim’s Pride court, acknowledging that it was bound by Bildisco and Mirant, observed that “the statutory construction arguments against applying a different test for rejection to some contracts support the court’s view that the public policy exception to the business judgment rule should be a very narrow one.” accordingly, the court in Pilgrim’s Pride de-lineated a “threshold showing” for application of the “public policy excep-tion” (i.e., the “rarely applied” Bildisco/Mirant test) for rejection of executory contracts in light of its concern that second-guessing every choice by a debtor


107

that may “economically harm any given locale” could lead to such “public policy exception” swallowing the business judgment rule applicable to con-tract rejection and other decisions in the chapter 11 process. the 1701 Commerce decision, by contrast, does not clarify in what cir-cumstances the “public interest,” as articulated by the court, should be con-sidered in the context of bad faith filings, leaving unanswered the questions of why fort worth’s economic policy was entitled to deference and how a court should determine whether and when deference should be granted to local public policies—and to which ones. Different expressions of the “public interest” are found in bankruptcy case law and in local statutes, regulations, and policy pronouncements. the court’s refusal to dismiss the case or lift the stay notwithstanding the debtor’s bad faith filing raises the question of how a court should determine when a local public policy represents a greater “public interest” (such that it should be granted “deference”) than the “public inter-est” in preventing abuse of the bankruptcy process (by the requirement that chapter 11 cases be filed in good faith). the 1701 Commerce decision also provokes other questions. for ex-ample, how are debtors and creditors able to predict when the “public inter-est”—and which “public interest”—may be invoked as a basis for a court’s granting or denying relief? could 1701 Commerce be cited as precedent for courts to consider the “public interest” in applying other sections of the Bankruptcy code? while the court’s decision in 1701 Commerce may have given the parties peace of mind as to the future of the hotel’s sojourn in bank-ruptcy, it may sew new uncertainty in the world of bad faith filing litigation and beyond.

noteS1 In re 1701 Commerce, LLC, 2012 wl 3932815 (Bankr. n.D. tex. aug 23, 2012)2 SEC v. U.S. Realty & Improvement Co., 310 u.s. 434, 455, 60 s.ct. 1044, 1053 (1940).3 In re Mirant Corp., 378 f.3d 511 (5th cir. 2004).4 NLRB v. Bildisco & Bildisco, 465 u.s. 513, 104 s.ct. 1188 (1984).5 Little Creek Dev. Co. v. Commonwealth Mortgage Corp. (In re Little Creek Dev.


108

Co.), 779 f.2d 1068 (5th cir. 1986).6 Humble Place Joint Venture v. Fory (In re Humble Place Joint Venture), 936 f.2d 814 (5th cir. 1991).7 In re Pilgrim’s Pride Corp., 403 B.r. 413 (Bankr. n.D. tex. 2009).8 In re General Electrodynamics Corp., 368 B.r. 543 (Bankr. n.D. tex. 2007).9 In its decision, however, the General Electrodynamics court temporarily deferred entering the statutorily required order denying confirmation of the plan until the parties attended a chambers conference because the court found that entry of such order would lead to the debtor’s conversion to chapter 7 and the negative consequences of lost jobs and destruction of a profitable company.

HEADNOTE - Weil, Gotshal & Manges LLP

Documents