Contributed by Lee Jason Goldberg
In this two-part series, we explore the decision by the United States Bankruptcy Court for the Northern District of Texas in In re 1701 Commerce, LLC, which allowed 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.  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 [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 . . . .”  SEC v. U.S. Realty & Improvement Co., 310 U.S. 434, 455, 60 S.Ct. 1044, 1053 (1940).

Consistent with the Supreme Court’s pronouncement 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 bankruptcy process, including by debtors seeking to unfairly delay creditors or achieve other improper purposes.
What happens, however, when enforcing the good faith requirement actually 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.
The 1701 Commerce case essentially involved a two-party dispute between 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 Originations (the junior lender) also loaned funds to the borrower, and Vestin assigned the loan to three of its affiliates.  The relationship between the senior and junior lenders was governed by a subordination and intercreditor agreement.  The hotel also received financial support and a commitment to the borrower for future financial support in the form of a twenty year tax agreement with the City of Fort Worth.  A hotel management company operated 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 obligations 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 restraining 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 dissolution or continuation of the TRO, the debtor filed its chapter 11 petition.
The senior lender sought dismissal of the debtor’s chapter 11 case pursuant 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 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 assertion 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 foreclosure 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 management 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 bankruptcy 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 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 certain 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 required 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 appraisals 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 lifting 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 suffer 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?  We explore the rationale underlying the court’s decision in our next installment.