Judge Tosses Bad Faith Involuntary Filing Primarily Seeking Management Change

An involuntary petition under chapter 7 of the Bankruptcy Code filed against a Mississippi casino developer was dismissed for bad faith, even though the petitioning creditors met the statutory requirements for filing the involuntary case.  In In re Diamondhead Casino Corporation, the U.S. Bankruptcy Court for the District of Delaware found the petitioning creditors’ primary concern was a change in management that could be pursued under Delaware state law, and was not a proper purpose for filing an involuntary petition. 
We’ve previously written about this case in our post Delaware Bankruptcy Court Denies Request to Appoint an Interim Trustee During the “Gap Period” in an Involuntary Case, in connection with a failed attempt to appoint an interim trustee during the “gap period” in the involuntary case.
The debtor had been trying for over fifteen years prior to the involuntary filing to develop a property near Diamondhead, Mississippi into a destination resort centered around a luxury waterfront casino.  The company had sold off its ship-based gambling operations in Florida in 2000 to focus on the Diamondhead project, but since that time had failed to make any progress, had no operations or revenue, and had failed to attract a joint venture partner.  The petitioning creditors testified that the debtor represented to them over the years that a deal to develop the property with significant players was always on the horizon.  With the passage of time, and the land still vacant, frustration grew and the petitioning creditors lost faith in management.  One of the petitioning creditors sought, unsuccessfully, to wage a proxy fight to take control of the board.
Each of the petitioning creditors was both a stockholder and noteholder.  The court found the evidence “overwhelming” that, by pursuing the involuntary petition, each individual petitioning creditor sought a change in management and, additionally, that the testimony of each petitioning creditor indicated that “the filing of the bankruptcy was an attempt, directly or indirectly, to collect on their promissory notes.”
Bad Faith Filings
A recent post on this blog, Keep Your Fights Out of Bankruptcy Court: Bad Faith Involuntary Petitions, discussed the Third Circuit’s Forever Green decision, which held that a court may dismiss an involuntary petition for bad faith even when the petitioning creditors otherwise meet the statutory criteria.  In Forever Green, the Third Circuit adopted a “totality of the circumstances” standard for determining bad faith.  This standard is fact-intensive and requires a court to look at any and all relevant factors, including (i) if the statutory criteria were satisfied, (ii) if a reasonable inquiry was made into the facts and law, (iii) whether the petition was meritorious, (iv) evidence of preferential payments, (v) evidence of ill will or desire to harass, (vi) suspicious timing, (vii) use of the filing to obtain a disproportionate advantage rather than to protect against other creditors doing the same, (viii) tactical advantage in pending litigations, and (ix) if the filing was intended to substitute for customary debt collection procedures.  The debtor bears the burden of proving by a preponderance of evidence that the petition was filed in bad faith.
The court questioned whether the petitioning creditors were motivated by their status as creditor, stockholder, or both, and found that the primary reason that they filed the involuntary petition was to change the company’s management and collect on their notes:

Based on the totality of the circumstances, the Court finds that the Petitioning Creditors’ primary concern in filing the involuntary petition was to effect a change in management to benefit their investments as stockholders. . . . A secondary concern was to collect on their notes.  While it may be proper in some circumstances for noteholders to band together to file an involuntary bankruptcy petition, it is not appropriate here, where the noteholders are looking to vindicate their equity interests and where myriad state law remedies are available.

Accordingly, the court dismissed the case.
Before filing an involuntary petition, creditors should remember that it is not sufficient to merely satisfy the statutory requirements for an involuntary filing; a creditor must also carefully consider the reasons for the involuntary filing, and all other available remedies.  Luckily for the petitioning creditors in Diamondhead, the court was sympathetic to their frustration over many years of stalled development and the low likelihood of repayment on their notes.  However, there is still the possibility of sanctions against the petitioning creditors.  The court made clear its ruling was not inviting a motion for sanctions, but it had discretion to award fees, which discretion “would be judiciously administered.”
Debora Hoehne is an Associate at Weil Gotshal & Manges, LLP in New York.