Contributed by Yvanna Custodio
Creditors and their counsel who go overboard in their litigation tactics may find themselves walking the plank, subjecting themselves to potential court sanctions, equitable subordination, loss of voting rights, costs, attorneys’ fees, and exemplary damages.  In In re Baytown Navigation Inc., a chapter 11 case before the United States Bankruptcy Court for the Southern District of Texas, the court entered an order to show cause to determine at a future hearing whether sanctions should be imposed against both HSH Nordbank AG and its counsel after the bankruptcy court determined that HSH’s litigation strategy appeared to “demonstrate a reckless disregard for truth and an intentional strategy to delay and impede the bankruptcy proceedings.”
The debtor, OMEGA Navigation, an international shipping company, as well as its nine wholly owned subsidiaries, sought chapter 11 protection on July 8, 2011.  As of the petition date, the debtor was a borrower pursuant to a senior secured facility as well as a borrower pursuant to a junior credit agreement.  In addition, the debtor was a borrower under a promissory note between the debtor and One Investments, Inc.  The president of One Investments, Inc. is also an officer and a director of all but one of the debtors.
On August 25, 2011, HSH, the appointed agent, security agent, and trustee for the senior lenders under the debtors’ senior credit facility, filed a motion to dismiss or to convert the chapter 11 cases to chapter 7 pursuant to section 1112(b) of the Bankruptcy Code.  A week later, on September 2, 2011, HSH filed a motion for relief from the stay seeking to foreclose and, ultimately sell, its collateral – certain vessels owned by the debtors.  The motion for relief from stay raised substantially the same arguments as the motion to dismiss or convert.  In particular, HSH argued in the motions that certain prepetition transfers were improper or warranted investigation and, therefore, amounted to a lack of good faith constituting cause for dismissal or conversion. Among other things, HSH accused the debtors’ principal of self-dealing, argued that the debtors’ holding company improperly transferred its interests prepetition, and accused the debtors of diverting millions of dollars in revenue from the senior lenders in violation of the senior loan documents.
The bankruptcy court scheduled an expedited hearing on HSH’s motions and, given the nature of HSH’s allegations and demands, HSH incurred “enormous” discovery costs in the process.  At a status conference conducted two weeks before the hearing on the motions, HSH advised the court that there would no longer be a need for the hearing on its motions.  HSH informed the court that it had entered into an agreement with the debtors’ junior lenders and the creditors’ committee to ensure their support of HSH’s motions.  In return for the creditors’ support, HSH agreed to pay them a portion of the proceeds of its prospective foreclosure sale of the vessels as a result of the conversion of the cases to chapter 7 or of the lifting of the stay.
The court refused to dismiss the chapter 11 cases without conducting a hearing, finding that dismissing the cases without a hearing would violate section 1109(b) and section 1112(b)(1) of the Bankruptcy Code, which sections provide for a party in interest’s right to be heard and the notice and hearing requirement in motions to convert or dismiss.
Despite the court’s ruling that it would go forward with the hearing on the two motions, HSH sent a letter to the debtors’ three independent directors.  The letter informed the directors of unanimous creditor support of HSH’s motions; admonished the directors to end their opposition to HSH’s motion for conversion; and threatened the directors with litigation based on the breach of their fiduciary duties.  The debtors requested that HSH retract the letters because they violated the automatic stay pursuant to section 362 of the Bankruptcy Code, but HSH refused.  As a result, the debtors initiated the adversary proceeding Baytown Navigation Inc. v. HSH Nordbank AG by filing a complaint with an application for a temporary restraining order, preliminary injunction, and permanent injunction.  At the hearing to consider the debtors’ request for a temporary restraining order, HSH argued that the letter was meant to only apprise the directors of the recent developments in the debtors’ cases; that the letter merely warned the directors of the possibility of suit, but in reality, HSH never sued them; and that HSH had a right to send such letter because it maintained its own cause of action against the directors for breach of their fiduciary duties.  The court found HSH’s arguments to be disingenuous, stating that whether a debtor or a creditor owns a cause of action is a complex and unsettled issue and that HSH had first recognized its duty to seek relief from the court and then subsequently ignored this duty.  The court thereafter granted the debtors’ request and directed HSH to retract the letters.
Moreover, at the court’s behest, the U.S. Trustee appointed an examiner to determine whether HSH’s actions in writing the letters were subject to sanctions.  Although the examiner did not believe that a criminal referral was proper, the examiner recommended that, among other things, the court should sanction HSH for all reasonable fees and expenses, including examiner’s fees, incurred by the debtors in the adversary proceeding.
On the day of trial on the two motions, the senior lenders announced that they were no longer pursuing three of the four allegations of bad faith that they had advanced for months.  It turned out the senior lenders had approved the transaction they had contended constituted “self-dealing,” they had no security interests in the assets they had previously asserted were improperly transferred prepetition, and the alleged prepetition “diversion” by the debtors of millions of dollars had amounted to nothing more than a technical mistake.
Against this backdrop and in a separate order entered on the same date as the order to show cause, the court denied the dismissal or conversion motion and the stay relief motion and stated that it would issue a formal opinion.  In the order to show cause, the court alluded to the fact that HSH had advanced many of its allegations in bad faith.  Further, the court noted that HSH’s trial strategy demonstrated an intent to delay and impede the court proceedings.  In particular, the court found it “extraordinary for a [l]ender to make an agreement for dismissal with parties other than the debtors and then declare that these parties will inevitably vote against the debtors and for liquidation by the [l]ender for any possible future plan.”
Ultimately, the court stated it would set a hearing to determine, among other things, (i) whether to sanction HSH, its counsel, and all of the senior lenders, (ii) whether HSH’s actions justified denying the senior lenders’ voting rights or subordinating their claims, and (iii) whether the joinder by the unsecured creditors’ committee and the junior lenders also justify the imposition of sanctions.
The court’s order to show cause in In re Baytown Navigation illustrates the possible growing trend among courts to push back against overly aggressive strategies that may border on bad faith. The Second Circuit decision in DBSD, N.A., Inc. is another such example.  For a more detailed discussion on the power of bankruptcy courts to monitor and punish creditor overreaching, see our prior blog entry on DBSD here. Unless creditors and their counsel are willing to walk the plank (and possibly fall overboard), they should be aware of the risks attendant to electing overly aggressive strategies.