Bad Faith Filing: A Debtor’s “Business” Must Consist of More Than Litigating with the Mortgagee

In re Encore Prop. Mgmt. of Western N.Y., LLC, 585 B.R. 22 (Bankr. W.D. N.Y. 2018) –

A mortgage lender moved to dismiss a chapter 11 case on the grounds that it was filed in bad faith. This was the second time the debtor filed bankruptcy on the eve of a foreclosure sale. The mortgagee was previously successful in moving for dismissal of the first case for bad faith.

In 2009 the mortgagee commenced a state court foreclosure after the debtor defaulted on a consolidated note and mortgage. The court pointed out that this was also the year that Mine That Bird won the Kentucky Derby “coming from last place to pull off a monumental upset by beating 50-to-1 odds” and Barack Obama was sworn in as President. Nine years later Mind That Bird and President Obama are enjoying retirement while the mortgagee “has been unable to retire from the field in its litigation battle” against the debtor.

The debtor owned an apartment project and a couple of other commercial properties. The mortgagee offered an appraisal valuing the properties at ~$25 million, while the debtor contended the fair market value was around $40 million. However, this dispute was not significant since the mortgage debt was over $117 million (accruing interest at ~$17,000/day) and there were virtually no unsecured creditors. In essence, this was a two-party dispute involving property that was hopelessly underwater.

Further, a receiver has been appointed in 2009 and continued to manage and operate the properties thereafter. So, the debtor itself had no cash flow or employees. The court concluded that the debtor’s only “business” was to litigate with the mortgagee.

It is clear that filing a bankruptcy petition in bad faith may be sufficient cause to dismiss a chapter 11 case. The purpose of chapter 11 is to “assist financially distressed business enterprises by providing them with breathing space in which to return to a viable state.” It should be used to reorganize rather than to relitigate.

Courts typically consider a series of factors as evidence of bad faith, including (1) the debtor has only one asset, (2) the debtor has few unsecured claims that are small in comparison to secured claims, (3) the asset is subject to a foreclosure action as a result of a default, (4) the debtor’s financial condition is essentially a two-party dispute with the secured creditor that can be resolved in the pending foreclosure action, (5) the timing shows an intent to frustrate legitimate efforts of a secured creditor to enforce its rights, (6) the debtor has little or no cash flow, (7) the debtor cannot meet current expenses including property taxes, and (8) the debtor has no employees.

Nearly all of these factors were present in the first bankruptcy case, with the result that the court dismissed that case with a finding that it was filed in bad faith.

In the second bankruptcy, the debtor’s counsel suggested that it might be able to propose a plan based on a sale of the property. The court assessed this as “a pipe dream, probably mentioned as a stall tactic.”

Debtor’s counsel further endeared himself to the court when he filed a response to the mortgagee’s motion that consisted of “an eleven-page unsworn manifesto” with 126 pages of “exhibits” including “57 pages of what appear to be newspaper articles, internet newsletters, and a white paper from an unknown source – complete with an illegible flowchart, looking very much like a page from a football playbook diagramming a fake punt-triple reverse.” In a footnote the court articulated its expectations for responses, including a memorandum of law. “[P]utting scraps of paper, bits of string, a lucky bottle cap, and an old red yo-yo in a cigar box doesn’t cut it.”

Notwithstanding the pleading deficiencies, the court chose to address the response. The debtor argued that it was not obstructionist, but rather was protecting the investors holding bonds representing the mortgage debt. However, the investors were represented in the bankruptcy by the bond trustee. The trustee was the party in interest, not the bondholders. Further, the debtor had no standing to assert the rights or legal interests of the bondholders.

Turning to the issue of whether the filing was in good faith, the court found that once again virtually all of the factors evidencing bad faith were present. Accordingly, the court granted the mortgagee’s motion to dismiss.

For single asset real estate cases with a substantially underwater mortgagee there is a tension between the view that a debtor ought to have an opportunity to reorganize and the view that this is typically a two-party dispute and the debtor should not be able to cram down a plan over the objection of the only other real party in interest. However, even those inclined to give a debtor an opportunity to reorganize would be hard-pressed to say that the debtor should have been allowed to proceed in this case.

Vicki R Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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