Potential Benefits in a Chapter 11 Bankruptcy

Written By: Eric D. Dean and Mark T. Domeyer  Published in “The Bankruptcy Issue” of the ALFN ANGLE

All too often mortgage servicers view a Motion for Relief from stay as their only way to obtain relief from stay to foreclose. Where a loan is subject to a Chapter 11 bankruptcy proceeding, a Motion for Dismissal or Conversion of a Case (“Motion to Dismiss”) offers a viable alternative to Motion for Relief from Stay and in certain limited circumstances can prove even more effective than a Motion for Relief from Stay. Those circumstances largely deal with those cases where a Chapter 11 is filed in bad faith as a stalling tactic to delay the foreclosure sale as opposed to an honest attempt to reorganize.

A Motion for Relief from Stay is generally considered a better method to obtain relief from stay because it is heard on an expedited basis and the burden of proof on all issues, except the value of the property, rests with the debtor. But these advantages can sometimes be offset by advantages unique to a Motion to Dismiss. For example, instead of the debtor merely facing the servicer, in a Motion to Dismiss the debtor must fight against a united front of many creditors, and often the US Trustee.

The united front adds considerable weight to the granting of the Motion. Similarly, since the focus of a Motion to Dismiss is not on any one property, the fact that the servicer’s property may have some equity does not weigh in the analysis and should not be grounds to deny the Motion to Dismiss. And even though the burden of proof in a Motion to Dismiss is on the mortgage servicer bringing the motion, it must be emphasized that the servicer need only show some proof after which the burden of proof shifts back to the Debtor.

For example, unless the Debtor can establish a “business purpose” for its filing, the burden shifts to the Debtor to prove that the case was not filed in bad faith. Similarly, if the servicer’s loan is secured by a Single Asset Real Estate (“SARE”) or if the property was transferred to a newly created owner just prior to bankruptcy filing (the “New Debtor Syndrome”), the burden shifts back to the debtor to prove good faith.

In a Motion to Dismiss, the Court may consider a number of factors that while relevant, are not the prime focus in a Motion for Relief from Stay. These factors include: (a) if the debtor suffered substantial losses from which it is not likely to rehabilitate and recover (b) if the Debtor has engaged in bad faith acts (c) if the Debtor is not likely or able to cure its bad faith within a reasonable period of time (d) whether or not the Debtor is collecting rent from its affiliated tenant (e) whether the debtor has not made payments for many months (f) whether there is sufficient evidence to support any proposed source of reinstatement funds.

The starting point of an analysis on a Motion to Dismiss or Convert is 11 U.S.C. §1112, which provides:

§1112. Conversion or dismissal

(a) The debtor may convert a case under this chapter to a case under chapter 7 of this title unless—

(1) the debtor is not a debtor in possession;

(2) the case originally was commenced as an involuntary case under this chapter; or

(3) the case was converted to a case under this chapter other than on the debtor’s request.

(b)(1) Except as provided in paragraph (2) and subsection (c), on request of a party in interest, and after notice and a hearing, the court shall convert a case under this chapter to a case under chapter 7 or dismiss a case under this chapter, whichever is in the best interests of creditors and the estate, for cause unless the court determines that the appointment under section 1104(a) of a trustee or an examiner is in the best interests of creditors and the estate.

(2) The court may not convert a case under this chapter to a case under chapter 7 or dismiss a case under this chapter if the court finds and specifically identifies unusual circumstances establishing that converting or dismissing the case is not in the best interests of creditors and the estate, and the debtor or any other party in interest establishes that—

(A) there is a reasonable likelihood that a plan will be confirmed within the time frames established in sections 1121(e) and 1129(e) of this title, or if such sections do not apply, within a reasonable period of time; and

(B) the grounds for converting or dismissing the case include an act or omission of the debtor other than under paragraph (4)(A)—

(i) for which there exists a reasonable justification for the act or omission; and

(ii) that will be cured within a reasonable period of time fixed by the court.

(3) The court shall commence the hearing on a motion under this subsection not later than 30 days after filing of the motion, and shall decide the motion not later than 15 days after commencement of such hearing, unless the movant expressly consents to a continuance for a specific period of time or compelling circumstances prevent the court from meeting the time limits established by this paragraph.

(4) For purposes of this subsection, the term “cause” includes—

(A) substantial or continuing loss to or diminution of the estate and the absence of a reasonable likelihood of rehabilitation;

(B) gross mismanagement of the estate;

(C) failure to maintain appropriate insurance that poses a risk to the estate or to the public;

(D) unauthorized use of cash collateral substantially harmful to 1 or more creditors;

(E) failure to comply with an order of the court;

(F) unexcused failure to satisfy timely any filing or reporting requirement established  by this title or by any rule applicable to a case under this chapter;

(G) failure to attend the meeting of creditors convened under section 341(a) or an examination ordered under rule 2004 of the Federal Rules of Bankruptcy Procedure without good cause shown by the debtor;

(H) failure timely to provide information or attend meetings reasonably requested by the United States trustee (or the bankruptcy administrator, if any);

(I) failure timely to pay taxes owed after the date of the order for relief or to file tax   returns due after the date of the order for relief;

(J) failure to file a disclosure statement, or to file or confirm a plan, within the time fixed by this title or by order of the court;

(K) failure to pay any fees or charges required under chapter 123 of title 28;

(L) revocation of an order of confirmation under section 1144;

(M) inability to effectuate substantial consummation of a confirmed plan;

(N) material default by the debtor with respect to a confirmed plan;

(O) termination of a confirmed plan by reason of the occurrence of a condition specified in the plan; and

(P) failure of the debtor to pay any domestic support obligation that first becomes payable after the date of the filing of the petition.

(c) The court may not convert a case under this chapter to a case under chapter 7 of this title if the debtor is a farmer or a corporation that is not a moneyed, business, or commercial corporation, unless the debtor requests such conversion.

(d) The court may convert a case under this chapter to a case under chapter 12 or 13 of this title only if—

(1) the debtor requests such conversion;

(2) the debtor has not been discharged under section 1141(d) of this title; and

(3) if the debtor requests conversion to chapter 12 of this title, such conversion is equitable.

(e) Except as provided in subsections (c) and (f), the court, on request of the United States trustee, may convert a case under this chapter to a case under chapter 7 of this title or may dismiss a case under this chapter, whichever is in the best interest of creditors and the estate if the debtor in a voluntary case fails to file, within fifteen days after the filing of the petition commencing such case or such additional time as the court may allow, the information required by paragraph (1) of section 521(a), including a list containing the names and addresses of the holders of the twenty largest unsecured claims (or of all unsecured claims if there are fewer than twenty unsecured claims), and the approximate dollar amounts of each of such claims. (f) Notwithstanding any other provision of this section, a case may not be converted to a case under another chapter of this title unless the debtor may be a debtor under such chapter.

Section 1112(b)(4) sets out a list of events that provide cause, but this list is not exhaustive.

St. Paul Self Storage Ltd. P’Ship v. Port Authority of the City of St. Paul (Inre St. Paul Self Storage Ltd. P’Ship ), 185 B.R. 580, 582 (9th Cir. B.A.P. 1995). Rather, a court has broad discretion to dismiss a Chapter 11 case for “cause” under section 1112(b), including a determination that the petition was filed in “bad faith.” Marsch v. Marsch (In re Marsch ), 36 F.3d 825, 828 (9th Cir. 1994). In fact, case law is clear that good faith is a predicate to the right to file a petition in bankruptcy, as only the “honest but unfortunate debtor” is eligible to avail itself of the protections afforded by the Bankruptcy Code. Marrama v. Citizens Bank of Mass. , 549 U.S. 365, 374 (2007) (quoting Grogan v. Garner , 498 U.S. 279, 287 (1991)). The analysis of the statute and case law can generally be divided into three parts: (1) Badges of Bad Faith, (2) the presence of specific enumerated grounds for dismissal, (3) the failure to follow the US Trustee’s Chapter 11 policies and procedures. Each is discussed briefly below.

1. The “New Debtor Syndrome” and consideration of certain indicia or badges of fraud or “Bad Faith” factors are a starting point in the analysis for many courts.

The test for a “bad faith” filing in the Ninth Circuit asks, “whether a debtor is attempting to unreasonably deter and harass creditors or attempting to effect a speedy, efficient reorganization on a feasible basis.” Marsch , 36 F.3d at 828 (citing In re Arnold , 806 F.2d 937, 939 (9th Cir. 1986)). In deciding whether a case was filed in bad faith, courts can weigh factors such as:

(i) the debtor has only one asset;

(ii) the mortgage servicer’s lien encumbers that lone asset;

(iii) there are generally no employees except for the principals;

(iv) there is little or no cash flow, and no available sources of income to sustain a plan of reorganization or to make adequate protection payments;

(v) there are few, if any, mortgage servicers whose claims are relatively small;

(vi) there are allegations of wrongdoing by the debtor or its principals;

(vii) the debtor is afflicted with the “new debtor syndrome” when an entity having one primary asset has been created or revitalized on the eve of foreclosure to isolate the insolvent property and its creditors; and

(viii) bankruptcy offers the only possibility of forestalling loss of the property.

In re Stolrow’s Inc ., 84 B.R. 167, 171 (9^th Cir. B.A.P. 1988); see also St. Paul Self Storage , 185 B.R. at 582-83; In re WLB-RSK Venture , 296 B.R. 509,514 (Bankr. C.D. Cal. 2003). A finding of “bad faith” is “based on a conglomeration of factors rather than on any single datum.” Can-Alta Properties, LTD., v. State Savings.

2. Specific Enumerated Grounds for cause commonly come into play for mortgage servicers and can be effectively pursued.

While a motion based on a lack of good faith is often very effective for the mortgage servicer particularly where multiple indicia of a lack of good faith appear to be present and the allegations themselves put the Debtor on the defensive, the analysis in this arena can get murky. As noted by Judge Ayer of the Bankruptcy Court for the Central District of California, the concept of good faith “covers too many different kinds of conduct, in too many different situations” and “functions at such a high level of abstraction that one can scarcely discern what might be underneath it.” In re Victory Constr. Co. , 42 B.R. 145, 149 (Bankr. C.D. Cal.  1984).

Many times evidence of the specific enumerated grounds as cause for relief in addition to allegations of a lack of good faith can be decisive. Resort to the monthly operating reports and a request for judicial notice may be sufficient to establish continuing loss or diminution of the estate. Schedules, operating reports and even applications to employ professionals can yield information tending to show gross mismanagement of the estate.

Several areas of particular concern (and within the knowledge of the mortgage servicer) can serve as statutory grounds for dismissal or conversion, including, failure to maintain appropriate insurance (11 U.S.C. §1141(b)(4)(C)); unauthorized use of cash collateral (11 U.S.C. § 1141(b)(4)(D)); and failure to timely pay taxes owed post-petition (11 U.S.C. § 1141(b)(4)(I)). The Mortgage servicer client can advise counsel if it is forced to make out-of-pocket advances to maintain insurance or to pay delinquent property taxes and this shortcoming supports a powerful argument that a Debtor is not serving as an appropriate steward of their case.

3. Filing A Memorandum In support of a US Trustee motion or joining in the request to dismiss or convert can be highly effective.

A Motion to Dismiss by The US Trustee’s Office, like a motion by a Mortgage servicer, is based under 11 USC §1112 of the Bankruptcy Code. Any opposition to the motion must be in writing and duly served and filed. There are numerous facts that Court will consider when ruling on such a motion. The Court in ruling on the motion will consider such things as:

1. Whether the Debtor placed in title to the property that is the subject of the motion far in advance of the filing of the petition;
2. The purpose of title to the property being placed in the Debtor.
3. The relationship between the Debtor and the owner to the property;
4. Whether adequate protection payments are being paid by the Debtor to the Mortgage servicer.
5. Whether the Debtor has any equity in the subject property.
6. Whether the Debtor paid any substantial consideration for the property
7. Whether the Debtor demonstrated the ability to reorganize.
8. Whether the property duly insured and whether the insurance and taxes paid current.
9. Whether the Debtor’s Schedules accurate and complete.
10. Whether the Debtor timely complied with the requirements of the US Trustee’s Office.
11. Whether the property transferred to the Debtor to avoid an imminent foreclosure.
12. Whether the Bankruptcy petition was filed in good faith:

US Trustee motions understandably tend to focus on the failure of a particular debtor to comply with duties that often are administrative in nature, such  as filing monthly operating reports, tax returns and cooperating with the office of the US Trustee. Often the views of mortgage servicers can be an essential factor for a court presented with facts showing that some form of relief is warranted, but input by the mortgage servicer can be vital to the determination of what is in the best efforts of mortgage servicers and the estate. Courts very often appreciate of the input of mortgage servicers that can be presented in a very cost effective manner when making the determination of whether conversion or dismissal is in the best interest of creditors. Generally both form of relief will be beneficial to creditors and at times conversion will be a better remedy than a dismissal, which is often followed by another bankruptcy filing. A chapter 7 debtor is not in a position to lien strip under Dewsnup v. Timm , 503 U.S. 410, 112 Sup. Ct. 773, 116 L. Ed. 2d 903 (1992), or to cram down and modify loan terms. Moreover, an independent chapter 7 trustee will typically move quickly and dispassionately in making decisions on how to best liquidate estate assets.

Motions to dismiss or convert or a memorandum in support of a US Trustee motion can be a very cost effective way to end a Chapter 11 bankruptcy that has little shot at success. Such motions may have unique advantages over a motion for relief from stay, where in the beginning stages of the case the Debtor will enjoy a presumption that a plan will be forthcoming in a reasonable period of time.

Conclusion

While a motion for relief from the automatic stay limited to a specific piece of collateral may be the preferred remedy for a mortgage servicer, there are occasions when a motion to dismiss or convert, or joining in such a motion may provide unique advantages. In addition, if the Court enters an order to show cause re dismissal or conversion, a memorandum in support of conversion or dismissal can prove highly effective. Practitioners should consider these tactics when the unique circumstances of the case warrant.