The Chapter 11 “Shell Game”
From Florida’s Northern District comes a cautionary tale of what can go wrong when¬†distressed real estate requires restructuring.¬† A copy of the decision is available here.
Davis Heritage GP Holdings, LLC (‚ÄúDebtor‚ÄĚ) was a family-owned LLC formed in 2002 to ‚Äúhold, develop, and sell condominium development properties in Mississippi and Louisiana.‚ÄĚ¬† Its sole assets were membership interests in a series of single-member “middle-tier” LLC’s, which themselves held no assets except for interests in a series of single-member “lower-tier” LLC’s – each formed to hold separate parcels of real property.
In December 2010, the Debtor sought protection under Chapter 11, ostensibly to deal with the adverse effects of a judgment entered against it.¬† None of the “middle-tier” or “lower-tier” LLC’s had sought bankruptcy protection.¬† Despite their separate,¬†three-tier structure, the Debtor’s management adminstered them as if they were a single business enterprise.¬† Until very shortly before the Debtor’s Chapter 11 filing, the expenses and income of the enterprise were processed through the Debtor’s bank account.¬† In fact, none of the “lower tier” LLCs held bank accounts in their names until after meeting with the Debtor’s bankruptcy counsel.¬† From at least January 2007 through August 2010, the Debtor’s bank accounts contained several millions of dollars, at one time exceeding $22 million.¬† The Debtor’s principals have used the Debtor’s accounts freely, to receive and disburse money to and from whomever the principals chose at any given time.¬† Despite this fact, the Debtor only disclosed one bank account in its Schedule B and did not disclose, but rather affirmatively denied, making any transfers to insiders within one year pre-petition.
Finally, the Debtor never disclosed the properties owned by the “lower tier” LLCs (or their income and expenses) in its Schedules or any other papers filed with the Court. Nevertheless, the Debtor’s Plan is based entirely upon the liquidation of some of those very properties.
The Debtor’s difficulties arose out of the purchase of land and subsequent construction of¬†the 21-story “Beau View” luxury condominium tower in Biloxi, Mississippi.¬† In exchange for the land, the Debtor had executed two junior-priority promissory notes to the seller, and obtained a senior-priority acquisition loan from Wells Fargo.¬† The Debtor then financed construction with a separate loan – also from Wells Fargo – and completed the tower.
Though it made considerable progress selling condominium units and repaying Wells Fargo’s construction loan, the Debtor made only sporadic payments on its purchase notes to the seller.¬† Eventually, the seller obtained a judgment on the note in Mississippi, then domesticated that note in Florida and sought to foreclose on all of the debtor’s membership interests in the “middle tier” LLC’s.
To avoid foreclosure on its “middle tier” LLC interests, the Debtor made a $200,000 payment in exchange for 60 days’ forbearance – then, promptly, sought Chapter 11 protection.¬† At the time of filing, the Wells Fargo¬†construction loan and acquisition loans¬†were current.¬† The Debtor had permitted two¬†mortgage loan actions filed against two of the “lower tier” LLC’s by Sun Trust Bank to go to default judgment.
Very shortly after filing, the seller of the Biloxi property sought relief from stay to continue its foreclosure on the “middle tier” LLC interests – or, in the alternative, dismissal of the Debtor’s Chapter 11 case.¬† The Debtor countered with an emergency motion for the sale of certain assets – and, a day prior to the hearing on the stay relief motion, a Chapter 11 Plan.
In reviewing the evidence and determining that dismissal of the Debtor’s case was appropriate, the court observed:
[W]hen determining whether to grant stay relief for cause or dismiss a chapter 11 case, . . . a number of factors may evidence an ‚Äúintent to abuse the judicial process and the purposes of the reorganizationprovisions‚ÄĚ . . . . . Those factors include:
a. the debtor has only one asset, the property;
b. the debtor has few unsecured creditors whose claims are small in relation to the claims of the secured creditors;
c. the debtor has few employees;
d. the property is the subject of a foreclosure action as a result of arrearages of the debt;
e. the debtor’s financial problems involve essentially a dispute between the debtor and the secured creditors which can be resolved in the pending state court action; and
f. the timing of the debtor’s filing evidences an intent to delay or frustrate the legitimate efforts of the debtor’s secured creditors to enforce their rights . . . . Once a court finds that the above factors are present, ‚Äú[t]he possibility of a successful reorganization cannot transform a bad faith filing into one undertaken in good faith.‚ÄĚ All of the [above-referenced] bad faith factors are present in this case, as are additional factors indicating bad faith. . . . The Debtor’s financial problems involve a two-party dispute between it and [the judgment creditor] that can be resolved in state court. Also, the timing of this petition shows an intent to delay or frustrate the legitimate collections efforts of [the judgment creditor]‚ÄĒwho is the only real direct creditor of the Debtor . . . .
The court then went on to explain why the essence of the Debtor’s Chapter 11 plan – essentially, an effort to pay Wells Fargo and Sun Trust at the expense of the seller of the Biloxi property – was a “sort of reverse marshalling” inappropriate for Chapter 11 under the facts of this case:
Unlike the traditional single asset case where a main creditor is stayed from collecting out of the debtor’s only asset, this case involves a three-tier corporate structure created by the Debtor and its principals whereby [the Biloxi land seller and judgment creditor] is the only creditor that is adversely affected by the automatic stay.¬† See 11 U.S.C. ¬ß 362(a).¬† All other creditors of the Debtor with claims to the properties owned by the “lower tier” LLCs are free to pursue those claims through foreclosure on those real properties, thereby diminishing the value of the Debtor’s only asset (membership in the “middle tier” LLCs), beyond the control of [the judgment creditor].¬† This fact is illustrated by Sun Trust’s pursuit of its post-petition mortgage foreclosure litigation against [two “lower-tier” LLC] properties, which has been unopposed by the Debtor and its principals.¬† Similarly, [the Debtor’s] testimony states that in spite of the bankruptcy, and the way the enterprise has historically been managed, all of the “lower tier” LLCs are doing business as usual, renting units, offering units for sale, selling property, signing contracts for sale, and paying their bills.¬† After a history of treating all the entities as a single corporate enterprise, the Debtor now takes the position that it lacks control of its wholly-owned subsidiaries and only it, the Debtor, is subject to the rules and constraints of Chapter 11.
In reviewing Chapter 11 cases alleged to have been filed in bad faith, courts may look to all of the evidence and the totality of the circumstances to determine what is really happening, and the true intent and purpose behind the filing. . . .¬† Here, the true intent and effect of this case and the Debtor’s Plan are plain: the Debtor’s insiders seek to donate assets subject to [the judgment creditor’s] judgment lien to Sun Trust and Wells Fargo in order to shield their own assets and money from those creditors.¬† This scheme, memorialized in the Debtor’s Chapter 11 Plan, amounts to a kind of reverse marshaling.¬† The Plan takes the only assets available to [the judgment creditor] (and subject to its levy), property owned not by the Debtor but by the “lower tier” LLCs, and shifts that property to Sun Trust and Wells Fargo, creditors with claims [are] secured by other assets owned by the insiders.¬† This Plan reduces the amount that [the judgment creditor] may collect and simultaneously reduces the guarantors’/insiders’ liability to Sun Trust and Wells Fargo.
The court’s discussion of what constitutes “bad faith” in filing a Chapter 11 case is instructive, as is its analysis of how “bankruptcy remote” entities can be treated in the absence of related Chapter 11 filings.