On June 7, 2016, Judge Laurie Selber Silverstein of the Delaware Bankruptcy Court ruled on a motion to dismiss Diamondhead’s involuntary bankruptcy petition.  The Creditors who filed the bankruptcy admitted to the Court that their intent in filing for bankruptcy was to remove management and to obtain a recovery for their equity investments.  The “Opinion” is available here.  This is the second recent opinion issued in this case.  The prior opinion was discussed in this blog post: Diamondhead Casino Bankruptcy – and the Challenge to Trustee Appointments.

While the parties involved in Diamondhead’s bankruptcy proceeding agreed to have the Court address the motion to appoint a trustee prior to addressing the Debtor’s motion to dismiss the involuntary petition, claiming it was filed in bad faith and that there is a bona fide dispute as to the debt held by the petitioning creditors.  Opinion at *2.

As became clear at trial, “the petitioning creditors’ primary purpose in filing this case was to effect a change in management, and their secondary purpose was to collect a debt. On the facts of this case, neither of these goals serves a proper bankruptcy purpose.”  Opinion at *1.

The Debtor put forward three arguments as to why the filing was improper – (1) the claims are all subject to bona fide dispute, (2) the petition was filed in bad faith, and (3) abstention is warranted under Section 305 of the Bankruptcy Code.  Opinion at *16.  Because Judge Silverstein finds that the petition was filed in bad faith, she did not address argument #3.

1) There is no bona fide dispute

The petitioning creditors made a prima facie showing that there was no bona fide dispute – the amounts are due and owing.  Thus, for purposes of an involuntary filing, there is no bona fide dispute.  Opinion at *19.  The Debtors argued that they had the right to convert the debt to equity under the contract, thus disputing that the amounts were owed.  While Judge Silverstein spent several pages of her Opinion addressing this argument, she ultimately held that while the Debtor has the right to convert, it is not unlimited, and is not a right the Debtor could have exercised prior to the bankruptcy filing (because it requires multiple and lengthy procedures).  Opinion at *25.

2) The filing was in bad faith

The Debtor argues that the creditors’ main motivation in filing the involuntary bankruptcy was to replace management.  They also argue that a bankruptcy petition is not a substitute for a state court collection action.  Opinion at *33-34.  While the petitioning creditors disagree, Judge Silverstein does not, finding that “the evidence is overwhelming that each individual Petitioning Creditor sought a change in management …”  Opinion at *36.  Additionally, each creditor “testified that the filing of the bankruptcy was an attempt, directly or indirectly, to collect on their promissory notes …”  Opinion at *42.

Judge Silverstein provides a summary of the reasons for her holding on page 45 of the Opinion.  “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. The Court finds this not to be a proper purpose for filing an involuntary bankruptcy petition. 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.”

My $.02

It isn’t just the actions that are taken, but also the reason for the actions which will be judged in a motion to dismiss an involuntary bankruptcy proceeding.  In this instance, the creditors’ professed reasons for filing an involuntary petition were not sufficient to support an involuntary bankruptcy.  It is vital when involved in litigation to ensure that your reasons justify the relief you seek – as determined by existing case law.  A failure in this respect can sink litigation even more quickly than procedural missteps.

John Bird practices with the law firm Fox Rothschild LLP in Wilmington, Delaware. You can reach John at 302-622-4263, or jbird@foxrothschild.com.