Ch. 11 Filing a ‘Tactical Litigation Maneuver' in Bad Faith

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By Diane Davis

Feb. 3 — The Chapter 11 bankruptcy filing of a business that conducted no business, had no employees, failed to pay taxes on its property, and only received income from related entities was filed in bad faith, and the bankruptcy court properly dismissed it, a district court in Connecticut held Feb. 1.

Affirming the judgment of the bankruptcy court, Judge Michael P. Shea of the U.S. District Court for the District of Connecticut concluded that the “dismissal for cause” was supported by the evidence that debtor Sapphire Development, LLC's bankruptcy filing was a “tactical litigation maneuver” that wasn't supported by the purpose of bankruptcy law.

The purpose of Chapter 11 reorganization, the court said, is “to assist financially distressed business enterprises by providing them with breathing space in which to return to a viable state.” Chapter 11 is for businesses or individuals whose debts exceed the statutory thresholds for Chapter 13.

Whether a finding of both subjective bad faith and objective futility is needed for a court to dismiss a bankruptcy case for cause under Bankruptcy Code Section 1112(b) isn't clear in the Second Circuit, the court said, citing In re C-TC 9th Ave. P'ship, 113 F.3d 1304 (2d Cir. 1997). Nevertheless, the district court found that Second Circuit precedents don't require both subjective bad faith and objective futility. According to the court, either one provides a sufficient basis for dismissal of a bankruptcy case.

Some circuits, like the Fourth Circuit, require both subjective bad faith and objective futility, but others like the Eleventh Circuit only require a finding of subjective bad faith, the court said.

‘Subjective Bad Faith' v. ‘Objective Futility.'

The debtor's intent had nothing to do with the equitable powers of the bankruptcy laws, the court said, and there was ample evidence on the record of the debtor's subjective bad faith, the court said. According to the court, there was no need for a “fresh start” to reorganize the business because Sapphire conducts no business. Sapphire had been dormant, with no employees, and none of its secured creditors was threatening to foreclose, the court said.

If Second Circuit precedent requires a finding of objective futility, the bankruptcy court's factual findings support such a conclusion even though the court didn't use the words “objective futility,” the court said. According to the court, there was no evidence that Sapphire was likely to emerge successfully from bankruptcy.

The bankruptcy court properly dismissed the debtor's case after finding cause, the court concluded.

State Law Suits Involving Fraud

Stuart Longman is the trustee of Gayla Longman Family Irrevocable Trust, which owns Sapphire. Longman is the company's operating manager. The company owns as its sole asset a 25 acre property in Connecticut.

Appellee Robert McKay obtained a $3.96 million judgment in a New York state court against Longman for fraud. Subsequently, McKay sued Longman, Sapphire, and other entities in a Connecticut state court, alleging that Longman fraudulently transferred property to Sapphire and that the corporate veil should be pierced.

One day before the start of a trial, the debtor filed bankruptcy. In its disclosure statement, the debtor said that its filing was precipitated by the “meritless, yet relentless, pre-petition litigation initiated by McKay against the Debtor.”

Debtor Has ‘Chutzpah.'

The bankruptcy court found that Sapphire was an artificial entity whose only purpose was to hold title to property, which was not income producing. According to the court, the debtor had a lot of “chutzpah” because Sapphire and Longman were attempting to lock McKay out of this court and state court in an effort to avoid paying a judgment Longman owed to McKay for fraud.

The bankruptcy court considered the eight factors in In re C-TC 9th Ave. P'ship, and concluded that Sapphire filed the case in bad faith, which was “cause” for dismissal under Section 1112(b)(1).

Sapphire and secured creditor Hudson City Savings Bank appealed to the district court arguing that the bankruptcy court failed to address whether Sapphire's reorganization was objectively futile.

According to Sapphire, Second Circuit precedent requires a two-part showing before a bankruptcy court can dismiss a case for bad faith.

Focus on Intent of Debtor

The district court, however, said it didn't read the Second Circuit's precedents to bar dismissal absent a finding of both subjective bad faith and objective futility. In evaluating the factors cited in In re C-TC 9th Ave. P'ship, the court said that they weren't to be applied mechanically and the focus should be on the overall intent of the debtor.

Further, courts universally hold that the court can take into account factors not listed in Section 1112(b)(4) to establish cause for dismissal or conversion of the case such as the debtor's bad faith or delay in filing a plan, according to Bloomberg Law: Bankruptcy Treatise. The plain language of the statute indicates that the list is “non-exhaustive,” according to the treatise.

Sapphire's bankruptcy filing had nothing to do with the purposes of bankruptcy law, the court said. There was no need for a “fresh start” to reorganize the business because Sapphire conducted no business, the court said.

David Y. Wolnerman, White & Wolnerman, PLLC, New York, N.Y., represented appellant Sapphire Development, LLC; James R. Fogarty, Fogarty, Cohen, Selby & Nemiroff LLC, Old Greenwich, Conn., represented appellee Robert J. McKay; David K. Fiveson, Butler, Fitzgerald, Fiveson & McCarthy, New York, N.Y., represented creditor/appellant Hudson City Savings Bank; Gary Scott Klein, Carmody Torrance Sandak & Hennessey, LLP - STMFD, Stamford, Conn., represented interested party Stuart Longman.

To contact the reporter on this story: Diane Davis in Washington at

To contact the editor responsible for this story: Jay Horowitz at

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