Contributed by Abigail Lerner
Although not granted frequently in chapter 11 cases, a motion to dismiss a chapter 11 petition is not to be taken lightly. JER/Jameson Mezz Borrower II, LLC (Mezz II) learned this lesson all too well when its chapter 11 petition was dismissed with prejudice by the United States Bankruptcy Court for the District of Delaware in In re JER/Jameson Mezz Borrower II, LLC.
Mezz II filed for bankruptcy on October 18, 2011, the eve of a UCC auction for Mezz II’s only asset – its membership interest in JER/Jameson Mezz Borrower I, LLC (Mezz I). Prior to the chapter 11 filing, Mezz II’s sole lenders issued a notice of intention to auction Mezz II’s asset. The notice was issued on the heels of the maturity date under Mezz II’s loan, when it became apparent that Mezz II was unable to repay its debt.
The debt was first incurred in 2006. At that time, Mezz II was formed as part of a capital structure to acquire a chain of 103 hotels known as the Jameson Inns and Signature Inns for approximately $400 million. Certain operating companies borrowed a portion of the funds, and four affiliates, including Mezz II, were formed for the sole purpose of borrowing additional funds.
Approximately one week after Mezz II filed its petition, Mezz I and the operating companies filed chapter 11 petitions. Days after Mezz II filed its petition but before Mezz I and the operating companies filed theirs, Mezz II’s lenders filed a motion to dismiss Mezz II’s petition and to obtain relief from the automatic stay to foreclose on their collateral. They sought to dismiss Mezz II’s petition with prejudice pursuant to sections 1112(b) and 349(a) of the Bankruptcy Code, arguing that the petition was filed in bad faith. According to the lenders, the bankruptcy filing was a litigation tactic designed to forestall their foreclosure efforts which, they argued, is an impermissible use of the Bankruptcy Code. Mezz II contended, however, that the petition was filed in good faith with an honest intent to reorganize its affairs and maximize its value for its constituents.
The bankruptcy court began its analysis by setting forth the burden that must be met to dismiss a chapter 11 petition. The court made clear that the burden is on the debtor to establish that it filed its petition in good faith to preserve its going concern value or to maximize the value of the debtor’s estate. In assessing whether Mezz II’s petition was filed in good faith, the bankruptcy court considered the factors set forth by the United States District Court for the District of Delaware in In re Primestone Inv. Partners, L.P., 272 B.R. 554, 557 (D. Del. 2002). Weighing the factors, the court concluded that it appeared the case had been filed for an improper purpose. Specifically, the court noted that Mezz II: (i) had only one asset (the membership interest in Mezz I); (ii) had few, if any unsecured creditors who, if they existed, were exerting no pressure on Mezz II before the filing; (iii) had no ongoing business operations or employees; (iv) filed the petition on the eve of foreclosure, solely to obtain the benefit of the automatic stay; (v) had no cash or income; and (vi) had no opportunity of reorganization because its sole lenders contended that they would oppose any plan of reorganization.
The bankruptcy court also found that the case involved “only a two-party dispute” between Mezz II’s lenders and lenders to Mezz II’s affiliates. Indeed, one of the more compelling evidentiary findings was a statement by Mezz II’s sole non-independent director, who admitted that the Mezz II bankruptcy petition was filed to stop its lenders’ UCC sale and that the primary beneficiaries of the bankruptcy filing were its affiliates’ lenders.
Although Mezz II recognized that the petition was filed to stay the foreclosure, it also argued that the purpose behind the filing was to preserve its enterprise value for the benefit of all constituents and that the bankruptcy court should not look at the filing by Mezz II in isolation, but must consider it as part of the filing by Mezz I and the operating companies. While the bankruptcy court concluded that it should, as Mezz II urged, consider the debtors wholistically, it ruled that, absent substantive consolidation, Mezz II had no chance of confirming a plan over its lenders’ objection because the lenders were its only creditors. Therefore, Mezz II would never be able to obtain an accepting class of any plan it proposed. Further, the bankruptcy court noted that Mezz II presented no evidence that more value would be realized in bankruptcy than without it.
Because the bankruptcy court concluded that the petition was filed in bad faith and for no legitimate purpose, the court found cause under section 349(a) of the Bankruptcy Code to dismiss the petition with prejudice. In addition, the bankruptcy court concluded that the Mezz II lenders were entitled to relief from the automatic stay under section 362(d)(1) of the Bankruptcy Code, finding that Mezz II’s interests were not adequately protected. The court also found that the lenders were entitled to stay relief pursuant to section 362(d)(2) of the Bankruptcy Code finding that the lenders’ collateral was not necessary for an effective reorganization – as one was not possible
Perhaps the bankruptcy court’s ruling will make the directors of a single asset entity with few creditors and no business operations that plans on filing for bankruptcy on the eve of a foreclosure think twice before they file the petition. Given the bankruptcy court’s opinion in the JER/Jameson case, if the entity files, its tenure in chapter 11 may be short lived.