Counsel Beware; Chapter 11 Filing Solely to Avoid Receiver is Sanctionable

Rule 9011(b) provides that by presenting to the court a petition, pleading, written motion or other paper, an attorney is certifying that, to the best of the person’s knowledge, information and belief, it is not presented “for any improper purpose, such as to harass or to cause unnecessary delay or needless increase in the cost of litigation.”[1] In In re EHC, LLC[2] the court found debtor’s counsel violated Rule 9011 when he filed chapter 11 bankruptcy petitions solely to avoid the appointment of a receiver in state court, causing delay and needless increase in the cost of litigation. In re EHC, LLC[3]. The court held that the filing of a bankruptcy petition for this purpose was inconsistent with the purpose of the bankruptcy system which is “designed to preserve enterprise value and to give deserving debtors a fresh start.”[4]

Prior to the filing of the chapter 11 petition, the secured creditor brought a foreclosure action and sought the appointment of a receiver in state court. In re EHC, LLC[5]. Within hours of the appointment of the receiver, counsel filed bankruptcy petitions for the debtor and a related entity. Id. Counsel failed to obtain the signatures of the representatives of the debtors on the petitions, and failed to disclose that both entities were owned by the same individual.[6] No list of creditors, schedules or statements of financial affairs were filed, nor did the debtor seek court approval for its use cash collateral or seek to employ counsel.[7] The debtor’s bankruptcy case was dismissed and the related entity’s case was subsequently dismissed for cause pursuant to 11 U.S.C. § 1112(b).[8] After dismissal of the debtor’s case, the creditor proceeded with the receivership action in state court, asking the court to set the receiver’s bond. On the date the motion was to be heard, debtor’s counsel filed a second bankruptcy petition.[9]

Counsel amplified his errors in the second bankruptcy case by failing to disclose the pending bankruptcy case of the related entity in the petition and providing an incorrect case number for the debtor’s previous petition. In re EHC, LLC.[10] Schedules were filed, however despite having received a payoff statement from the secured creditor, counsel inaccurately reported the amount of the secured debt.[11] A motion for use of cash collateral was filed, however court approval was never obtained.[12] The court found that debtor’s counsel advised employees of the debtor to use cash collateral despite the lack of an order or an agreement as required by 11 U.S.C. § 363(b)(2).  Id. Moreover, the numbers on the budget attached to the cash collateral motion were significantly less than the amount of cash collateral the debtor actually used. Id. at 695. Counsel filed no monthly operating reports on behalf of the debtor, and he failed to properly disclose pre-petition transfers on the statement of financial affairs. Id. at 696.

In response to the secured creditor’s motion for sanctions pursuant to Rule 9011, debtor’s counsel claimed the case was filed in good faith for the purpose of selling the debtor’s commercial property and contesting the amount of the secured debt. In re EHC, LLC, 561 B.R. at 695; 697. The court was unpersuaded by these untimely assertions, in part because the debtor had received an offer on the property prior to filing the second bankruptcy case, yet failed to file a sale motion until more than forty-five days after the second bankruptcy case was filed. Id. at 695; 697. In further support of his good faith argument, counsel asserted that he intended to dispute the calculation of default interest on the secured claim. Id. at 697. The court did not find this assertion credible as the amount of the claim listed in the debtor’s schedules included default interest and the argument did not arise until after the debtor retained new counsel who disputed the default interest. Id. at 697.

Against this factual background, the court conducted a good faith analysis, analyzing the facts of the case against a non-exclusive list of bad faith factors articulated in In re Tekena USA, LLC,.[13] In its good faith analysis, the court applied the bad faith factors to the actions of debtor’s counsel and found that his many failures and his “serious disregard” for bankruptcy procedure weighed against a finding of good faith. In re EHC, LLC.[14] The court sanctioned counsel pursuant to Fed.R.Bankr.P. 9011(c), holding that debtor’s counsel filed the bankruptcy petition in bad faith, “solely” to avoid appointment of a receiver which caused delay and a needless increase in the cost of litigation.[15]

Debtors, through counsel, often file bankruptcy petitions to avoid the appointment of a receiver or to avoid foreclosure of real property. The distinction between counsel’s sanctionable conduct and proper use of the bankruptcy process, albeit to avoid receivership and foreclosure, is timely compliance with the requirements of the Bankruptcy Code, the Federal Rules of Bankruptcy Procedure and any applicable Local Rules. In In re EHC, LLC, had debtor’s counsel caused the debtor to timely comply with its duties under the Bankruptcy Code and complied with procedural requirements, then timely sought a sale pursuant to 11 U.S.C. § 363(f) and disputed the amount of the secured claim, the court is unlikely to have found that counsel acted in bad faith. Timely compliance would have allowed the debtor to at least attempt a proper reorganization and the creditor would have an opportunity to dispute the reorganization on legal grounds. Counsel’s actions deprived both parties of this opportunity and caused unnecessary delay.