From time to time, judges at all levels are bedeviled with frivolous lawsuits or egregious behavior in discovery. Recently, the Fourth Circuit and Bankruptcy Judge Robert E. Grossman were fed up.

The Fourth Circuit upheld a $31 million default judgment against several defendants, while Judge Grossman, on the same day, denied all compensation to counsel for a corporate chapter 11 debtor.

In its January 17 opinion dealing with “egregious conduct,” the Fourth Circuit upheld the bankruptcy court’s entry of a default judgment based on the defendants’ “blatant disregard for the judicial process.” Judge Grossman, of Central Islip, N.Y., denied compensation to the debtor’s attorney because he had “no real understanding of what is required of a chapter 11 attorney” and had filed a petition “for a purpose for which it should not be used.”

The Fourth Circuit Appeal

We invite readers to read both opinions in full text, because they detail more alleged litigation misconduct than we could recount here. The Fourth Circuit appeal involved a corporate debtor for which a chapter 11 trustee was soon appointed following what District Judge Rossie D. Alston, Jr., characterized as concealment of millions of dollars in prepetition transfers. Judge Alston was sitting by designation.

The chapter 11 trustee confirmed a liquidating plan and was charged with pursuing causes of action. The trustee sued the debtor’s owners and entities related to them, based on claims including fraudulent transfer and violation of North Carolina’s Unfair and Deceptive Trade Practices Act.

Following two evidentiary hearings, the bankruptcy court issued a 70-page opinion granting the trustee’s motion for a default judgment for more than $31 million against all defendants for what Judge Alston called “numerous discovery disputes.” The district court affirmed, prompting an appeal to the Fourth Circuit.

Citing Fourth Circuit authority, Judge Alston said that courts have “broad discretion” to manage discovery, including authority to impose sanctions. When the sanction is default, he said that the “range of discretion is more narrow.” See Mut. Fed. Sav. & Loan Ass’n v. Richards & Assocs., Inc., 872 F.2d 88, 92 (4th Cir. 1989). However, he went on to find “no clear error” under the Wilson factors when the bankruptcy court entered default based on the defendants’ “obstructive and bad faith conduct.” See Wilson v. Volkswagen of America, Inc., 561 F.2d 494 (4th Cir. 1977).

Judge Alston recited the defendants’ failure to make discovery, the defendants’ “false interrogatory responses” and the bankruptcy court’s “extraordinary level of patience in dealing with [the defendants’] efforts to bring the bankruptcy and adversary proceedings to a standstill.” Again quoting the Fourth Circuit, he said that “the need for deterrence is particularly strong where, as here, a party is ‘stalling and ignoring the direct orders of the court with impunity.’”

Simply barring the defendants from presenting evidence related to their discovery failures would not be sufficient, Judge Alston said, because the trustee bore the burden of proof. Therefore, he said that default was “the only sanction sufficient to address [the defendants’] egregious conduct.”

Judge Alston affirmed the bankruptcy court’s entry of a default judgment for more than $31 million, “plus costs and attorneys’ fees.”

Misuse of Chapter 11 to Halt Foreclosure

In the Eastern District of New York, Bankruptcy Judge Grossman presided over the attempted reorganization of a corporate chapter 11 debtor with basically one creditor, the holder of a mortgage with a secured claim of $630,000 and a judgment of foreclosure. The debtor’s commercial property had one tenant who paid $10,000 a month in rent. However, Judge Grossman said that the rent “apparently was not used to pay the Secured Creditor.”

In chapter 11, the debtor’s counsel contended that the filing was necessary because the foreclosure court had not credited a $250,000 payment made toward the mortgage. The lender filed a proof of claim showing that the $250,000 had been applied against the mortgage debt.

When confronted with evidence about the payment at a hearing on the U.S. Trustee’s motion to dismiss, Judge Grossman said that the “Debtor’s Counsel had no response and just shrugged his shoulders.” At that juncture, Judge Grossman decided to dismiss the case once the debtor had filed missing operating reports and had paid U.S. Trustee fees.

Referring to the debtor’s argument that the $250,000 payment had not been applied to the mortgage, Judge Grossman said it “became clear to” him that the debtor’s counsel “never even looked at documents showing the very argument the Debtor was attempting to make, which was [that] the very foundation for this chapter 11 filing was without merit.”

Judge Grossman’s January 17 opinion dealt with the debtor’s counsel’s final application for about $25,000 in compensation for some five months in chapter 11. He said that counsel’s time records had “no evidence” that the debtor’s attorney had spent any time toward refinancing or selling the property, which counsel had professed to be among the strategies for emerging from chapter 11.

Although debtor’s counsel “did perform the services as required by statute,” Judge Grossman said that the firm had “no real understanding of what is required of a chapter 11 attorney.”

“To add value warranting compensation,” Judge Grossman said, “the chapter 11 debtor’s counsel must enter the bankruptcy proceeding with, at a minimum, a viable theory to support a successful emergence from bankruptcy.” He added, “The chapter 11 process is not intended to provide a safe harbor for a debtor solely to delay creditors. This is not a proper use of bankruptcy or the automatic stay.” In the case at hand, he said that the firm “had no legal theory or viable plan to emerge from bankruptcy in this case.”

In other cases where there is a chapter 11 filing to halt foreclosure, Judge Grossman said that “bankruptcy is often employed as a legitimate strategy to preserve a debtor’s legal options.” However, he said that a debtor’s lawyer “must have a clear and effective plan as to how the debtor might achieve its desired outcome.”

Judge Grossman found that “the purpose [of filing in chapter 11] was solely to obtain a stay of the state court foreclosure and frustrate the secured creditor.” He said that “the use of the automatic stay solely to frustrate a secured creditor with no legitimate legal plan is not a service [for which] a lawyer should be compensated.”

Judge Grossman disallowed the entire fee request aside from permitting reimbursement for $2,400 in expenses. He directed the debtor’s counsel to refund the $30,000 retainer, less allowed expenses.

Commentary

In his opinion, Judge Grossman explained the impetus for his decision:

As more lawyers venture into the bankruptcy courts, particularly in representing chapter 11 debtors, it has become apparent that some lack the fundamental knowledge and skills necessary to effectively serve their clients. This has contributed to an overload of cases that more experienced bankruptcy professionals likely would not have filed.

* * * * *

Unfortunately, filing bankruptcy solely for the purpose of delaying creditors is what a large portion of this Court’s smaller chapter 11 cases have become over time, and it has become commonplace and increasingly an accepted use of the bankruptcy process.

* * * * *

To allow cases that should be resolved quickly to burden the court’s docket without any real chance for success has far-reaching impact on the otherwise legitimate cases that require and deserve the court’s time and resources.

Counsel for the debtor, Ronald D. Weiss of Melville, N.Y., provided ABI with the following commentary:

We respectfully disagree with the decisions of Judge Grossman in the Chapter 11 case of Home Building Corporation. 

As we will show on appeal, the Bankruptcy Court erred in that the Chapter 11 case was not a “bad faith filing”. There was significant equity property that allowed the debtor to seek refinancing and/or a sale. We had retained a broker to market the property and sought to adjust the amount owed the lender given several large post-Judgment payments by the debtor/ defendant which exceeded $300,000. The lender was protected by a huge equity cushion and by the debtor’s post-petition mortgage payments. The debtor’s commercial tenant was paying timely rent. The debtor meticulously met all its administrative requirements. 

Our office did not deserve to have our fees disgorged in that we  had spent significant time on a good file. Our client did not deserve to be negatively characterized, as just seeking a stay, and instead deserved an opportunity to reorganize. The decision needlessly sends the wrong message in discouraging and intimidating debtors and debtor’s attorneys who are proceeding in good faith and are hoping for a fair rather than an adversarial Bankruptcy Court.

The opinions are Smith v. Devine, 24-1335 (4th Cir. Jan. 17, 2025); and In re Home Building Corp., 24-72229 (Bankr. E.D.N.Y. Jan. 17, 2025).