E-Alert Case Updates

In Involuntary Bankruptcy Petition Case, Alleged Debtor’s Motion to Dismiss is Granted.

In re Diamondhead Casino Corp.
No. 15-11647 (LSS) (Bankr. D. Del. June 7, 2016). U.S. Bankruptcy Court for the District of Delaware
by Matthew S. Sarna, Summer Associate
Semmes, Bowen & Semmes (www.semmes.com)

Available at: http://www.deb.uscourts.gov/sites/default/files/opinions/judge-laurie-selber-silverstein/diamondhead-combo.pdf

In In re Diamondhead Casino Corp., No. 15-11647 (LSS) (Bankr. D. Del. June 7, 2016), an involuntary bankruptcy petition case, the Court granted Alleged Debtor Diamondhead Casino Corporation’s (“Diamondhead”) motion to dismiss the involuntary petition. The Court ruled that although the Alleged Debtor failed to establish that a bona fide dispute existed as to the claims of the individual petitioning creditors, the petitioning creditors’ primary and secondary goals for filing this case, effecting a change in management and collecting a debt, did not serve a proper bankruptcy purpose.

On August 6, 2015, several creditors filed an involuntary petition against Diamondhead. Several additional creditors soon after joined the involuntary petition (collectively “Petitioning Creditors”). Diamondhead previously operated a ship-based gambling operation out of the ports of Florida, but decided in 2000 to divest its ship-based operations and focus on the development of a land-based casino in Diamondhead, Mississippi. Since then, Diamondhead has had no operations, its only tangible asset being its wholly owned subsidiary, which owns 404 acres of undeveloped land. In 2010, Diamondhead completed two rounds of financing, raising a total of $950,000 in exchange for promissory notes with two-year maturity dates, 9% or 12% interest rates, and a conversion feature. However, at the time of maturity, Diamondhead failed to fulfill its obligations.

Prepetition, Diamondhead was involved in five events that lead to the eventual Petitioning Creditors’ involuntary petition. First, the SEC temporarily and then permanently suspended Diamondhead stock for failure to make the required filings. Second, Diamondhead granted a lien on its undeveloped land to its CEO and other members of the board in the form of a security agreement with an anaconda clause. As both the CEO and the board previously stressed that this land would never become encumbered, the Petitioning Creditors were enraged at the granting of the lien. Third, Diamondhead’s board ratified Diamondhead’s lease of the CEO’s townhome, which served as the company’s headquarters. Specifically, Diamondhead entered into a month-to-month lease, paying rent in place of the CEO. Fourth, Diamondhead twice refused certain Petitioning Creditors’ requests to add new members to the board. Fifth, Petitioning Creditors claim that they lost faith in management.

On June 8, 2015, after being ordered by the Court of Chancery of the State of Delaware to hold an annual meeting, one of the Petitioning Creditors launched a proxy fight to effect a change in management. However, approximately 29.5 million votes were cast, with the incumbent group prevailing. As of the end of 2015, Diamondhead’s current debt was $7.65 million, including outstanding notes, interest on preferred stock, fees owed to directors, loans, and miscellaneous obligations. The only asset of consequence was the piece of undeveloped land, appraised at $39,350,000. However, the book value of this property was listed at $5,409,913.

In order to determine whether any of the Petitioning Creditors’ claims fell subject to a bona fide dispute, the Court looked to Section 303(h) of Chapter 3 of the U.S. Bankruptcy Code. Section 303(h) provides:

[A]fter trial, the court shall order relief against the debtor in an involuntary case under the chapter which the petition was filed, only if–

(1) the debtor is generally not paying such debtor’s debts as such debts become due unless such debts are the subject of a bona fide dispute as to liability or amount….”

See 11 U.S.C. § 303(h) (2016).

The Court followed the Third Circuit’s definition of bona fide dispute, which explained that this type of dispute exists if “there is a genuine issue of material fact that bears upon the debtor’s liability, or a meritorious contention as to the application of law to undisputed facts.” B.D.W. Associates, Inc. v. Busy Beaver Bldg. Centers, Inc., 865 F.2d 65, 66 (3d Cir. 1989). The Petitioning Creditors had the initial burden of establishing a prima facie case that no bona fide dispute existed. The Court looked to the valid and matured promissory notes, establishing the existence of contract obligations to repay the amounts borrowed, as well as a copy of the Delaware Superior Court’s decision holding that Diamondhead had to pay an additional creditor cash pursuant to a matured, unconverted note. Accordingly, the Court determined that the Petitioning Creditors carried their initial burden to show that liability existed on the promissory notes. Because the Petitioning Creditors carried their initial burden, the burden shifted to Diamondhead, requiring it to present evidence that a bona fide dispute existed. Following In re Mylotte, David & Fitzpatrick, 2007 WL 2033812, at *7 (Bankr. E.D. Pa. 2007), the Court utilized an objective test for evaluating whether Diamondhead had met this burden.

Diamondhead’s primary argument was that section 2.1 of the promissory notes permitted, after maturity, the conversion of its obligation to pay cash into an obligation to transfer stock. In support of its argument, Diamondhead attempted to use the same argument it had put forth in a previous matter with a creditor before the Superior Court of Delaware. Its creditor, College Health, had filed a complaint for the unpaid principal and interest on its promissory note. Diamondhead filed a motion to dismiss, which was denied, asserting that, by converting, it had satisfied the note’s obligations. Using the Superior Court’s decision, the Petitioning Creditors argued that this should either offensively preclude Diamondhead from reasserting this argument or per se establish that the dispute is not bona fide. The Court did not need to reach this theoretical argument, however, because it found that Diamondhead’s argument did not in itself constitute a bona fide dispute.

While the Court noted that affirmative defenses may suggest a bona fide dispute exists, none of Diamondhead’s defenses were determined meritorious. See In re TPG Troy, LLC, 492 B.R. 150, 159 (Bankr. S.D.N.Y. 2013). Diamondhead’s fifth affirmative defense, the prior four were inapposite to the current dispute, provided that the noteholders assumed the risk of conversion to common stock. However, Diamondhead, first, failed to make an objective record to support its argument by providing a copy of the private placement memorandum, and second, Diamondhead waived any and all defenses pursuant to the promissory notes’ terms. Applying the principles of contract interpretation, the Court read the first paragraph of the promissory notes to signify that Diamondhead’s right to convert was limited temporally to the time prior to maturity. Additionally, in response to Diamondhead’s assertion that section 2.1 of the notes gave it the right to convert after maturity, the Court explained that section 2.1 was silent as to any temporal limitation on the conversion right. This silence, accompanied by the language in the Holder’s Right to Convert, giving it the right to convert at any time, as opposed to the absence of such language in the Borrower’s Right to Convert, led the Court to rule that there was no bona fide dispute over whether Diamondhead owed the Petitioning Creditors cash from its promissory note obligations.

The Court next moved on to Diamondhead’s assertion that the involuntary petition was filed in bad faith. Quoting the Third Circuit, the Court stated, “[a]t its most fundamental level, the good faith requirement ensures that the Bankruptcy Code’s careful balancing of interests is not undermined by petitioners whose aims are antithetical to the basic purposes of bankruptcy.” In re Forever Green Athletic Fields, Inc., 804 F.3d 328, 335 (3d Cir. 2015). Accordingly, the Court utilized a “totality of the circumstances” test to determine whether the Petitioning Creditors had in fact filed in bad faith. The Court looked to a variety of factors, most specifically at whether the involuntary petition filing was motivated by ill will or a desire to harass, to obtain a disproportionate advantage for these Petitioning Creditors as opposed to other creditors, whether it was used as a substitute for customary debt-collection procedures, and whether the filing had suspicious timing. Diamondhead argued that the filing was motivated by a desire to oust management after losing the proxy contest, that the petition did not serve a valid bankruptcy purpose because bankruptcy would not maximize Diamondhead’s assets, and that bankruptcy court is not a substitute for a collection action in state court.

The Court began its analysis by distinguishing the Petitioning Creditors as unique among the overall pool of creditors. These individuals wore two hats – that of a noteholder and that of a stockholder. Looking at whether the Petitioning Creditors were motivated by their status as a creditor, a stockholder, or both, the Court determined that the primary motivation for filing was to effect a change in management, perceiving the involuntary petition as the only way the Petitioning Creditors could do so after the failed proxy contest. The Court supported this determination by looking at the testimony of each of the Petitioning Creditors, the leader of which testified, “Had the opposition slate won the proxy contest, he would not have filed the involuntary petition.” Citing Matter of Win-Sum, Inc., 14 B.R. 389 (Bankr. D. Conn. 1981), the Court noted that the desire to replace management with a bankruptcy trustee as an alternative to state court proceedings is a factor warranting dismissal.

The Petitioning Creditors insisted that they filed the involuntary petition to protect the undeveloped land’s value and prevent any other liens from being placed on it, as to forestall the dissipation of assets from the reach of creditors. Siding with Diamondhead, the Court noted that neither placing a lien on the property nor payment of legitimate debts to its executives constituted a dissipation of assets. The Petitioning Creditors’ concern about preferential treatment towards its executives would have been a valid purpose for this filing. However, the Petitioning Creditors did not adduce enough evidence to explain how placing a lien on the property was equivalent to a transfer of an interest of the debtor in property – necessary for a preference action. Further, the Court explained that it was not certain whether Diamondhead was insolvent at the time the lien was placed on the property – another prerequisite for a preferential transfer.

In its brief analysis of Diamondhead’s solvency, the Court acknowledged the discrepancy between the undeveloped land’s appraised value and the value stated in Diamondhead’s books. Consequently, the appraisal value justified Diamondhead’s opinion of solvency, while the book value placed them into insolvency. Not actually conducting a robust insolvency analysis, the Court instead looked to real-world logic; had there truly been doubts about whether Diamondhead could remain a going concern back in 2010, no reasonable person would have invested money if he/she believed the value of the property was worth no more than its book value. Accordingly, the Court made the determination that a bankruptcy trustee would have significant hurdles in proving insolvency as of September, 2014.

In response to Diamondhead’s contention that the Petitioning Creditors filed the involuntary petition as a substitute for state debt collection actions and that the timing was “suspicious”, the Petitioning Creditors asserted several inapposite cases, attempting to show that involuntary petition is a remedy available to noteholders following payment defaults. The Court firmly disagreed with this argument. Further, as to the suspicious timing of the filing, one of the Petitioning Creditors actually confirmed that it was filed subsequent to the failed proxy contest because they saw it as hopeless for the company to move forward with current management.

Finally, the Court determined that the filing was an attempt to obtain a disproportionate advantage over other stockholders. By filing to effect a change in management, the Petitioning Creditors sought to upend the results of the stockholder vote, analogous to an attempt by a creditor to gain advantage over another creditor.

In conclusion, based on the totality of the circumstances, the Court held that Diamondhead had met its burden to show that the involuntary petition was filed in bad faith. Effecting a change in management as the primary motivation for filing did not serve a valid bankruptcy purpose. As such, the Court ruled to dismiss the involuntary petition and the case.