In re Sunshine Group – Chapter 11 Case Dismissed for Bad Faith When State Court Had Already Approved Receiver’s Abatement Plan for Non-Operating Motel

The following is a case update analyzing a recent case of interest:

Summary

In Sunshine Grp., LLC v. City of Dana Point (In re Sunshine Grp., LLC), 2020 Bankr. LEXIS 1000 (9th Cir. BAP Apr. 10, 2020), the U.S. Bankruptcy Appellate Panel for the Ninth Circuit held the bankruptcy court did not err in dismissing a chapter 11 case as a bad faith filing designed to thwart a pending receivership involving the debtor’s sole asset, a motel in Dana Point with no ongoing business and nuisance conditions.

To read the full unpublished decision, click here.

Facts

Sunshine Group, LLC purchased a motel property in Dana Point, California (the “Property”) for $2.4 million in 1998.  The debtor operated the motel and earned revenues for approximately 18 years.  In 2016, the City of Dana Point “red tagged” the Property after a Fire and Life Safety Inspection uncovered violations of the California Fire Code, the California Building Code, and the Dana Point Municipal Code which posed an immediate fire and threat and safety hazard to the public.

The City precluded the debtor from using the Property for any purpose until the violations were abated.  During this time, the Orange County Sheriff’s Department received increased calls for service at the Property related to homeless individuals sleeping on the Property, breaking into vacant rooms, and using open flames on the Property. 

The debtor advised the City that it intended to demolish the Property rather than abate the code violations.  Approximately seven months after the red tagging, however, the City filed a nuisance action in Orange County Superior Court and moved for appointment of a health and safety receiver to take possession and control of the Property.  The City stated that, because of the Property’s status as a “low cost overnight accommodation” and a “historic resource,” it expected the debtor’s application to demolish the Property to take approximately 36 months to be processed by the City and the California Coastal Commission and ultimately to be denied.  The City decided to pursue the receivership action because of continuing health and safety risks at the Property.

Despite opposition from the debtor, the state court appointed a receiver and authorized the receiver to take control of the Property and correct the code violations.  The state court also authorized the receiver to issue a receiver’s certificate with super priority status in the amount of $55,000 (later increased to $998,000) for the purpose of securing the Property, cleaning it out, and obtaining bids to remediate the violations.  The debtor’s principal agreed to fund the receiver’s certificate.

Structural engineers retained by the receiver reported that the Property was in a seismic hazard zone and that hillside movement had caused a partial failure of the retaining wall.  The receiver developed a construction plan to remediate the hazardous conditions and abate the code violations while preserving the historical character of the Property and its affordable accommodation status.  The receiver then filed a motion in the state court seeking approval of additional funding of $4,063,832 for pre-construction demolition costs, hillside protection and retaining wall work, and remaining health and safety repair costs.

Over the debtor’s objection, the state court determined that the receiver’s plan was reasonable and necessary to remediate the violations.  The debtor appealed the ruling to the California Court of Appeal but ultimately dismissed the appeal when its motion for a stay was denied.

Litigation continued in the state court receivership, and the day before a hearing on a motion filed by the receiver to subordinate the existing receiver’s certificate held by the debtor’s principal to a new third party loan, the debtor filed a chapter 11 petition.

In the chapter 11 case, the debtor listed the Property and certain notes receivable as assets.  The debtor’s listed liabilities consisted only of attorneys’ fees, loans from the principal’s family trust, and debts related to the receivership.

The City and the receiver each filed a motion to dismiss the chapter 11 case on the ground that the petition was filed in bad faith.  The debtor filed a motion for sale of the Property for the sum of $1.6 million subject to the principal’s first priority lien.  The bankruptcy court determined that the debtor filed the petition in bad faith for three reasons:  (1) the debtor filed the case as a litigation tactic to avoid implementation of the receiver’s plan; (2) the case was essentially a two-party dispute over the competing plans to rehabilitate the Property which had already been the subject of significant argument before the state court; and (3) the Property, which was the debtor’s only valuable asset, was not operating and had no revenues with which to reorganize debt, and all unsecured creditors arose from the two-party dispute in state court.  The bankruptcy court therefore granted the motion to dismiss the chapter 11 case.  The bankruptcy court also denied the debtor’s sale motion, finding that it was proposed in furtherance of the debtor’s bad faith tactic to evade state court orders.  The debtor appealed both orders to the BAP.

Reasoning

The BAP ruled that the bankruptcy court did not abuse its discretion in dismissing the chapter 11 case or in denying the sale motion.

The bad faith filing of a bankruptcy petition constitutes “cause” for dismissal under Section 1112(b) of the Bankruptcy Code.  As previously stated by the BAP in St. Paul Self Storage Ltd. P’ship v. Port Authority of St. Paul (In re St. Paul Self Storage Ltd. P’ship), 185 B.R. 580 (9th Cir. BAP 1995), the factors to be weighed and considered in determining whether a petition has been filed in bad faith include factors such as whether:  “(1) the debtor only has one asset; (2) the debtor has an ongoing business to reorganize; (3) there are any unsecured creditors; (4) the debtor has any cash flow or sources of income to sustain a plan of reorganization or to make adequate protection payments; and (5) the case is essentially a two party dispute capable of prompt adjudication in state court.”

Applying these factors, the BAP agreed with the bankruptcy court that the debtor’s bankruptcy was a litigation tactic and was a two-party dispute capable of resolution in state court.  The BAP acknowledged that while “a bankruptcy petition during a pending receivership is not, per se, a litigation tactic or forum shopping,” it was in this case.  The receiver’s plan was specifically approved by the state court as a means to fully abate the nuisance conditions on the Property, and the bankruptcy court lacks jurisdiction to hear a de facto appeal of a state court decision.  The other St. Paul Self Storage factors also favored dismissal, and the bankruptcy court did not err in dismissing the case.

The BAP further held that once the bankruptcy court had determined that the bankruptcy petition was filed in bad faith, there was no basis for granting the debtor’s sale motion even if some creditors might have benefitted.

Author’s Commentary

This debtor clearly waited too long to commence its chapter 11 case.  The state court had already approved the receiver’s plan for remediation of the Property in the health and safety receivership.

These materials were written by Mary H. Rose of Buchalter, P.C. in Los Angeles (mrose@buchalter.com).  Ms. Rose is a member of the Insolvency Law Committee.