PETER H. CARROLL, Bankruptcy Judge.
Before the court are two motions filed by creditor, Fred Kayne ("Kayne"): (1) Motion by Judgment Creditor Fred Kayne for Relief from the Automatic Stay under 11 U.S.C. § 362 (Action in Non-Bankruptcy Forum) ("Kayne's Stay Relief Motion"); and (2) Motion by Judgment Creditor Fred Kayne for Entry of Order Dismissing Debtors' Chapter 11 Cases ("Kayne's Dismissal Motion"). Debtors, Raphael Mense ("Mense") and Cottonsmith, LLC ("Cottonsmith") oppose the motions. Having considered the motions and oppositions thereto, the replies, the evidentiary record,
Cottonsmith is a limited liability company. Mense is the managing member of Cottonsmith, and owns 90% of the outstanding shares of the corporation. The remaining 10% of Cottonsmith is owned by the Fred and Lenore Kayne Family Trust (the "Trust"). Prior to July 2011, "Cottonsmith was in the business of manufacturing and importing so-called `blank' tee shirts for sale to customers who dye and/or screen print them according to customer specifications."
On August 24, 2011, Kayne filed a complaint against Mense and Cottonsmith in Case No. BC468228, Kayne v. Mense, et al., in the Superior Court of California, County of Los Angeles, seeking, among other things, damages for alleged breach of contract, breach of fiduciary duty, and treble damages under Cal.Penal Code § 496(c). On June 12, 2013, following a four-week trial, Kayne obtained a jury verdict against Mense and Cottonsmith on all counts. The next day, the jury awarded Kayne punitive damages against Mense in the amount of $750,000. After seven months of haggling over the form and substance of the judgment, a Third Amended Judgment was entered in the state court action on January 27, 2014, awarding (1) judgment for Kayne against Mense and Cottonsmith, jointly and severally, the sum of $2,997,698, plus prejudgment interest of $132,227; and (2) judgment for Kayne against Mense in the amount of $750,000, plus prejudgment interest of $35,881.77.
On January 22, 2014, Cottonsmith filed a voluntary petition under chapter 11 in Case No. 2:14-bk-11194-PC, In re Cottonsmith, LLC, Debtor. Cottonsmith is no longer engaged in business. It has no employees and no income. In its schedules filed on February 26, 2014, Cottonsmith disclosed that its sole asset is the balance on deposit in a "business checking account" at Wells Fargo Bank which was $1,400,000 on the petition date. Cottonsmith has no creditors, except two creditors listed in Schedule F: (1) Kayne; and (2) Horvitz & Levy LLP, the holder of a disputed unsecured nonpriority claim for attorneys' fees in the amount of $12,142.58.
On January 22, 2014, Mense filed a voluntary petition under chapter 11 in Case No. 2:14-bk-11195-PC, In re Raphael Mense, Debtor. In his schedules filed on February 26, 2014, Mense disclosed assets totaling $20,096,615.49, consisting of interests in real property valued at $10,375,000 and personal property valued at $9,721,615.49.
Rental or home ownership expenses for residence $12,000.
Home maintenance, repair and upkeep expenses 500.
Electricity, heat, natural gas 500.
Water, sewer, garbage collection 500.
Telephone, cell phone, Internet, satellite, and cable services 500.
Food and housekeeping supplies 1,000.
Clothing, laundry, and dry cleaning 1,500.
Medical and dental expenses 1,000.
Transportation 500.
Entertainment, clubs, recreation, newspapers, magazines, and books 3,000.
Charitable contributions and religious donations 500.
Life insurance 1,000.
Health insurance 1,000.
Vehicle insurance 500.
Property Tax 1,600.
Legal/Accounting 500.
________
Total $26,100.9
Mense stated in Schedules I and J that he does not anticipate any increase in income or decrease in expenses in the next 12 months.
On February 19, 2014, the court entered an order directing joint administration of
In response to the court's inquiry regarding the type of plan to be proposed, Mense responded in the Amended Status Report:
The court also inquired whether any proposed plan would require the sale of assets after confirmation. Mense reiterated in the Amended Status Report:
On March 10, 2014, the court granted relief from the automatic stay under § 362(d)(1) to permit Mense and Cottonsmith to appeal the judgment obtained by Kayne in the state court action.
On March 12, 2014, Kayne filed Kayne's Dismissal Motion and Kayne's Stay Relief Motion. Cottonsmith and Mense filed written opposition to each of the motions on March 19, 2014, to which Kayne replied on March 26, 2014. After a hearing on April 2, 2014, the matters were taken under submission.
This court has jurisdiction over these contested matters pursuant to 28 U.S.C. §§ 157(b) and 1334(b). The matters are core proceedings under 28 U.S.C. § 157(b)(2)(A), (G) and (O). Venue is appropriate in this court. 28 U.S.C. § 1409(a).
Good faith is required in the commencement and prosecution of a chapter 11 case, and the lack thereof constitutes "cause" for dismissal under § 1112(b)(1) and relief from the automatic stay under § 362(d)(1). Little Creek Dev. Co. v. Commonwealth Mortgage Corp. (Matter of Little Creek Dev. Co.), 779 F.2d 1068, 1071-72 (5th Cir.1986); see Marsch v. Marsch (In re Marsch), 36 F.3d 825, 828 (9th Cir.1994) ("Although section 1112(b) does not expressly require that cases be filed in `good faith,' courts have overwhelmingly held that a lack of good faith in filing a Chapter 11 petition establishes cause for dismissal."); State of Idaho v. Arnold (In re Arnold), 806 F.2d 937, 939 (9th Cir.1986) ("The debtor's lack of good faith in filing a bankruptcy petition has often been used as cause for removing the automatic stay."). The good faith requirement "deter[s] filings that seek to achieve objectives outside the legitimate scope of the bankruptcy laws." Marsch, 36 F.3d at 828. As the Fifth Circuit observed in Little Creek:
Id. at 1071-72.
Bankruptcy courts must divine "`[t]he existence of good faith [based upon] on an amalgam of factors and not upon a specific fact.'" See Marsch, 36 F.3d at 828, quoting Arnold, 806 F.2d at 939. The determination "depends largely upon the bankruptcy court's on-the-spot evaluation of the debtor's financial condition, motives, and the local financial realities." Little Creek, 779 F.2d at 1072. "In finding a lack of good faith, courts have emphasized an intent to abuse the judicial process and the purposes of the reorganization provisions ... [p]articularly when there is no realistic possibility of an effective reorganization and it is evident that the debtor seeks merely to delay or frustrate the legitimate efforts of secured creditors to enforce their rights." Albany Partners, Ltd. v. Westbrook (In re Albany Partners, Ltd.), 749 F.2d 670, 674 (11th Cir.1984). Ultimately, "[t]he test is whether the debtor is attempting to unreasonably deter and harass creditors or attempting to effect a speedy, efficient reorganization on a feasible basis." Marsch, 36 F.3d at 828.
Section 1112(b)(1) states, in pertinent part, that "on request of a party in interest and after notice and a hearing, ... the court shall convert a [chapter 11] case to a case under chapter 7 or dismiss a [chapter 11] case, whichever is in the best interest of creditors and the estate, if the movant establishes cause...." 11 U.S.C. § 1112(b)(1) (emphasis added). "Cause" is defined in § 1112(b)(4), but the list contained in § 1112(b)(4) is illustrative, not exhaustive. See Albany Partners, 749 F.2d at 674. If the motion is predicated on bad faith, "[t]he moving party has the initial burden of making a prima facie case to support its allegations of bad faith." In re Avalon Hotel Partners, LLC, 302 B.R. 377, 384 (Bankr.D.Or.2003). "Once such a showing has been made, the burden shifts to the debtor to establish that its chapter 11 case was filed in good faith." Id.; see In re Integrated Telecom Express, Inc., 384 F.3d 108, 118 (3d Cir.2004) ("Chapter 11 bankruptcy petitions are subject to dismissal under 11 U.S.C. § 1112(b) unless filed in good faith, and the burden is on the bankruptcy petitioner to establish that its petition has been filed in good faith."). If cause is established, the court has discretion to dismiss the case if to do so would serve the best interest of creditors and the estate. See Nelson v. Meyer (In re Nelson), 343 B.R. 671, 675 (9th Cir. BAP 2006) ("[O]nce a determination of `cause' has been made, a choice must be made between conversion and dismissal based on the `best interests of creditors and the estate.'") (citation omitted)); In re Erkins, 253 B.R. 470, 474 (Bankr.D.Idaho 2000) ("The decision whether to dismiss a Chapter 11 case as a bad faith filing is subject to the discretion of the bankruptcy court.").
Section 362(d)(1) directs the court to grant relief from the automatic
"To obtain relief from the automatic stay, the party seeking relief must first establish a prima facie case that `cause' exists for relief under § 362(d)(1)." Plumberex, 311 B.R. at 557 (footnote omitted). "Once a prima facie case has been established, the burden shifts to the debtor to show that relief from the stay is unwarranted." Id. "The decision whether to grant or deny stay relief is within the broad discretion of the bankruptcy court." Id. at 558; see Kronemyer, 405 B.R. at 919 ("The decision of a bankruptcy court to grant relief from the automatic stay under § 362(d) is reviewed for abuse of discretion.").
Kayne seeks dismissal of the chapter 11 petitions filed by Cottonsmith and Mense or, alternatively, relief from the automatic stay to enforce and collect his judgment. Kayne argues that:
Cottonsmith and Mense freely admit that their chapter 11 petitions were filed for the specific purpose of staying Kayne's efforts to enforce his judgment pending an appeal, but they deny that their bankruptcy petitions were filed in bad faith. Cottonsmith and Mense argue that they "made good faith efforts to obtain an appeal bond, did not have immediately available funds to post that bond, and filed their bankruptcy cases with the desire to restructure and reorganize their assets and liabilities so that such liquid funds can be made available to provide payment to creditors in full regardless of the outcome
In California, a party seeking to appeal from a judgment entered in state court must post a bond to forestall enforcement and collection of the judgment pending the appeal. See Cal.Code Civ. Proc. § 917.1. The purpose of the statute is "to protect the judgment won in the trial court from becoming uncollectible while the judgment is subjected to appellate review" and to preserve for the "successful litigant ... an assured source of funds to meet the amount of the money judgment, costs and prejudgment interest after postponing enjoyment of a trial court victory." Grant v. Superior Court, 225 Cal.App.3d 929, 934, 275 Cal.Rptr. 564 (1990).
The Ninth Circuit has yet to decide the specific issue of whether a debtor, who seeks to appeal an adverse state court judgment, can file a chapter 11 petition and use the automatic stay to trump state law requirements for an appeal bond. See Marsch, 36 F.3d at 829 ("We need not decide whether the bankruptcy laws can be used to skirt state court procedural laws in this manner...."). Cf. Integrated Telecom Express, 384 F.3d at 128 ("Indeed, if there is a `classic' bad faith petition, it may be one in which the petitioner's only goal is to use the automatic stay to avoid posting an appeal bond in another court."). In Marsch, however, the Ninth Circuit upheld a bankruptcy court's determination that a debtor, who filed a chapter 11 petition to delay collection of a $2,557,000 restitution judgment and to avoid posting an appeal bond, did so in bad faith. 36 F.3d at 829. In making its determination, the Ninth Circuit stated:
Id.
The majority of bankruptcy courts tackling this issue have held that the filing of a chapter 11 petition as a litigation tactic to circumvent the requirement of an appeal bond in state court litigation is in bad faith. See, e.g., In re Liptak, 304 B.R. 820, 843 (Bankr.N.D.Ill.2004); Erkins, 253 B.R. at 477; In re Boynton, 184 B.R. 580, 584 (Bankr.S.D.Cal.1995); In re Byrd, 172 B.R. 970, 974 (Bankr.D.Wash.1994); Mueller v. Sparklet Devices, Inc. (In re Sparklet Devices, Inc.), 154 B.R. 544, 549 (Bankr.E.D.Mo.1993); In re Harvey, 101 B.R. 250, 252 (Bankr.D.Nev.1989); In re Karum Group, Inc., 66 B.R. 436, 438 (Bankr.W.D.Wash.1986); In re Smith, 58 B.R. 448, 451 (Bankr.W.D.Ky.1986); In re Wally Findlay Galleries (New York), Inc., 36 B.R. 849, 851 (Bankr.S.D.N.Y.1984). Bankruptcy courts have also reached the opposite conclusion. See, e.g., In re Dilling, 322 B.R. 353, 363 (Bankr.N.D.Ill. 2005); In re Fox, 232 B.R. 229, 240 (Bankr.D.Kan.1999); In re Holm, 75 B.R. 86, 88 (Bankr.N.D.Cal.1987); In re Alton Telegraph Printing Co., 14 B.R. 238, 241 (Bankr.S.D.Ill.1981). When a debtor files chapter 11 to dodge the requirement for an appeal bond, a court's determination of good faith typically hinges on the following factors:
Cottonsmith is not an operating business. It ceased doing business and liquidated its assets in 2011. Cottonsmith has no employees, no cash flow, and no sources of income. It has no reasonable prospects for the conduct of business in the future. Cottonsmith has only 1 unsecured creditor besides Kayne, and that creditor holds a relatively small disputed unsecured nonpriority claim. Cottonsmith's remaining asset is a business checking account at Wells Fargo Bank, and the funds in that account are being depleted by Mense. According to Cottonsmith's Monthly Operating Report No. 2 filed on April 9, 2014, the balance in the account has decreased from $1,400,000 to $1,118,082.70 since the filing of the petition. Cottonsmith's bankruptcy was filed for the purpose of preventing Kayne, its primary creditor, from seizing Cottonsmith's cash which Mense is now using to pay his personal expenses and to fund the appeal.
Mense has not shown that chapter 11 relief is necessary to protect a viable business. Although he lists his occupation in Schedule J as "self-employed," Mense does not operate a business nor is he involved in the management of an entity engaged in business. He did not list any gross receipts or business expenses in his Chapter 11 Statement of Current Monthly Income,
It is undisputed that Mense is solvent. His schedules reveal a net worth in excess of $13.4 million. Other than Kayne's judgment, Mense had no financial problems when he commenced his chapter 11 case. He has no tax obligations. Mense was current in the payment of all secured debt on the petition date. He remains current on such debt.
Notwithstanding the disclosures in Schedule F, Mense actually has few unsecured creditors other than Kayne. Azami Investments, Inc., who is listed in Schedule F as the holder of an unsecured non-priority claim in the amount of $844,000, is the contractor retained by Mense to complete an extensive renovation of his residence. Debtor's counsel confirmed at the hearing that the renovation is underway and that the claim of Azami Investments, Inc. will be paid in full at the end of the job. The only other unsecured claims are: (1) the disputed claim of Horvitz & Levy LLP; (2) a claim of Mense's accountant, Ofir Alfassi for $4,000 in unpaid fees; and (3) a claim for the balance of $255,000 due on a loan from Mense's nephew, Ronen Mense.
Mense admits that the purpose of the filing was to avoid posting an appeal bond, despite the fact that he has the net worth to either satisfy the judgment from his assets or to post the bond required by California law. Mense asserts on behalf of himself and Cottonsmith that they made "a good faith effort to secure a bond, and ... [determined] there were insufficient liquid assets to do so."
The jury rendered its verdict in the state court action on June 12, 2013. Cottonsmith and Mense filed their respective chapter 11 petitions on January 22, 2014. There is no evidence regarding the specific efforts undertaken by Mense or Cottonsmith during the intervening six month period to search for and obtain an appeal bond. Mense does not disclose: (1) the name of each surety company consulted; (2) the date of consultation; (3) whether an application for an appeal bond was made to a surety company; (4) the terms of an appeal bond, if any, offered pursuant to the application; or (5) the reasons why an appeal bond was declined in response to the application. Mense simply states that he "was told" by an unidentified individual or entity that an appeal bond would be costly and the underwriting period would be lengthy. At the hearing, Debtors' counsel stated that he made one unsuccessful inquiry by telephone to Bond Services on behalf of the Debtors shortly before the petition date, but was unable to provide any specific information in response to the court's inquiry regarding Mense's attempts to secure an appeal bond between June 12, 2013 and January 22, 2014.
Moreover, there is no evidence that either Cottonsmith or Mense have made any effort to secure an appeal bond since the commencement of their bankruptcy cases. Mense testified that he was prepared to liquidate assets "as needed," but Debtors' counsel confirmed at the hearing that Mense's use of the term "as needed" meant that liquidation of any assets depended upon the outcome of the appeal. In sum, Mense has over $4 million in cash, but is unwilling to borrow against his real estate investments or to liquidate any portion of his real estate holdings to provide the additional cash necessary to obtain an appeal bond.
Debtors assert that they "are prepared to file disclosure statements and plans of reorganization as quickly as the Court directs."
In the meantime, the assets of each bankruptcy estate are being diminished by the combined ongoing expenses of the Debtors, the chapter 11 cases, and the cost of the appeal. The balance in Cottonsmith's account has shrunk approximately $300,000 since the petition date due to the payment of a $250,000 retainer to Chodos and Mense's personal expenses. Mense is completing a major renovation of his residence at a cost of nearly $1 million and drawing nearly $20,000 a month from his investment account to meet the deficiency between his monthly income and expenses. Assuming the appeal lasts 24 months, Mense will have drawn nearly $1.5 million
184 B.R. at 584; see Erkins, 253 B.R. at 476 ("If Creditor's judgment is affirmed on appeal, the Court suspects that Creditor will have received no benefit from the bankruptcy, but will have suffered additional delay in the enforcement of its rights.").
Based on the foregoing, the court concludes that Cottonsmith and Mense are using their bankruptcy cases to re-litigate, not to reorganize. When they commenced their respective cases, Cottonsmith and Mense had no intention to "effect a speedy, efficient reorganization on a feasible basis." See Marsch, 36 F.3d at 828. Instead, Cottonsmith and Mense invoked the chapter 11 process as a litigation tactic to avoid the posting of an appeal bond. The filing of each chapter 11 petition was in bad faith.
"Cause" for dismissal or conversion of a chapter 11 case includes "a substantial or continuing loss to or diminution of the estate and the absence of a reasonable likelihood of rehabilitation." 11 U.S.C. § 1112(b)(4)(A). With respect to the first element, "[t]here need not be a significant diminution in the estate to satisfy Section 1112(b)[1]." In re East Coast Airways, Ltd., 146 B.R. 325, 336 (Bankr. E.D.N.Y.1992). "All that need to be found is that the estate has suffered some diminution in value." Id.; see In re Kanterman, 88 B.R. 26, 29 (S.D.N.Y.1988) ("All that need be found is that the estate is suffering some diminution in value."). "In the context of a debtor who has ceased business operations and liquidated virtually all of its assets, any negative cash flow — including that resulting only from administrative expenses — effectively comes straight from the pockets of the creditors." Loop Corp. v. U.S. Trustee, 379 F.3d 511, 516 (8th Cir.2004), cert. denied, 543 U.S. 1055, 125 S.Ct. 915, 160 L.Ed.2d 778 (2005).
"Rehabilitation `contemplates the successful maintenance of the debtor's business operations.'" In re Vallambrosa Holdings, LLC, 419 B.R. 81, 89 (Bankr. S.D.Ga.2009) (citation omitted). A reasonable likelihood of rehabilitation is absent when the debtor's business operations do not justify continuance of the reorganization effort. See, e.g., In re LG Motors, Inc., 422 B.R. 110, 116 (Bankr.N.D.Ill. 2009); Vallambrosa Holdings, 419 B.R. at 89; In re Original IFPC Shareholders, Inc., 317 B.R. 738, 742 (Bankr.N.D.Ill. 2004). "Because the debtors here [intend]
Neither Cottonsmith or Mense have a business to rehabilitate. Debtors filed chapter 11 with the intention of using the automatic stay as a substitute for an appeal bond, and intend to liquidate assets as necessary in chapter 11 to pay claims only after all efforts to reverse Kayne's judgment on appeal have been exhausted. Because Cottonsmith has no income and Mense's personal expenses exceed his income, the cash in each estate continues to dissipate as the appeal takes its course largely due to Mense's significant personal expenses, accruing administrative expenses, and the cost of the appeal. There is a continuing loss to or diminution of each estate, and no reasonable likelihood of rehabilitation in either case.
Once cause is established, the court must "choose between dismissal or conversion, `whichever is in the best interest of creditors and the estate.'" In re Staff Inv. Co., 146 B.R. 256, 260 (Bankr. E.D.Cal.1993). "The standard for choosing conversion or dismissal based on `the best interest of creditors and the estate' implies a balancing test to be applied through case-by-case analysis." Id.; see Rand v. Porsche Fin. Servs., Inc. (In re Rand), 2010 WL 6259960, *10 (9th Cir. BAP 2010) ("Upon determining cause exists and that there are no unusual circumstances to negate dismissal or conversion, the bankruptcy court must engage in a `balancing test' to determine whether appointment of a Chapter 11 Trustee, conversion, or dismissal is `in the best interests of creditors and the estate.'").
With respect to both Cottonsmith and Mense, dismissal rather than conversion is in the best interest of creditors. Kayne, who is the creditor holding the largest unsecured nonpriority claim in each case, favors dismissal. No creditor or other party in interest favors conversion or opposes dismissal. Cottonsmith has no creditors, except Kayne and Horvitz & Levy LLP. Mense is solvent and was free of financial problems when he commenced his chapter 11 case, except for the Kayne judgment. Mense's secured debt is current and there are no unsecured priority claims in either case. Dismissal is also in the best interest of the estate because the economic value of the respective estates would diminish rather than improve if the cases either remained in chapter 11 or were exposed to the significant administrative fees and costs associated with a conversion to chapter 7. See Staff Inv. Co., 146 B.R. at 261 ("The element of the best interest of the estate focuses upon whether the economic value of the estate is greater inside or outside of bankruptcy.").
Based on the reasons stated, the court will grant Kayne's Stay Relief Motion and lift the automatic stay for cause as to Mense and Cottonsmith under 11 U.S.C. § 362(d)(1). The court will also grant Kayne's Dismissal Motion and dismiss the jointly administered bankruptcy cases of Mense and Cottonsmith for cause pursuant to 11 U.S.C. § 1112(b)(1) and (4)(A).
The court will enter separate orders consistent with this Memorandum Decision.
