DALE L. SOMERS, Bankruptcy Judge.
This memorandum addresses two competing motions — Debtor's Motion to Dismiss Chapter 11 Case and Close Case
Debtor filed a voluntary petition under Chapter 11 on November 1, 2016. Debtor is a Kansas limited partnership that owns and operates a hotel located in Lenexa, Kansas. Ventura Hotel Corporation (Ventura) is a general partner and owns a 61 percent interest in Debtor. Steven J. Craig (Craig) is the limited partner, owning a 39 percent interest in Debtor. Ventura is owned by Craig. Debtor has been operating the hotel as a debtor in possession throughout this case. CoreFirst Bank & Trust (CoreFirst) has a claim that is secured in part by a first priority lien on Debtor's real property, the hotel and an adjacent lot. Ventura made numerous advances to Debtor that are secured by a second priority lien on Debtor's real property. From May 2008 through August 2017, Debtor operated under a franchise agreement with Holiday Hospitality Franchising, LLC (HHF), under the Crowne Plaza brand. The HHF franchise has terminated, and Debtor currently operates under the Clarion brand.
Debtor's primary assets are the hotel and a claim against HHF in a lawsuit that is pending in the United States District Court for the District of Kansas. Debtor's Schedule A states that the appraised value of its real property is approximately $13.5 million; the parties do not dispute this value for purposes of the pending motions. Schedule D lists CoreFirst's claim in the amount of $17 million secured by the real property. Ventura is listed as the holder of a $13.5 million claim secured by a second lien on Debtor's real property. HHF filed four proofs of claim totaling in excess of $1.1 million, and it asserts it is Debtor's largest unsecured creditor. Debtor contends that HHF's claims are contingent because Debtor's claim against HHF in the federal district court litigation exceeds the total of HHF's claims. Debtor's schedules state there are about 100 unsecured trade creditors whose claims total approximately $510,000. These claims include $130,00 owed to HHF's predecessor, Intercontinental Group. Debtor estimates the true unsecured trade debt to be $280,000.
Debtor's hotel has been conducting business during the pendency of this case, and the monthly operating reports show it is operating at a loss. Debtor has obtained extensions of the exclusive period for filing a plan. No proposed disclosure statement or plan has been filed.
The competing motions to dismiss and to convert are governed by § 1112(b)(1) of the Bankruptcy Code.
For purposes of § 1112(b), the statute defines "cause" to include a non-exclusive list of 16 circumstances, the first of which is "substantial or continuing loss to or diminution of the estate and the absence of a reasonable likelihood of rehabilitation."
Once cause for relief has been found, and the appointment of a trustee is removed from consideration, the Court must choose between dismissal and conversion. The Code does not state the applicable criteria, and the Court is given broad discretion. Case law has developed a list of ten factors which the Court should consider when balancing the alternatives. The Court has adopted the formulation stated by Bankruptcy Judge Nugent in Helmers.
When moving to dismiss on August 8, 2017, Debtor argued that dismissal is in the best interests of creditors and the estate because a sale of the hotel is necessary and the sale can best be accomplished outside of bankruptcy. At that time, Debtor, Craig, and Ventura had agreed to a work-out agreement to settle CoreFirst's claim based on notes owed by the Debtor and Craig. The agreement was contingent on dismissal of the case. The agreement required the sale of the hotel before December 29, 2017, for an amount sufficient to pay Debtor's obligations to CoreFirst in full, or if the sale did not occur, the giving of a deed to the property to CoreFirst. The Court has been advised that the 2017 work-out agreement is no longer in effect and there is no new agreement, so this is no longer a factor for the Court's consideration.
In addition to arguing that dismissal was in the best interests of creditors and the estate because it would allow for the performance of the work-out agreement, Debtor argued against conversion on other grounds. Conversion would result in additional administrative expenses and most likely in termination of the hotel's operations, causing a loss of value of the asset and the loss of jobs. Debtor's second principal asset, its claim against HHF, is being liquidated in the district court, so liquidation does not require the continuation of the bankruptcy case. After a dismissal, all creditors would retain their rights under state and federal law to collect from Debtor.
CoreFirst supported dismissal and the sale of the hotel outside of bankruptcy. It asserted that it has a claim of approximately $21 million, secured by five mortgages on Debtor's real property and that its first priority liens encumber the full value of the property, estimated to be $13.5 million. In the alternative, and in response to HHF's argument that two of CoreFirst's mortgages are not effective to secure its claim, CoreFirst argued that if its claim is secured by only three of its five mortgages, the amount of its secured claim still exceeds $14 million, so that after satisfaction of that claim, there would be no equity available for other creditors. CoreFirst has not advised the Court of any change in its position since the expiration of the work-out agreement.
HHF responded that conversion to Chapter 7, not dismissal, is in the best interests of creditors and the estate. It argued that conversion would result in benefits to the unsecured creditors because: Only a Chapter 7 trustee could claw back unapproved post-petition professional fees and loans; only a Chapter 7 trustee could examine and possibly subordinate insider claims; an examination by a Chapter 7 trustee could reveal that some of CoreFirst's mortgages do not secure its claim; and conversion would halt monthly management and professional fees that are currently being paid.
The United States Trustee supported dismissal.
After notice, the Court held its first hearing on the competing motions on September 8, 2017, when it heard extensive arguments on the motions. There was no request for discovery or for an evidentiary hearing. At the close of the hearing, the parties and the United States Trustee were granted leave to file additional briefs. Briefs were filed by Debtor, HHF, and CoreFirst. In addition, CoreFirst filed a proof of claim for $20,785,920.06, comprised of a secured claim of $13,490,000, the value of Debtor's real property, and an unsecured claim of $7,295,920.06.
On September 29, 2017, during a telephonic hearing, the Court announced its findings of fact and conclusions of law.
HHF filed a motion for reconsideration on October 10, 2017.
Arguments on the motion to reconsider were heard at a telephonic hearing on October 19, 2017.
The Court granted the motion to reconsider. It pointed out that when it granted the motion to dismiss, HHF had clearly waived any right to an evidentiary hearing. It further noted it had relied on statements of CoreFirst's counsel in the bank's brief about the amount of the bank's secured claim if only three of its five mortgages secured its claim, rather than on the bank's post-hearing proof of claim. Nevertheless, the Court found that HHF's challenges to the estimated amount of CoreFirst's secured claim could have merit and should be considered. The Court ruled that an evidentiary hearing would be held on one issue, estimating the amount of CoreFirst's secured claim, and if necessary, a subsequent evidentiary hearing would be held to estimate Ventura's secured claim. With respect to the other ground for reconsideration, the Court held that any misunderstanding of the work-out agreement was not material to its decision to dismiss.
The evidentiary hearing to estimate CoreFirst's claim was held on October 31, 2017. In an oral ruling made on November 27, 2017, the Court held that the total estimated secured claim Debtor owed CoreFirst as of the date of filing was approximately $11,600,000, which was approximately $1,900,000 less than the estimated value of Debtor's real property.
Given this conclusion, the Court further held that before it could reconsider the balancing of the factors relevant to choosing between dismissal and conversion, the extent of the liens held by creditors other than CoreFirst must be estimated. Debtor's Schedule D includes a $13,540,477 claim of Ventura secured by a second priority lien on Debtor's real property, the same property that secures CoreFirst's claim. Since HHF challenged whether Ventura's claim should be estimated at this amount, the Court scheduled an evidentiary hearing to determine if Ventura's estimated secured claim exceeds $2 million so that in a hypothetical Chapter 7 liquidation, Debtor's real property would be fully encumbered, as the Court had assumed when granting the motion to dismiss.
An evidentiary hearing on the estimation of Ventura's secured claim was held on January 17, 2018, after the completion of limited discovery. HHF's position was that Ventura's claim should be estimated as having no value because: (1) Since Ventura is the general partner of Debtor, under Kansas partnership law its claim is subordinated to those of other partnership creditors; (2) the advances Ventura made to Debtor should be recharacterized as equity investments; and (3) if they are not recharacterized, Ventura's claim should be subordinated to the claims of other creditors. Based on the following findings of fact and conclusions of law, the Court rejects HHF's contentions and holds that for purposes of ruling on the competing motions, Ventura will be considered to be the holder of a secured claim in an amount greatly exceeding any equity that might remain in Debtor's real property after the allowance of CoreFirst's secured claim if this case were converted to Chapter 7.
Debtor has owned and operated a full-service hotel in Lenexa, Kansas, since Debtor's formation in 1982. Debtor's original general partner was Linquist & Craig Hotels & Resorts, Inc. In 2006, Ventura become the general partner and Craig the limited partner. Debtor is a party to a Management Agreement dated May 1, 2009, with SJC V, LLC, under which SJC V provides management services for the operation of the hotel. Debtor and SJC V are also parties to a Technical Services Agreement dated March 1, 2008, pursuant to which SJC V provides additional management services. Craig is the owner of SJC V.
Since June of 2003, CoreFirst has been Debtor's primary lender. Funds CoreFirst provided were used to upgrade the hotel when it was converted to a Crowne Plaza in May 2008 and for ongoing operating expenses. However, from time to time starting in 2009 and continuing through the Chapter 11 proceedings, additional operating funds were needed and were advanced to Debtor by Ventura. Each advance was recorded on the books of Debtor and Ventura, reflected on the parties' respective bank records, and evidenced by a contemporaneously executed promissory note. The notes required payment of interest at 9% and were payable on demand. Most of the loan proceeds were used for operating expenses, not capital expenditures.
On December 29, 2010, Debtor executed a Second Mortgage of its real property in favor of Ventura to secure an attached promissory note for $3,642,634.81. This note was a consolidation of the loans Ventura made to Debtor through mid-year 2010, as evidenced by a series of contemporaneous promissory notes. On April 30, 2012, Debtor executed a Third Mortgage of its real property on favor of Ventura in the amount of $2,264,991.52, as shown in an attached note that was a consolidation of the notes for advances to Debtor since the execution of the Second Mortgage. The Third Mortgage secured a maximum principal of $4 million and included a future advance clause.
Craig testified that he advanced the funds to Debtor through Ventura for several reasons. The hotel was a good operation in a good location. Funds were needed for its continued operation. If the hotel were not operational, it would have been a problem for Craig, CoreFirst, approximately 60 to 65 hotel employees, and vendors. Craig's involvement in management did not change as a result of the loans. Although Ventura never demanded payment of the loans, Craig expected them to be repaid. Until 2012, based on his experience, Craig believed that the operational problems, including the problems which Debtor experienced under the HHF franchise agreement, would be corrected.
From May 2008 through August 2017, $3.6 million in licensing fees were paid to HHF. Some of the loans from Ventura enabled Debtor to make these payments. Ventura was audited by the IRS for tax years 2004, 2006, 2009, 2010, and 2011. Craig was never advised that the IRS questioned the characterization of Ventura's advances to Debtor as loans.
Craig testified that he is engaged in negotiations to sell the hotel even though the work-out agreement with CoreFirst has expired.
Debtor's schedules report payments, distributions, or withdrawals within one year of the filing of the case to Craig as an insider of Debtor. Debtor's motion for authorization to continue using existing bank accounts and banking systems states:
HHF's expert, an accountant, computed that payments Debtor made to Craig entities, such as SJC V, for the period from 2010 through 2017 totaled $5,900,673.44, and the deposits from Craig entities to Debtor totaled $291,692.26. For the same period, payments Ventura made to Debtor totaled $4,841,245.43, and payments Debtor made to Ventura totaled $272,878.49.
In addition to Craig, the fact witnesses included Debtor's outside accountant and Debtor's controller. In addition to the notes, the mortgages, and the relevant agreements, the exhibits included Debtor's and Ventura's balance sheets and profit-and-loss statements for the years ending in 2013 and 2016, and bank statements for both entities for numerous years. No instance was brought to the Court's attention where a purported Ventura loan to Debtor was not supported by a note and the bank statements. From a review of these exhibits and the testimony of the witnesses, the Court concludes that Ventura and Debtor maintained accurate, contemporaneous, and internally consistent records concerning the loan transactions.
HHF's first argument is purely legal. It asserts that converting this case to Chapter 7 would "unleash"
On the other hand, there is no question that the general partner of a Kansas limited partnership may make secured loans to the partnership and be entitled to payment to the same extent as other creditors. K.S.A. 56-1a107, a section of the Revised Uniform Limited Partnership Act, provides, "[e]xcept as provided in the partnership agreement, a partner may lend money to and transact other business with the limited partnership and, subject to other applicable law, has the same rights and obligations with respect thereto as a person who is not a partner."
Section 723 on which HHF relies limits the Chapter 7 trustee's claim to "any deficiency remaining after administration of the partnership's chapter 7 estate." Contrary to HHF's argument, the section provides no basis to "unleash" Debtor's property from Ventura's secured claim; that claim would be satisfied, at least in part, during the administration of the Chapter 7 case, before maturity of the trustee's claim under § 723. Further, § 723 does not create rights; its merely allows the trustee to enforce rights under state law. The rights which the trustee could enforce would be the same rights that such creditors could enforce under Kansas law even if the case is dismissed.
The Court concludes that a Chapter 7 trustee's rights under § 723 do not provide a reason to convert the case rather than dismiss it.
Although the Bankruptcy Code does not expressly address recharacterization, the Tenth Circuit has held that "the authority to recharacterize putative debt as equity arises from a court's general equitable powers under 11 U.S.C. § 105(a)."
Factor 1: "the names given to the certificates evidencing the indebtedness." Each of the certificates is named "Promissory Note." Each was executed substantially contemporaneously with an advance of funds to Debtor. The bank and accounting records of Debtor and Ventura report the transactions as loans. The lien documents are named "Second Mortgage" and "Third Mortgage," thereby reflecting an awareness of CoreFirst's previously filed mortgages. This factor strongly supports treating the advances as loans.
Factor 2: "the presence or absence of a fixed maturity date." The promissory notes are payable on demand, but they do have a fixed rate of interest. The absence of a fixed maturity date or a repayment schedule is indicative of an equity investment.
Factor 3: "the source of [principal] payments." If payments to Ventura were made, they came from Debtor's earnings. In the long term, the prospect of repayment depended on the success of the hotel. This factor favors an equity finding.
Factor 4: "the right to enforce payment of principal and interest." The promissory notes provide the entire unpaid principal and accrued interest are payable on demand. Further, the mortgages provide that Ventura may pursue its remedies if there is a payment default or other breach of the loan documents. This is indicative of true secured loans.
Factor 5: "participation in management flowing as a result" of the advances. Craig's participation in the management of Debtor did not change as a result of the Ventura loans. Craig participated in the management through SJC V before and after the making of the loans. This is indicative of true loans.
Factor 6: "the status of the contribution in relation to other corporate creditors." Subordination of advances to loans made by other creditors indicates capital contributions.
Factor 7: "the intent of the parties." The testimony of the witnesses, the loan documentation, and the accounting records of Debtor and Ventura evidence that they intended the advances to be loans. HHF argued in its pretrial brief that the "evidence will show that the circular structure of capital infusions by Craig to Ventura, `loans' by Ventura to Debtor, and management fees paid by Debtor to SJC were simply for Craig to enjoy tax benefits, not to provide a real loan."
HHF also erroneously asserts that "[t]he motivation behind classifying as loans the transfers from Ventura to Debtor is highlighted by the promissory notes that post-date the Third Mortgage, which [are not secured because they] were never `rolled-up' into any subsequent mortgage and do not describe any sort of lien or security interest in the Debtor's property."
Factor 8: "`thin'" or adequate capitalization." HHF argues that Debtor was thinly capitalized because after 2009, it continually needed cash. The cause of Debtor's cash needs is an issue in the District Court litigation pending against HHF. Although the long history of operation of the hotel suggests that Debtor was adequately capitalized, the Court has insufficient evidence to make a finding on the adequacy of its capitalization. Further, the Tenth Circuit has warned against placing too heavy an emphasis on this factor. To do so "would create an `unhealthy deterrent effect,' causing business owners to fear that, should their `rescue efforts' fail, a court will `give disproportionate weight to the poor capital condition of their failing companies and thus too quickly refuse to treat their cash infusions as loans.'"
Factor 9: "the identity of interest between the creditor and stock holder." Here, there is an identity of interest between Ventura and Debtor because Ventura is both the lender and the general partner of Debtor. Also, Craig is the owner of Ventura and the limited partner of Debtor. This factor supports recharacterization, but only minimally. The Tenth Circuit has cautioned against recharacterizing advances when they were made by the sole owner of a struggling company:
The Court rejects HHF's argument that because the notes are held by an insider, they should be recharacterized even though there is no evidence of overreaching or inequitable conduct.
Factor 10: "the source of interest payments." In the long term, the prospect of repayment depended on the success of the hotel. This factor favors an equity finding.
Factor 11: "the ability of the corporation to obtain loans from outside lenders." Debtor had a long-term lending relationship with CoreFirst. There is no evidence whether attempts were made to obtain from an outside lender the funds Ventura provided.
Factor 12: "the extent to which funds were used to acquire capital assets." "Use of advances to meet the daily operating needs of the corporation, rather than to purchase capital assets, is indicative of bona fide indebtedness."
Factor 13: "the failure of the debtor to repay on the due date or to seek a postponement." This fact is not relevant since the notes were payable on demand and no demand was ever made.
The Court concludes that recharacterization would be totally inappropriate. In this case, the most important factors — the meticulous records, the documentation, the right to demand payment, the absence of subordination to the claims of other creditors, the intent to make loans, the absence of any change in Craig's involvement in management as a result of the transactions, and the use of the funds for operating expenses — are the hallmarks of arm's-length operating loans.
The Tenth Circuit rejected recharacterization in Alternate Fuels, even though a review of the bankruptcy court's
If this case were to continue under Chapter 7, recharacterization of Ventura's loans to Debtor would only serve to punish Craig for his willingness to help Debtor's struggling business.
Alternatively, HHF argues that in a Chapter 7 proceeding, Ventura's claim would be subordinated to the claims of unsecured creditors under § 510(c) so that the equity in Debtor's real property not securing CoreFirst's claim would be available to unsecured creditors. Subsection 510(c) in relevant part provides "under principles of equitable subordination, [the court may] subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim." Like recharacterization, equitable subordination is to be used sparingly.
HHF's inequitable conduct argument is misdirected. The inequitable conduct required for subordination relates to the transaction which gave rise to the insider's claim. Here, other than the fact of insider status, HHF's arguments focus on post-petition events, including Ventura's involvement in (1) Debtor's entering into the work-out agreement with CoreFirst, (2) Debtor's use of cash collateral, and (3) Debtor's filing of a motion to dismiss before CoreFirst had filed its proof of claim.
HHF complains of the arrangement between Craig, Ventura, Debtor, and SJC V for Debtor to pay Craig for management of Debtor. Such management services were necessary, and Craig was entitled to compensation for performing them. HHF and other unsecured creditors who continued to receive payments from Debtor benefitted from Craig's efforts to operate the hotel despite its need for operating funds. HHF's subordination argument ultimately rests on the fact that Ventura is an insider of Debtor. Insider status alone is not grounds for subordination. The Court concludes that if this case were converted to a Chapter 7 proceeding, it is highly unlikely that Ventura's claim would be subordinated to the unsecured claims.
For the foregoing reasons, the Court finds that HHF's arguments do not provide a basis to estimate that in a Chapter 7 proceeding, Ventura's secured claim would be allowed in an amount less than the equity remaining in Debtor's real property after satisfaction of CoreFirst's secured claim. Most likely, the claim would be allowed in an amount substantially equivalent to $13.5 million, the amount which Ventura claims it is owed. The Court finds it highly unlikely that in a Chapter 7 proceeding, either Kansas partnership law, or the doctrines of recharacterization or equitable subordination would provide a basis to reduce Ventura's secured claim to less than approximately $2 million, the estimated amount by which the value of the hotel exceeds CoreFirst's secured claim.
The Court next examines its analysis of the factors which it previously found favored dismissal. For the following reasons, the Court concludes that the estimations of CoreFirst's and Ventura's claims and the expiration of the work-out agreement do not change the result — dismissal of the case is in the best interests of creditors and the estate.
First, the Court observes that the basic premises supporting dismissal have not changed as a result of the hearings after the motion to reconsider was granted. The hotel still must be sold; the sale proceeds will be maximized by a sale outside of bankruptcy, rather than in Chapter 7; and if the sale took place in a Chapter 7 proceeding, the sale proceeds would likely be less than the estimated claims secured by the property, leaving no equity for the payment of unsecured claims. When initially granting dismissal, the Court estimated that CoreFirst's secured claim would exceed the value of the real property, leaving no value in Debtor's primary asset for payment of unsecured creditors. After two evidentiary hearings, the Court now estimates CoreFirst's secured claim to be less than the value of the real property, leaving some equity beyond that claim, but also estimates Ventura's secured claim to be far in excess of that remaining equity. If the case were converted to Chapter 7, unsecured creditors would be unlikely to receive any distribution attributable to the sale of the real property. In addition, if the Court's claim estimates are correct, in a Chapter 7 case, CoreFirst's and Ventura's unsecured claims would dwarf those of the other unsecured creditors, whom HHF erroneously argues would benefit from conversion.
As previously observed, Debtor's only significant asset other than its real property is its claim against HHF that is being litigated in federal district court. During oral argument following the January 17, 2018 evidentiary hearing, counsel for HHF did not dispute the Court's observation that HHF's motivation for its vigorous opposition to dismissal appears to be to obtain the transfer of control of that litigation to a Chapter 7 trustee. But the Court fails to comprehend how this would benefit unsecured creditors other than HHF. In addition, if the case is dismissed and Debtor obtains a judgment, unsecured creditors could use state and federal law remedies to obtain payment of their claims.
Since the date of the Court's September 29, 2017 order dismissing the case and the January 17, 2018 hearing, the work-out agreement between Debtor, Craig, and CoreFirst expired and it has not been replaced. Debtor's and CoreFirst's arguments in support of dismissal relied significantly on the agreement, and the Court's findings of fact likewise thoroughly discussed it.
The work-out agreement was mentioned in the following italicized sentences in the combined analysis of factors 1 and 4 and in the analysis of factors 5 and 6. Nothing in the circumstances relevant to the analysis of the additional Helmers factors has changed, and the Court incorporates those findings into this opinion by reference.
With respect to factors 1 and 4, the Court previously stated:
Since the work-out agreement has expired, there is no basis for the last sentence of the third paragraph (the italicized sentence). Under the present circumstances, if the case is dismissed, CoreFirst (and also Ventura) will have a significant unsecured claim, just as it would in a Chapter 7 case. Factors 1 and 4 remain a "push."
The Court's prior analysis of factor 5 was as follows:
The italicized sentence is no longer true. But the analysis remains true if this sentence is omitted. Continued operation of the hotel after dismissal will maximize its value even though there is no work-out agreement, so factor 5 strongly supports dismissal.
With respect to factor 6, the Court previously stated:
The italicized sentence of the second paragraph is no longer true, thereby requiring reconsideration of the remainder of the paragraph. An estimate of the amount of CoreFirst's secured claim has been undertaken by this Court, providing an objective estimate for the parties to use when negotiating disputes about the claim, but a final judicial determination of the amount of the claim could be necessary if there is no agreement. Whether that judicial determination is made inside or outside of bankruptcy is a "push." It now appears that CoreFirst's secured claim is less than the value of the real property, but any equity remaining after satisfaction of CoreFirst's claim in a Chapter 7 case would go to Ventura, not to the unsecured creditors. The analysis of factor 6 continues to favor dismissal.
For the foregoing reasons, the Court determines the balance of the factors still supports dismissal even though the work-out agreement has expired since the Court's initial ruling.
The Court again finds that the interests of creditors and the estate are best served by dismissal of this case.
Debtor's motion to dismiss and close the case is hereby granted. The foregoing constitutes Findings of Fact and Conclusion of Law under Rules 7052 and 9014(c) of the Federal Rules of Bankruptcy Procedure, which make Rule 52(a) of the Federal Rules of Civil Procedure applicable to this matter.
Judgment is hereby entered granting Debtor's motion to dismiss the case and denying HHF's motion to convert the case to Chapter 7. This case is hereby dismissed. The judgment based on this ruling will become effective 14 days after it is entered on the docket for this case.
Further, under Kansas law, a general partner of a limited partnership, such as Ventura, "has the rights and powers and is subject to the restrictions of a partner in a partnership without limited partners." K.S.A. 56-1a253(a). The Kansas Uniform Partnership Act requires partnerships to reimburse partners for payments made in the ordinary course of the business of the partnership or for the preservation of its business, and for advances to the partnership beyond the amount of capital the partner agreed to contribute. K.S.A. 56a-401(c) and (d). A payment made by a partner which gives rise to such a partnership obligation "constitutes a loan to the partnership which accrues interest from the date of the payment." K.S.A. 56a-401(e).
