“Desperate times call for desperate measures” is often a rallying cry to justify harsh actions taken during times of panic and uncertainty which, in retrospect, are regrettable.  To protect against such adverse consequences in bankruptcy, there are and should be safeguards in place to prevent creditors from imposing unreasonable restrictions on a debtor at the immediate onset of an involuntary case.  In In re Diamondhead Casino Corp., Judge Silverstein of the United States Bankruptcy Court for the District of Delaware held that creditors who commenced an involuntary case (the “Petitioning Creditors”) had not met their burden to demonstrate that it would be appropriate to appoint an interim trustee prior to the hearing on the debtor’s motion to dismiss the involuntary petition (i.e., the “gap period”).  

Background

In Diamondhead Casino Corp., the debtor, which formerly operated ship-based gambling operations, had the stated objective of developing a destination resort centered around a luxury casino in Mississippi.  However, since 2000, the debtor had no operations or revenue.  Consequently, the debtor did not have the financial resources to develop the property on its own and had failed over the past fifteen years to attract a joint venture partner.  At the time the involuntary case was commenced, the debtor had limited cash on hand and its primary asset was 404 acres of undeveloped land off of Interstate 10 in Diamondhead, Mississippi.

In 2010, the debtor completed two rounds of financing which raised a total of $950,000.    In exchange, the debtor signed promissory notes, with maturity dates two years from issuance and interest at 9%.  Each of these notes had matured and the debtor had not paid them.  In February 2014, the debtor further sought to raise $3 million through a Private Placement Memorandum in three $1 million tranches.  The debentures issued by the debtor pursuant to the Private Placement Memorandum were collateralized by a lien on the undeveloped property.  The debtor admitted that it was in default of obligations owed to the Petitioning Creditors and was also in default of a $1 million line of credit.

The Appointment of an Interim Trustee in an Involuntary Case is an Extraordinary Remedy

As an initial matter, the court noted that an involuntary petition was “an extreme remedy with serious consequences to the alleged debtor” and the appointment of an interim trustee was “an even more extreme remedy.”  However, the court noted that section 303(g) of the Bankruptcy Code authorized the appointment of an interim trustee to take possession of property of the estate and operate the debtor’s business “if necessary to preserve the property of the estate or to prevent loss to the estate.”

The court noted there was limited case law applying section 303(g), likely because requests for such relief are rare.  After analyzing the available precedent, the court determined that a request to appoint an interim trustee should be denied in “the absence of an exceptionally strong need for doing so” or “where no facts are alleged showing a necessity for the appointment.”  The court also determined that to prevail on such a motion, the movant must show “a substantial risk of loss to the estate.”  In addition, to avoid the appointment of an interim trustee in an involuntary case that may ultimately be dismissed, the court stated that it should determine whether there is a “reasonable likelihood” that an order for relief would be entered in the involuntary case.

The Court Found a Reasonable Likelihood that an Order for Relief Would be Entered in the Involuntary Case

Evaluating the applicable requirements of section 303(b)(1) to the facts at hand, the court found that the statutory requirements for commencing an involuntary case were met and the debt held by the Petitioning Creditors was not subject to a bona fide dispute.

The court also concluded that the debtor was generally not paying its debts as they become due, and, thus, the requirements of section 303(h)(1) were satisfied.  The court expressed reservations as to whether the involuntary petition was filed in bad faith and noted that further review was required to reach a determination.  However, the court concluded that the Petitioning Creditors were entitled to a presumption that the involuntary petition was filed in good faith, and, thus, the court reasoned there was a “reasonable likelihood” that an order for relief would be entered for purposes of the trustee motion.

The Petitioning Creditors Failed to Show that the Appointment of an Interim Trustee was Appropriate

Next, the court turned to the merits of the Petitioning Creditors request for an interim trustee.  The court considered the Petitioning Creditors’ arguments for the appointment of an interim trustee, including: (i) mismanagement resulting in lack of development of the property; (ii) the loss of shareholder value over the years; (iii) alleged misuse of the Employee Stock Ownership Plan to entrench management; (iv) the debtor’s balance sheet insolvency; (v) alleged breaches of the duty of loyalty under Delaware law; and (vi) alleged misrepresentations made in both the solicitation of funds from investors and in connection with a proxy contest.

Dismissing these arguments, the court found that the Petitioning Creditors had failed to demonstrate that any loss to the estate would occur or that any property would not be preserved during the involuntary gap period.  In reaching its conclusion, the court noted that the debtor had been a non-operating entity for the past 15 years and it was unlikely that this status would change during the gap period.  The court also did not find any evidence that the value of the property would dramatically decline during the gap period.  Furthermore, the court observed that the appointment of an interim trustee would further exacerbate the debtor’s liquidity issues as the interim trustee would need to pay ongoing expenses, including attorney’s fees.  While acknowledging that the Petitioning Creditors may have justifiable concerns over the trustworthiness of management and the lack of progress on the development of the property, the court believed these considerations were not sufficient to warrant the appointment of an interim trustee.

Conclusion

While the debtor may breathe a sigh of relief, the court’s decision may only be a temporary respite from the debtor’s ultimate day of reckoning.  As stated in its decision, the court found that the debts held by the Petitioning Creditors were not subject to a bona fide dispute and there was a “reasonable likelihood” that an order for relief in the involuntary case would be entered.  Yet, this case serves as a useful reminder to creditors that filing an involuntary petition is considered an extraordinary remedy and the appointment of an interim trustee in such a case is even more so.  Creditors seeking to obtain such relief should be prepared to overcome significant obstacles, including the burden to prove a “substantial risk of loss to the estate” during the interim period between the filing of an involuntary petition and the hearing to determine whether such relief will be granted.