Branch Bank & Trust Co. v. Michael’s Enterprises of Virginia, Inc. (In re Michael’s Enterprises of Virginia, Inc.), 519 B.R. 916 (Bankr. E.D. Va. 2014)  –

A mortgage lender sought sanctions against the debtor, its sole shareholder and its attorney.  It alleged that the bankruptcy petition was filed for an improper purpose.

The debtor executed a note and deed of trust to secure the note in 2008.  In May 2013 it defaulted, and a judgment was entered against the debtor in favor of the lender for amounts owed in September 2013.  The lender then initiated foreclosure proceedings, and the foreclosure sale was scheduled for mid-November.

About a week before the sale, the debtor sought a temporary injunction from the state court, which denied the motion.  The sale proceeded and a trustee’s deed conveying the property to the lender was recorded at the end of November 2013.  However, the debtor refused to vacate the property and filed bankruptcy a few months later in February 2014.

The lender argued that the petition was filed for an improper purpose, namely to re-litigate claims that had already been decided in state court.  When it first moved for sanctions, the court took the request under advisement while it waited to see if the debtor would file a timely plan of reorganization that could be confirmed within a reasonable time.

In September 2014 the U.S. Trustee filed a motion to convert or dismiss the case, and the court granted the motion to dismiss in October.  At that time the lender renewed its motion for sanctions.

As a preliminary matter, the court noted that Bankruptcy Rule 9011 is similar to FRCP 11.  Under Rule 9011, filing a petition constitutes a certification by the attorney that (1) it is not being presented for any improper purpose “such as to harass or to cause unnecessary delay or needless increase in the cost of litigation,” and (2) the legal contentions are “warranted by existing law or by a nonfrivolous argument for the extension, modification, or reversal of existing law or the establishment of new law.”

The court applied an objective standard, and found that there was sufficient evidence to show that the case was filed for an improper purpose.  Based on the totality of the circumstances, the court concluded that the debtor had sufficient opportunity to litigate issues in the state court, and did little more than collaterally attack the state court judgment and foreclosure sale in the bankruptcy case.  The debtor made no attempt to reorganize and was not engaged in any business activity.  Rather, it filed the bankruptcy so that it could try again to set aside the foreclosure sale based on a theory that the U.S. Supreme Court rejected “decades ago.”

Courts have consistently held that filing a bankruptcy to collaterally attack a state court judgment is an improper purpose that can justify sanctions.  Sanctions are also appropriate if counsel makes arguments that are unwarranted by existing law or makes a frivolous argument to modify existing law or establish new precedent.

In this case the debtor’s counsel repeatedly advanced an argument based on a 5th Circuit decision (Durrett v. Washington Nat’l. Ins. Co., 621 F.2d 201 (5th Cir. 1980)) that a foreclosure sale could be considered a constructive fraudulent conveyance based in part on the position that there was not “reasonably equivalent value” if the sale price was less than 70% of market value of the property.  However, this argument ignored the fact that the U.S. Supreme Court rejected Durrett in BFP v. Resolution Trust Corp., 511 U.S. 531, 114 Sup. Ct. 1757, 128 L. Ed. 2d 556 (1994) “finding it to be a ‘radical departure’ from over ‘400 years’ of fraudulent transfer in foreclosure law.”

Based on the Supreme Court decision in BFP, it was clear that a regularly conducted foreclosure sale in compliance with state law is deemed to be for “reasonably equivalent value,” and thus is not a constructive fraudulent conveyance.  The only argument made by counsel that could have arguably caused a reexamination of BFP was that the foreclosure sale was a preference that could be avoided.  However the court found that this argument was “entirely without merit” and “baseless” since the lender did not receive any interest in the debtor’s property during the applicable 90-day pre-bankruptcy preference period.

Consequently the court determined that sanctions were justified and that $10,000 should be assessed jointly and severally against the debtor, its shareholder and its counsel.

Sometimes it may seem that there are no limits on a debtor’s exercise of its option to file bankruptcy.  However, this case illustrates that there are indeed limits, and there may be consequences if a debtor goes beyond those limits.