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Petitioning Creditors Cannot Meet High Burden For “Extreme Remedy” of Appointment of Interim Trustee

In re Diamondhead Casino Corp., 540 B.R. 459 (Bankr. D. Del. Nov. 13, 2015)

In this Memorandum Opinion, Judge Silverstein of Delaware’s Bankruptcy Court held, on a limited record, that the petitioning creditors did not met their burden of proof to show that an interim trustee is necessary during the “gap period”—that is, the period between the filing of the involuntary case and the Court’s decision on whether to enter an order for relief.  In so holding, the Court relied primarily on the undisputed facts that debtor Diamondhead Casino Corporation (“Diamondhead”) is (and has been) a non-operating entity for the past 15 years and that the property value of its sole asset will not dramatically decline in the near future.  Although the Court did not rule upon Diamondhead’s motion to dismiss the involuntary bankruptcy case as a bad faith filing, which remains sub judice, the Court indicated that there is a reasonable likelihood that such relief will be granted.

Diamondhead owns 404 acres of undeveloped land in Diamondhead, Mississippi, 50 acres of which has recently been approved for gaming operations.  The property has an aggregate valuation of approximately $40 million.  Over the years, Diamondhead has been unsuccessful in its attempts to develop the property into a resort destination centered around a casino.  However, the company held several rounds of financing to raise enough capital to jumpstart the business.  At least two of the petitioning creditors are shareholders of Diamondhead and also loaned money to Diamondhead in the form of promissory notes, which are now in default.

In order to evaluate whether the appointment of an interim trustee is appropriate, the Court must first determine whether there is a reasonable likelihood that an order for relief will be granted.  To determine a reasonable likelihood, the Court must decide, consistent with sections 303(b)(1) and 303(h) of the Bankruptcy Code, that: (i) the petitioning creditors’ claims are neither contingent nor subject to a bona fide dispute; (ii) the petitioning creditors’ claims are unsecured by at least $15,325; and (iii) the alleged debtor is generally not paying its debts as they come due.  Op. at 10.  While Diamondhead argued that the claims at issue were subject to a bona fide dispute because there existed a question as to whether the petitioning creditors could be paid in stock or cash for their notes, the Court did not agree.  Not only did Diamondhead fail to challenge the amount of debt, the validity of the notes’ issuance, or the existence of a default, the Court relied on a recent Delaware Superior Court decision on substantially similar notes between Diamondhead and another creditor that held that conversion of the notes to stock could only occur prior to maturity or default.  See College Health & Inv., L.P. v. Diamondhead Casino Corp., (Del. Super. Ct. July 2, 2015).  The Court also easily found for the petitioning creditors on the other two determinations as well, which left only the issue of a bad faith filing.

The Third Circuit Court of Appeals recently held that bad faith provides an independent basis for dismissing an involuntary petition (see our blog post here).  While this issue will undoubtedly take center stage when the Court adjudicates the pending motion to dismiss, under the very limited evidence submitted on this issue, the Court held that the petitioning creditors are entitled to a presumption that the petition was filed in good faith, thus finding that there is a reasonable likelihood that an order for relief could be granted in this case.

Finally arriving at the “main event”, as noted above, the petitioning creditors could not meet their burden for showing that the extraordinary relief of an interim trustee during the gap period is appropriate primarily because there is no threatened and immediate loss of estate value to warrant an appointment.  The record as presented indicates that Diamondhead has not operated for 15 years, that there is no danger that the estate’s sole asset (the property) will be sold or that it will dramatically decline in value over the next few months, and that the limited cash in the estate would decline regardless of whether an interim trustee was appointed due to the need to satisfy ongoing expenses.