Orchestrated Involuntary Case Not Dismissed On Bad-Faith Grounds

In In re Houston Regional Sports Network LP,1 Hon. Marvin Isgur of the U.S. Bankruptcy Court for the Southern District of Texas held that an involuntary case commenced to circumvent a contractual clause requiring unanimous director consent to commence a voluntary case (the "unanimous-consent clause") was not subject to dismissal on bad-faith grounds pursuant to § 1112 (b) of the Bankruptcy Code. This holding is significant because, despite the existence of thousands of agreements with unanimous-consent clauses, the two previously reported decisions directly addressing this issue reached opposite conclusions. While it remains to be seen how other courts will rule on this issue, Houston Regional may encourage efforts by a debtor's principals to circumvent unanimous-consent clauses by convincing creditors to commence an involuntary case.

Standard for Dismissal

Section 1112 (b) (1) provides, subject to certain limitations, that "the court shall ... dismiss a case under this chapter ... if the movant establishes cause." Section 1112 (b) (4), in turn, lists various events that would satisfy "cause." The exact standard for determining whether cause for dismissal exists on the grounds that a case was commenced in bad faith varies somewhat by district. In general, however, cause for a bad-faith dismissal may be established by demonstrating that a reorganization would be "objectively futile" and that the case was commenced in "subjective bad faith" (i.e., as a litigation tactic and not with intent to effect a reorganization).2

Kingston Square Associates

In In re Kingston Square Associates,3 the court held that an involuntary case that was commenced to circumvent a unanimous-consent clause is not subject to dismissal on bad-faith grounds where the debtor has a reasonable possibility of reorganizing. In Kingston Square, 11 corporations and limited partnerships that owned various apartment complexes issued mortgage-backed securities (MBS), substantially all of which were beneficially owned by Donaldson, Lufkin & Jenrette Securities Corp. and its affiliates (DLJ).4 To render the borrowers "bankruptcy remote," the corporations' charters and general partners' bylaws were amended to include a unanimous-consent clause, and an independent director selected by DLJ was added to the board of directors of each such corporation and partnership within the general partner to ensure that the unanimous consent that was required to commence a voluntary case would not be obtained without the independent director's vote.5

Foreclosure proceedings were subsequently commenced that, if consummated, would have transferred ownership of the borrowers' apartment complexes to DLJ, leaving nothing for unsecured creditors.6 Believing there to be equity in the apartment complexes and that the independent director was a DLJ pawn who would never approve the commencement of a voluntary case, the borrowers' other directors launched a campaign to find other creditors that would file involuntary petitions against the borrowers.7

Following the commencement of the involuntary cases, DLJ and the MBS trustee moved...